1. The portfolio managers of a firm determined that over the next year interest-
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Question
1. The portfolio managers of a firm determined that over the next year interest-sensitive assets are in the amount of $1.5 billion while interest-sensitive liabilities are in the amount of $1.8 billion. Moreover, when considering all of the firm's assets and liabilities, they determined that the average duration of assets is 3.6 years while the average duration of liabilities is 4.0 years. The firm’s debt-to-equity ratio is 4-to-1.
1) Calculate GAP and Duration GAP (DGAP) for this situation.
2) What will happen to net interest income and relative asset prices (market values) as interest rates rise or fall?
(In other words, how are net income and overall market value impacted by changes in interest rates?)
3) What strategies could management employ to hedge against this risk?For instance should it buy or sell futures, call options or put options (i.e., for each derivative is it a buy or sell strategy?)?
Explanation / Answer
1) GAP = Duration of Assets - Duration of Liabilities
= 3.6 - 4
= -0.40 Years
Duration GAP = Modified Duration of Assets - Weight of Liabilities * Modified Duration of Liabilities
Weight = Rate Sensitive Liabilities / Rate Sensitive Assets
= 1.8 / 1.5
= 1.2
Duration GAP = 3.6 years - (1.2*4.0 years)
= -1.2 years
2) As if rising interest rates weren’t bad enough for bonds, if you are a shareholder in a bond fund during a period such as this, your pain will likely be greater than an investor invested in an individual bond. For example, a given bond fund will hold hundreds, perhaps several thousand individual bonds. When interest rates rise, to avoid further losses, shareholders in a bond fund will liquidate their shares. When this occurs, the fund manager may be forced to sell bonds prematurely in order to raise enough cash to meet its redemption requests. This can have a destructive effect on the average price of a bond fund, called its net asset value (NAV). Hence, bond funds have an additional risk during periods of rising interest rates, referred to as redemption risk. Redemption risk exaggerates the pain for those who remain in the fund. However, if you own an individual bond, as long as you hold it until maturity, none of this price fluctuation means very much because when your bond matures, you will receive its par value or 100% of its original value.
3) Hedging is a sophisticated mechanism which provides the necessary immunity to the above interests in the marketing of commodities from the risk of price fluctuations. It basically involves the purchase or sale of a futures contract to reduce or offset the risk of a position in the underlying asset. A hedger gives up the potential to profit from a favourable price change in the position being hedged in order to minimize the risk of loss from an adverse price change.
A hedge may be either short or long. A short hedge involves a short position in futures contracts. It is appropriate when the hedger already owns an asset and expects to sell it at some time in the future or even when an asset is not owned right now but will be owned some time in the future. Take, for instance, a farmer who expects a harvest only after 6 months and is unsure about the price fluctuations. To hedge this risk, the farmer can enter into a futures contract for sale of rice, 6 months from now, at the prevailing market price.
Hedges that involve taking a long position in a futures contract are known as long hedges. A long hedge is appropriate when a company / individual knows it will have to purchase a certain asset in the future and wants to lock in a price now. Taking the same example as above, if a consumer is uncertain about the price movements of rice, he can hedge his risk by going long a futures contract at the prevailing market price. This would neutralize his position in case of inflation. Though hedging protects from price risk, a hedged position often suffers from basis risk.
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