Hedging Interest Rate Risk in a Low-Rate Environment

December 10, 2020

Source: Bloomberg Source: Bloomberg

When looking at the equity market, it's hard to notice that we have just experienced the deepest recession in U.S. history. But indeed, the recession has inflicted wounds that still need to be healed. The U.S. gross domestic product (GDP) is 3% below the pre-COVID-19 level and the U.S. has 10 million fewer jobs than it did in February. Interest rates have dropped to the lowest levels in history (as seen in this week’s chart). The 10-year swap rate on Aug. 4, 2020, was only 50 basis points (bps). The main driver for such low rates has been the Federal Reserve (Fed). In order to sustain smooth market functioning and help foster accommodative financial conditions, the Fed cut the Fed Funds Rate to zero in March. Since then, the central bank has expanded its balance sheet by over $3 trillion through asset purchasing and other activities. In addition, there is the possibility that the Fed will shift the composition of its asset purchase program toward longer-duration assets, which could deter rates from rising.

For most financial institutions, a low-interest-rate environment is by no means a blessing. It drags down the profit margin of insurance companies and banks and makes it challenging to offer attractive products. For insurance companies and pensions, low rates increase the liability since they dampen the discounting effect on long-term liabilities. To counter this effect, there are usually asset-liability management programs in place. For most general account products, assets with matching liability durations are purchased. For separate account products and pensions, strategies usually involve interest rate derivatives for hedging risks. Interest rate swaps are simple, standardized and very liquid. Hedging with interest rate swaps is probably the most popular type of strategy. However, for the low-rate environment that we are in, it is worth looking at some other types of strategies.

In this Chart of the Week post, I would like to explore several types of strategies that involve “interest rate swaptions,” which are options on interest rate swaps. Purchasing a receiver/payer swaption means obtaining the right to enter a receiver/payer swap with a specified fixed rate (the strike) at specified expiry, and is applicable for hedging rates going lower/higher respectively. Since most insurance companies and pensions are hedging the risks of interest rates dropping even lower, the main argument for using swaptions is that interest rates cannot fall much lower from here. The Fed has iterated multiple times that it is not considering going to negative interest rates now. This has effectively established lower bounds for interest rates. Combined with the low implied interest rate volatility (as the chart shows) and the favorable implied volatility skew dynamics, swaption strategies could be more effective options.

For simplification, all of the following swaptions have a three-month maturity and an underlying 10-year interest rate swap. All pricing is in the yield value of the underlying swap. For example, if the price of a swaption is 10 bps, it is equivalent to the market value change of the underlying swap for a 10 bps swap rate movement.

  • The first strategy involves selling an at-the-money (ATM) payer swaption. This strategy is suitable when interest rates are low and implied volatility is high. For example, on March 31, 2020, an ATM payer swaption with the aforementioned maturity and underlying swap could have been sold for 18 bps. The tradeoff is that as long as the 10-year swap rate does not fall more than 18 bps, the strategy would outperform the simple interest rate swap hedging strategy.
  • The second strategy to consider is buying a receiver spread, which entails purchasing an ATM receiver swaption and selling an out-of-the-money (OTM) receiver swaption. In this demonstration, the OTM strike is set to ATM-25 bps. This strategy works when both interest rates and implied volatility are low, with strong conviction that interest rates would go higher. The strategy would slightly underperform on the interest rate downside and outperform on the upside.
  • Lastly, the third strategy is entering a receiver spread collar. It involves buying a receiver spread, with strikes of ATM and ATM-25 bps, respectively. An OTM payer swaption is sold to achieve upfront cost-neutral. This strategy is applicable when both interest rates and implied volatility are low and payer swaptions are relatively more expensive than receiver swaptions. The more expensive the relative payer swaptions are, the higher the strike can be set on the short payer swaption. The tradeoff is that the strategy fully protects the downside up to 25 bps and outperforms on the upside up to the strike of the OTM payer swaption.

To demonstrate their effectiveness, I ran back tests for each of the strategies. Hypothetically, starting from March 31, 2020, new structures were repeatedly traded and held to maturity every three months. As of Dec. 4, 2020, the three strategies outperformed the simple interest rate swap hedging strategy by 38 bps, 7 bps and 22 bps in yield value, respectively.

Key Takeaway

The COVID-19 pandemic has brought the U.S. into an unprecedented low-interest-rate environment, which is challenging for financial institutions in many ways. However, for managing interest rate risks, it also presents opportunities. Many strategies, including the three discussed above, could be more effective than a simple interest rate swap hedging strategy. Most of those strategies require an understanding of different types of derivatives, market dynamics and the conditions of the economy. They are most likely to be tactical and subject to frequent adjustments. Other considerations, including risk tolerance, operational infrastructure, accounting impact and modeling capacity, might need to be taken into account as well. In this low-interest-rate environment, anything that could potentially add value to a business should not be overlooked.

Tags: Equity market | recession | Interest Rate | Coronavirus | hedging | interest rate risk

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