Benchmark tipping and the role of the swap market in price discovery

Abstract

The author uses a high‐frequency data set to investigate the roles of the sterling swap and futures markets in price discovery at the short‐end of the sterling yield curve. Information flows between the futures and swap markets are found to be largely contemporaneous. Causal information flows are bidirectional, although the futures market dominates the information flow over the very short term. Thus, the futures market remains the primary locus of price discovery despite the increased use of swaps as a pricing benchmark and hedging instrument in recent years. © 2007 Wiley Periodicals, Inc. Jrl Fut Mark 27:981–1001, 2007

Price discovery in short‐term interest rate markets: Futures versus swaps

“… The relative size of swap turnover to short‐term interest rate futures market turnover for the Australian sample we examine in this study is similar to that examined by Poskitt (). For example, in his sample, the ratio of average daily futures volume to swap volume in April 2004 is approximately 2.7 times (£68 billion/£25 billion; see page 984), the analogous ratio for the sample that we examine in this study is approximately 2 times ($104.7 billion/$53.4 billion; see Table ). …”

“…Based on prior research, we implement a lead–lag model similar to Sims (), Frino et al (), and Poskitt (), to investigate the price discovery relationship between the swap and futures markets during daytime and overnight trading. In addition, we examine the impact of macroeconomic information releases on information flow between these two markets.…”

“…This is especially surprising since interest rate derivatives markets dwarf equity derivatives markets in terms of trading activity . To our knowledge, the only study that investigates price discovery across different interest rate derivatives markets is Poskitt (). In this study, we bring further evidence to bear on this issue and provide some new insights.…”

“…Poskitt () sets out to examine the possibility that “benchmark tipping” has occurred away from interest rate futures markets toward swap markets at the short end of the yield curve, as a consequence of the dramatic increase in swap volumes relative to the volumes of short‐term interest rate futures in the UK. Examining data for the year to June 2003, Poskitt () documents a largely contemporaneous relationship in price movements and concludes that information flows between futures and swaps and vice versa for up to 20 min. However, he also finds that, over the very short term (1 min), information flows from futures to swaps are dominant.…”

“…Poskitt () notes that swaps trade 24 hr/day, while during the sample period he examines, UK interest rate futures traded during the day only (from 7:30 a.m. to 6:00 p.m.). More recently, futures exchanges have moved to trading almost 24 hr/day.…”