Interdealer Trading in the UK Government Bond Market

Abstract

This paper examines the nature of trading between dealers in a competitive dealership bond market where the primary risk factors are driven by public macro-economic information, and for hedging there exist liquid futures contracts as well as numerous close spot market substitutes. We find that, cross-sectionally across bonds, idiosyncratic risk is a deterrent to interdealer trading but systematic risk is correlated with it. The primary risk factor that can be hedged via the liquid futures contract is often hedged by trading with other dealers suggesting that interdealer trading supplements risk management via derivatives. The risk exposure of dealers over time is hedged partially via interdealer trading and portfolio considerations play a part in this. There also appears to be some degree of pooling of risk across dealers who are heterogeneous in their beliefs about future prices. We also find that effective bid-ask spreads in the public market are negatively correlated with the extent of interdealer trading, which does not produce a more volatile prices in the public market. Finally, we find that prices bid and offered to the public are in the region of four basis points worse than corresponding interdealer trade prices.