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Hedging bond portfolios. CLS Winter Conference 2014. Historical yields. Measures taken to mitigate duration risk. Hedges utilising simple derivative strategies. Short gilts 6 year bank issued note 1, 2 or 3 times short 7-10 year gilts at maturity Rolling of gilts to maintain duration
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Hedging bond portfolios CLS Winter Conference 2014
Hedges utilising simple derivative strategies • Short gilts • 6 year bank issued note • 1, 2 or 3 times short 7-10 year gilts at maturity • Rolling of gilts to maintain duration • Additional floating coupon of 3 month libor +…. Assuming a gradual increase in yields over the next six years Structure implicitly floored if you assume rates can’t go below zero
Fixed rate bonds into floating Day 1 • Investor sells existing portfolio of fixed coupon bonds. • Investor buys a floating rate note with the cash proceeds. During the life • Cash flows arising from the Collateral are passed to the Bank Counterparty. • In return, the Bank Counterparty will pay a libor linked coupon. At maturity • Investor receives 100 less any default amounts on collateral Investor 3 Month Libor + /- Principal at maturity Cash Collateralised Note Platform Fixed Coupons 3 Month Libor + /- Collateral Bank Counterparty Investor effectively creating floating rate notes, whilst maintaining the credit profile of their original portfolio.
Hedges utilising simple derivative strategies Digital Options Coupon Paid Are current rates above the option strike level? Yes Yes Are we at maturity of the option? No Coupon Option traded in secondary at MTM No No 2.5 pence premium buys you
Hedges utilising simple derivative strategies • Digital Option • 5 years • GBP • Strike 6% • Coupon 16.5% • 2.5% Premium
Hedges utilising simple derivative strategies Payer Swaptions • Provides the holder with the right to enter into a fixed versus float swap Pay a fixed rate Fixed versus float swaps Party A Party B Receive a float rate • At inception the value of the swap is zero, since PV of float leg equal to that of fixed leg. • If rates go up, the mark-to-market of the swap will go in favour of Party A and vice versa.
Hedges utilising simple derivative strategies Payer Swaptions • 6 month duration • Option to enter into 10 year fixed versus float swap • Cash settled, based upon market value of the fixed v float swap at expiry of the option Swap value Are current rates above the option strike level? Yes Yes Are we at maturity of the option? No Payment Option traded in secondary at MTM No No
Hedges utilising simple derivative strategies Payer Swaptions • 6 month duration • Strike ATMF + 100bps
Hedges utilising simple derivative strategies • Digital Option • 6 months • GBP • 7th July 14 – 7th July 24 fixed v float • 35bps premium
Alternative ways to play rates • Equity linked digital • 6 years • GBP • S&P / FTSE • EKI Put 60% • Digital Barrier 60% • Coupon Payment Semi-annual • Digital Coupon • Both underlyings at or above Digital Barrier • 226% * GBP 6-month Libor p.a. • Equity linked reverse convertible • 10 years • GBP • S&P / FTSE • EKI Put 60% • Payment at maturity • Both underlyings at or above put barrier • 100% + Max (5.80%; 3M Libor +1.30%) • Worst of underlying below put barrier • 100% + Max (5.80%; 3M Libor +1.30%)minus worst underlying performance
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