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Incorporating Expectations into Hedging Decisions

How risk managers should respond to changing yield curves.

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The problem with expectations is that you can’t count on them.

Although the financial landscape is ever-evolving, this year’s inversion of the yield curve on Treasuries marked a significant shift in expectations. Under a normal yield curve, where longer-maturity interest rates are higher than shorter-maturity rates, consensus expectations generally call for rising short-term interest rates. But the recent inversion flipped those expectations. For as long as the inverted yield curve persists, the consensus forecast will point to falling short-term interest rates. This change has a critical impact on the economics of hedging.

For most commercial enterprises that bear interest rate risk, the preferred tool for managing that risk is the interest rate swap, which allows counterparties to transform any variable-rate interest rate exposure to a synthetic fixed interest rate, or vice versa. Companies outside the financial services industry commonly face interest rate exposures as a result of variable-rate borrowing, and they frequently hedge these exposures using interest rate swaps to lock in a known, fixed interest rate.

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