In selecting the hedging ratio. For example, the mandate could be to stay within a range of 25% to 75%. When the manager anticipates lower market rates and gains on receive- fixed interest rate swaps, the manager prefers to be at the top of an allowable range. On the other hand, if market (swap) rates are expected to go up, the manager could reduce the hedging ratio to the lower end of the range
The above paragaraph can some one explain. why we are overhedging when the interest rate swaps are in gain? we shouldn’t under hedge in this gain as we are receiving fixed and paying floating. The idea
lets assume we are hedging a fixed rate bond with IRS.
The hedge ratio is then the notional to hedge the fixed coupon with respective to interest rate change.
When we expect rate to fall we would like to increase duration because longer maturity bond pays higher interest and also we want large duration to benefit from the larger raise in bond price.
First if we want duration from IRS we have to be the fixed receiver. Assuming now you are already a fixed receiver in the swap and you want MORE of it and so you increase your hedge ratio ( notional ) and so you become top of the range ( overhanging ) when we expect rate to fall.
Swaps is a tool of hedging. If you expects gains on swaps then you should increasing the hedge ratio to gain more. When the market rates fall, there’s a gain on received-fixed interest rate swaps.