From the September/October 2012 issue of Treasury & Risk magazine

Interest Rate Hedges

Market intelligence, Trade Analysis, and Regulatory Change

Multiple factors affect decisions on mitigating interest rate risk. In the current market environment, understanding these many factors is challenging but the need to manage them is also more critical. To help you map a successful strategy, Christian Miller, Senior Fixed Income Markets Specialist at Bloomberg, explains how to interpret interest rate trends and analyze forecasts to make better informed hedging decisions.

The current environment is a bit of a gut check in that it differs significantly from market conditions in past years. Treasury yields are at historic lows. The yield curve has recently flattened fairly dramatically, making it harder to exploit a steep yield curve. Recovery could take longer than expected and political risk is extremely high.

To get a picture of where we are now, consider quarterly 10-year bond yields going back to the 1960s. We are currently down around 1.5 percent, the historically lowest levels in the past half century. That is a boon for anyone wanting to borrow in the long end of their curve but there is also the question of whether that will continue and if in fact rates may drop even lower.

The same thing is seen in the swap market which is really just a spread to the treasury market. The current 1.6 percent in 10 year swap yields is low for the year and also among the lowest in the past 50 years or so. 

In fact, if you go back to any period in history, what is priced in never comes to pass. Either markets will stay lower or rise higher than predicted. Especially when the Fed goes into a tightening mode, the forward curve tends to under-predict how much the Fed may actually tighten. This is something to keep firmly in mind when using forwards in hedge determinations.

To sum up current market conditions: rates are low but expected to rise and the yield curve implies but does not guarantee higher rates. The implications to your bottom line depend on how exactly you are exposed and your opportunity cost or risk does too. That said, there are a number of ways to respond to opportunity and risk now.

The important definitions to remember are that coupon means a fixed rate; spread is the constant number of bps over floating rate; market value is the value of swap at a given time; and DV01 is the change in market value when the underlying curve moves by one basis point.

Another way to think about this trade is in terms of what the cash flow looks like. You can used fixed rate to prevent any jump in payments or potentially use a floating rate to reduce payments for part or all of the repayment period to increase cash flow.

Interest rate caps, such as a LIBOR cap, on floating rates hedges volatility. They can match cash flows, hedge spread and curve risk, and you can customize it. However, caps can be a less liquid hedge, its more expensive and complex, and you have to pay some cash upfront in a premium.

Regulations must also be figured into the risk model. For example, under Dodd Frank, rules govern the market maker, the dealer, profits made, and the swaps business in general. 

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