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11 26 2015 | by Victor Xing | Capital Markets

What are ways to establish interest rates exposure?

Investors can indeed establish interest rates exposure via multiple instruments, such as interest rate swap, Treasury futures, or nominal (cash) Treasury notes and bonds.  They each come with advantages and disadvantages.

Scenario: an institution plans to establish a 90,000 DV01 risk exposure in the dollar denominated 10 year interest rates sector (basically the portfolio would gain or lose $90,000 for every one basis point, or 0.01%, change in the 10 year sector) .

Establish interest rates exposure via Treasury futures

Currently there is no true 10 year Treasury futures.  TY futures are a little over 7 years in duration, and US futures are a little over 21 years.  CME will launch its Ultra 10-year futures (TN) in January 2016 to fill the gap, but until then, investors will have to use a 7+ year futures instrument as a proxy to establish 10 year interest rate exposure – the slippage is real, as 7 and 10 years are considered two separate tenors (with different sensitivity toward central bank policy and risk sentiment).  Nevertheless, the institution can buy 1,154 TY contracts to establish approximately 90,000 DV01 in the 7 year sector as a proxy for 10 year risk.

Pros: balance sheet friendly, highly liquid, supports long and short positions
Cons: have to roll futures positions, cannot precisely target duration exposure as not all major tenors are covered by futures contracts.  Does not support forward positions

Ultra 10 – it may be the greatest thing since sliced bread, but it is not here yet

Interest rates exposure - Ultra 10s

Nominal Treasuries

The institution needs to buy $101 million 10 year on-the-run Treasury notes.  This means the institution needs to have room in its balance sheet to warehouse the bonds (balance sheet constraint)

Interest rates exposure - nominal USTs

Pros: highly liquid, major tenors are well represented in cash bonds
Cons: balance sheet intensive (ties up cash), does not support outright short positions (some part of the curve are relatively less liquid), does not support forward positions

Interest rate swaps

The institution can receive $99 million in 10 year swaps with an investment bank’s trading desk, which will be cleared through either LCH or CME.

Interest rates exposure - swaps
Interest rates exposure - swaps

Pros: highly liquid, all tenors (including forward rates) are represented.  Balance sheet friendly, supports long and short positions (receive vs. pay), The position can be unwound quickly on-demand
Cons: swap spreads risk exposure if the investor wants to hedge instruments correlated with part of the Treasury curve.  It can be a bit unwieldy to transact under volatile market conditions (many investors prefer to call the dealer by voice to establish the positions – something that takes precious time when market is moving, but unwinding is easy)

Conclusion

IRS beats Treasury futures and nominal Treasuries by allowing institutional investors to target a very specific part of the yield curve (or in forward space such as 3y5y or 10y10y).  Unlike nominal Treasuries, swap positions can be both long and short, and it is balance sheet friendly (no initial cash transactions).  Not having to micro-manage the futures roll can free up resource to focus on other market events.  Once established, it is also easy to unwind.  Generally, many mutual fund companies prefer to establish interest rates exposure via derivatives.

Next article11 26 2015 | by Victor Xing | Other

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