Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 19. The Basics of Cash-Market Hedging

SHRIKANT RAMAMURTHY

Managing Director, RBS Greenwich Capital

Abstract: Fixed income instruments, like securities in other asset classes, exhibit price volatility on a daily basis. For many participants in these markets, these price fluctuations are not always desirable. For investors who want to reduce price volatility, hedging offers a way to minimize or eliminate price risk. Hedging strategies are of interest to many market participants including, among others, dealers and traders whose goal is to provide liquidity to investors without incurring large losses, portfolio managers who need to protect positions from potential loss, and corporate treasurers who want to lock in rates prior to issuing fixed income debt.

Keywords: hedging, cash-market hedging, dollar-value-of-a-basis-point (DVBP), risk management, bullet bonds, option-embedded bonds, mortgage-backed securities, interest rate risk, perfect hedge, hedging instrument, hedge position, option-adjusted spread, hedge ratio, adjusted hedge ratio, 10-year Treasury-note equivalent, yield-spread risk, cost of carry

This chapter provides an introduction to hedging fixed income securities using the dollar-value-of-a-basis-point (DVBP) approach and develops a framework for analyzing and managing risk through the use of hedging strategies in the cash market. While many types of financial instruments can serve as hedge vehicles, this chapter will focus on Treasury securities as hedge instruments. ...