# Interest Rate Futures

So the text says that if we expect -

Interest rates to go up, we under hedge using Int Rate Futures.

Can someone explain the rationale behind this? Rates going up implies that prices will drop, shouldn’t we completely/overhedge this?

¯\_(ツ)_/¯

Schweser CFA® study packages are the key to CFA exam success. Serious about the passing the CFA exam? Just choose Schweser.

Simplify the complicated side; don't complify the simplicated side.

Financial Exam Help 123: The place to get help for the CFA® exams
http://financialexamhelp123.com/

My question pertains to Reading 22 Examples 5 and 6.

I just dont seem to get the relation between the hedging and the Interest rate movements.

¯\_(ツ)_/¯

I’ll take a look.

Simplify the complicated side; don't complify the simplicated side.

Financial Exam Help 123: The place to get help for the CFA® exams
http://financialexamhelp123.com/

so you have a portfolio of assets and a liability that would have a duration gap.

now calculate the number of future contracts needed to close this duration gap to 0 (and to whether buy or sell)

compare it with the amount of contracts the manager has sold/bought.

if duration gap is negative (duration of assets is lower than duration of liabilities), the manager should buy futures. however, if the amount of futures he bought is less than what is required to close the gap, the manager is under-hedging and duration gap is not 0, but still a slight negative. this implies that the manager expects rates to rise as the lower asset duration would benefit from this move.

The same goes if the manager buys way too many futures and causes the duration gap to be positive instead. this implies that the manager expects rate to fall.

if duration gap is positive (duration of assets is higher than duration of liabilities), the manager should sell futures. however, if the amount of futures he sold is less than what is required to close the gap, the manager is again under-hedging and duration gap is not 0, but a slight positive. this implies that the manager expects rates to fall as the higher asset duration would benefit from this move.

The same goes if the manager sells way too many futures and cause the duration gap to be negative instead. this implies that the manager expects rate to rise.

Isn’t duration gap calculated by Duration of L - Duration of A? Therefore wouldn’t a positive duration gap be when liabilities is higher? I might be just overtired…..

for me, it doesn’t really matter, but I use DA  - DL because this sequence is also used in calculating leverage adjusted duration gap for banks in institutional investors reading (DA - kDL)

Thanks! I get it now. It’s basically a comparison between how much the manager should hedge to close the duration gap vs how much he actually hedges to incorporate IR expectations.

So, if there is a positive gap (A > L) and:

- rates increase = OVER hedge

- rates decrease = UNDER hedge

And if there is a negative gap (A < L) and:

- rates increase = UNDER hedge

- rates decrease = OVER hedge

Please correct me if I am wrong.

¯\_(ツ)_/¯

That’s correct.

And another way to look at it is:

1) If you expect an interest rate decrease, you want your assets to be sensitive (Higher asset duration.)

2) If you expect an increase in interest, you want your liabilities to be more sensitive (Higher liabilities duration.)

Then look at your starting position, see whether your liabilities are exposed or your assets are, and then over/under hedge accordingly.

Edbert wrote:

for me, it doesn’t really matter, but I use DA  - DL because this sequence is also used in calculating leverage adjusted duration gap for banks in institutional investors reading (DA - kDL)

Thanks for this. I kept forgetting the leveraged adjusted formula for banks, and your comment was like a light bulb ”duh” moment for me. Much appreciated!