Hedging Bond Interest Rate Risk
In bond investment, interest rates are very crucial in the process of determining the outcome of a given investment. The asset manager should ensure that Interest rates are analyzed and handled in a way which makes them profitable (Burghardt, Belton, Lane & Papa, 2005). Hedging the interest rate risk of bonds is one of the best ways to ensure that bonds are beneficial to the holder. Hedging the bond interest rates is one of the commonly used methods. This is because it ensures that the asset stays stable in the market. This is because the interest rate is one of the things that hit asset investments the most.
With the data below, the number of futures to be sold for full hedging of the interest rate risk can be derived.
Notional/Amount = eur 1,000,000
Security = Schatz
Term = 2 year on-the-run
According to http://www.eurexchange.com, Schatz Futures are offered at 1.75 to 2.25
Bond price=110.30
The CTD Price=CTD Index * Bond price
Therefore, the CTD Price=1.75(110.30) =193.025
The duration=2 years
Conversion factor=1.285
Number of bond futures that should be sold = (Benchmark Duration – Portfolio Duration)*Portfolio Value. / (BondPrice (CTDIndex)*ContractSize*Duration (CTDIndex)*ConversionFactor (CTD Index)
The duration targeted is 2 years.
The Schatz bonds are for four quarters, thus the portfolio duration=1 year
The bonds are in 100,000; therefore, the number of 100,000 bonds in 1 million portfolio size is 10. This gives the contract size.
= (2-1)*1,000,000/110.3(1.75)*10*2(1.75)*1.285
=1,000,000/8681.299=115.1901
=115.19 Futures
The asset manager should ensure that 115.1901bond futures are sold so as to hedge the bond interest risk fully. This will be able to make the bond investment safe. The formula chosen is usually useful in ensuring that it captures the various components required in bond interest rate hedging.
The fact that the prices of the bonds seem stable is a very encouraging aspect. This is because handling bond interest rates in an environment where stability is present becomes very easy. It is worth noting that volatility in asset prices is a major drawback in the process of hedging interest rate risk (Krgin, 2002). The asset manager should take advantage of this fact and make long strides in delivering benefits to the asset owners. This is because continued stability will keep on accumulating benefits to the bond owners, but only when there is proper asset management.
References
Burghardt, G., Belton, T., Lane, M & Papa, J. (2005). The Treasury Bond Basis. New York, NY: McGraw-Hill.
Krgin, D. (2002). Handbook of Global Fixed Income Calculations. New York, NY: John Wiley & Sons.
