How Do Dealers in Government Bond Markets Manage Their Spot Risk with Derivatives? Evidence from London

Using a comprehensive data-set from the Bank of England containing the close-of-business positions of individual UK government bond dealers in each bond issue and in all related futures contracts, we examine how the dealers use futures markets to manage the risk of their spot portfolio. We find that the size of dealers' positions in futures contracts is comparable in magnitude to their positions in the spot market, and that the dealers take on significant directional risks often by holding futures that are in the same direction as the spot. Although, in general, the dealers do not seem to use futures to reduce the level of their spot risk, we so find that they actively use futures to offset the changes in the levels of their spot risk. However, this offset is partial in most cases. They use futures to offset changes in their spot exposure to a greater extent when the bonds they hold in their portfolio are more efficiently hedgeable with futures contracts, and on days when the cost of offsetting (as measured by the predictable change in futures mispricing) is lower. They also offset more when the level of their spot risk is high and when recent changes in the spot risk are in a direction that exacerbates their spot risk exposure (i.e., when the potential costs of regulatory distress are high). Finally, we observe that dealers offset changes in their spot exposure to a greater extent immediately prior to important macroeconomic announcements and to a lesser extent immediately thereafter.