7 - Hedging sovereign bonds: The traditional approach

Abstract

This chapter discusses the hedging positions in interest sensitive instruments. The chapter begins by reviewing the traditional duration approach to hedging long positions in sovereign securities. To appreciate the strengths and weaknesses of this approach, one needs to fully understand its duration and convexity. The chapter explores the construction of several hedge ratios and then demonstrates the most common methods of hedging long positions in sovereign bonds. The chapter discusses some measures of interest rate sensitivity such as the Macaulay duration. The chapter also discusses bond futures contracts. These contracts are an attractive hedging instrument because (1) pricing is transparent, (2) the bond futures contract tends to be very liquid where the risk of delivery squeezes is minimized, (3) the contract is exchange traded with little or no counterparty risk, and (4) the hedger chooses when to terminate the hedge. The chapter concludes with a discussion on basis risk.