Pekka Honkanen – University of Georgia, Terry College of Business

Intermediation, Pricing, and Hedging in OTC Markets: Equity Total Return Swaps

 Abstract

I present a simple theoretical framework for pricing and hedging equity total return swaps and test the model’s predictions using novel, transaction level data. I find that swap spreads are based on a dealer’s financing cost when the dealer’s net swap exposure is positive but that the spread is determined by the short-selling cost of the reference security when the dealer’s net exposure is negative. I also show that dealers hedge their exposure fully, first, by matching long and short trades internally and, second, by trading the underlying security. Dealers offer lower spreads on trades that reduce their net exposure, i.e., contribute to hedging the overall position. Using a natural experiment, I show that reduced competition between dealers leads to higher spreads.