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Polkin A.S.
Master student, Bachelor of Economics Financial University under the Government of Russian Federation
Tutor: Kazakova A. V. Moscow, Russia INTEREST RATE RISK HEDGING: PROS AND CONS One of the ways to manage and prevent interest rate risks is hedging. Insuring possible losses is assessed as a reliable safeguard against poor decisions, which exceeds the responsibility for the choice of an optimum strategy. The primary aim of hedging along with protecting from unfriendly environment of the dynamics of the interest rate is profiting when the dynamics of the interest rate have a positive spin.
Traditionally we classify hedging according to scale - micro-hedging (hedging of profits in accordance with specific requirements and obligations) and macro-hedging (hedging of aggregate profit or net interest yields). The first type of hedging is employed to protect profit received from key operations. The second type of hedging is used as a supplementary instrument for overcoming the lag that exists in the management of the assets' and liabilities' management based on the GAP method.
Interest rate risk hedging may be structural or may be conducted with the help of market instruments (pic.1)
Pic. 4: Types and means of interest rate risk hedging
Structural hedging is based on the optimization of the ration between interest yields and costs of interest payments. This way is the least costly and the simplest, it allows companies with large credit load to lower the level of interest risks.
Hedging methods with the usage of market instruments are based on loans, futures, options and other instruments.
We should note certain peculiarities of hedging in context of different model of managing interest rate risks of a company: if hedging based on GAP contributes to the increase in the level of proximity between short-term cash flows, then hedging through duration established portfolios of assets and liabilities, the value of which changes according to the changes of the interest rate.
Here the hedge is a separate combination or a part of a different strategy. Hedging has several stages:
- Achieving the planned financial result; the more - the better;
- Achieving the planned financial result - the less - the better;
- Achieving the planned financial result with a set acceptable minimum;
- Achieving the planned financial result with a set acceptable maximum;
- Maintain status quo. In this case any deviation from the current situation is considered unacceptable.
Hedging in passive strategies allows to close GAP in order to immunize the interest margin. The aim of immunization is to minimize the interest rate risk, its graphic interpretation can be seen on pic.2.
Стоимость, V(t)
V(yi)
Kvi) Piy)
V(y)
V(yJ
P(yr) Г
время, t
r
Pic. 5: Duration window
The solid line on the graph reflects the value of the portfolio if the interest rate is stable. The immunized portfolio at a given moment it time t should have equal value despite of the direction and the amount of interest rate. Therefore, the principle of this strategy is as follows: in order to make the portfolio independent from parallel shifts of the yield curve, the duration of the portfolio has to be equial to the planned investment horizon t. The immunization strategy requires revising the portfolio should any significant changes of the interest rates occur after a certain period of time, which is an element of active measures1.
The active strategy can be based on acquiring a market portfolio in combination with loans. The portfolio includes more assets with a positive a2 and less assets with a negative a. A very important issue is the appropriate choice of securities and estimating the weight of risk and non-risk assets in the portfolio. This depends on the estimated profitability and risk of these groups of assets and on the quotient of acceptability of risk for the client.
Return on assets of each of the groups usually has a high level of correlation, therefore it is important to determine the most profitable asset in the group.
Then it is necessary to choose assets within each category. In this case the choice is important in case if the operator of the market agrees with the situation on the market in terms of the majority of assets, but believe that some of them are improperly evaluated. In that case assets with a more positive alfa are of greater importance. There is an additional opportunity when the manager distributes resources among groups within each category, for example, between short-term,
1 Interest rate risk estimation: a new duration-based approach, Applied Economics, Volume 45, Number 19, 1 July 2013 , pp. 2697-2704(8)
2 а (альфа) - is a difference between expected return of the asset and equilibrium expected return, in other words it is a return which market require with that level of risk
medium-term and long-term bonds, stocks in different spheres of economy3.
An example of hedging in active strategies is strategies of the relative value group, for, example, arbitrage of convertible securities. The source of yield of active strategies of the market hedging group is in the isolation of yield strategy from the yield of the main category of assets. The risk in such strategies isn't completely excluded, which explains their usage for increasing yield. Typical structure of the position based on the principles of the market hedging strategy is different from the position based on the strategy of relative value, because hedging strategies combine basic long positions with selling short-term instrument (while strategies of relative value combine long positions and selling short-term stocks, i.e. basic assets)
There are also strategies that provide protection for the capital funds, based on the combined method of portfolio management. These strategies allow to guarantee safety of the capital value of the portfolio by a certain moment in the future, at the same time participating in the growth of the risk asset. Such strategies are usually used by investors who try to circumvent high risks but at the same time are interested in using financial instruments and their derivative (pension funds and insurance companies). One of these strategies will be explored and tried in the following chapters.
To sum up, we can draw the conclusion about the unviability of estimating interest rate risks as a possibility of decreasing income from transactions as a consequence of force majeure with interest rates as well as of distribution of financial instruments of economic entities.
Fluctuations of interest rates put portfolio and investments under risk. The main factors, that determine changes in the level of interest rates, are increasing money in circulation, dynamics of the level of prices, national income growth ration, the state of governmental budget. The shape of the yield curve depends on how investors' expectations change overtime. The amplitude of fluctuations of market value of the portfolio is determined by durations of bonds, which it includes, and the level of stability of common risk-factors. In order to minimize interest rate risks we should use hedging methods and strategies that are determined by investor's predisposition to risks.
List of references:
1. Interest rate risk estimation: a new duration-based approach, Applied Economics, Volume 45, Number 19, 1 July 2013 , pp. 2697-2704(8)
2. Christoffersen, P. F. (2003). Elements of Financial Risk Management, AcademicPress.
3 Christoffersen, P. F. (2003). Elements of Financial Risk Management, AcademicPress.
