Hedging recurring interest rate exposure: an evaluation of alternative strategies with Eurodollar futures contracts

Date

1999-05

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Publisher

Texas Tech University

Abstract

One unique type of exposure that many financial institutions and corporate treasuries encounter is repetitive or recurring interest rate or price exposure. When one is faced with repetitive or recurring interest rate exposure, a question arises as to which expiration month futures contracts should be employed to hedge against this type of exposure. With regard to this issue at least two alternative hedging strategies are available; a stack (rollover) hedge and a strip hedge (Kawaller, 1991). The purpose of this dissertation is twofold. First, to fully layout the conceptual issues in order to examine how different factors (i.e., basis, risk premium, calendar spread, transaction costs etc.) related to liquidity and pricing considerations influence the risk/return characteristics of the alternative (no-hedge, strip and stack) hedging strategies. Second, to investigate empirically the effectiveness of these strategies in managing repetitive interest rate exposure with Eurodollar futures contracts.

The empirical investigation examines the historical performance of the three alternative Hedging strategies over the period December 1, 1983-Febmary 28, 1999. The alternative strategies are evaluated against four evaluation criteria that are based on different hedging objectives (risk minimization, target rate realization, return maximization and risk-return optimization). In addition, under each Hedging objective we examine the factors that contribute to the differences in the performance of the Hedging strategies. The ex-post effectiveness of alternative hedging strategies is tested by simulating quarterly cost of a representative bank's loanable funds used to finance a series of hypothesized fixed-rate loans. Three alternative hedge periods/loan terms are considered (two-quarter, four-quarter period and six-quarter). Under each hedge period, both overlapping and non-overlapping samples are examined.

Review of the literature on Hedging theories clearly indicates that there is not a single objective that motivates all hedgers. In order to compare the performances of alternative strategies, specific criterion consistent with specific Hedging objective needs to be utilized. Our empirical evidence provides guidance for a potential short or long Hedger to select the strategy that suits his or her risk-return preferences.

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