Hedging with interest rate caps compared with a policy of maintaining a balanced portfolio of loans (PLA) and averaging the borrowing costs

Abstract

This paper compares two different strategies for managing interest rate exposure. One involves maintaining a borrowing portfolio using short and long term debt lines in order to maintain an average borrowing cost. The second involves using interest rate caps to manage exposure to interest rate risk. The two strategies are compared using a set of daily quarterly rates from three months out to 10 years (120 months) of BBSW zero rates, par rates and forward rates from June 2000 to September 2006. The data set of implied volatilities (Appendix I used for interest cap quoting and pricing) consists of volatilities for 1, 2, 3, 4, 5, 7 and 10 year maturities; the data set is made up of daily closing mid-quotes for the period. We examine whether interest rate caps would be a better alternative for minimising interest rate risk as compared to a structure that combines a portfolio of rolling short-term debt with one of rolling long-term debt lines. Using principal component analysis (PCA) we explore the behaviour of, and the number of factors driving volatilities. As caps are quoted in terms of implied volatilities, and we know BlackÃŒs (1976) model is very sensitive to changes in these volatilities. We use PCA to examine the factors driving cap price volatilities. We explore the best way of using caps to manage interest rate risk. This should help us understand what factors affect cap prices and how many factors might be used in the interest rate models used to price interest rate derivatives such as caps and floors. We use Sharpe ratios to assess the relative borrowing costs of different strategies in relation to the volatility of their outcomes. We examine whether interest rate caps would be a more efficient method for minimising interest rate risk as compared to the a portfolio of loans.Hedging with interest rate caps, Vegas, Sharpe ratios, Principle components analysis