An Explanation of Negative Swap Spreads: Demand for Duration from Underfunded Pension Plans

Klingler, Sven; Sundaresan, Suresh

doi:10.2139/ssrn.2814975

Cited by 19 publications

(14 citation statements)

References 49 publications

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“…The regulations and currency match requirements are mainly applicable for large institutional investors such as pensions and insurers. These two sectors hold relatively large amounts of debt investments and have been documented to have a large impact on yield curve (Greenwood and Vissing-Jorgensen, 2018) and swap spreads (Klinger and Sundaresan, 2019). Australia additionally provides country-level surveys of foreign currency exposure and hedging, which shows a much higher level of hedging for debt relative to equities.…”

Section: Currency Hedging and Institutional Detailsmentioning

confidence: 99%

“…From a theory perspective, our paper is most closely related to the literature studying portfolio balance effects in currency markets (Gabaix and Maggiori, 2015;Greenwood, Hanson, Stein, and Sunderam, 2019). The portfolio balance view argues for a quantity driven, supply-and-demand approach towards explaining asset prices, and has been successful in explaining puzzles in bonds (Vayanos and Vila, 2009;Greenwood and Vayanos, 2010;Krishnamurthy and Vissing-Jorgensen, 2011), swap spreads (Klinger and Sundaresan, 2019), mortgage-backed securities (Hanson, 2014), and equities (Shleifer, 1986). Most relevant to our paper is Gabaix and Maggiori (2015), who highlight the role of financial intermediary in determining spot exchange rates and Greenwood et al (2019), who considers bond term premia and exchange rates jointly through a model of bond investors that operate in multiple markets.…”

Section: Introductionmentioning

confidence: 98%

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The Hedging Channel of Exchange Rate Determination

Liao

Zhang

2020

SSRN Journal

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We document the exchange rate hedging channel that connects country-level measures of net external financial imbalances with exchange rates. In times of market distress, countries with large positive external imbalances (e.g. Japan) experience domestic currency appreciation, and crucially, forward exchange rates appreciate relatively more than the spot after adjusting for interest rate differentials. Countries with large negative foreign asset positions experience the opposite currency movements. We present a model demonstrating that exchange rate hedging coupled with intermediary constraints can explain these observed relationships between net external imbalances and spot and forward exchange rates. We find empirical support for this currency hedging channel of exchange rate determination in both the conditional and unconditional moments of exchange rates, option prices, large institutional investors' disclosure of hedging activities, and central bank swap line usage during the COVID-19 market turmoil.

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Section: Currency Hedging and Institutional Detailsmentioning

confidence: 99%

Section: Introductionmentioning

confidence: 98%

The Hedging Channel of Exchange Rate Determination

Liao

Zhang

2020

SSRN Journal

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“…Du et al (2018) show that constraints on banks' balanced sheets induced by capital regulation play a role in sustaining deviations from Covered Interest Parity (CIP). Klinger and Sundaresan (2019) and Boyarchenko et al (2018) attribute to the same cause the fact that swap spreads have been low since the financial crisis and have recently turned negative for some contract maturities. Cenedese et al (2019) show that swap contracts that are bilaterally cleared trade at a premium, relative to centrally cleared ones, due to higher regulatory costs (e.g., higher risk weights) that are passed on to market prices via the so-called valuation adjustments (XVA) and Ranaldo et al (2019) show that prices for European repos drop, during quarterly reporting periods, when Basel III leverage ratio requirements constrain banks' repo borrowing demand the most.…”

Section: Literature Reviewmentioning

confidence: 98%

The Cost of Clearing Fragmentation

et al. 2019

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BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. This publication is available on the BIS website (www.bis.org).

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“…As discussed earlier, receiving fixed in an interest rate swap can be viewed as a synthetic position in a fixed rate bond, while paying fixed in a swap is the equivalent of a short position. Thus, abstracting from Libor and swap counterparty credit risk issues, the spread between swap rates and Treasury yields-known as the swap spread-may also reflect the impact of the balance sheet costs faced by intermediaries in the fixed income markets (see Klingler and Sundaresan (2016) and Jermann (2016)).…”

Section: Commonalities Across Marketsmentioning

confidence: 99%

Shadow Funding Costs: Measuring the Cost of Balance Sheet Constraints

Fleckenstein¹,

Longstaff²

2018

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Recent theory suggests that balance sheet frictions and constraints faced by financial intermediaries can have major asset pricing implications. We propose a new measure of the impact of these constraints on intermediary funding costs that is based on the implied cost of renting intermediary balance sheet space. On average, balance sheet constraints add 81 basis points to intermediary funding costs, but the impact often exceeds 200 basis points during a crisis. We find that these balance sheet costs have real effects on intermediary investment decisions and asset holdings. Increases in balance sheet costs are associated with short-term increases in the use of derivatives, but longer-term declines in risk-taking by financial institutions. Balance sheet costs introduce a wedge between on-and off-balance-sheet investments which may help resolve a number of asset pricing puzzles.There is an extensive literature on how the various types of balance sheet constraints faced by financial intermediaries may affect asset prices. A number of recent papers have focused on the implications of collateral constraints, funding liquidity, margin requirements, leverage constraints, regulatory capital requirements, and other types of balance sheet frictions and restrictions for financial markets.There is also a rapidly growing literature on the potential impact on asset prices and market liquidity of recent legal and regulatory measures including the Dodd Frank Act, the Volcker Rule, and the Supplementary Leverage and the Liquidity Coverage Ratios of Basel III. . This issue has also been extensively discussed among industry participants and policy makers are actively considering the impact of these regulatory measures on market liquidity. Recent examples include the International Capital Market Association (2015) and Chen, Korapaty, and Swaminathan (2016). This paper contributes to this literature in several ways. First, we provide strong evidence that the relative pricing of Treasury securities in the cash and futures markets is directly related to the balance sheet constraints faced by financial intermediaries. Second, we show that increases in balance sheet costs have real effects on the leverage, holdings of Treasury securities, and asset growth rates of financial intermediaries, as well as on the use of derivatives by market participants. Third, our measure of the impact of balance sheet constraints provides a metric for monetary policy authorities and others for evaluating the effects of capital regulation on financial markets. Fourth, our results provide a framework for resolving a number of puzzling asset pricing anomalies involving financial derivatives and cash market instruments. Finally, our results provide direct empirical support for the rapidly growing literature on intermediary asset 4

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An Explanation of Negative Swap Spreads: Demand for Duration from Underfunded Pension Plans

Cited by 19 publications

References 49 publications

The Hedging Channel of Exchange Rate Determination

The Hedging Channel of Exchange Rate Determination

The Cost of Clearing Fragmentation

Shadow Funding Costs: Measuring the Cost of Balance Sheet Constraints

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