The financial sector is, correspondingly, structurally short options, which it can – and does – slice and dice in various ways in an attempt to distribute the option exposure to those who want it. But to a greater or lesser extent, a residue is left, some of it with institutions which de facto seem to have short holding periods. They dynamically hedge, either continuously or within thresholds. A rather graphic – if, ultimately, not stability-threatening – example of what I’m describing occurred a few weeks ago in the structured credit markets. I’ll spend a few moments on this as the distribution of optionality was quite complex. For some while, a wide range of regional banks, insurers and pension funds in Europe and Asia have been selling protection on intermediate tranches of credit portfolios, say on losses between 3% and 7%. Although they are effectively short an option on portfolio credit risk, they are widely regarded as passive investors who do not dynamically hedge. Their counterparts, the dealers, are initially long an option on portfolio credit risk; as spreads generally widen, the value of the bought-protection position increases non-linearly. Over time it became popular amongst short-term leveraged traders to exploit the strong supply of intermediate (or mezzanine) protection by holding a bought-protection position on mezzanine tranches as a hedge against selling protection on equity tranches. This was a so-called long credit correlation position, as its value would tend to increase with rises in the implied correlation of default risk among the companies represented in the underlying portfolios.

3 The effective federal funds rate is calculated as a volume-weighted median of overnight federal funds transactions reported by banks on the FR 2420 Report of Selected Money Market Rates. The New York Fed publishes the EFFR for the prior business day, along with volumes and rate percentiles, on its website daily at approximately 9:00 a.m. Eastern Time. The EFFR is used as a measure of the typical fed funds transaction and is the way the New York Fed’s Open Market Trading Desk (the Desk) measures its success in meeting the directive on interest rate control from the FOMC. 1  confidence in its ability to appropriately control overnight interest rates over the period of normalization. I will then conclude with some comments on recent developments in broader money market rates, in particular U.S.-dollar LIBOR. U.S. term money market rates are of global significance, owing to the heavy use of the dollar outside the United States and the large stock of dollar-LIBOR-linked debt issued abroad. 4 The spread of LIBOR to overnight indexed swaps has fluctuated in recent years, along with similar term unsecured dollar borrowing rates, driven in part by the same factors influencing overnight rates but also by specific past regulatory and legislative changes that have impacted flows in term markets. Evidence, such as from the FX swaps market, suggests that dollar borrowing markets continue to function well. Policy Normalization Continues As Expected I’d like to start by taking stock of where we are with the normalization of monetary policy in the United States.