R22 - Hedging interest rate risk using futures, swaps, and options Flashcards
Formula for number of contracts needed
Nf = ( (Dr - Dp)Vp / (DctdPctd) ) x CF x Yield Beta
Dt = target portfolio duration
Dp = current duration
Vp = value of portfolio
Dctd = duration of cheapest to deliver bond and futures
Pctd = price of cheapest to deliver bond
CF = ctd conversion factor
Yield Beta = ratio of yield changes for item to hedge and ctd
Bond hedging risks:
- basis risk
- cross hedging risk
- changing contract characteristics due to seller’s delivery options
- other
What is “basis” and basis risk?
Basis is difference between spot price of asset and futures price
Basis risk is risk that basis changes in unexpected ways (contract expiration basis converges to 0 = not unexpected so not a risk)
What is cross hedging risk?
When bonds hedged not identical to bond underlying contract
What are risks inherent in Seller’s delivery options?
Quality option (deliver any acceptable bond) Timing options to deliver at any point in delivery month Wild card option to decide delivery in evening but be paid based on afternoon price
Characteristics of best contract for a hedge?
- expiration of contract matches desired period
- high correlation with futures price and price of hedged asset
- contract is liquid
Hedging using swaps: fixed vs floating, receive vs pay
Fixed rate bonds have high duration; floating rate bonds have low.
Enter into swap to receive fixed to increase portfolio duration; pay fixed to decrease it
Long call vs long put interest rate futures contract on an interest rate option
Long call gives right to purchase interest rate futures contract
Long put gives right to sell interest rate futures contract
Option duration formula
D-option = delta-option*(D-underlying)(P-underlying/P-option)
D-option = duration of option D-underlying = duration of underlying P-x = Price
