CHAPTER 27Hedging Convexity Bias
Anyone who receives fixed on a fixed/floating interest rate swap and hedges the directional exposure with Eurodollar futures is long volatility—both implied and realized. Increases in expected interest rate volatility will increase the value of the swap relative to Eurodollar futures, and large, realized swings in interest rates produce profitable opportunities to rebalance the hedge.
The risks in such a position, though, are that implied rate volatility might fall or that rates may prove to be less volatile than was expected when the swap was priced. In either case, the position loses money. The purpose of this note is to ...