Overbidding in fixed rate tenders: The role of exposure risk

Abstract

The fixed rate tender is one of the main procedures used by central banks in the implementation of their monetary policies. While academic research has largely dismissed the procedure owing to its tendency to encourage overbidding, central banks such as the ECB and the Bank of England have continued using it. We investigate this apparent conflict by considering an auction-theoretic setting with private information about declining marginal valuations. Since overbidding entails exposure risk, an equilibrium may exist even if bids are costless and the intended volume is pre-announced. In fact, the allotment quota may be strictly below one with certainty. Also with adaptive expectations, overbidding need not escalate. However, the resulting allocation is typically inefficient. Empirical proxies of exposure risk are significant in both euro and sterling operations. Our findings have implications, in particular, for the potential reintroduction of pro rata allotment in the main refinancing operations of the Eurosystem. The …xed rate tender is one of the main procedures used by central banks in the implementation of their monetary policies. While academic research has largely dismissed the procedure owing to its tendency to encourage overbidding, central banks such as the ECB and the Bank of England have continued using it. We investigate this apparent con ‡ict by considering an auction-theoretic setting with private information about declining marginal valuations. Since overbidding entails exposure risk, an equilibrium may exist even if bids are costless and the intended volume is pre-announced. In fact, the allotment quota may be strictly below one with certainty. Also with adaptive expectations, overbidding need not escalate. However, the resulting allocation is typically ine¢ cient. Empirical proxies of exposure risk are signi…cant in both euro and sterling operations. Our …ndings have implications, in particular, for the potential reintroduction of pro rata allotment in the main re…nancing operations of the Eurosystem.

Vulnerability of fixed-rate funds-supplying operations to overbidding: An experimental approach

“…In terms of theoretical analysis, in addition to Nautz and Oechssler [14], Ayuso and Repullo [2] model fixed-rate tenders conducted by the ECB in its open market operations and describe overbidding as a unique equilibrium under an asymmetric objective function of the central bank. Later, Ewerhart et al [10] theoretically identify that the extent of overbidding is heavily influenced by exposure risk i.e., the risk of receiving an overly large allotment. Elsewhere, Catalao-Lopes [8] compares fixed-and variable-rate tenders using a game-theoretic framework and concludes that overbidding is inherent to fixed-rate tenders, but very mitigatable under a variable-rate procedure, and that unlike fixed-rate tenders, variablerate tenders allow the keeping of some of the informational content of quantity bids.…”

“…For t = 1, the null is rejected for both scenarios (and for t = 2 for Scenario 2). This might be because subjects' behaviors in the very initial periods of an experiment tend to be subject to "initial effects," i.e., some periods may be needed for subjects to learn the structure of the game and choose an "optimal" strategy using their own reasoning 10 . In sum, the results of the test in Table 1 largely support the hypothesis that each participant follows the unique Nash strategy during 1 ≤ t ≤ 7.…”

Demand for reserves and the central bank’s management of interest rates

“…Furthermore they also show that the bank's bidding behavior reflects a strategic response to other bidders. Nevertheless several central banks prefer to use a fixed rate auction framework as the central bank can provide a very clear signal about the current monetary policy stance by setting the interest rate in the auction (see for example Ewerhart et al, 2012). This paper contributes to the existing literature by providing an empirical estimation of a demand curve for reserves in a fixed rate tender auction framework.…”