Interest Rate Risk and Hedging Instruments
Core concepts
Interest rate risk includes repricing risk, yield curve risk, basis risk, and option risk. Candidates must know the main hedging instruments: interest rate swaps (fixed-for-floating), FRAs, interest rate futures (e.g., Eurodollar/SOFR-style contracts), caps, floors, and collars, and swaptions. Understand duration and DV01 as sensitivity measures and how they drive hedge ratios.
Hedging mechanics
A pay-fixed swap converts floating-rate exposure into fixed (hedges against rising rates for a borrower); a receive-fixed swap does the opposite. A cap protects a floating-rate borrower against rising rates; a floor protects a floating-rate lender against falling rates; a collar combines a purchased cap and sold floor to reduce cost at the expense of upside. Know that DV01 measures the dollar change in value for a 1 basis point move and is the natural unit for matching hedge notionals.
Traps in questions
- Confusing duration (percentage price sensitivity) with DV01 (dollar sensitivity).
- Reversing the pay-fixed vs. receive-fixed hedge direction.
- Forgetting that a swap's initial value is near zero but its DV01 is not.
- Ignoring basis risk when the hedge instrument's floating index differs from the exposure's index.
Worked example
A portfolio has DV01 of $50,000 per bp. A swap has DV01 of $250 per bp per $1M notional. Hedge notional = 50,000 / 250 × $1M = $200M. Direction: if the portfolio loses value when rates rise (long duration), pay fixed on the swap to offset.
Rule of thumb
Match DV01, not notional, and always confirm hedge direction against the sign of the exposure.