Interest rate risk hedging

There is a loan-to-value limit imposed of 60% for residential mortgages and 100% for public sector loans and hedging contracts against interest rate risk are permitted in the collateral pool. 

This chapter explores interest rate options—a vitat part of the European fixed income securities market. The first section tooks at exchange-traded options, where 20 bittion worth of bond options and over 250 billion of options on short-term rates change hands every day. Next, we ll look at the flexible OTC markets for interest rate options, including caps, collars, swaptions, and structured products. Finally, having explained the products themselves, we ll move on to explore how they can be used to hedge interest rate risk. 

L. Martellini and P. Priaulet, Fixed-Income Securities Dynamic Methods for Interest Rate Risk Pricing and Hedging (New York John Wiley 8c Sons, 2000). France (1995-98)—Spot ZC IM-lOY 3 66.64/20.52/6.96... 

Bond traders wishing to hedge the interest rate risk of their bond positions have several tools to choose from, including other bonds, bond futures, and bond options, as well as swaps. Swaps, however, are particularly efficient hedging instruments, because they display positive convexity. As explained in chapter 2, this means that they increase in value when interest rates fall more than they lose when rates rise by a similar amount—just as plain vanilla bonds do. 

Gup and Brooks (1993) noted that swaps credit risk, unlike their interest rate risk, could not be hedged. That was true in 1993. The situation changed quickly, however, in years following. By 1996 a liquid market existed in instruments designed for just such hedging. Credit derivatives are, in essence, insurance policies against a deterioration in the credit quality of borrowers. The simplest ones even require regular premiums, paid by the protection buyer to the protection seller, and make payouts should a specified credit event occur. 

A credit default swap (CDS) price provides fundamental credit risk information of a specific reference entity or asset. As explained before, asset swaps are used to transform the cash flows of a corporate bond for interest rate hedging purpose. Since the asset swaps are priced at a spread over the interbank rate, the ASW spread is the credit risk of the same one. However, market evidence shows that credit default swaps trade at a different level to asset swaps due to technical... 

A fixed-rate bond pays fixed coupons during the bond s life known with certainty. Conversely, a floating-rate note ox floater pays variable coupons linked to a reference rate. This makes the coupon payments uncertain. The main pim-pose of this debt instrument is to hedge the risk of rising interest rates. Although the financial crisis and liquidity provided by central banks have decreased the level of interest rates, they will at some point of course rise in future years. 

Floating-rate notes can include additional features. One example is the inclusion of cap, floor and collar clauses. A floater with cap feature means that the reference rate cannot overcome the threshold rate defined in the indenture. Usually the threshold is expressed in terms of coupon, that is after a coupon threshold (e.g. 6%, reference rate plus quoted margin) the investor receives at maximum the cap level. In this case, the floater is not completely covered by rising interest rates, in which after the threshold the floater trades as a conventional bond. In contrast, a floater with a floor feature represents the minimum coupon level that an investor can receive, hedging to the downside risk of interest rates. If the bond includes both cap and floor, this feature is known as collar or collared floating-rate note. The bond can include also a drop-lock feature that after a threshold it ceases to float. 

The relationship is reduced as maturity is increased because of the low liquidity of futures markets beyond two to five years, increased futures execution risk, and increased interest rate volatility. The convexity problem when using futures contracts (nonconvex instruments) to hedge interest rate swap positions (convex instruments) is more pronounced for long-term transactions, resulting in reduced hedge efficiency. The convexity issue is addressed in detail later in this chapter. 

An example would be that a protection buyer holding a fixed-rate risky bond and wishes to hedge the credit risk of this position via a credit default swap. However, by means of an asset swap the protection seller (e.g., a bank) will agree to pay the protection buyer LIBOR +/-spread in return for the cash flows of the risky bond. In this way the protection buyer (investor) may be able to explicitly finance the credit default swap premium from the asset swap spread income if there is a negative basis between them. If the asset swap was terminated, it is common for the buyer of the asset swap package to take the unwind cost of the interest rate swap. 

This chapter discusses the uses of interest rate swaps, including as a hedging tool, from the point of view of bond-market participants. The discussion touches on pricing, valuation, and credit risk, but for complete... 

The primary risk measure required when using a swap to hedge is the present value of a basis point. PVBP, known in the U.S. market as the dollar value of a basis point, or DVBP indicates how much a swap s value will move for each basis point change in interest rates and is employed to calculate the hedge ratio. PVBP is derived using equation (7 23). 

The principle of arbitrage-free pricing requires that the hedged portfolio s return equal the risk-free interest rate. This equivalence plus an expansion of dC(F,t) produces partial differential equation (8.33). 

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