Inferring Intermediary Risk Exposure from Trade

Abstract

We propose a novel measure of intermediary risk exposure based on the fraction of all trade that is conducted between dealers, called the interdealer trade (IDT) measure. Intuitively, when dealers’ aggregate risk exposure rises, they trade more with each other to redistribute inventory shocks. Consistent with risk exposures relating to expected returns, market-specific IDT measures add incremental return predictability across five different markets. For example, one-standard-deviation increases in the Treasury and foreign exchange (FX) IDT measures, respectively, forecast a 1.8% higher annual excess return on a five-year bond and a 3.7% higher annual excess return on currency-specific FX trades. This paper was accepted by David Sraer, finance. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2021.01831 .