Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 20. Hedging Fixed Income Securities with Interest Rate Swaps

SHRIKANT RAMAMURTHY

Managing Director, RBS Greenwich Capital

Abstract: The interest rate swap market has grown at such a phenomenal pace because swaps can be used in so many different ways by a variety of market participants. Today, swaps are used by issuers to match their funding requirements while still tailoring bonds to match investor demand; they are also used by a variety of participants for asset/liability management. They can be a vehicle for speculating on a financed basis on interest rates and for hedging interest rate risk.

Keywords: hedging, interest rate swaps, swap rate, swap spread, interest rate sensitivity of a swap, dollar value of a basis point (DVBP), hedge ratio, hedge instrument

This chapter explains how fixed income securities can be hedged using interest rate swaps. Although different types of interest rate swaps exist, including vanilla swaps, basis swaps, indexed-amortizing swaps, and callable swaps, to name a few, this chapter focuses on generic interest rate swaps as hedge instruments.

The discussion begins with a brief description of the characteristics of interest rate swaps and how a swap can alternatively be viewed as a financed bond position. This alternate view is particularly useful in the hedging context. We then focus on the valuation and interest rate sensitivity of swaps and go on to develop hedge ratios and hedge strategies using swaps. As we shall illustrate, hedging with swaps ...