Herfindahl-Hirschman Index in OTC Derivatives Market
It is a measure of market concentration, defined as the sum of the squared market shares of each individual entity. The index ranges from 0 to 10,000. If only one entity dominates the market, the measure will have the maximum value of 10,000. It is also called as HHI Score or Index.
Formula and Example:
The formula for HHI Index is:
\[ HHI = S^2_1 + S^2_2 + S^2_3 + S^2_4 + ..... S^2_n\]
Sn = the market share percentage of firm n.
For example, let's consider that there are five firms in an industry and the following are their market shares.
Firm 1 = 25%
Firm 2 = 30%
Firm 3 = 10%
Firm 4 = 20%
Firm 5 = 15%
\[ HHI Index = 25^2 + 30^2 + 10^2 + 20^2 + 15^2 \]
\[ = 625 + 900 + 100 + 400 + 225 \]
\[ = 2,250\]
Theoretically, we can have a range of 0 to 10,000.
In general, the following is the interpretation.
HHI value is less than 100, the industry is highly competitive.
HHI value is less than 1500, the industry is competitive.
HHI value is less than 2,500, the industry is moderately competitive or moderately concentrated.
HHI value is less than 5,000, the industry is concentrated.
HHI value is less than 7,500, the industry is highly concentrated.
HHI value is 10,000, the industry is a monopoly.
In our example above, the score of 2,500 indicates that the industry is moderatively competitive or moderately concentrated.
Limitations of the HHI Index:
The index is very simply and that itself is a limitation because it does not take into consideration factors such as the nature of the industry, the variety of products and/or services offered within that industry (we can handle this through creating an index for each segment, but it would be difficult to gather data, particularly if we were to consider all substitutes and complementary products and/or services)
, and the geographical area of operation. For example, an industry might consists of 4 companies each with 25% market share. The HHI Index would be 2,500, which would indicate an moderately competitive industry. However, it is quite possible that each of the four companies are operating in four different regions and they are a monopoly in that region. So, what is actually a regional monopoly industry is depicted as a moderately competitive industry by the HHI Index.
Therefore, the HHI Index alone cannot be used for interpretation. It has to be supplemented by other data and analysis.
HHI Index in OTC Derivatives:
The Bank for International Settlements (BIS) publishes reports on the market concentration in various OTC derivative segments using HHI Index.
The following are the index numbers for various OTC market segments as on end of 2019
||Foreign Exchange Derivatives
||Outright forwards, forex swaps and currency swaps
||Interest Rate Derivatives
||Equity Linked Derivatives
||Forwards and Swaps
END OF MY NOTES