CBOE preps first hedge for fixed-income volatility.
Corporates have long had a variety of tools to hedge against the impact of rising interest rates, and soon they will have a futures contract enabling them to hedge against rate volatility, or sharp movements either up or down.
The Federal Reserve assuaged concerns last week that it would pursue higher interest rates in the near future, but market observers generally agree that it is likely to start bumping up rates sometime in 2015. And some fear they could jump sooner, ahead of any Fed moves, should inflation show signs of increasing.
Across the pond, however, rates on German and French government bonds have recently moved in the other direction, to offer negative returns, displaying how rates can swing either way in uncertain times and put investors in even traditionally safe fixed-income at risk.
“Hedging bond portfolios is going to be one of the primary applications of interest-rate volatility futures,” said Yoshiki Obayashi, founder and managing director of Applied Academics.
Those future contracts will be based on the CBOE/CBOT 10-year U.S. Treasury Note Volatility Index (ticker symbol VXTYN), which Applied Academics helped the CBOE develop and launch in May 2013. The Chicago Board Options Exchange’s (CBOE) CEO, Edward Tilly, announced in early September at the Chicago-based company’s risk management conference in Dublin that its futures exchange affiliate plans to begin trading the contracts on Nov. 13.
The Chicago Board Options Exchange’s most popular option and future contracts in recent years have been based on its Volatility Index (VIX). It first used the proprietary methodology to design derivatives giving exposure to S&P 500 Index volatility, and it later expanded to other equity exposures as well as commodities.
The bond market, however, dwarfs those asset classes. Corporates invest in Treasury bonds as well as high-rated corporate and structured bonds, and the VXTYN future will provide a tool to hedge volatility risk across those bond types.
“Whenever Treasury volatility makes big moves, the rest of the fixed-income market is impacted,” Mr. Obayashi said. “When there are big upheavals, all volatility goes up and down. So this is a good representative for a lot of fixed-income assets.”
Amol Dhargalkar, managing director at advisory firm Chatham Financial, said that to use such a product effectively corporate treasury executives should carefully evaluate the composition of their company’s fixed-income portfolio. Depending on the shape of the interest-rate curve, some bond investments’ value could remain steady while the future contract changes in value.
“Anything less than a 100 percent match, exactly hedging your specific portfolio, leaves the corporate treasury open to some level of risk,” Mr. Dhargalkar said.
Another consideration, he said, is the company’s mix of assets and liabilities. If it is frequently rolling over short-term securities, for example, rising rates could increase its interest income, depending on how the yield curve is shifting.
“If part of the portfolio is longer term Treasuries or corporate bonds, then a company could potentially use this product to hedge,” Mr. Dhargalkar said. “But it must be very careful about matching up maturities and other parts of the bonds, to reduce the basis risk as much as possible.”