Dealers at commercial banks do most of the market making that is done in
the interest rate swap and currency swap markets. In addition to making markets
to their customers, these traders will also make prices to other financial
institutions in the wholesale or interbank market, often in transactions
facilitated by interbank brokers. In any given day, the dealer at the bank may
engage in several transactions or several dozen transactions, all of which are
added to his general position. The combination of all of the different swaps
and bond trades and futures trades that the dealer has conducted constitutes a
portfolio.
While it may be easier for us to understand intuitively the way in which the
dealer manages the risk of an individual swap transaction, in practice this is
prohibitively difficult and it does not take advantage of the natural hedges
within the portfolio. Therefore, the swaps dealer will manage the risks of his
position using portfolio management techniques that are similar to but more
sophisticated than the portfolio management techniques used for a simple cash
position in fixed income or equities.
In portfolio hedging, the dealer's objective is to construct a portfolio of
hedges using swaps, forward rate agreements (FRAs), futures and bonds the
changes in value of which offsets the change in value of the underlying swap
portfolio for a given set of fluctuations in interest rates, currency rates or
basis between the futures and the bonds.
Identifying the risk of the swaps portfolio
The first necessary step in hedging the swaps portfolio is to measure the risk of the swaps portfolio. Namely, the dealer must answer a
series of questions. How much will the portfolio lose on a mark-to-market basis
if interest rates move up in a parallel fashion (i.e. all interest rates
increase by the same amount) by 50 basis points? How much will the portfolio
lose on a mark-to-market basis if interest rates fall in a parallel fashion by
50 basis points? How much will the portfolio lose if the spread between the
30-year government bond and the 2-year government note increases by 25 basis
points? How will the position's sensitivity to interest rates change if
the level of interest rates change?
After reading the earlier articles on "Measuring Risk" and "An Introduction to the
Hedging Greeks", the reader will recognize that the greeks are one
useful way for measuring these kinds of sensitivities.
Cash flows are grouped in maturity buckets (or intervals of consecutive
maturity). One example might be all of the cash flows from 1 year to 1 year and
3 months. Another example might be all of the cash flows from 29 years to
maturity to 30 years to maturity. These grouped cash flows are then valued at
market rates. Doing so enables the dealer to get a true picture of the cash
flow's local sensitivity to market rates. The sensitivity of the portfolio
maturity bucket may be dependent on the level of interest rates because of the
convexity of fixed income flows.
One way of looking at the delta is just the
fixed income instrument with a term to maturity equal to the average maturity
for the interval in question that is as sensitive in profit and loss terms to
small changes in the interest rate for that bucket as the swaps portfolio is
for that bucket.
Similarly, the gamma is an expression of the
changes in the position size (i.e. the changes in the delta) for changes in the
level of interest rates.
Vega is the sensitivity of the portfolio to
changes in implied volatilities for at-the-money options associated with the
maturity bucket in question. This may be important, for example, if the
portfolio contains swaptions.
In categorizing the risk of the swaps portfolio, the dealer must look at
different types of yield curve risk including parallel shifts in the yield
curve, non-parallel shifts in the yield curve and changes in swap spreads.
Sophisticated dealers may incorporate some assumptions about the correlation
between swap spreads and interest rates in doing their scenario analysis. It
may be reasonable to believe that swap spreads will widen out if interest rates
back up because of degrading credit conditions, for example.
Constructing the hedge portfolio
The dealer will then take this analysis of the behavioural characteristics
of the swap portfolio and he will construct a hedging portfolio using one or
more financial instruments in order to offset those aspects of the risk that he
is unhappy carrying. Note that the dealer will not close out all of the aspects
of the risk.
Why will the dealer only partially hedge the swaps portfolio?
Hedging costs money. The main benefit of hedging activity is to reduce the
risk of the portfolio. This benefit must be compared to the hedging cost. If
the marginal benefit of reducing the risk with an individual transaction is
less than its marginal cost, it is not worthwhile to hedge that risk.
Another reason for not completely hedging the swaps portfolio is the fact
that the dealer may carry a proprietary position in one or more aspects of the
risk. If, for example, he thinks that interest rates are going to fall in the
2-year to 3-year bucket, he may be happy to continue received fixed interest
payments for that period. If he is correct, he will make money on a
mark-to-market basis that he can realize by hedging the position at a
preferable level.
Floating rate cash flow management
One of the more difficult aspects of managing a swap portfolio is managing
the short-term cash flows or the floating rate cash flows. There are two
problems that confront the dealer.
First, there may be mismatches in the
timing of short-term cash flows.
Consider a hedge that was entered into two years ago to hedge a two year
fixed-floating plain vanilla interest rate swap where the hedge transaction
took place a week after the initial customer transaction. Unless the dealer
matched the dates precisely at the time he conducted the hedge transaction,
there will be a one-week mismatch of flows. Matching the dates may have cost
extra money in terms of the market prices at the time of transaction making it
too expensive to match the timing of the cash flows. Some people might argue
that one week is not very much of a difference. That is no way to run a
business. To paraphrase an old saying, ten grand here and one hundred grand
there and pretty soon you're talking about some real money.
Second, there may be mismatches in the type of index used to hedge.
Consider a swap in which the floating rate index is the 3-month US Bankers'
Acceptance rate. If the best swap available at the time is the 3-month US LIBOR
(London Interbank Offered Rate for US dollars), then there is an index mismatch
risk. If the correlation between these two indices changes (and correlation
between financial indices is rarely stable), then the swap portfolio is exposed
to refunding risk.
One way for the commercial bank to hedge its floating rate cash flows is to
establish a separate book dedicated to hedging such risks, one which
participates actively in the futures markets such as the IMM Eurodollar market
and one which takes aggressive positions in short-term interest rates.
An alternative might be to pay the hedging costs necessary for closing out
the mismatches. This can get expensive. With the increased commoditization of
global derivatives markets, dealers are losing much of their pricing edge, a
phenomenon that makes paying for outside hedging more difficult.
By giving an appreciation for the way swaps dealers manage their combined
portfolio risk, this article has identified some of the key types of risk in
interest rate swaps and interest rate products, generally.
Article by Chand Sooran, Principal Victory
Risk Management Consulting, Inc.
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