You are a risk manager that needs to hedge the IR risk on a portfolio of bonds. Your hedging instruments are futures and swaps. Discuss how you would go about mitigating sensitivity to changes in the interest rates. You may consider either bucketing the risk or using a holistic approach where you look at dollar duration for the entire portfolio. I suggest you use one of the course calculators to build a curve than price a portfolio of bonds than compute key rate sensitivities. Portfolio duration is the sum of component durations.
To mitigate sensitivity to changes in interest rates and hedge the interest rate (IR) risk on a portfolio of bonds using futures and swaps, you can follow these steps:
1. Calculate the portfolio's duration: Duration measures the sensitivity of the portfolio's value to changes in interest rates. It is the weighted average of the durations of the individual bonds in the portfolio. You can calculate the duration by multiplying the weight of each bond by its respective duration and summing them up.
2. Identify the key rate durations: Key rate durations allow you to assess the sensitivity of your portfolio to changes in specific interest rate maturities. You can use a course calculator to build a yield curve and price the portfolio of bonds. Once you have the bond prices, you can then compute the key rate sensitivities (also known as bucket exposures or bucket risk) for different maturity points on the yield curve.
3. Determine the desired hedge ratio: The hedge ratio represents the proportion of the portfolio's value that needs to be hedged to minimize the risk. It can be calculated by dividing the portfolio's duration by the duration of the hedging instrument you plan to use (e.g., futures or swaps).
4. Choose the appropriate hedging instruments: Depending on the market and available instruments, you can choose either futures or swaps as your hedging instruments. Futures contracts can be used to offset the risk associated with the entire portfolio, while swaps can help target specific maturities along the yield curve.
5. Implement the hedge: Once you have determined the desired hedge ratio and selected the suitable hedging instruments, take the necessary actions to execute the hedge. For futures contracts, you would enter into a futures contract position that offsets a proportionate amount of your portfolio's duration. For swaps, you can enter into interest rate swap contracts that provide the desired hedging exposure to the specific maturities you are targeting.
6. Monitor and adjust the hedge: Regularly monitor the hedge and take appropriate actions to rebalance if necessary. Re-evaluate the hedge ratio and adjust the hedge position if there are changes in the portfolio composition or market conditions.
By following these steps, you can effectively mitigate interest rate risk and hedge the portfolio's sensitivity to changes in interest rates using futures and swaps.