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

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  • Schröder, Thomas

    (John F. Welch College of Business, Sacred Heart University)

  • Dunbar, Kwamie

    ()
    (John F. Welch College of Business, Sacred Heart University)

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.

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Bibliographic Info

Paper provided by Sacred Heart University, John F. Welch College of Business in its series Working Papers with number 2010001.

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Length: 30 pages
Date of creation: Mar 2010
Date of revision:
Handle: RePEc:she:wpaper:2010001

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Keywords: Portfolio Immunization; Interest Rate Swaps; Hedging; Floating Rate Spreads; Interest Rate Risk and Yield Curve;

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  1. Li, Haitao & Mao, Connie X., 2003. "Corporate use of interest rate swaps: Theory and evidence," Journal of Banking & Finance, Elsevier, Elsevier, vol. 27(8), pages 1511-1538, August.
  2. Nance, Deana R & Smith, Clifford W, Jr & Smithson, Charles W, 1993. " On the Determinants of Corporate Hedging," Journal of Finance, American Finance Association, American Finance Association, vol. 48(1), pages 267-84, March.
  3. Huang, Ying & Chen, Carl R., 2007. "The effect of Fed monetary policy regimes on the US interest rate swap spreads," Review of Financial Economics, Elsevier, Elsevier, vol. 16(4), pages 375-399.
  4. Bicksler, James & Chen, Andrew H, 1986. " An Economic Analysis of Interest Rate Swaps," Journal of Finance, American Finance Association, American Finance Association, vol. 41(3), pages 645-55, July.
  5. Sun, Tong-sheng & Sundaresan, Suresh & Wang, Ching, 1993. "Interest rate swaps: An empirical investigation," Journal of Financial Economics, Elsevier, Elsevier, vol. 34(1), pages 77-99, August.
  6. Hugues Pirotte & Didier Cossin, 1997. "Swap Credit Risk: An Empirical Investigation on Transaction Data," Working Papers CEB, ULB -- Universite Libre de Bruxelles 97-001, ULB -- Universite Libre de Bruxelles.
  7. Duffie, Darrell & Huang, Ming, 1996. " Swap Rates and Credit Quality," Journal of Finance, American Finance Association, American Finance Association, vol. 51(3), pages 921-49, July.
  8. Minton, Bernadette A., 1997. "An empirical examination of basic valuation models for plain vanilla U.S. interest rate swaps," Journal of Financial Economics, Elsevier, Elsevier, vol. 44(2), pages 251-277, May.
  9. Larry D. Wall & John J. Pringle, 1988. "Interest rate swaps: a review of the issues," Economic Review, Federal Reserve Bank of Atlanta, Federal Reserve Bank of Atlanta, issue Nov, pages 22-40.
  10. Lang, Larry H. P. & Litzenberger, Robert H. & Luchuan Liu, Andy, 1998. "Determinants of interest rate swap spreads," Journal of Banking & Finance, Elsevier, Elsevier, vol. 22(12), pages 1507-1532, December.
  11. Balsam, Steven & Kim, Sungsoo, 2001. "Effects of interest rate swaps," Journal of Economics and Business, Elsevier, Elsevier, vol. 53(6), pages 547-562.
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