Effectively hedging the interest rate risk of wide floating-rate coupon spreads

Abstract

Bond issuers frequently immunise/hedge their interest rate exposure by means of interest rate swaps (IRS). The receiving leg matches all bond cash flows, while the pay leg requires floating rate coupon payments of form LIBOR plus a spread. The goal of hedging against interest rate risk is only achieved in full if the present value of this spread is zero. Using market data it is shown that under a traditional IRS hedging strategy an investor could still experience significant cash flow losses given a 1 per cent shift in the underlying benchmark yield curve. Consideration is given to the instantaneous interest rate risk of a bond portfolio that allows for general changes in interest rates. Two contributions are made. The paper analyses the size of hedging imperfections arising from the widening of the floating rate spread in a traditional swap contract and subsequently proposes two new practical, effective and analytically tractable swap structures: Structure 1: an improved parallel hedge swap, hedges against parallel shifts of the yield curve; and Structure 2: an improved non-parallel hedge swap, hedges against any movement of the swap curve. Analytical representations of these swaps are provided such that spreadsheet implementations are easily attainable.