How Swap Dealer Inventory and Hedging Affect Swap Rates
Summary
The explanation describes how an imbalance in client demand can affect swap rates through the inventory of dealers and issuers. A dealer may temporarily absorb opposing trades, much as a market maker buffers buy and sell orders. If client positions offset across products or risk exposures, the dealer’s net inventory can remain small, limiting immediate price movement.
The examples include opposite swaps and total return swaps on different equity indices, where exposures may offset approximately. For derivatives, the same reasoning applies to sensitivities, or Greeks. When the issuer’s balance sheet cannot absorb a risk exposure, it may hedge in the market, which can move prices and rates in the expected direction. The account is conceptual: it does not quantify how much swap rates move, specify the direction of every hedge, or model factors such as funding, collateral, and market conditions. The timing of the buffer depends on dealers’ capital and risk tolerance.
Key ideas
- Dealer inventory can temporarily absorb an imbalance between clients seeking opposite swap exposures.
- Opposing client trades can offset, reducing the dealer’s net risk and immediate need to hedge.
- Exposures across different products may partly offset when their underlying risks are related.
- Derivative dealers assess inventory through sensitivities such as the Greeks.
- When balance sheet capacity is insufficient, hedging can transmit client flow into market prices.
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Full text
# If everyone wanted to sell swaps, why does that drive swap rates down? # If everyone wanted to sell swaps, why does that drive swap rates down? If everyone wanted to sell swaps (pay fixed, receive floating) why does that drive down swap rates? Wouldn't that raise rates because in order to compete with each other they would have offer to pay higher fixed rates to get people to take the other side? ## Answer by lehalle (score 2, accepted) https://quant.stackexchange.com/a/69276 When you buy or sell a financial instrument on a double auctions (ie involving buyers and sellers, for instance in an orderbook), it is straightforward to understand that when you have more buyers than sellers, the price will, on average, go up (and the reverse). When market makers are in between buyers and sellers, their inventory acts as a "buffer". As a consequence: if they are temporarily more buyers and sellers, but if the market makers have the "intuition" that other sellers will come soon, the inventory of market makers allows the prices to not vary that much. Of course, this mechanism has a time scale: is it minutes? hours? days? weeks? It depends of the way the Market Maker (MM) is averse to a large inventory, that is a function of its capital. For instance: HF MM have a small capital and hence provide a very short term buffer. If an issuer or structurer is at the origin of the product (like swaps), in practice it acts as a market maker on the risk exposures that are contents in the products it buys: - If a bank sells 1 swap to one client and the exact opposite one to another client, its inventory (in term of risk exposure) is zero. - If it sells for instance a Total Return Swap (TRS) on Eurostoxx50 and sells one TRS on a short exposure to the CAC40 and sells another one on a short exposure to the DAX, its inventory will be close to zero. Hence the price will not move a lot. - For derivatives, the same reasoning applies, on the directions of the Greeks (sensitivities of the bought products in a set of risky exposures); it is explained in Financial Markets in Practice, From Post-Crisis Intermediation to FinTechs, by L and Raboun. The balance sheet of the issuer acts as to inventory of a market maker. Ultimately the issuer, to counter a too high exposure to a risk factor, will have to hedge it and hence will move the price in the expected direction.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.