Interest rate risk:
Investments in Fixed Asset like bonds are risky only because of the volatility of its price which can lead to unexpected capital profits or losses. The risk of this assets are valued on the volatility of the return that these securities provide which is achieved on two fronts:
1) The fixed return that is being provided on the basis of the coupon
2) The return earned on change of its price
The former is fixed on the basis of coupon decided and that the maturity value is also predetermined there lies no risk, but the later has got huge amount of risk involved as it is inversely proportional to the interest rates prevalent in the markets.
Thus if the interest rates rises the price of the bond will fall, but if reverse is the case the price of the bond will rise.
This makes it clear that the volatility in the prices of a fixed income asset is the because of the interest rate volatility and such volatility is termed as ‘Interest Rate Risk’. The Sensitivity of the Fixed Income Assets prices to the interest rates overall depends on the maturity of the asset. The longer the maturity the larger is the amount of volatility or change observed.
How to manage this risk?
Investors and business manages their risk by first choosing the amount of risk to which they want to get exposed to. This choice depends on their risk taking ability, some might be aggressive risk taker, some might be risk aversive, and depending on this they try to manage their risk.
Traditionally investors found it difficult to manage their risk in fixed income assets; Investors in bonds could reduce their risk only by selling some of their holding and by buying short term money market instruments. Financial institutions that got exposed to such were only able to restructure their balance sheet to reduce the mismatch between the maturities of their assets and liabilities.
But, now in recent years there are some financial instruments developed such as Interest rates Futures, Options on Interest Rates Futures and Interest rates Swaps that allowed investors of fixed assets to manage interest rate Risks. Thus now in order to manage the risk of Fixed Income Assets the investors can but the financial instruments in such a manner that the changes in the prices of the assets gets offsets with such instruments.
Interest Rate Futures:
An Interest Rate Future is an agreement between two parties to buy or sell a fixed income asset, Such as a T-bill or T-Bond at a given time in future at a pre-determined price.
Thus For Eg:
A person in January has agreed to But a T-bond Future, he has agreed to buy a T-bond of March, and if a person has agreed to Sell a T-Bond Future, then it means that the person will sell T-Bond in March. The Price of the futures contract is the price buyer agrees to pay to the seller for the asset.
Example of IRF:
On January 1, the notional 10-year bond (From ZCYC) was Rs. 45.43, One Believes the long rate will go up, and so one should Short 3 future contract at Rs. 49. Now if on January 31st the notional 10 Year bond is at Rs. 39, then one makes profit of Rs. 10 per bond.
Example of IRF:
On Jan, if the notional 10 Year notional bond was trading at Rs. 32, and Futures were at @ Rs. 33, with an intuition that the interest rates would go down one makes purchase of Futures @ Rs. 33and if the interest rates went up then one may make loss.
Hedging With IRF
Duration:
One Should Make A Weighted Average of all ti, where the weight for cash flow i, is proportional to its importance in the Net Present Value of the bond.
Weighted of cash flow:
Wi =
Duration
Hedging one’s Portfolio:
If one had portfolio of 10 year ZC bond and wanted to protect then one will short a 10 year futures.
In general one’s portfolio should have duration D, which is not 10.
If one has Duration of 10 then one must calculate how many rupees one would lose for a 1bps rise in the interest yield curve and then one should find a future position that can closely offset the loss.
For Example:
If one has Rs. 100 Lacs with duration of 11 years, then every rise in one bps in the yield curve will lead to a loss of Rs. 11 thousand.
Then one should look for a future position that can gain 11000 if the yield curve moves up by 1 bp
Therefore I must Take Short on Rs. 110 Lacs of the Futures.
But this is just s simple approach where one has captured the parallel shift in the yield curve, as the yield curve keeps on moving and fluctuating one must recompute whether one has made a proper hedge or not.
Different types of Assetes are hedged differently:
Hedging of a T-Bond Portfolio:
T-bond prices fall when Interest Rates rises, so a investor would hedge by selling Interest Rates Futures.
Hedging Corporate Bond:
Corporate bond Prices Fall with the increase in Interest rates and hence an investor of corporate bond would sell IRF to manage his risk. An investor might use T-Bond to hedge against a corporate bond.
Depository Institution:
Depository Institution like banks would Hedge their net worth against the changes in Interest
Securities Dealer:
Security Dealers Hedge IRR by selling IRF sometimes and buying them other times. Security dealers might sell the bonds in their inventory against the changes in interest rates like any other bond holder to hedge their risk. On the other hand they might buy IRF in order to meet their commitments to deliver at a future date at a pre-determined price against changes in interest rates.
Mortgage Banks:
The value of mortgage commitments fall with the increase in interest rates mortgage bankers would sell interest rates futures in order to hedge their position.
Life Insurance Companies:
Life Insurance Companies would hedge their GIC commitments against the changes in interest rates by buying interest rates futures.
Rates by selling IRF because their net worth generally falls with the increase in Interest Rates.
Interest Rate Futures are Considered Good Hedging Tools:
There are two reasons that substantiate the point of IRF as good hedging tools:
1) The transaction costs of buying and selling them are relatively low.
2) IRF Prices are closely related to the prices of many fixed income assets when Interest Rates Change.
Risk In Hedging With IRF:
Basis Risk:
The risk that remains after the hedging is done is called the Basis or residual risk. The Hedging made does not perfectly offsets the changes in prices, there are lot many factors affecting the prices of the assets other than interest rates and therefore the basis risk will be much higher if the change is prices is more due to other factors other than interest rates.
Credit Risk:
The risk exposed when the opposite party in the asset that is being hedged defaults is called Credit Risk. Note that it is not the risk Exposed due to the opposite party in the futures default, as there are clearing houses that takes care of this risk.
Marking to Market Risk:
It is the risk that the investor has to cover future losses when the contract is marked to market at the end of each day. Though the losses are usually offset by the gains of the hedge those gains are not received immediately and therefore the investor has clear and make immediate cash outlay for the loss he has made in having a long position on asset.
Conclusion:
Thus with this one can conclude that IRF can be used as an effective tool to offset the risk exposed due to interest rates changes that has its impact on fixed income assets. One has to keep a note of all the other risks coming along with the hedge and if managed properly the tool can help them to offset all the losses.
Original: Written By Nainish Jhaveri.
Posts
