Understanding and Hedging Interest Rate Risk

The interest rate market is both a global and local market which affects both borrowers and lenders worldwide.  Interest rates are the backbone to the housing markets and are the driving force behind consumer sentiment on a retail level as they influence credit card purchases, home loans, and business loans.  Similar to business on a retail level, institutional businesses fund their daily operations using overnight interest rates which help manage cash flows. This article will analyze interest rate risk, and discuss some of the ways investors can speculate and hedge interest rate exposure. [Also See: How to Minimize Investment Risk]

The Markets

The most liquid debt instruments that allow investors to quickly enter and exit the market are sovereign developed government rates. Debt from municipalities and corporation, follow debt from governments in terms of liquidity.

The changes of medium and longer term interest rates are a function of market supply and demand. Short term rates (rates less than 1 year) are influence more by monetary policy than market forces. Monetary policy is guidelines used by a central bank within a country to control target overnight interest rates along with money supply. Central banks usually have a mandate of price stability but many central banks have multiple mandates which include employment and growth.

The central bank of a country will target lower rates when growth is contracting and prices are falling. On the other hand, a central bank will desire higher interest rates when employment and growth are expanding and prices are rising.  In the US, the central bank generally uses the fed funds rate and discount rate to change short term interest rates.

Adjustments that central banks make to short term interest rates spill over into the secondary market influencing both short term and long term rates. Short term rates are greatly influenced by changes in monetary policy, while longer dated rates are influenced by market forces.

Risk

Interest rate risk is inherent in many products despite the lack of specific interest rate product which provide direct exposure to interest rate risk.  In a case where an individual investor has a portfolio of equities, the present value of the portfolio is generated by the current cash flows of the portfolio.

The net present value of a portfolio examines future unrealized gains and losses to calculate the current value of a portfolio. For example, trades that produce realized gains three years from the present would use a 3-year yield to determine the current present value. Additionally if an investor has interest rate products within a portfolio, these products will fluctuate in value based on currency interest rates movements.

Market Forces

Changes in yields are described per a basis point which is 1/1000 of a percent. When describing the interest rate risk of a portfolio the nomenclature refers to the dollar value per basis point, which is commonly written as DV01. Changes in an interest rate market can have a significant effect on an investor’s portfolio.

Hedging Risk

Interest rate exposure as discussed early is a function of unrealized or realized future gains or direction market exposure.  An investor can hedge future gains with interest rate products that mitigate their exposure to fluctuations in rates. Investors can use an ETF’s (for example – NYSE:TLT) or futures products to hedge exposure by shorting an interest rate product that gains in value as interest rates rise.

Additionally, there will be times that individual investors will initiate interest rate positions in an attempt to produce profits from directional movements within the interest rate market.

To initiate an interest rate position, an investor could purchase or short (sell) an interest rate product, such as a bond or swap or futures contract or ETF. These products prices move higher as interest rates move lower, and lower as interest rates move higher.

When hedging an interest rate position, an investor can generally calculate their DV01 and look for a financial instrument that could offset the risk created by the portfolio.  Most hedging cannot be offset completely, which creates a mismatch called basis risk exposure.

Summary

Interest rate risk is generally a function of direct speculation to the debt market or the hedging of unrealized gains or losses created by financial products. Debt risk can be offset by hedging using specific financial products that have the same tenor of the portfolio risk.

Rate risk within a portfolio can be measured by duration and convexity along with any interest rate basis. Shorter term interest rate risk is heavily influenced by monetary policy while longer term interest rate exposure fluctuates with market forces. Understanding interest rate risk is a key component to successful portfolio management. Investors can use a number of financial products to hedge their exposure to interest rates.