Pricing and hedging contingent claims using variance and higher order moment swaps

This paper suggests perfect hedging strategies of contingent claims under stochastic volatility and random jumps of the underlying asset price. This is done by enlarging the market with appropriate swaps whose pay-offs depend on higher order sample moments of the asset price process. Using European options and variance swaps, as well as barrier options written on the S&P 500 index, the paper provides clear cut evidence that hedging strategies employing variance and higher order moment swaps considerably improves upon the performance of traditional delta hedging strategies. Inclusion of the third-order moment swap improves upon the performance of variance swap-based strategies to hedge against random jumps. This result is more profound for short-term out-of-the money put options.     

Synthetic Floating‐Rate Debt: An Example of an Asset‐Driven Liability Structure

An asset‐driven liability (ADL) structure is analogous to a liability‐driven investment (LDI) strategy. In both cases, the intent is to reduce the risk arising from a mismatch of assets and liabilities by aligning the interest rate sensitivity of cash flows on both sides of the balance sheet. Increasingly, defined‐benefit pension plans have adopted LDI strategies that reduce their equity assets and increase the average duration of their debt assets to better match the typical long duration of their retirement obligations to its employees. To illustrate the concept of ADL, the authors use the example of a corporate issue of traditional fixed‐rate debt that is transformed into synthetic floating‐rate debt using an interest rate swap (in which the corporation receives the fixed rate on the swap and pays at money market reference rate like three‐month LIBOR). The use of such long‐term, floating‐rate debt reduces interest rate risk when the firm has operating revenues that are positively correlated to the business cycle. However, a problem arises in that there is limited demand for such debt securities from institutional investors, many of which, because of LDI guidelines, prefer long‐term, fixed‐rate securities. Derivatives provide a way of resolving this mismatch between issuer and investor interests. In the article, the authors present a detailed example of the cash flows on the “receive‐fixed” interest rate swap (and its valuation for financial reporting) to show how the synthetic ADL debt structure obtains the desired outcome.     

Foreign Currency Derivatives versus Foreign Currency Debt and the Hedging Premium

This paper compares the effect on firm value of different foreign currency (FC) financial hedging strategies identified by type of exposure (short‐ or long‐term) and type of instrument (forwards, options, swaps and foreign currency debt). We find that hedging instruments depend on the type of exposure. Short‐term instruments such as FC forwards and/or options are used to hedge short‐term exposure generated from export activity while FC debt and FC swaps into foreign currency (but not into domestic currency) are used to hedge long‐term exposure arising from assets located in foreign locations. Our results relating to the value effects of foreign currency hedging indicate that foreign currency derivatives use increases firm value but there is no hedging premium associated with foreign currency debt hedging, except when combined with foreign currency derivatives. Taken individually, FC swaps generate more value than short‐term derivatives.     

Swaps: Plain and Fanciful

The outstanding face amount of plain vanilla interest rate swaps exceeds two trillion dollars. While pricing and hedging of such swaps appear to be quite simple, many existing theories are based on the incorrect characterization of a swap as a simple exchange of a fixed for a floating rate note. This characterization is not consistent with standarized swap contracts and the treatment of swaps in bankruptcy. This paper provides an alternative perspective on swaps.     

Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers*

In this article, the authors summarize the findings of their recent study of the hedging activities of 92 North American gold mining companies during the period 1989‐1999. The aim of the study was to answer two questions: (1) Did such hedging activities increase corporate cash flows? (2) And if yes, were such increases the result of management's ability to anticipate price movements when adjusting their hedge ratios? Although the author's answer to the first question is “yes,” their answer to the second is “no.” More specifically, the authors concluded that:

• ? During the 1989‐1999 period, the gold derivatives market was characterized by a persistent positive risk premium— that is, a positive spread between the forward price and the realized future spot price—that caused short forward positions to generate positive cash flows. The gold mining companies that hedged their future gold production realized an average total cash flow gain of $11 million, or $24 per ounce of gold hedged, per year, as compared to average annual net income of only $3.5 million. Because of the positive risk premium, short derivatives positions did not generate significant losses even during those subperiods of the study when the gold price increased.
• ? There was considerable volatility in corporate hedge ratios during the period of the study, which is consistent with managers incorporating market views into their hedging programs and attempting to time the market by hedging selectively. But after attempting to distinguish between derivatives activities designed to hedge and those designed to profit from a view, the authors conclude that corporate efforts to time the market through selective hedging were largely if not completely futile. In fact, the companies' adjustments of hedge ratios appeared to consistently lag instead of leading the market.

     

Fine‐Tuning a Corporate Hedging Portfolio: The Case of an Airline

Industrial companies typically face a multitude of risks that could cause significant fluctuations in their cash flow. This is a case study of the hedging strategy adopted by an international air carrier to manage its jet‐fuel price exposure. The airline's hedging approach uses “strips” of monthly collars constructed with Asian options whose payoffs are based on average of “within‐prompt‐month” oil prices. Using the carrier's own implicit objective function based on an annual granularity, the authors show how the air carrier could fine‐tune its current hedge portfolio by adding tailored exotic options. The article describes annual average‐price options, provides an explicit valuation of them, and considers how such instruments may affect corporate liquidity. Consistent with its annual objective function, the airline made this exotic derivative the central tool to hedge across all potential realized values of annual jet‐fuel spot prices. The authors believe this modified portfolio is better suited to address the firm's hedging cost and its overall exposure to jet‐fuel price fluctuations.     

The Impact of Collateralization on Swap Rates

Interest rate swap pricing theory traditionally views swaps as a portfolio of forward contracts with net swap payments discounted at LIBOR rates. In practice, the use of marking‐to‐market and collateralization questions this view as they introduce intermediate cash flows and alter credit characteristics. We provide a swap valuation theory under marking‐to‐market and costly collateral and examine the theory's empirical implications. We find evidence consistent with costly collateral using two different approaches; the first uses single‐factor models and Eurodollar futures prices, and the second uses a formal term structure model and Treasury/swap data.     

Determinants of Swap Spreads in a Developing Financial Market: Evidence from Finland

This paper presents empirical evidence on the determinants of swap spreads in Finland using four years of data. Spreads exhibit a significant negative relationship with the amount of fixed rate deposits with banks, which reflects the importance of banks in the Finnish capital markets. Spreads are positively linked to business cycle and market risk factors such as the slope of the yield curve and the volatility of interest rates. The influence of hedging costs has become increasingly important over time, especially in longer dated swaps. A relationship is also observed between swap spreads and the external value of the currency.     

An Economic Analysis of Interest Rate Swaps

Interest rate swaps, a financial innovation in recent years, are based upon the principle of comparative advantage. An interest rate swap is a useful tool for active liability management and for hedging against interest rate risk. The purpose of this paper is to provide a simple economic analysis of interest rate swaps. Alternative uses of and the appropriate valuation procedure for interest rate swaps are described.     

Carry Trades and Global Foreign Exchange Volatility

We investigate the relation between global foreign exchange (FX) volatility risk and the cross section of excess returns arising from popular strategies that borrow in low interest rate currencies and invest in high interest rate currencies, so‐called “carry trades.” We find that high interest rate currencies are negatively related to innovations in global FX volatility, and thus deliver low returns in times of unexpected high volatility, when low interest rate currencies provide a hedge by yielding positive returns. Furthermore, we show that volatility risk dominates liquidity risk and our volatility risk proxy also performs well for pricing returns of other portfolios.     

Interest Rate Risk Management in Major Finnish Firms

The interest rate policies of Finnish firms appear risk aversive, but hedging decisions are influenced by market view. Managers find they can forecast trends in interest rate development, and employ the forecasts in the choice of debt and hedging instruments. The use of risk assessment methods and hedging instruments are related to firm size but not to leverage. Most frequently employed hedging instruments are interest rate swaps and forward rate agreements. The respondents find their firms' interest rate risk management is successful, but performance is seldom measured against an explicitly defined benchmark.     

The pricing of interest rate swaps

Interest rate swaps have become an important tool for financial institutions because they provide a convenient way to reduce interest rate risk. Swaps allow financial institutions to obtain short-term deposits in the local deposit market and then transform these into longer-term liabilities. The growth of swaps has been explosive, with the swap market growing from nothing in 1981 to an estimated $889 billion in 1987. In addition to their role in managing interest rate risk, swaps have become important to financial managers for other reasons, and as a result the swap market is monitored by financial managers as are money and capital markets. Because of its growing importance, an empirical perspective on how swaps are priced is needed. This article develops a simple market model and then estimates the model using data provided by three major swap market participants.     

中国利率市场的价格发现——对国债现货、期货以及利率互换市场的研究

本文采用信息份额模型和基于向量自回归(VAR)模型的格兰杰因果检验,研究了国债现货、国债期货和利率互换三个市场之间的价格发现机制。信息份额模型表明,从整体来看利率互换相对于国债期货和国债现货都具有信息优势,而国债期货相对于国债现货具有信息优势。另外,国债期货的价格发现能力相对于另外两个市场都在随时间增强。格兰杰因果检验结果显示,利率互换在价格发现中单向引领国债期货以及国债现货,国债期货单向引领国债现货。所有结果一致表明, 利率互换和国债期货这两种利率衍生产品在引导中国利率市场价格发现中发挥了重要作用。     

交易商持仓行为对期货市场的影响

金融危机发生之后,CFTC将原有的交易商持仓报告(Commitment of Traders,简称"COT")进行了扩容,新版的COT报告包含现货交易商、互换交易商、管理基金的持仓情况。分析COMEX铜和NYMEX原油的COT报告,可以发现,互换交易商的持仓占比最高,超过30%;具有现货背景的套期保值持仓保持一定比例,大约为20%~50%。现货交易商持仓占比的增加,有助于缓解价格的波动;而互换交易商持仓占比的提高,却加剧了市场的波动。由于互换交易商享有投机持仓豁免的权利,金融危机发生后,CFTC对互换交易商的监管更趋严格。     

Interest Rate Swaps and Corporate Financing Choices

This paper describes the firm's decision to borrow short-term versus long-term and shows how the introduction of interest rate swaps affects this choice. The model shows that in the absence of a swap market, interest rate uncertainty can lead firms to substitute long-term for short-term financing. However, when swaps exist, there is a tendency for firms that expect their credit quality to improve to borrow short-term and use swaps to hedge interest rate risk. The model suggests that, while the demand for fixed for floating swaps is enhanced, the demand for floating for fixed swaps is reduced by the presence of asymmetric information.     

Modeling volatility and changes in the swap spread

We investigate the determinants of changes in U.S. interest rate swap spreads using a model that explicitly allows for volatility interactions between swaps of different terms to maturity. Changes in the swap spread are found to be positively related to interest rate volatility, to changes in the default risk premium in the corporate bond market, and to changes in the liquidity premium for government securities. Swap spread changes are negatively related to changes in the level of interest rates and changes in the slope of the term structure. We also find that there is a strong and significant volatility interaction among spreads for swaps of different maturities and that the process for the conditional variance of the spread is highly persistent across all maturities.     

Conditional volatility in affine term-structure models: Evidence from Treasury and swap markets

We study the ability of three-factor affine term-structure models to extract conditional volatility using interest rate swap yields for 1991–2005 and Treasury yields for 1970–2003. For the Treasury sample, the correlation between model-implied and EGARCH volatility is between 60% and 75%. For the swap sample, this correlation is rather low or negative. We find that these differences in model performance are primarily due to the timing of the swap sample, and not to institutional differences between swap and Treasury markets. We conclude that the ability of multifactor affine models to extract conditional volatility depends on the sample period, but that overall these models perform better than has been argued in the literature.     

Discussion of “Hedge commitments and agency costs of debt: evidence from interest rate protection covenants and accounting conservatism”

Beatty, Petacchi, and Zhang investigate the role of two hedge commitment mechanisms??interest rate protection covenants and accounting conservatism??in reducing agency costs of debt. Using a large sample of syndicated loan agreements, they provide evidence that borrowers required to hedge interest rate risk through interest rate protection covenants receive lower interest rate charges. However, borrowers who voluntarily hedge interest rate risks receive lower rates only if they implement conservative financial reporting. The authors conclude that the benefits of hedging are realized only when borrowers can credibly commit to maintain hedge positions once a syndicated loan is issued. While the evidence provided by the authors is novel and interesting, I argue that the empirical assessment of hedge benefits is more complex. In addition, there are still some important open issues left unanswered that could be tackled by future research.     

Hedging Corporate Bonds

We examine Treasury bond and stock index futures, the swap curve and two types of hypothetical corporate bond assets as alternative hedging instruments for portfolios of corporate bonds. Conducting ex post and ex ante tests we find evidence that credit quality and maturity are important sources of basis risk when hedging corporate bonds whose credit rating are below triple A. We conclude that a new corporate hedging instrument may be useful for those wishing to hedge corporate bond portfolios provided that transaction costs are not too high relative to existing futures contracts.     

Hedging or Market Timing? Selecting the Interest Rate Exposure of Corporate Debt

This paper examines whether firms are hedging or timing the market when selecting the interest rate exposure of their new debt issuances. I use a more accurate measure of the interest rate exposure chosen by firms by combining the initial exposure of newly issued debt securities with their use of interest rate swaps. The results indicate that the final interest rate exposure is largely driven by the slope of the yield curve at the time the debt is issued. These results suggest that interest rate risk management practices are primarily driven by speculation or myopia, not hedging considerations.