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

  • Thomas Schroeder

    (European Investment Bank and Sacred Heart University)

  • Kwamie Dunbar

    (University of Connecticut and Sacred Heart University)

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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Paper provided by University of Connecticut, Department of Economics in its series Working papers with number 2010-05.

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Length: 30 pages
Date of creation: Feb 2010
Date of revision:
Handle: RePEc:uct:uconnp:2010-05
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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  1. Lang, Larry H. P. & Litzenberger, Robert H. & Luchuan Liu, Andy, 1998. "Determinants of interest rate swap spreads," Journal of Banking & Finance, Elsevier, vol. 22(12), pages 1507-1532, December.
  2. Larry D. Wall & John J. Pringle, 1988. "Interest rate swaps: a review of the issues," Economic Review, Federal Reserve Bank of Atlanta, issue Nov, pages 22-40.
  3. Minton, Bernadette A., 1997. "An empirical examination of basic valuation models for plain vanilla U.S. interest rate swaps," Journal of Financial Economics, Elsevier, vol. 44(2), pages 251-277, May.
  4. Cossin, Didier & Pirotte, Hugues, 1997. "Swap credit risk: An empirical investigation on transaction data," Journal of Banking & Finance, Elsevier, vol. 21(10), pages 1351-1373, October.
  5. 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, vol. 16(4), pages 375-399.
  6. Li, Haitao & Mao, Connie X., 2003. "Corporate use of interest rate swaps: Theory and evidence," Journal of Banking & Finance, Elsevier, vol. 27(8), pages 1511-1538, August.
  7. Nance, Deana R & Smith, Clifford W, Jr & Smithson, Charles W, 1993. " On the Determinants of Corporate Hedging," Journal of Finance, American Finance Association, vol. 48(1), pages 267-84, March.
  8. Duffie, Darrell & Huang, Ming, 1996. " Swap Rates and Credit Quality," Journal of Finance, American Finance Association, vol. 51(3), pages 921-49, July.
  9. Sun, Tong-sheng & Sundaresan, Suresh & Wang, Ching, 1993. "Interest rate swaps: An empirical investigation," Journal of Financial Economics, Elsevier, vol. 34(1), pages 77-99, August.
  10. Bicksler, James & Chen, Andrew H, 1986. " An Economic Analysis of Interest Rate Swaps," Journal of Finance, American Finance Association, vol. 41(3), pages 645-55, July.
  11. Balsam, Steven & Kim, Sungsoo, 2001. "Effects of interest rate swaps," Journal of Economics and Business, Elsevier, vol. 53(6), pages 547-562.
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