duration hedging - how to change a duration of portfolio

so i understand that duration hedging means you set the duration of your assets equal to the duration of your liabilities and so then your portfolio will be protected if rates shift up or down in a parallel way. but how do the banks actually change the duration of the assets or liabilities? do they just buy or sell more investments with a shorter or longer duration such that the whole portfolio’s duration shortens? or do you use derivatives to change the duration? if so can someone plz give me an example of how a derivative can be used to change the duration of the portfolio? thanks a lot!

Treasury futures will have a similar duration to their underlying Treasury instrument and can be implemented long or short, as necessary, so that is an inexpensive way to change the duration rapidly. It’s a big topic in Level III. You can also do it with swaps. If you are trying to hedge credit duration, that is trickier. Swaps might work there if you can get someone to do a swap on your particular credit instrument. I imagine that there’s a way to do it with CDSs, but I haven’t thought it through fully.

thanks bchad!

ARMs are also a way for banks to shorten their mortgage portfolio duration. Meanwhile longer-term CDs are also used to lengthen the duration of a bank’s deposit base. I’m not sure however, to what extent the above measures contribute to their overall immunization strategies.

banks & other liability matching FI’s go as deep as managing key rates sensitivities. Swap market is the way to go as it’s very liquid in 1-7 year.

thanks guys! im not very familiar w these topics, can someone explain, lets say the swap market is used or even ARM’s or treasury futures, can someone give an example of how using one of these products will reduce or increase ur duration? im just looking for the theory behind this. i know that buying more investments with longer terms can increase ur duration or vice versa, but im just trying tro understand how it works with the other products. thx in advance

A swap can be thought of as a pairs trade between a fixed rate bond and a floating rate bond with the same maturities (in this case, maturity = the maturity or tenor of the swap). So the duration of the swap (from the perspective of the fixed rate receiver) = duration of the fixed bond minus duration of the floating bond. The duration of the floating rate is usually close to zero and pretty much always < 1. If the floating rate bond reset rates daily, it would have zero duration. The duration of a floating instrument at anyone time is approximately length of time (in years) to to the next rate reset. For annual-pay bonds, it averages out as 0.5, for semi-annual pay bonds, it averages out to 0.25. If you’re reciving floating rates, it’s the reverse (so a swap is one way to acquire a negative duration instrument; another way is to short a bond future, or to sell a bond/borrow money). A fixed pay bond + a short swap (i.e. receive floating) with the same tenor will reduce the duration of the portfolio (assuming there is just a bond in the portfolio) to about 0.25 by converting the fixed bond into a floating bond (that assumes that the fixed rates of the swap = the fixed rates of the paying bond; if not, then you get a duration of 0.25 + the duration of a bond with coupon payments = difference between floating rates).

thanks a lot bchad! so i understand the swap part. you’re saying if we have one bond in the portfolio that is paying a fixed rate. and then you hedge with a receive floating rate and pay fixed rate swap and your portfolio’s duration will fall. but im a little confused about the acquiring a negative duration part. so if im receiving floating rates, then i enter into a pay floating and receive fixed swap? but doesnt that increase the duration then? and how would selling a bond affect the duration then? is it because now the duration has increased because you’re paying fixed for the bond? sorry if the qs are too basic, appreciate the help!

in real life asset managers use software like bloomberg and they change their portfolio duration by buying or selling bonds with varying duration. derivatives are also an option but may not be required (also its expensive and silly to buy derivatives every week to change your duration when you can just adjust your holdings)

I’m not a fixed income manager, but my sense was that derivatives was for tactical adjustments to duration and using derivatives tended to have a lower overall transaction costs (plus you continue to accumulate coupon payments on the underlying stuff). I forgot to mention in the post above (though dukatu2 mentioned it), that the advantage of swaps is that you can target them to a specific key rate, 2yr, 5yr, 7yr, etc, whereas treasury futures are tied to a 15 year T-bond (or is that a T-note?), and so isn’t as helpful as a swap for targeting key rates (though it’s fine for parallel shifts).

jimjohn - Think of a bond, receiving fixed is like recieving the coupon on a bond. Owning a bond will give you positive duration, so receiving fixed will give you positive duration. If you pay fixed, you are paying the coupon, you have negative duration, you’re short the bond. Floating is the opposite of what your fixed action is (i.e. receive fixed/pay floating = positive duration. The opposite is also true). How this affects the portfolio’s duration depends on the portfolio’s duration before making changes. …at least I think that’s right, ha.

thanks guys!

bchad you mention that t-bond futures are for 15yr bonds. I found some on the CME site for the other rates (for instance: http://www.cmegroup.com/trading/interest-rates/us-treasury/10-year-us-treasury-note.html) It also seems like the 10-yr has higher volume than the 15-yr. I don’t know much about these products beyond what’s in the CFA materials so I went here to download some materials. http://www.cmegroup.com/trading/interest-rates/index.html They have some good white papers on the site that might help the OP with understanding this stuff also.