Most of the market making in the interest rate swap and currency swap markets is done by dealers at commercial banks. In addition to making markets to their customers, these traders will also make prices to other financial institutions in the wholesale or interbank market, in transactions that are often facilitated by interbank brokers.
In any given day, the dealer at the bank may engage in several transactions that are added to his general position. The combination of all of the different swaps, bond trades and futures trades the dealer conducts constitutes a portfolio.
It may be easier to intuitively understand the way in which the dealer manages the risk of an individual swap transaction, but in practice that would be prohibitively difficult and it wouldn’t take advantage of the natural hedges within a portfolio.
The swaps dealer will therefore manage the risks of his position by using portfolio management techniques that are similar to – but more sophisticated than – those used for a simple cash position in fixed income or equities to construct a portfolio of hedges using swaps, forward rate agreements (FRAs), futures and bonds.
The changes in value of assets can then offset 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
Cash flows are grouped in maturity buckets (or intervals of consecutive maturity). That may mean, for example, that all of the cash flows from a period between one year and one year and three months. Another example might be all of the cash flows from 29 years to maturity to 30 years to maturity.
After being grouped, these cash flows are then valued at market rates, which 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.
Before engaging in hedging swaps, the dealer has to assess the risk of the swaps portfolio by answering a series of questions like, “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)?” He may also look at how much the portfolio will lose on a mark-to-market basis if interest rates fall in a parallel fashion by 50 basis points, or if the spread between the 30-year government bond and the two-year government note increases by 25 basis points.
One useful way to figure out the impact of such sensitivities is through “Greek options”, a set of techniques used to explain the behavioral characteristics of an options position or a portfolio of options, futures, forwards and cash.
Delta hedging is particularly useful for managing risk and minimizing volatility. In hedging swaps, delta hedging would involve having an evaluator look at a fixed income instrument with a term to maturity equal to the average maturity for the interval in question, or 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 as a whole.
Another Greek option, the gamma, is an expression of the changes in the position size (i.e. the changes in the delta) as it corresponds with changes in the level of interest rates, while vega is the sensitivity of the portfolio to changes in implied volatilities for at-the-money options associated with the maturity bucket in question. That may be important, for example, if the portfolio contains swap options.
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, for example, because of degrading credit conditions.
Constructing the Hedge Portfolio
Once the dealer has such an analysis in hand, he can construct a hedging swaps portfolio using one or more financial instruments in order to offset those aspects of the risk that he’s unhappy carrying.
It’s important to note, however, that the dealer will not close out all of the aspects of the risk – he’ll only partially hedge the swaps portfolio.
That’s because hedging costs money, so like with any investment, the risk reduction benefits must be compared to the cost. If the marginal benefit of reducing the risk with an individual transaction is less than its marginal cost, it’s not worthwhile to hedge that risk.
The dealer may also 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 two-year to three-year bucket, he may be happy to continue received fixed interest payments for that period.
If he’s right, he’ll 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 a hedging swaps portfolio is managing the short-term cash flows, or the floating rate cash flows, for the following reasons:
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 can be a mismatch of cash flows. It’s also possible that 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.
Second, there may be mismatches in the type of index used to hedge.
A swap in which the floating rate index is the three-month US Bankers’ Acceptance rate would have an index mismatch risk if, for instance, the best swap available at the time is the three-month US LIBOR (London Interbank Offered Rate for US dollars). If the correlation between the two indices used to hedge the transaction changes, then the swap portfolio is exposed to refunding risk.
Commercial banks will sometimes try to hedge their floating rate cash flows by establishing a separate book dedicated to hedging such risks. The book will participate actively in futures markets such as the IMM Eurodollar market and takes aggressive positions in short-term interest rates.
They can also pay the hedging costs necessary for closing out the mismatches, but this can get expensive. With the increased commoditization of global derivatives markets, dealers are losing much of their pricing edge, which makes paying for outside hedging more difficult.
Hedging Swaps Overview
Hedging swaps require a level of sophistication on the part of the dealer, but they’re a useful tool for managing risk in derivatives portfolios and preventing changes in the condition of one asset from affecting the conditions of another in the same portfolio.