Separating USD Rate, Sovereign Spread, and Local-Currency Risk in Bond Hedges

# Hedge Active Duration by Issue Currency or Country of Risk


# Hedge Active Duration by Issue Currency or Country of Risk












For example, lets say I own a bond issued by a company in Mexico that's denominated in USD and I want to hedge my duration exposure. I obviously need to hedge duration to the US yield curve. Do I also need to hedge my duration to the local Mexican gov yield curve? Even thought the MEX bond is denominated in USD, I feel like it should still move relative to the MEX gov yield curve. Thanks.

## Answer by Dimitri Vulis (score 0, accepted)

https://quant.stackexchange.com/a/57877

Suppose that you are long a USD-denominated foreign corporate bond, external-law I assume. Your exposures are:

- The risk-free USD interest rate (unless your corporate bonds are floaters). You can hedge it with USD IR swaps, US treasuries, etc.

- The additional spread of USD-denominated external-law sovereign bonds (United Mexican States - UMS) on top of the risk-free USD rate. If you don't want to earn carry by keeping this exposure, you can short fixed-coupon UMS bonds, which will also reduce your risk-free IR exposure above. In theory you could also buy CDS protection on the sovereign.

- The additional idiosyncratic spread of your bond on top of UMS. You can't really hedge it. (In case of Mexican quasi-sovereigns like PEMEX and CFELEC, there isn't a lot.) However you can monitor your exposures to these spreads by country, by industry (e.g., assume that America Movil spread is correlated to other telecoms, Cemex spread is correlated to Heidelberg Cement and lafarge, etc) and rating (assume that all A's, BB', etc in the world are correlated, especially IG ratings).

You have no exposures to the foreign local-currency interest rate curves or the foreign exchange rate. They probably have significant correlation to the USD interest rate and to the sovereign spread, but you can't hedge them. If you had these exposures elsewhere in your portfolio, then the VaR would reflect the correlation.

You could get exposure to the foreign interest rate and FX if you added a cross-currency asset swap to your portfolio - you pay to someone the USD cash flows of your bond, and you receive local currency fixed or floating. (But you have to consider the possibility that the corporate bond defaults and you're stuck with the asset swap.) Then if you receive fixed local currency, you have local IR exposure, that you can hedge with local treasury bonds (MBONOs) or an IR swap; and you also get the FX exposure.

If you stop thinking about "hedging duration" and start thinking about hedging your dollar exposure to a change in a particular key rate or spread, everything will become much clearer.