**3. Microstructure Literature**

Standard models of market making behaviour assume that bid and offer quotes involve a fixed component to cover order processing costs, an inventory managemen<sup>t</sup> component (e.g., Amihud and Mendelson 1980; Demsetz 1968; Tinic and West 1972; Ho and Stoll 1981; Ho and Stoll 1983 and Stoll 1978) and an adverse selection component to protect the dealer from losses to more informed traders (e.g., Copeland and Galai 1983; Easley and O'Hara 1987 and Glosten and Milgrom 1985). In the case of sovereign bonds, however, the adverse selection component is regarded as small since nearly all information about underlying value of such bonds is public.<sup>8</sup>

In respect of the inventory imbalance component, Stoll (1978) was one of the first to empirically assess the differential effects of systematic and idiosyncratic risk on dealer pricing. Huang and Stoll (1997) simply assert that the inventory component is mainly related to dealers' portfolio-wide inventory imbalances rather than stock-specific imbalances. They use this fact to separate the inventory component of the spread from the adverse selection component. More recently, Hagströmer et al. (2016) develops a structural model for price formation and liquidity supply explaining how inventory

<sup>6</sup> It may also be supposed that this benign outcome would be compromised if the SBBS has a difficult-to-forecast correlation with the bond (i.e., if out of sample hedge ratios turn out to be less efficient than they could have been). This is really a type of operational risk and (assuming forecasts are as efficient as possible ex ante) this also gives rise to mostly idiosyncratic and diversifiable risks.

<sup>7</sup> Bessler et al. (2016) point out that several futures markets for individual sovereign bonds existed pre-EMU and that the alignment of yields during the years of the Great Moderation was largely responsible for the disappearance of all but the German Bund futures. The Great Financial Crisis and the Sovereign Debt Crisis in Europe ultimately led to the reintroduction of futures on Italian BTPs and French OATs. Futures on Spanish Bonos only reappeared in 2015. Naik and Yadav (2003) examine the use of futures to hedge interest rate risk (undesirable duration) in sovereign bond portfolios of dealers and they find support for the propositions about hedging behaviour by Froot and Stein (1998).

<sup>8</sup> For example, Naik and Yadav (2003) strongly reject the notion that dealers benefit from their information about orderflow even in the relatively concentrated UK Gilts market.

pressure and price discovery is influenced by joint trading of the same or a similar asset in a parallel market. This shows that where hedging opportunities exist trading costs are partially determined by characteristics of the hedge instrument rather than the specific asset.

Naik and Yadav (2003) provide extensive evidence of the use of futures by dealers in the UK Gilts market to hedge duration (they do not discuss credit risk hedging). They measure risk exposure in two ways; using value-weighted average duration of the whole portfolio of spot and futures bond positions of 15 dealers and alternatively, a value-weighted average of the duration-weighted hedge ratios (where hedge ratios are betas from regressions of returns on individual bonds on the long-gilt futures return). The two measures are very highly correlated (0.92). They show that dealers maintain a short position on average, but the spot and futures positions diverge in opposite directions from their means. They conclude that dealers actively use the futures contract to hedge their spot exposures in order to maintain a target level of interest rate exposure.

This hedging behaviour is consistent with theoretical predictions of Amihud and Mendelson (1980). The evidence of partial hedging supports the findings of Stulz (1996) and suggests that what is not hedged is idiosyncratic (only interest rate risk is being hedged in this case as the sample did not involve significant fluctuations in UK sovereign credit risk). The Naik and Yadav study goes on to show that hedging varies with the costs of hedging, volatility of holding returns, risk aversion and capital shortage. They also show that bigger dealing banks hedge less but do not seem to make profits from this—implying that their knowledge of a significant fraction of orderflow does not translate into an economic advantage.
