Interest Rate Risk Hedging with Swaps
Interest Rate Risk Hedging with Swaps
Interest rate swaps are the primary tool for managing interest rate risk in corporate treasuries and investment portfolios. Companies convert floating-rate debt to fixed, investors adjust portfolio duration, and banks manage asset-liability mismatches—all through swap transactions that exchange fixed for floating interest payments.
Definition and Key Concepts
Swap Structures for Hedging
| Hedger Type | Exposure | Swap Position | Result |
|---|---|---|---|
| Floating-rate borrower | Rates rise = higher cost | Pay fixed, receive floating | Fixed rate debt |
| Fixed-rate borrower | Opportunity cost if rates fall | Pay floating, receive fixed | Floating rate debt |
| Fixed-rate asset holder | Value falls if rates rise | Pay fixed, receive floating | Duration reduction |
| Floating-rate asset holder | Income falls if rates fall | Pay floating, receive fixed | Fixed income stream |
Duration and DV01
Duration: Sensitivity of value to rate changes (% change per 1% rate move)
DV01: Dollar value of one basis point DV01 = (Portfolio Value × Duration) / 10,000
Example: $100 million portfolio, duration 5 years DV01 = ($100,000,000 × 5) / 10,000 = $50,000
A 1 bp rate rise reduces portfolio value by $50,000.
Hedge Ratio
Swap notional for duration hedge: Swap Notional = (Portfolio DV01 / Swap DV01) × $1,000,000
Swap DV01 by tenor (per $1M):
| Tenor | Approximate DV01 |
|---|---|
| 2 year | $190 |
| 5 year | $450 |
| 10 year | $850 |
| 30 year | $1,700 |
How It Works in Practice
Floating-to-Fixed Conversion
Situation: Company has $50 million floating-rate bank loan (SOFR + 150 bps).
Concern: Rising rates will increase interest expense.
Hedge: Enter pay-fixed swap:
- Notional: $50 million
- Pay: 4.50% fixed
- Receive: SOFR
- Tenor: 5 years (matching loan)
Net position:
| Component | Rate |
|---|---|
| Loan interest | SOFR + 150 bps |
| Swap pay | -4.50% |
| Swap receive | +SOFR |
| Net cost | 4.50% + 150 bps = 6.00% |
The floating rate is converted to a fixed 6.00%.
Duration Hedging
Situation: Pension fund has $500 million fixed-income portfolio with duration of 8 years.
Objective: Reduce duration to 4 years to limit rate risk.
Calculation: Current DV01 = ($500M × 8) / 10,000 = $400,000 Target DV01 = ($500M × 4) / 10,000 = $200,000 Hedge DV01 needed = $200,000
Using 10-year swap (DV01 = $850 per $1M): Swap notional = ($200,000 / $850) × $1,000,000 = $235 million
Hedge: Enter pay-fixed swap at $235 million notional.
Worked Example
Corporate hedging scenario:
Company profile:
- Floating-rate debt: $200 million (SOFR + 200 bps)
- Current SOFR: 4.50%
- Current interest expense: 6.50% = $13 million annually
- Concern: Fed hiking rates further
Swap terms:
- Notional: $200 million
- Fixed rate: 4.75%
- Floating rate: SOFR (flat)
- Tenor: 3 years
Year 1 analysis (SOFR rises to 5.25%):
| Component | Without Hedge | With Hedge |
|---|---|---|
| Loan interest (SOFR + 200) | $14.5M (7.25%) | $14.5M |
| Swap: Pay fixed | — | -$9.5M (4.75%) |
| Swap: Receive SOFR | — | +$10.5M (5.25%) |
| Net interest cost | $14.5M (7.25%) | $13.5M (6.75%) |
Savings from hedge: $1 million
Year 2 analysis (SOFR falls to 3.75%):
| Component | Without Hedge | With Hedge |
|---|---|---|
| Loan interest (SOFR + 200) | $11.5M (5.75%) | $11.5M |
| Swap: Pay fixed | — | -$9.5M (4.75%) |
| Swap: Receive SOFR | — | +$7.5M (3.75%) |
| Net interest cost | $11.5M (5.75%) | $13.5M (6.75%) |
Cost of hedge: $2 million (rates fell, hedge unnecessary in hindsight)
VaR Analysis
Unhedged interest cost VaR (95%, 1-year): Assuming 1% annual SOFR volatility: VaR = $200M × 1% × 1.65 = $3.3 million potential increase in interest expense
Hedged VaR: Interest expense locked at $13.5M (fixed rate × notional) VaR ≈ $0 for interest rate component
Mark-to-market VaR: Swap MTM changes with rates, but this is accounting volatility, not cash flow risk.
Hedge Ratio Sensitivity
| Hedge Ratio | Duration Reduction | Residual Risk |
|---|---|---|
| 100% | 8 → 0 | Over-hedged if rates fall |
| 75% | 8 → 2 | Moderate residual |
| 50% | 8 → 4 | Balanced |
| 25% | 8 → 6 | Minimal hedge |
Risks, Limitations, and Tradeoffs
Basis Risk
SOFR vs. loan rate: If loan is priced at SOFR + spread but spread changes:
| Scenario | Impact |
|---|---|
| Spread widens | Higher cost than expected |
| Spread narrows | Lower cost than expected |
Term SOFR vs. overnight SOFR: Different SOFR variants may not move identically.
Accounting Considerations
| Treatment | Requirement |
|---|---|
| Hedge accounting | Must designate and document |
| MTM through P/L | If no hedge accounting |
| Cash flow hedge | For floating-to-fixed conversion |
| Fair value hedge | For fixed-rate asset/liability |
Counterparty Risk
Cleared swaps: CCP guarantees; minimal counterparty risk Bilateral swaps: Counterparty exposure on MTM gains
Opportunity Cost
Fixing rates means:
- Missing benefits of rate decreases
- Locked into fixed payment regardless of market
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Tenor mismatch | Swap maturity differs from debt | Match tenors |
| Notional mismatch | Swap amount differs from exposure | Verify amounts |
| Index mismatch | Swap SOFR vs. loan prime rate | Use matching index |
| Early termination | Debt paid off early; swap remains | Include break clauses |
Advanced Strategies
Forward-Starting Swaps
Lock in rates for future debt:
- Execute swap today
- Swap starts in 6 months
- Useful for anticipated borrowing
Swaptions
Buy optionality on rate exposure:
- Payer swaption: Right to pay fixed
- Receiver swaption: Right to receive fixed
Partial Hedging
Hedge portion of exposure:
| Hedge % | Fixed Cost | Rate View |
|---|---|---|
| 100% | Known | Rates will rise |
| 50% | Partially known | Uncertain |
| 0% | Fully floating | Rates will fall |
Checklist and Next Steps
Pre-hedge assessment:
- Quantify interest rate exposure
- Calculate current DV01 or sensitivity
- Determine hedge objective (cash flow vs. MTM)
- Select appropriate swap tenor
- Calculate required notional
- Evaluate accounting treatment
Execution:
- Obtain swap quotes
- Verify ISDA documentation in place
- Execute swap
- Confirm trade details
- Document hedge designation (if hedge accounting)
Ongoing management:
- Monitor swap MTM
- Track effectiveness
- Plan for debt maturity or refinancing
- Review quarterly for rebalancing
- Document P/L attribution
Related articles:
- For commodity hedging, see Using Futures to Hedge Commodity Exposure
- For currency hedging, see Currency Hedging for International Holdings