(thinking about) hedging municipal portfolios with...
TRANSCRIPT
(Thinking About) Hedging Municipal Portfolios
with DerivativesCadmus Hicks
February 20, 2003
2003 by Nuveen Investments
Why is duration so long?
Municipal Yield Curve
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Maturity
Why is duration so long?
Municipal Yield Curve
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 18.00
Duration
The Challenge
• To reduce the price volatility of a fund to match that of a benchmark.
Moving Target, Moving Train
Parallel Shift: Durations of Fund vs. Benchmark
5
6
7
8
9
10
11
12
125i
100i 75
i
50i
25i
Baseli
ne -25i
-50i
-75i
-100i
-125i
paralle l s hift yie ld s ce nario
dura
tion
Benchmark Fund
Moving Target, Moving Train
D ifference in D urations of Fund - B enchmark
0.4
0.9
1.4
1.9
2.4
2.9
3.4
3.9
4.4
125i
100i 75
i
50i
25i
Baseli
ne -25i
-50i
-75i
-100i
-125i
paralle l s hift yie ld s ce nar io
dura
tion
diffe
renc
e
The Bond Buyer 40
TV = Theoretical value of the contract
I = Index valueSMR= Short-term municipal rateLMR = Long-term municipal rateDR = Days remaining until expirationCGTR= Capital gains tax rate
The Bond Buyer 40
CGTR
DRLMRSMRIITV
−
−+=
1360
)(
The Bond Buyer 40
Advantages:In use for many years.No counterparty risk.
Disadvantages:Low trading volume, low liquidity.Underlying Index subject to manipulation.
MMD Rate Locks
• Maturity: 2023 Yield:4.65%
• Value of 1 bp per $1 million: $1,289
• 5 bp spread x DV01/$1MM: $6,443
• Effect of spread on return: 64 bp
• Annualized effect: 258 bp.
MMD Rate Locks
Assume:
Portfolio = $100MM
Average Life = 15 Years
Average Duration = 11 years
DV01 = $110,000
MMD Rate Locks
Assume Target:
Average Life = 10 Years
Average Duration = 8.25 years
DV01/$MM = $825
Target DV01 of Portfolio = $82,500
MMD Rate Locks
Actual DV01 = $110,000
Target DV01 = $ 82,500
Hedge Need =$ 27,500
DV01/$MM of 10 year MMD = $825
$27,500 / $825 = 33 contracts
MMD Rate Locks
Hedge Need =$ 27,500
DV01/$MM of 15 year MMD = $1,100
$27,500 / $1,100 = 25 contracts
DV01/$MM of 20 year MMD = $1,300
$27,500 / $1,300 = 21 contracts
Moving Target, Moving Train
Parallel Shift: Durations of Fund vs. Benchmark
5
6
7
8
9
10
11
12
125i
100i 75
i
50i
25i
Baseli
ne -25i
-50i
-75i
-100i
-125i
paralle l s hift yie ld s ce nario
dura
tion
Benchmark Fund
MMD Rate Locks
Advantages:Can take position on specific maturity.Simple to track value.
Disadvantages:Counterparty risk.Large bid/ask spread.
BMA Swaps
Advantages:Can take position on specific maturity.Bid/Ask spread of 3 basis points.
Disadvantages:Counterparty risk.Negative carry lowers tax-exempt income.Less liquid than LIBOR swaps.
Forward Starting BMA Swaps
R1 = 1-year BMA rate = 1.26%R20 = 20-year BMA rate = 4.20%F19 = Rate on 19-year swap that starts in
1 year.
(To simplify, illustration assumes annual compounding.)
Forward Starting BMA Swaps
To simplify, illustration assumes annual compounding
2020
1919
11 )1()1(*)1( RFR +=++
201919
1 042.1)1(*0126.1 =+ F
Forward Starting BMA Swaps
=+
0126.1277.2)1( 19
19F
191
19 0126.1277.2)1(
=+ F
Forward Starting BMA Swaps
0435.1)1( 19 =+ F
%35.419 =F
Forward Starting BMA Swaps
Advantages:Can take position on specific maturity.Capital gains/losses do not affect income.
Disadvantages:Counterparty risk.Less liquid than LIBOR swaps.Forward start costs more.
(Thinking About) Hedging Municipal Portfolios
with DerivativesCadmus Hicks
February 20, 2003
2003 by Nuveen Investments