2 - The sovereign term structure and the risk structure of interest rates

Abstract

This chapter discusses how to price and hedge all sorts of interest sensitive instruments. An intelligent use of hedge ratios is to recognize that what one wants to do is to control risk, taking on the amount of risk he/she judge to be appropriate in the given circumstances of the market. From this point of view, one can think of the perfect hedge ratio as a benchmark. If one wishes to make no bet on the direction of interest rates then one can hedge using the perfect hedge ratio. The chapter also discusses the term and risk structure of interest rates. The term structure of interest rates is the schedule of sovereign interest rates organized by term to maturity. A sovereign bond investor experiences losses if interest rates increases unexpectedly. If the bond investor actually sells a sovereign bond once sovereign interest rates increase, then the loss is realized. But even if they do not sell the bond once interest rates have increased, an opportunity loss is experienced because they now have a bond that is not worth as much as they had hoped earlier. The risk structure of interest rates may be defined as a series of term structures, each of which is composed of a series of yields on corporate bonds of the same credit risk class organized by term to maturity.