Financial Instruments and Markets: A Casebook

5

Ticonderoga: Inverse Floating Rate Bond

Late in the evening on December 17, 2004, David Talbot, founder and partner of London-based hedge fund group Ticonderoga Management, stepped into the office of Greg Bower, responsible for the fund's capital management overview. Like all hedge funds, Ticonderoga had a capital management function that monitored the trading risk of the hedge fund's portfolio. Many trades that entered the hedge fund's portfolio came with risk types that the hedge fund was not comfortable holding—and it was Bower's role to make sure such risks were hedged out and fully passed on.

When deciding which risks to hedge out, Bower followed a policy put in place by Ticonderoga's Investment Committee, which was made up by the fund's partners. The policy's main rule was that the fund should not take any bets on interest rates; all interest rate exposure should be completely hedged out. The fund implemented this policy by duration and convexity hedging its portfolio. It typically utilized cash instruments in addition to interest rate derivatives to accomplish this hedge.

This evening, Bower had an interesting story to tell Talbot. A recently proposed trade would bring with it some fairly large interest rate exposure, and Talbot was trying to figure out how to hedge the interest rate exposure and what the consequences of a hedge might be. He explained,

It is a trade that has been proposed to us by a small merchant bank and Shannon at the trading desk would like us to ...