How do sell-side institutions manage interest rate derivatives books in practice?

Question

I'm interested in real practices of hedging interest rate caps and floors. There are plenty of articles explaining pricing of interest rate derivatives, but not so many explaining hedging such derivatives in practice. How do banks manage their interest rate caps and floors books?

The easiest approach seems to be delta-hedging each of the caplets individually with futures or FRA, however the amount of hedges needed for products with long maturities and therefore constituted from many caplets can be quite high and each of these hedges comes with corresponding bid-ask spread and transaction costs. Therefore a more sophisticated approach treating a cap as a whole product is desired. Are there any articles or sources treating hedging strategies for interest rate caps and floors?

Answer 1

I don’t know of any articles on this subject but I can tell you broadly what the approach is. First of all this is all done on a portfolio basis- all the similar trades are placed in the same book, so that only the net exposure is calculated and hedged. So for example the model would generate FRA hedges along the curve, one for each bucket which is perfectly manageable. I’d also add that swaptions are generally considered a similar product to caps and floors, so those would often be in the same portfolio.