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Using Derivatives for Hedging Fixed Income Portfolios

Using Derivatives for Hedging Fixed Income Portfolios. Andrea Zager May 13 2006. Address European Headquarters 30, St Mary Axe London. Environment of rising interest rates. EUR,USD 5Y last year. EUR, USD 5Y5Y Volatility. Are you long of bonds?. What can be done about it?.

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Using Derivatives for Hedging Fixed Income Portfolios

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  1. Using Derivatives for Hedging Fixed Income Portfolios Andrea Zager May 13 2006

  2. Address European Headquarters 30, St Mary Axe London

  3. Environment of rising interest rates

  4. EUR,USD 5Y last year

  5. EUR, USD 5Y5Y Volatility

  6. Are you long of bonds?

  7. What can be done about it? You can sell the bonds and go home OR: You can use Derivatives to protect against rising interest rates

  8. Which Derivatives? • Futures • Swaps • Caps and Floors

  9. What are Futures contracts? • An agreement between two counterparties to exchange a cash amount at the expiry of the contract • Cash amount: difference between the Forward Implied Interest Rate Actual Fixing of the same tenor Interest Rate at Expiry of the contract

  10. Future Rates

  11. How to use futures to hedge? • To protect long bond portfolio you need to SELL Futures If the interest rates go up The prices of both bonds and futures fall The bond portfolio losses its value but The short futures position generates profit and therefore offsets the losses of the portfolio

  12. Swap • Agreement in which both parties agree to exchange a strip of interest payments (coupons) in the future where the amount each has to pay is calculated on a different basis Pays Floating rate Counterparty A Counterparty B Pays Fixed Rate

  13. Swap

  14. Swap

  15. Swap

  16. How to use Swaps to hedge? • To protect a long bond portfolio against the parallel upward shift of the yield curve: Enter into Pay Fixed X Receive Float swap If the whole yield curve moves up Bond prices fall The portfolio losses its value but The swap hedge increases its value due to higher receivables from the floating side and offsets the losses of the portfolio

  17. The spread is currently 0.6% The spread is currently 1.2%

  18. How to use Swaps to hedge? • To protect against the change in the shape of the yield curve(the yield curve steepens or flattens): Enter into a CMS swap Steepening of the yield curve Bond positions with long maturity lose value This is offset by CMS where higher receivables of the long-term interest rate prevails lower payables of the short-term interest rate, and profit is generated

  19. CMS Swap, CMT Treasury • Swap transactions where both of the counterparties agree to exchange strip of future payments both calculated on the basis of floating rates, e.g.: One based on the short term interest rate e.g. LIBOR 3M The other based on some long term interest rate e.g. CMSwap – the index is the 10 year Swap Rate CMTreasury – the index is a bond yield

  20. CMS Swap, CMT Treasury • Constant Maturity refers to the fact that one party pays in each period the 3M LIBOR and the other the 10Y Swap Rate. • The maturity of the indexes is constant during the whole life of the swap.

  21. CMS Swap, CMT Treasury

  22. CMS Swap, CMT Treasury

  23. How to price CMS? • One the most sophisticated and complex instruments to price • Difficulties arise the non-linear function of yield the discrepancy in time between when the index is fixed and the payment is made and the forward interest rate between those dates • Price calculation requires volatility of the forward swap/bond and volatility of the forward short-term rate

  24. Swaption ATF Rates Volatility Surface

  25. Swaption Volatility Surface

  26. CAPs and FLOORs • Are series of interest rate options called “Caplets” & “Floorlets” • Each Caplet/Floorlet has the same strike the same underlying The difference: The expiry date • The Cap/Floor buyer pays the seller an upfront premium • Exercised automatically and cash settled

  27. CAPs and FLOORs • CAP – the holder of the cap gains protection against rising interest rates • FLOOR –the holder of the floor gains protection against falling interest rates

  28. CAP

  29. Cash Flow and Dates

  30. Delta Risk Matrix

  31. CAPs and FLOORs Volatility Surface

  32. How to use Caps and Floors? • In order to protect a long bond portfolio you need to BUY a CAP at a certain strike If the interest rates increase The bond portfolio losses its value but the CAP is automatically exercised and the profit arising from the difference between the strike of the CAP and the market rate is received

  33. Thank you  Andrea Zager Tel: + 44.20.7724.4167 Email: a.zager@superderivatives.com

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