INTEREST RATE RISK,MARKET VALUE,AND HEDGING FINANCIAL PORTFOLIOS

This paper derives theoretical hedge ratios for the financial portfolio that preserve its present value in the presence of interest rate risk. From a practical point of view and for any given portfolio, the existence of the financial futures market allows the investor to employ any of a number of different hedges, each of which approximately satisfies the theoretical condition. The theory indicates that wealth-preserving hedges depend on the interest elasticities (durations) of the spot assets and liabilities contained in the portfolio, portfolio leverage, and the interest elasticity (duration) of the financial instrument underlying the futures contract that is employed in constructing the hedge. Also, hedges designed to maintain net interest margin or net cash flow do not minimize exposure to interest rate risk.