Book title: Understanding
Financial Markets & Instruments
10.1.1 Fixed interest rate exposures
Fixed interest-bearing investments, such as an investment in long-term government stock or shorter term bankers' acceptances, have basically two definable risks:
a) A specific risk that applies to each security;
b) A general market risk relating to the entire portfolio of investments in fixed interest-bearing securities.
The specific risk of an individual security relates to the fact that individually it can move against the general market. This would mean that the individual security would decrease in value (the market rate on that security increases) when the general market value of interest-bearing securities increases (the market rate decreases).
The general market risk is that the market value of interest-bearing securities decreases, because of an increase in the market interest rate. If securities in the investment portfolio follow the trend in the market, this increase in interest rates would result in a decline in the value of the portfolio.
Increased interest rate volatility has led to greater volatility in the return on bonds and other fixed-income assets. The volatility of the interest rates and the resulting value of fixed interest rate securities, can lead to an unexpected capital loss.
In the same manner the current value of interest-bearing liabilities can increase and decrease in value if the market rate fluctuates. The current value is arrived at by discounting the cash flows of the asset or liability back to the present date, making use of the current market rate.
10.1.2 Floating interest rate exposures
In the case of interest-bearing assets where the interest received is linked to a floating interest rate, the risk is that the floating interest rate would move negatively resulting in interest received on an investment (asset), such as cash kept on short-term deposit earning the prime rate, declining to less than the general money market interest rate or the expected yield.
For the purposes of clarity the investment risks discussed above can be defined as:
a) The risk of losses from holding capital;
b) The risk of losses from interest income declining.
10.2 Derivative instruments and methods of hedging
When deciding on a technique to hedge a risk associated with a financial position, a number of aspects have to be taken into account. Some of the aspects to be considered are named below:
10.2.1.1 Hedging fixed interest rate investments or non-interest-bearing investments with option contracts
When an investment is made in a fixed interest-bearing instrument, the risk is that the secondary market rate at which these instruments trade will increase, with a resulting decrease in the value of the instrument. Investments in non-interest-bearing assets such as shares, carry the risk that prices may decrease, resulting in a loss of value.
This risk can be hedged by buying a put option with the investment as the underlying asset. The put option will establish investment as the underlying asset. The put option will establish the rate or price at which the underlying asset can be sold to the writer of the option. The maximum possible loss (or minimum possible profit) is thus known. If the rates decrease or the prices increase beyond the strike price of the option, the asset can be sold in the market at a higher value than would be the case if the option were exercised. In this case, the option would not be exercised, and the loss on the hedge is the option premium paid.
If the investor is of the opinion that rates will increase, with the result of decreasing prices of assets, the investor may also write and sell a call option at current rates or rates that are expected to be less than future rates. If the rates increase, the option will most probably not be exercised, and the investor would have made a profit equal to the option premium received when the option was sold. This is, however, not a full hedge of an underlying investment, as the maximum profit that can be made is limited to the premium received. The decline in the price of the investment might be more than the premium received. To enhance this strategy, an additional measure such as a stop-loss limit on the underlying asset should be put into place.
10.2.1.2 Hedging floating interest rate investments with option contracts
Option contracts, as seen previously, gives a right to but does not place an obligation on the holder. When an OTC option is exercised, in most cases the underlying asset is physically delivered. Options can be applied to floating-rate investments in the same manner as with fixed-rate investments, where the underlying instrument can physically be delivered. Where the investment is a cash amount, for instance, in a short-term deposit, in some cases this asset cannot at will be liquidated and delivered for the exercising of an option. Terms of an option are, however, in most cases negotiated between the two parties, and it is not impossible to negotiate an option that suits the investor. These options with customized terms are, however, not common and often cannot be traded effectively in the secondary market.
Options traded on an exchange such as options traded on SAFEX are, however, cash settled in most cases and can effectively be used to hedge an income stream if movements in the rate of the underlying asset of the option and the rate of the position that needs to be hedged, coincide.
10.2.2.1 Hedging fixed interest rate exposures and non-interest-bearing instruments with futures contracts
An investor can guarantee a minimum price that he would get for his asset by selling a future (closing a future contract to sell the underlying asset). One of the major disadvantages of the future (in comparison to options, for instance) is that a futures contract places an obligation on both parties to honour the terms of the contract. There is no choice whether to exercise the contract or not. The investor could thus be forced to sell the underlying asset at the close-out date of the contract at a price that is lower than the market value of the underling asset at that date.
A prospective investor can determine the price at which he will buy the investment at a future date, by buying a future (closing a contract to buy an asset at a future date). This could, however, force the investor to buy the investment at a higher value than the market value at the close-out date of the contract.
As is the case with options, when dealing with futures where the underlying asset is a fixed interest rate asset, the futures contract will specify the rate at which the asset will be bought or sold. The price will be the future cash flows discounted at the rate stipulated in the futures contract.
10.2.2.3 Hedging floating interest rate investments with futures
Similar to options, futures were mainly developed to determine and establish a fixed price received on an investment at a certain date in the future. It was not specifically intended to hedge risks associated with floating-rate investments, although this risk can be managed if a financial future with an interest rate instrument as underlying asset is available, and the market rate movements on this instrument more or less matched the floating interest rate of the investment. The risk for the investor in a floating interest rate product would be that the rate and income stream from the investment decreases.
The fact that futures are cash settled and not physically delivered gives this investor the chance to establish an interest rate (income stream received) for a future date, if he can match the nominal amounts of his investment and the futures contract. By closing the futures contract now, the investor can fix the yield on his investment for the period of the futures contract. It is important to note that the yield can only be determined if the floating rate on his investment matches the market rate of the underlying asset to the future.
10.2.3 Interest rate swaps
10.2.3.1 Hedging fixed interest rate investments with an interest rate swap agreement
Where the interest received on an investment is a fixed interest rate, this interest rate can be swapped for a period of time, or for the duration of the loan, for a floating interest rate. The effect would be that the investor would pay the fixed income payments which he receives on his investment to the other party in the swap transaction, who would in turn pay the investor the payments earned according to the floating rate of the swap transaction.
A swap transaction such as the one described above, would hedge the risk that the investor has of the market rate increasing above the rate earned on his investment. It has the risk, however, that if the floating rate of the swap contract decreases to a level below the fixed rate received on his investment, he will lose money because of the swap contract.
10.2.3.2 Hedging a floating interest rate exposure with an interest rate swap agreement
An exposure on an investment with a floating interest rate stream of payments can be hedged by swapping the floating rate income stream for a fixed rate income stream. This will give the investor certainty about the income that he will receive on his investment, and future cash flows. Depending on the movement of the floating rate involved, this could be positive or negative to the investor.
10.2.4 Interest rate cap, floor and collar agreements
10.2.4.1 Hedging fixed interest rate exposures using caps, floors and collars
Caps, floors and collars were designed to hedge the income stream on an investment, and not necessarily the capital amount. On a fixed rate investment, the income stream is certain and need not be hedged. The capital amount is the value that needs hedging against increasing interest rates (this will decrease the capital value). To supplement the decrease in capital value with rising interest rates, the investor can, however, buy a cap. The investor can also buy a collar. The purchase of a collar will, within the spread of the cap and floor rates, change the fixed income stream to a floating income stream, because if the floating rate of the collar agreement increases above the cap rate, the investor will receive money, whereas if the floating rate of the collar agreement decreases below the floor rate, the investor will have to pay out money.
Selling a floor will result in a premium being received, and if the hedger is optimistic that rates will not decline, this strategy can be used similarly to writing options.
10.2.4.2 Hedging floating rate exposures with caps, floors and collars
An investor earning a floating interest rate can hedge the risk of declining interest rates by buying a floor or selling a collar. In this case the investor will receive money if the floating rate drops below the floor rate.
From the above discussion it is apparent that there are numerous ways and means available for an investor to hedge investment exposures, using derivative instruments. The risks must first be analysed to establish whether the risk is that of a decrease in capital value, or a decrease in income stream. Taking into account the other aspects surrounding the investment, a decision must be made about the most effective hedging strategy in those circumstances.