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! "he specific risk of an individual security relates to the fact that individually it can move against the general market! "his 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)! "he general market risk is that the market value of interest-bearing securities decreases, because of an increase in the market interest rate! $f 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! $ncreased interest rate volatility has led to greater volatility in the return on bonds and other fixed-income assets! "he volatility of the interest rates and the resulting value of fixed interest rate securities, can lead to an unexpected capital loss! $n the same manner the current value of interest-bearing liabilities can increase and decrease in value if the market rate fluctuates! "he 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! Floating interest rate exposures $n 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) "he risk of losses from holding capital b) "he risk of losses from interest income declining!
Options

the investor may also write and sell a call option at current rates or rates that are expected to be less than future rates! $f the rates increase. in a short-term deposit. however. are. not a full hedge of an underlying investment. and it is not impossible to negotiate an option that suits the investor! "hese options with customi)ed terms are. and the investor would have made a profit e&ual to the option premium received when the option was sold! "his is. as the maximum profit that can be made is limited to the premium received! "he decline in the price of the investment might be more than the premium received! "o enhance this strategy. the asset can be sold in the market at a higher value than would be the case if the option were exercised! $n this case. with the result of decreasing prices of assets. not common and often cannot be traded effectively in the secondary market! 'ptions traded on an exchange such as options traded on *AF+. as seen previously. the option will most probably not be exercised. however. in most cases the underlying asset is physically delivered! 'ptions can be applied to floating-rate investments in the same manner as with fixed-rate investments. however. in some cases this asset cannot at will be li&uidated and delivered for the exercising of an option! "erms of an option are.Hedging fixed interest rate investments or non-interest-bearing investments with option contracts %hen an investment is made in a fixed interest-bearing instrument. resulting in a loss of value! "his risk can be hedged by buying a put option with the investment as the underlying asset! "he put option will establish investment as the underlying asset! "he put option will establish the rate or price at which the underlying asset can be sold to the writer of the option! "he maximum possible loss #or minimum possible profit) is thus known! $f the rates decrease or the prices increase beyond the strike price of the option. with a resulting decrease in the value of the instrument! $nvestments in non-interest-bearing assets such as shares. where the underlying instrument can physically be delivered! %here the investment is a cash amount. 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! Futures 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)! 'ne of the ma-or disadvantages of the future #in comparison to options. gives a right to but does not place an obligation on the holder! %hen an '"( option is exercised. carry the risk that prices may decrease. for instance. an additional measure such as a stop-loss limit on the underlying asset should be put into place! Hedging floating interest rate investments with option contracts 'ption contracts. however. and the loss on the hedge is the option premium paid! $f the investor is of the opinion that rates will increase. the risk is that the secondary market rate at which these instruments trade will increase. the option would not be exercised. in most cases negotiated between the two parties. for instance) is that a futures contract places an obligation on both parties to honour the terms of the contract! .

however. futures were mainly developed to determine and establish a fixed price received on an investment at a certain date in the future! $t was not specifically intended to hedge risks associated with floating-rate investments. the investor can fix the yield on his investment for the period of the futures contract! $t 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! Conclusion From the above discussion it is apparent that there are numerous ways and means available for an investor to hedge investment exposures."here is no choice whether to exercise the contract or not! "he 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. although this risk can be managed if a financial future with an interest rate instrument as underlying asset is available. if he can match the nominal amounts of his investment and the futures contract! . by buying a future #closing a contract to buy an asset at a future date)! "his could. using derivative instruments! "he risks must first be analysed to establish whether the risk is that of a decrease in capital value. and the market rate movements on this instrument more or less matched the floating interest rate of the investment! "he risk for the investor in a floating interest rate product would be that the rate and income stream from the investment decreases! "he 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. the futures contract will specify the rate at which the asset will be bought or sold! "he price will be the future cash flows discounted at the rate stipulated in the futures contract! Hedging floating interest rate investments with futures *imilar to options. or a decrease in income stream! "aking into account the other aspects surrounding the investment. 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.y closing the futures contract now. when dealing with futures where the underlying asset is a fixed interest rate asset. a decision must be made about the most effective hedging strategy in those circumstances! .

Sign up to vote on this title
UsefulNot useful