Effectively Hedging the Interest Rate Risk of Wide Floating Rate Coupon Spreads

Thomas Schroeder and Kwamie Dunbar
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Thomas Schroeder: European Investment Bank and Sacred Heart University

No 2010-05, Working papers from University of Connecticut, Department of Economics

Abstract: Bond issuers frequently immunize/hedge their interest rate exposure by means of interest rate swaps (IRS). The receiving leg matches all bond cash-flows, while the pay leg requires floating rate coupon payments of form LIBOR + a spread. The goal of hedging against interest rate risk is only achieved in full if the present value of this spread is zero. Using market data we show that under a traditional IRS hedging strategy an investor could still experience significant cash flow losses given a 1% shift in the underlying benchmark yield curve. We consider the instantaneous interest-rate risk of a bond portfolio that allows for general changes in interest rates. We make two contributions. The paper analyzes the size of hedging imperfections arising from the widening of the floating rate spread in a traditional swap contract and subsequently proposes two new practical, effective and analytically tractable swap structures; Structure 1: An Improved Parallel Hedge Swap, hedges against parallel shifts of the yield curve and Structure 2: An Improved Non-Parallel Hedge Swap, hedges against any movement of the swap curve. Analytical representations of these swaps are provided such that spreadsheet implementations are easily attainable.

Keywords: Portfolio Immunization; Interest Rate Swaps; Hedging; Floating Rate Spreads; Interest Rate Risk and Yield Curve (search for similar items in EconPapers)
JEL-codes: G11 G12 G32 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2010-02
Note: The opinions expressed in this article refer to the authors only and do not necessarily reflect the positions of European Investment Bank.
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Related works:
Journal Article: Effectively hedging the interest rate risk of wide floating-rate coupon spreads (2011)
Working Paper: Effectively Hedging the Interest Rate Risk of Wide Floating Rate Coupon Spreads (2010)
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