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Hedging an Over the Counter (OTC) Swap
Hedging an Over the Counter (OTC) Swap

Constructing a basis point value hedge ratio for a 5-year "vanilla" interest rate swap
To construct the best hedge it is important to reconcile the price sensitivity — often referred to as the swap’s "duration" — of a cash market "vanilla" interest rate swap with that of the CME Swap Rate futures contract.

It's important to determine the value of a 1-basis point change in the yield on the notional amount of the cash interest rate swap to be hedged and the value of a 1-basis point change on the 5-year Swap futures. The $200,000 notional CME 5-year Swap Rate futures contact has a fixed 1-basis point value of $100.

Assume that on July 16, 2003, a "fixed" rate receiver of 5.57% semi-annual 30/360 and "floating" rate payer of 3-month LIBOR for approximately the next 5-years on a notional amount of $10,000,000 wants to hedge against a rise in interest rates by selling or "shorting" some number of 5-year Swap futures. Being a fixed rate "receiver" ("payer") on a swap is similar to being long (short) a note or bond and the hedge would involve selling (purchasing) futures contracts. We are looking to construct a duration based hedge ratio when the current value of a swap of this maturity — or yield — is at 5.57%. The value of a 1-basis point change in yield on this cash $10 million notional interest rate swap is $4,486.

 

$4,486

 

 

 

 

Hedge ratio:

------

 

=

 

45 5–year Swap

 

$100

 

 

 

contracts to "short"