Fixed Income Analysis, Second Edition

CHAPTER 22

CONTROLLING INTEREST RATE RISK WITH DERIVATIVES³⁴⁷

I . INTRODUCTION

Previously, the features and characteristics of interest rate futures and swaps were explained. In addition, at Level II, the valuation of these derivative instruments was explained. In this chapter, our focus is on using derivatives to control the interest rate risk of a portfolio. Other uses for derivatives include speculating on interest rate movements and speculating on changes in interest rate volatility. These strategies are similar to those employed in the equity market and are not covered in this book.

II. CONTROLLING INTEREST RATE RISK WITH FUTURES

The price of an interest rate futures contract moves in the opposite direction from the change in interest rates: when rates rise, the futures price falls; when rates fall, the futures price rises. Buying a futures contract increases a portfolio’s exposure to a rate change. That is, the portfolio’s duration increases. Selling a futures contract decreases a portfolio’s exposure to a rate change. Equivalently, selling a futures contract that reduces the portfolio’s duration. Consequently, buying and selling futures can be used to alter the duration of a portfolio.

While managers can alter the duration of their portfolios with cash market instruments (buying or selling Treasury securities), using interest rate futures has the following four advantages:

Advantage 1: Transaction costs for trading futures are lower than trading in the cash market. ...