Hedging Fixed-Income Rate Risk with Futures and Swaps
Summary
The note outlines ways to offset interest-rate exposure in a corporate bond using interest-rate futures or swaps. For a futures hedge, it recommends comparing the bond’s DV01 with the DV01 of the futures contract’s cheapest-to-deliver bond, using a contract with a maturity close to the bond’s. The resulting ratio estimates how many contracts to sell against a long bond position. The example also accounts for the futures contract’s delivery size and notes that the hedge must be recalculated as contracts expire.
For swaps, the note suggests a payer-fixed, receiver-floating swap with a maturity and notional matched to the bond position. It characterizes swaps as less straightforward to adjust than exchange-traded futures and proposes examining how changes in swap rates affect the swap’s value and offset bond P&L. These are simplified interest-rate hedges: the note does not explain basis risk, changing durations, curve exposures, transaction costs, or how to hedge the distinct prepayment, credit, and currency risks raised in its opening question.
Key ideas
- DV01 provides a way to compare the interest-rate sensitivity of a bond with that of a futures delivery bond.
- A futures hedge ratio can be estimated by dividing the bond exposure’s DV01 by the cheapest-to-deliver bond’s DV01, with contract size accounted for.
- Futures hedges need review when contracts expire.
- A payer-fixed swap can offset interest-rate exposure in a bond position when maturity and notional are matched.
- The note does not provide a method for isolating mortgage prepayment, credit, or currency risks.
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# Hedging Ratios for Fixed Income Instruments # Hedging Ratios for Fixed Income Instruments If you buy a corporate bond and you want to hedge the interest rate risk, how would you know how many interest rate futures/swaps to hedge the bond with? The same with an MBS security, if you want to isolate the prepayment risk how do you work on the hedge ratios for the interest rate risk, any (small) credit risk, fx risk? ## Answer by Mike Kipnis (score 3, accepted) https://quant.stackexchange.com/a/41357 Hedging with futures - Calculate DV01 of your corporate bond - Calculate DV01 of the cheapest to deliver of the future contact that is closest to the maturity of your bond - Ratio between DV01 of Cheapest to Deliver and DV01 of your corporate will give you a number of future contract that you will have to sell in order to be hedged. I.e. if you are long 5 Million corporates with dv01 of 500 per million whereas dv01 of CTD is 400, you will need to sell 62.5 contacts of 5 YEAR future contract : 5500/40010 = 62.5; You need to multiply by 10 because futures trade in 100k lots. Because futures expire every 3 months, you will need to repeat this process every time futures expire. You may calculate DV01s on the following website: https://www.opencminc.com (this is my website) - Switch to Bond section in the calculator window panel - Setup term structure of your bond, DV01 will be automatically calculated in the result section. - Pick cheapest to deliver in the Quick Fixed Rate Bond Section, in-order to calculate its DV01. Hedging with interest rate swap Hedging with interest rate swaps is more expensive because you can’t just buy or sell them in-order to delta hedge. Each trade is a bilateral contact that can be difficult to amend. You can think of them as insurance policies against the changes in interest rates rather than as securities. But if you choose to hedge with IRS then you are better of entering the contact against the entire notional of you position. i.e. if you long 1 million 5 Year note, you want to enter a 5 year interest rate swap contact as a payer of fix rate and a receiver of float with 1 million dollar notional. - Switch to interest rate swap section of the website above - Select 5Y in the Quick Vanilla Swap Calculator section, hit setup - Shift Spread(bps) up and down to see how changes in swap rates with effect NPV of your swap trade, hence offset you P&L in bonds
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.