Interest rate risk management: Hedging misspecification in interest rate swaps.
详细信息
文摘
An interest rate swap is a financial agreement between two parties who agree to make single currency-denominated periodic interest rate payments to each other at predetermined intervals. The interest rate swap market has grown forty percent annually since 1990 according to the International Swap and Derivatives Association (ISDA). As the interest rate swap market expands rapidly and longer-dated swaps become more available, the significance of hedging swap portfolios has become more pronounced. In a volatile interest rate environment, interest rate swap portfolios are exposed to a volatility-related risk known as convexity bias. An interest rate risk measure, called Duration, represents the price sensitivity to changes in interest rates. A duration-based hedging strategy determines the appropriate number of hedging instruments to minimize volatility-related interest rate risks. Market participants can hedge their swap portfolios by buying or selling short-term interest rate futures contracts, which have an identical floating-rate base. However, duration-based hedging strategy is appropriate only for small changes in interest rates. For large changes in interest rates, investors should consider convexity, illustrating the nonlinear relationship between the security price and interest rates. While short-term interest rate futures contracts have linear profit/loss functions, interest rate swaps have convex profit/loss functions. Convexity bias (CB) is defined as the spread between the convex payoffs of an interest rate swap and the linear payoffs of a hedging instrument. Therefore, market participants hedge their positions by adjusting the convexity bias under the duration-based hedging strategy in a volatile interest rate world.;This study examines the interest rate swap hedging misspecification, which arises in the conventional duration-based approach of measuring convexity bias. The major contribution of this study is the building of a term structure of convexity bias consistent with market-observed interest rate volatilities given the term structure specification. This study integrates conventional and new efforts in order to estimate the convexity bias more accurately under an arbitrage-free framework. This study also demonstrates that the model-based, convexity bias-adjusted hedge ratio, which is employed in this study, significantly enhances the performance of the hedging strategy since it incorporates market views on the stochastic interest rate process.