HEDGING SWAPS

Dealers at commercial banks do most of the market making that is done in the interest rate swap and currency swap markets. In addition to making markets to their customers, these traders will also make prices to other financial institutions in the wholesale or interbank market, often in transactions facilitated by interbank brokers. In any given day, the dealer at the bank may engage in several transactions or several dozen transactions, all of which are added to his general position. The combination of all of the different swaps and bond trades and futures trades that the dealer has conducted constitutes a portfolio.

While it may be easier for us to understand intuitively the way in which the dealer manages the risk of an individual swap transaction, in practice this is prohibitively difficult and it does not take advantage of the natural hedges within the portfolio. Therefore, the swaps dealer will manage the risks of his position using portfolio management techniques that are similar to but more sophisticated than the portfolio management techniques used for a simple cash position in fixed income or equities.

In portfolio hedging, the dealer's objective is to construct a portfolio of hedges using swaps, forward rate agreements (FRAs), futures and bonds the changes in value of which offsets the change in value of the underlying swap portfolio for a given set of fluctuations in interest rates, currency rates or basis between the futures and the bonds.

Identifying the risk of the swaps portfolio

The first necessary step in hedging the swaps portfolio is to measure the risk of the swaps portfolio. Namely, the dealer must answer a series of questions. How much will the portfolio lose on a mark-to-market basis if interest rates move up in a parallel fashion (i.e. all interest rates increase by the same amount) by 50 basis points? How much will the portfolio lose on a mark-to-market basis if interest rates fall in a parallel fashion by 50 basis points? How much will the portfolio lose if the spread between the 30-year government bond and the 2-year government note increases by 25 basis points? How will the position's sensitivity to interest rates change if the level of interest rates change?

After reading the earlier articles on "Measuring Risk" and "An Introduction to the Hedging Greeks", the reader will recognize that the greeks are one useful way for measuring these kinds of sensitivities.

Cash flows are grouped in maturity buckets (or intervals of consecutive maturity). One example might be all of the cash flows from 1 year to 1 year and 3 months. Another example might be all of the cash flows from 29 years to maturity to 30 years to maturity. These grouped cash flows are then valued at market rates. Doing so enables the dealer to get a true picture of the cash flow's local sensitivity to market rates. The sensitivity of the portfolio maturity bucket may be dependent on the level of interest rates because of the convexity of fixed income flows.

One way of looking at the delta is just the fixed income instrument with a term to maturity equal to the average maturity for the interval in question that is as sensitive in profit and loss terms to small changes in the interest rate for that bucket as the swaps portfolio is for that bucket.

Similarly, the gamma is an expression of the changes in the position size (i.e. the changes in the delta) for changes in the level of interest rates.

Vega is the sensitivity of the portfolio to changes in implied volatilities for at-the-money options associated with the maturity bucket in question. This may be important, for example, if the portfolio contains swaptions.

In categorizing the risk of the swaps portfolio, the dealer must look at different types of yield curve risk including parallel shifts in the yield curve, non-parallel shifts in the yield curve and changes in swap spreads. Sophisticated dealers may incorporate some assumptions about the correlation between swap spreads and interest rates in doing their scenario analysis. It may be reasonable to believe that swap spreads will widen out if interest rates back up because of degrading credit conditions, for example.

Constructing the hedge portfolio

The dealer will then take this analysis of the behavioural characteristics of the swap portfolio and he will construct a hedging portfolio using one or more financial instruments in order to offset those aspects of the risk that he is unhappy carrying. Note that the dealer will not close out all of the aspects of the risk.

Why will the dealer only partially hedge the swaps portfolio?

Hedging costs money. The main benefit of hedging activity is to reduce the risk of the portfolio. This benefit must be compared to the hedging cost. If the marginal benefit of reducing the risk with an individual transaction is less than its marginal cost, it is not worthwhile to hedge that risk.

Another reason for not completely hedging the swaps portfolio is the fact that the dealer may carry a proprietary position in one or more aspects of the risk. If, for example, he thinks that interest rates are going to fall in the 2-year to 3-year bucket, he may be happy to continue received fixed interest payments for that period. If he is correct, he will make money on a mark-to-market basis that he can realize by hedging the position at a preferable level.

Floating rate cash flow management

One of the more difficult aspects of managing a swap portfolio is managing the short-term cash flows or the floating rate cash flows. There are two problems that confront the dealer.

First, there may be mismatches in the timing of short-term cash flows.

Consider a hedge that was entered into two years ago to hedge a two year fixed-floating plain vanilla interest rate swap where the hedge transaction took place a week after the initial customer transaction. Unless the dealer matched the dates precisely at the time he conducted the hedge transaction, there will be a one-week mismatch of flows. Matching the dates may have cost extra money in terms of the market prices at the time of transaction making it too expensive to match the timing of the cash flows. Some people might argue that one week is not very much of a difference. That is no way to run a business. To paraphrase an old saying, ten grand here and one hundred grand there and pretty soon you're talking about some real money.

Second, there may be mismatches in the type of index used to hedge.

Consider a swap in which the floating rate index is the 3-month US Bankers' Acceptance rate. If the best swap available at the time is the 3-month US LIBOR (London Interbank Offered Rate for US dollars), then there is an index mismatch risk. If the correlation between these two indices changes (and correlation between financial indices is rarely stable), then the swap portfolio is exposed to refunding risk.

One way for the commercial bank to hedge its floating rate cash flows is to establish a separate book dedicated to hedging such risks, one which participates actively in the futures markets such as the IMM Eurodollar market and one which takes aggressive positions in short-term interest rates.

An alternative might be to pay the hedging costs necessary for closing out the mismatches. This can get expensive. With the increased commoditization of global derivatives markets, dealers are losing much of their pricing edge, a phenomenon that makes paying for outside hedging more difficult.

By giving an appreciation for the way swaps dealers manage their combined portfolio risk, this article has identified some of the key types of risk in interest rate swaps and interest rate products, generally.