Interest Rate Markets: A Practical Approach to Fixed Income

Chapter 8

Hedging Risks in Interest Rate Products

Chapters 6 and 7 discussed different techniques investors use to profit in the rates market, either from taking outright views on the yield curve or through carry and relative value trades. These methods pertain to taking advantage of a view on interest rates, relating to either specific trends or rangebound conditions. This chapter considers hedging, which focuses on controlling different risks that arise in any trade. The term hedging refers to transacting in an offsetting manner relative to the current holdings of an investor in order to reduce a particular risk to the transaction. Recall from Chapter 2 that a single bond has a package of risks embedded in it, such as interest rate risk and taxation risk. With more complex trades, the range of embedded risks increases and more sophisticated methods of hedging are required. The goal of hedging in general is to reduce exposure of a risk in the market; in this chapter, we will focus on interest rate risk given that it is a dominant risk for a wide variety of fixed income instruments. Often, investors view speculation and hedging as separate—speculators are supposed to have a view on rates and trade based on that view, while hedgers are supposed to be involved purely for risk offsetting purposes. However, such a view can be misleading. Hedging is essential to understand not just for investors looking to offset risks but also for traders expressing views in the market. Traders also ...