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

Author

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  • Thomas Schroeder

    (European Investment Bank and Sacred Heart University)

  • Kwamie Dunbar

    (University of Connecticut and 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.

Suggested Citation

  • Thomas Schroeder & Kwamie Dunbar, 2010. "Effectively Hedging the Interest Rate Risk of Wide Floating Rate Coupon Spreads," Working papers 2010-05, University of Connecticut, Department of Economics.
  • 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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    References listed on IDEAS

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    1. 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.
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    3. Balsam, Steven & Kim, Sungsoo, 2001. "Effects of interest rate swaps," Journal of Economics and Business, Elsevier, vol. 53(6), pages 547-562.
    4. 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.
    5. 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.
    6. 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.
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    More about this item

    Keywords

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

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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