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TRADING RISK, MARKET LIQUIDITY, AND CONVERGENCE TRADING IN THE INTEREST RATE SWAP SPREAD

HEADNOTE

* Trading activity is generally considered to be a stabilizing force in markets; however, trading risk can sometimes lead to behavior that has the opposite effect.

* An analysis of the interest rate swap market finds stabilizing

as well as destabilizing forces attributable to leveraged trading activity. The study considers how convergence trading risk affects market liquidity and asset price volatility by examining the interest rate swap spread and the volume of repo contracts.

* The swap spread tends to converge to its normal level more slowly when traders are weakened by losses, while higher trading risk can cause the spread to diverge from that level.

* Convergence trading typically absorbs shocks, but an unusually large shock can be amplified when traders close out positions prematurely. Destabilizing shocks in the swap spread are associated with a fall in repo volume consistent with the premature closing out of trading positions. Repo volume also falls in response to convergence trading losses.

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