Sharing interest rate risk: who is trading and what affects the costs?

Ioana Neamțu, Umang Khetan, Jian Li and Ishita Sen

What do the 2023 Silicon Valley Bank collapse and the 2022 UK pension fund crisis have in common? Interest rate risk. Several sectors in the economy run significant asset-liability mismatch that makes them vulnerable to rapid interest rate changes: pension funds and insurers have short-term cash flows and long-term liabilities, while banks follow a lend-long-borrow-short approach. While interest rate derivatives enable risk transfers to hedge these exposures, research on this market is limited, leaving important questions on the extent of risk sharing and the consequences of imbalances unanswered. We construct the largest data set on interest rate swaps using confidential Bank of England data to unlock insights into how investors use these instruments, and their relative importance in determining swap prices.

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SONIA: steady as she goes

Joanna McLafferty, Kirstine McMillan and Joseph Smart

On 7 May 2024 the SONIA rate, the UK’s risk-free reference rate, printed at exactly 5.2000% and has remained there to the end of July 2024 (the time of writing). Flatlining of SONIA is not a phenomenon we see often. Prior to this, over the past six years SONIA had been ‘flat’ for only four consecutive days, on two occasions. So how is it possible for the SONIA calculation methodology to create such a flat rate? What is happening in the underlying market? And most importantly… does the lack of volatility indicate an issue? We argue this should not cause concern since flatlining is explained by the calculation mechanics and behavioural dynamics in the market.

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Caring for the ‘future’

David Glanville and Arif Merali

Short term interest rate (STIR) futures are the bedrock of interest rate markets, used to price expectations of central bank policy rates and other UK rate derivative markets such as swaps and options (see Figure 1). They are key for the transmission of monetary policy and provide an avenue for interest rate risk hedging which is important for financial stability. Financial market liquidity usually worsens when volatility rises, however liquidity in the UK’s STIR futures during 2022 was especially poor. Liquidity in some metrics such as open interest and volumes has since improved as volatility has reduced, however our extensive market intelligence conversations suggest that many still believe there is further to go when looking ‘under-the-bonnet’ at another key metric, market depth. Volatility continues to play a role, but a reversion to publishing key data releases within market hours may help to build liquidity further.

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