DURATION,IMMUNIZATION, AND HEDGING WITH INTEREST RATE FUTURES

The recent advent of the interest rate futures markets has greatly enriched the hedging opportunities of market participants faced with undesired interest rate risk. The variety of futures contracts presently spans a number of instruments with different risk, maturity, and coupon characteristics. This paper modifies the concept of duration and extends the duration hedging approach to cases where futures contracts are used as the hedging instrument. The derived hedge ratios take into account differences in coupon, maturity, and risk for three different regimes. Usage of these hedge ratios should lead to more efficient hedging of interest rate risk.     

Derivatives Usage in Emerging Markets Following the GFC: Evidence from the GCC Countries

In this article, we avail of International Accounting Standards IFRS 7 to investigate the usage and motivation of hedging by firms in the Gulf Cooperation Council (GCC) countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates). The results of our panel and cross-sectional data logistic regressions indicate a focus on foreign exchange exposure, interest rates risk, and commodity risk in this region. We find that the use of hedging instruments in this region is also influenced positively by the firm’s size and, to a lesser degree, positively by the firm’s gearing ratio and negatively by its propensity to growth. The level of activity, nevertheless, remains lower than is the case for firms globally.     

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.     

Mitigating Interest Rate Risk in Variable Annuities: An Analysis of Hedging Effectiveness under Model Risk

Variable annuities are investment vehicles offered by insurance companies that combine a life insurance policy with long-term financial guarantees. These guarantees expose the insurer to market risks, such as volatility and interest rate risks, which can be managed only with a hedging strategy. The objective of this article is to study the effectiveness of dynamic delta-rho hedging strategies for mitigating interest rate risk in variable annuities with either a guaranteed minimum death benefit or guaranteed minimum withdrawal benefit rider. Our analysis centers on three important practical issues: (1) the robustness of delta-rho hedging strategies to model uncertainty, (2) the impact of guarantee features (maturity versus withdrawal benefits) on the performance of the hedging strategy, and (3) the importance of hedging interest rate risk in either a low and stable or rising interest rate environment. Overall, we find that the impact of interest rate risk is equally felt for the two types of products considered, and that interest rate hedges do lead to a significant risk reduction for the insurer, even when the ongoing low interest rate environment is factored in.     

Corporate reputation and hedging activities

This study examines whether corporate reputation affects derivative hedging. We posit that high-reputation firms are more likely to engage in hedging due to greater reputation costs and/or their commitment to lower financial risks. We find that high-reputation firms are more likely to engage in hedging, especially when their hedging efforts or effects are more observable to stakeholders. We also find that high-reputation firms are less likely to disclose the notional values of hedging positions and that interest rate hedging by high-reputation firms is detrimental to firm value. Our results shed light on the impact of reputational concerns on corporate risk management and disclosure policies.     

Corporate risk management and firm value: evidence from the UK market

The paper evaluates the effect of corporate risk management activities on firm value, using a sample of large UK non-financial firms. Following recent changes in financial reporting standards, we are able to collect detailed information on risk management activities from audited financial reports. This enables us to gain a better understanding of risk management practices and to investigate value implications of different types of hedging. Overall 86.88% of the firms in the sample use derivatives to manage at least one type of price risk. The hedging premium is statistically and economically significant for foreign currency derivative users, while we provide weak evidence that interest rate hedging increases firm value. The extent of hedging and the hedging horizon have an impact on the hedging premium, whereas operational risk management activities do not significantly influence the market value of the firm.     

Cohort and value-based multi-country longevity risk management

ABSTRACT

Multi-country risk management of longevity risk provides new opportunities to hedge mortality and interest rate risks in guaranteed lifetime income streams. This requires consideration of both interest rate and mortality risks in multiple countries. For this purpose, we develop value-based longevity indexes for multiple cohorts in two different countries that take into account the major sources of risks impacting life insurance portfolios, mortality and interest rates. To construct the indexes we propose a cohort-based affine model for multi-country mortality and use an arbitrage-free multi-country Nelson–Siegel model for the dynamics of interest rates. Index-based longevity hedging strategies have the advantages of efficiency, liquidity and lower cost but introduce basis risk. Graphical risk metrics are a way to effectively capture the relationship between an insurer's portfolio and hedging strategies. We illustrate the effectiveness of using a value-based index for longevity risk management between two countries using graphical basis risk metrics. To show the impact of both interest rate and mortality risk we use Australia and the UK as domestic and foreign countries, and, to show the impact of mortality only, we use the male populations of the Netherlands and France with common interest rates and basis risk arising only from differences in mortality risks.     

The impact of hedging on the market value of equity

We examine the annual stock performance of firms that disclose the use of derivatives to hedge over the period 1995 to 1999. We find that only 21.6% of publicly traded U.S. corporations in our sample hedged with derivative instruments over this period and their use is concentrated in the larger companies. Similar to other studies we find that when derivatives are used, interest rate and currency securities are used much more frequently than commodity products. Our sample of 1308 companies that hedge outperforms other securities by 4.3% per year on average over our sample period. This result is robust to several alternative methods of estimating abnormal returns. When we segment performance by the type of hedge used, however, we find that the over-performance is due entirely to larger firms that hedge currency. We find no abnormal returns for firms hedging either interest rates or commodities. The abnormal returns in firms hedging currency is robust to alternative models that seek to control for exchange rate fluctuations and global equity returns; however, we find no significant abnormal returns to currency hedgers when using an augmented model that controls for the role of intangible assets.     

An Intertemporal International Asset Pricing Model: Theory and Empirical Evidence

We extend Campbell's (1993) model to develop an intertemporal international asset pricing model (IAPM). We show that the expected international asset return is determined by a weighted average of market risk, market hedging risk, exchange rate risk and exchange rate hedging risk. These weights sum up to one. Our model explicitly separates hedging against changes in the investment opportunity set from hedging against exchange rate changes as well as exchange rate risk from intertemporal hedging risk. A test of the conditional version of our intertemporal IAPM using a multivariate GARCH process supports the asset pricing model. We find that the exchange rate risk is important for pricing international equity returns and it is much more important than intertemporal hedging risk.     

The impact of enterprise risk management on the marginal cost of reducing risk: Evidence from the insurance industry

We test the hypothesis that practicing enterprise risk management (ERM) reduces firms’ cost of reducing risk. Adoption of ERM represents a radical paradigm shift from the traditional method of managing risks individually to managing risks collectively allowing ERM-adopting firms to better recognize natural hedges, prioritize hedging activities towards the risks that contribute most to the total risk of the firm, and optimize the evaluation and selection of available hedging instruments. We hypothesize that these advantages allow ERM-adopting firms to produce greater risk reduction per dollar spent. Our hypothesis further predicts that, after implementing ERM, firms experience profit maximizing incentives to lower risk. Consistent with this hypothesis, we find that firms adopting ERM experience a reduction in stock return volatility. We also find that the reduction in return volatility for ERM-adopting firms becomes stronger over time. Further, we find that operating profits per unit of risk (ROA/return volatility) increase post ERM adoption.     

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.     

The management of interest rate risk during the crisis: Evidence from Italian banks

We use a unique dataset to analyze how Italian banking groups managed their exposure to interest rate risk during the recent financial crisis. First of all, we document that on average the interest rate risk exposure – measured by duration gap approach – has been limited and well below the alert level enforced by regulators. Second, our econometric results indicate a relation of substitutability between banks’ on-balance-sheet interest rate risk and their use of interest rate derivatives suggesting that banks used these two instruments to curb their overall interest rate risk exposure in case of an increase in interest rates. Furthermore, we also find robust evidence of a negative correlation between banks’ interest rate risk and liquidity risk.     

Retracted: Risk Management in Financial Institutions

We study risk management in financial institutions using data on hedging of interest rate and foreign exchange risk. We find strong evidence that institutions with higher net worth hedge more, controlling for risk exposures, across institutions and within institutions over time. For identification, we exploit net worth shocks resulting from loan losses due to declines in house prices. Institutions that sustain such shocks reduce hedging significantly relative to otherwise-similar institutions. The reduction in hedging is differentially larger among institutions with high real estate exposure. The evidence is consistent with the theory that financial constraints impede both financing and hedging.     

The Interest Rate Risk of Fannie Mae and Freddie Mac

This paper evaluates the interest rate risk of Fannie Mae and Freddie Mac (F&F) and develops related public policy proposals. F&F merit special attention due to (1) their potentially very large interest rate risk, and (2) their status as U.S. government sponsored enterprises. The analysis focuses on the dynamic hedging strategy and extensive use of interest rate derivatives employed by F&F to control their interest rate risk. While dynamic hedging is highly cost effective for F&F, it creates imperfect hedges and thus could impose significant costs on U.S. taxpayers in a potential future F&F bailout. The policy discussion includes proposals to modify the F&F interest rate disclosures and the OFHEO stress test, and to create rate interest risk standards for F&F.     

Risk and Market Segmentation in Financial Intermediaries' Returns

This study examines both the quantity and price of risk exposure for different segments of financial intermediaries. Overall, we find evidence of market segmentation in the U.S. financial services industry. Specifically, we find that securities firms, consistently over the sampling period 1974–1994, had the most market risk exposure with the lowest market risk premium. Banks' market risk fluctuated over the sampling period. Banks increased their market risk-taking after the shift in monetary target in October 1979 and the announcement of the risk-based capital requirements in July 1988. The banks' market risk became the highest and insignificantly different from securities firms'. The results are consistent with the moral hazard argument; that is, banks took on more risk to take advantage of government guarantees as their charter value declined. Banks were subject to relatively high interest rate risk premium. However, in response to increased interest rate volatility and decreased charter value after October 1979, banks (while they increased their market risk exposure) lowered their interest rate risk exposure to an insignificant level. The results suggest that the federal safety net may have been perceived by the market as covering only market risk but not interest rate risk. Overall, we find little evidence of interest rate risk exposure, suggesting the prevalence of hedging programs using interest rate derivatives. The interest rate risk premiums, unlike the risk exposure, differ across financial intermediaries.     

Derivatives Usage and Financial Risk Management in Large and Small Economies: A Comparative Analysis

The objective of this paper is to expand and update previous New Zealand — based surveys in order to compare and contrast risk management practices of firms in the small, foreign trade-dependent economy of New Zealand to those of firms in the considerably larger, more developed US, UK, and German markets. This survey examines patterns of usage, reasons and objectives for derivatives use, and reporting and control procedures and finds that the practice of hedging with derivative instruments among New Zealand firms appears to be evolving as global markets become more integrated. We find that the percentage of firms involved in hedging, both large and small, has grown since the last New Zealand surveys, and that New Zealand firms have many of the same reasons and objectives for using derivatives as firms in the much larger American and European economies. We also find that the focus on control and reporting derivatives transactions in New Zealand is similar to that of firms in the other countries and appears to have strengthened since previous surveys.     

A Simple Approach to Valuing Risky Fixed and Floating Rate Debt

We develop a simple approach to valuing risky corporate debt that incorporates both default and interest rate risk. We use this approach to derive simple closed-form valuation expressions for fixed and floating rate debt. The model provides a number of interesting new insights about pricing and hedging corporate debt securities. For example, we find that the correlation between default risk and the interest rate has a significant effect on the properties of the credit spread. Using Moody's corporate bond yield data, we find that credit spreads are negatively related to interest rates and that durations of risky bonds depend on the correlation with interest rates. This empirical evidence is consistent with the implications of the valuation model.     

How fair-value accounting can influence firm hedging

The potential influence of accounting regulations on hedging strategies and the use of financial derivatives is a research topic that has attracted little attention in both the finance and the accounting literature. However, recent surveys suggest that company hedging can be substantially influenced by the accounting for financial instruments. In this study, we illustrate not only why but also how the accounting regulations may affect hedging behavior. We find that under mark-to-market accounting, most firms concerned with earnings smoothness adopt myopic hedging strategies relative to the benchmark, cash flow hedging. The specific influence of the accounting regulations depends on market and firm-specific characteristics, but, in general, the firms dramatically reduce the extent of hedging addressing price risk in future accounting periods. We illustrate that the change in hedging behavior significantly dampens the increase in earnings volatility stemming from fair value accounting of derivatives. However, the adjusted hedging strategies may substantially increase the firms’ cash flow volatility.     

The economic determinants of interest rate option smiles

We address three questions relating to the interest rate options market: What is the shape of the smile? What are the economic determinants of the shape of the smile? Do these determinants have predictive power for the future shape of the smile and vice versa? We investigate these issues using daily bid and ask prices of euro (€) interest rate caps/floors. We find a clear smile pattern in interest rate options. The shape of the smile varies over time and is affected in a dynamic manner by yield curve variables and the future uncertainty in the interest rate markets; it also has information about future aggregate default risk. Our findings are useful for the pricing, hedging and risk management of these derivatives.     

An Empirical Comparison of Alternative Models of the Short-Term Interest Rate

We estimate and compare a variety of continuous-time models of the short-term riskless rate using the Generalized Method of Moments. We find that the most successful models in capturing the dynamics of the short-term interest rate are those that allow the volatility of interest rate changes to be highly sensitive to the level of the riskless rate. A number of well-known models perform poorly in the comparisons because of their implicit restrictions on term structure volatility. We show that these results have important implications for the use of different term structure models in valuing interest rate contingent claims and in hedging interest rate risk.