By: Adam Dean

In last month’s issue I went over the process of mortgage securitization. Once these and other fixed income securities are created, there are a variety of ways institutions and investors can manage the associated risks.

One possible move is shorting other fixed income products with a shorter duration (government bonds, for example) as this will help hedge against interest rate risk. If interest rates rise, the hit you’ve taken on your loan portfolio will be partly offset by the decrease in value of your short positions.

Another possible move is entering into an interest rate swap. This essentially allows two parties to exchange liabilities, providing a suitable way for firms to align incoming cash flows with their liability schedules. For instance, consider Company A, which is invested primarily in fixed-rate instruments but pays a LIBOR +20 basis points floating rate on their debt. Company B has the opposite problem – it is invested in floating-rate securities but paying a 4% fixed rate on their debt. With an interest rate swap, Company A and Company B can exchange interest payments without exchanging the underlying assets, thereby matching incoming and outgoing cash flows and reducing the effect of an unfavourable interest rate movement.

A third opportunity lies in buying the credit protection offered in a credit default swap (CDS). This allows investors to transfer default risk off the balance sheet without a transfer of the underlying asset or reference entity. In a physically-settled CDS, the protection seller receives payments from the buyer and in turn assumes exposure to the reference entity. If a credit event occurs, whether the result of bankruptcy, failure to pay, or restructuring (specific events will be defined in the contract), the buyer will transfer ownership of a debt instrument to the seller in exchange for payment at par. The physical settlement allows the seller recourse to the company in default. In a cash settlement, however, no physical asset is transferred; the protection seller will pay the buyer an amount equal to par value minus the current value of the debt instrument.

Finally, holders of fixed income products can hedge risk with interest rate forwards and futures. The value of these contracts will move in the opposite direction of current market rates, and therefore travel in the same direction as the value of your debt holdings. Accordingly, shorting interest rate futures will ensure that when interest rates rise, the resulting loss in your portfolio will be somewhat offset by an inflow from your short position.

The difference between futures and forwards is subtle. Futures contracts are readily tradable instruments with a feature known as mark-to-market. At the end of each trading day, the change in market value of the future is settled with a cash transaction between the long and short. In a forward contract, however, the agreement is made privately between the buyer and seller, and the only physical or cash exchange occurs on the settlement date specified in the contract.

The instruments described above only scratch the surface of a deep and influential derivatives market. While speculative use of these products has gotten us into trouble recently (see 2008), they are an important tool in financial risk management.