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How would a bond trader hedge his/her interest rate risk? A nature way is to hedge it with interest rate swap. Is this a choice in practice ? is their any risks associating with this hedging strategy.

of course bond would have credit risks that IR swap does not have. I am only considering IR risk here only

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    $\begingroup$ Are you trying to protect against a rise in interest rates? $\endgroup$
    – Bob
    Commented Sep 24, 2018 at 2:01

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I suppose it depends on the context, i.e. what the trader is trying to do. But arguably this is one of the thing swaps were invented for:

If you are long a bond you receive fixed payments from the bond (the coupons). By entering a swap where you pay fixed and receive floating you can largely get rid of the interest rate risk. Essentially you have turned your bond into a floating rate instrument.

Whether it is common or not, it is good to be familiar with this type of thinking.

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The trader (excluding credit risk) would be more likely to hedge his rates risk through offsetting Treasuries (either spot or futures).

If you think about it, a dynamically hedged swap book (from the dealer's perspective) is a pool of cash flows (either from bonds or hedges) that even out. It's easier to buy and sell the more liquid Treasuries than try to hedge with an OTC swap through another dealer.

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  • $\begingroup$ Not necessarily - it depends upon the liquidity of the market, and of the correlation of the hedge. Many European credit bonds are benchmarked against swaps and have a better correlation with swaps (but not all of course). In Sterling the swaps are often more liquid than the treasuries. $\endgroup$
    – Attack68 ♦
    Commented Sep 24, 2018 at 20:12
  • $\begingroup$ Assuming US market as it is by far the largest by a long shot. $\endgroup$
    – Kch
    Commented Sep 24, 2018 at 21:55
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First, I am assuming that the bond trader has a long position in bonds and therefore is concerned that if interest rates go up the price of the bonds will go down. The problem here might be that he/she bought 20 years bonds when he/she should have bought 5 year bonds.

One way to hedge against a rise in interest rates would be options on interest rates. For more information about that, I refer you to a PDF by the COBE which can be found at the following URL: http://www.cboe.com/learncenter/pdf/iro.pdf

Bob

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    $\begingroup$ Personally I wouldn't call this a hedge, in the sense of a minimising a trader's daily PnL fluctuation from the underlying long position. It is a more a protection or insurance strategy. If you chose to match the delta on the option to offset the underlying, you could effectively serve the same purpose by simply selling the underlying (funding permitting), without, then, the need to introduce additional risks (vega and gamma) to your portfolio. Even if funding didn't permit the short selling, treasury futures might be a more direct hedging option than an 'option', ironically. $\endgroup$
    – Attack68 ♦
    Commented Sep 24, 2018 at 20:22

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