What's the proper way to hedge interest rate risk on a stock position?

A stock or a bunch of stocks, e.g. spooz?

For simplicity, let's start with an Index - eg S&P

I am not an expert at this by any means, but wouldn't this be an application of a dividend discount model? That would make sense to me, based on first principles. Once you have obtained a value from DDM, just perturb the discount rate and you will have the "DV01" (interest rate sensitivity) of the index. Obviously, there's all sorts of devils in the details and somewhat arbitrary assumptions that you'll have to make, but it's a start. Once you have the DV01, you may choose to "hedge" it with some offsetting instrument(s). The choice of instruments will depend on the exact way you discount.

Maybe more equity-oriented peeps can chime in and offer their thoughts...

Theres two ways to do it really:

1) If you think interest rate acts as part of the discount rate for future cash flows/dividends then if you have your projected divs/CF's then i guess you can find the sensitivity to changes in rates and then hedge with hte appropriate term structure of euribor futures

2) Take your stock, or portfolio of stocks and look historically what happens when there is a large jump in interest rates, if you find a relationship/correlation you are comfortable with then use that relationship. I would do the analysis for all days, but then also make sure to do it just using days with large interest rate changes.

Method 2 in my opinion is the way to go, wiht method 1 really being just some intellectual masturbation.

derivstrading:

Theres two ways to do it really:

1) If you think interest rate acts as part of the discount rate for future cash flows/dividends then if you have your projected divs/CF's then i guess you can find the sensitivity to changes in rates and then hedge with hte appropriate term structure of euribor futures

2) Take your stock, or portfolio of stocks and look historically what happens when there is a large jump in interest rates, if you find a relationship/correlation you are comfortable with then use that relationship. I would do the analysis for all days, but then also make sure to do it just using days with large interest rate changes.

Method 2 in my opinion is the way to go, wiht method 1 really being just some intellectual masturbation.

IMHO, it's the Method 1 that the OP needs to use, although I wouldn't insist on euribors to hedge non-European equities :). There's a few simple dividend discount calculators online, if the OP wanted a quick and dirty answer.

Martinghoul:

Have you actually tried the 2nd method? I was curious about the OP's question and first thing I did was try a whole variety of regressions (e.g. Spooz vs nominal yields, Spooz vs real yields, using changes, levels, log levels, etc). I even tried to use sub-indices that are supposed to be traditionally more sensitive to rates, such as utilities. None of the regressions produced anything useful, i.e. very low R^2s (most below 0.2) and high sensitivity to the choice of sample periods. Maybe I was doing smth wrong...

IMHO, it's the Method 1 that the OP needs to use, although I wouldn't insist on euribors to hedge non-European equities :). There's a few simple dividend discount calculators online, if the OP wanted a quick and dirty answer.

Im european based so euribor futures is what i deal with to hedge some of the rho on the book.

I havent really hedged pure stock positons against interest rate changes with IR futures, its always been if I believe there is an assymetric opportunity off a rate decision I will skew the delta position a bit. Personally I think the only hedge is reducing the size of your position, not to introduce new instruments into the mix. IMO hedging equities with IR futures for interest rate risk is not a hedge but a pair trade and should be treated as such, and so you need to think there is an assymetric opportunity, where the relationship of the pair can break down in your favor

But if someone held a gun to my head and told me to pick a way of doing it, Id feel much more comfortable looking at what has happened to equities after large interest rate moves. Find the top 30 largest moves and find out why they happened, what caused the equity reaction, then think to how those situations compare to the current environment. In a way do the historical statistical analysis and then add your own judgement on top of it instead of looking at some fundamental discount model to value stocks. Id much rather trade on something that is stats + judgement based than based on some valuation model.

As you said oyu looked into regressions and didnt find relationships, so you know based on market prices that the relationship isnt there to trade on in your opinion, so how does switching to a valuation based discount model suddenly make there be a relationship.

The problem with the dividend discount model is that it will tell you to hedge one way always. For example if a company pays a dividend of 10usd for the foreseeable future, increasing rates will lower the PV of the div stream so you are inherently short rates. But this completely avoids the asset and liability structure of the company. What if one of your stocks you are holding has all its debt in fixed rate long maturity loans, but has lent out short term, if rates suddenly rise it will be able to roll over the money it lent out at a higher rate so it benefits, compared to a company that has a lot of short term debt that it will need to roll over in the next year. And then you have to consider the credit spread of the individual name etc etc. My point being is that you try looking at it through a fundamental valuation model and things get very complicated very quickly, and there are just too many moving parts.

My point is try to find a simple method that has shown to work, or reduce your position if you dont like the risk :)

IR sensitivity for a stock depends on the term structure of its assets and liabilities, including future cash flows. So it really varies by stock. If you're afraid of the general drag of a rate hike on the equity market and therefore your stock, you could simply short the S&P (or whatever other index).

i would not recomend even attempting to "hedge out the interest rate risk" in stocks because I think aside from some single names there isnt any negative correlation to speak of between stocks and rates. At specific moments, like a couple of weeks ago, the risk of a spike in rates definitely does weigh on the stock market and if you really felt the need to hedge this then maybe buy some puts on eurodollars or something like that. Sizing the hedge is difficult and there is really no right answer...you could size it many different ways depending on what your goals are. There are many ways to justify a hedge size using historic volatility, historic correlations etc but at the end of the day its all an art and sizing a hedge properly is very difficult...which is why when i have a trade that i feel the need to start hedging i generally prefer to just take it off.

Short treasuries.

Right, here we go... I've decided to look at this a little more closely. Inspired by this old paper here: http://www.federalreserve.gov/pubs/feds/1996/199603/199603pap.pdf

Unfort, the tool I used has issues w/their stored time series of Spooz total returns. So I had to confine myself to just price returns. The best regression I was able to produce was for a long-run relationship (starting point 1997) between 5y real yield (TIPS) and the realized Spooz 5y price return. The result is here: http://i.imgur.com/FrasOFE.jpg

Basically, if you're truly intending to hold your stock position for a long time (5y or more), based on historical experience, you're actually already short duration (nominal and real), which might be somewhat counterintuitive.

Obviously, there are caveats, such as: 1) For short-term mark-to-mkt fluctuations of your portfolio, there's supposedly evidence of a relationship (a rise in yields lowers returns), but I cannot find it. 2) We are currently at a somewhat unprecedented juncture in the mkts, which may imply that history is no guide.

It depends what the equities are/what impact of a rate rise you want to hedge against. You have to always keep in mind that rates are a dependent variable - rates don't just magically widen because the rate fairy came along and hit Ben Bernanke with her magic wand or whatever. All else equal, in a robust economy like the US wider benchmark rates imply a stronger macro environment, so that changes the calculus in terms of what hedge you want to put on. Like... if you were running some sort of a "high rate" stress scenario, you'd have to assume that rates increase for some specific reason, and that will partially determine your response. I mean look, the easiest answer is to say just buy some rate referenced derivative like a cap or a swap, but if you want to go a little deeper, you should think about the specific impact of a rate increase that is a threat to the business in which you own equity, and construct the hedge based on that. Some examples below:

1. Let's say your equity is in an insurance company with a large resi exposure on the asset side. If rates blow out, prepayments (CPR) falls because people tend not to refinance in high rate environments, but default rate and severity also fall because the higher rates imply a stronger macro environment. So you're going to get more cash out of the bonds, but it's going to come later. The bonds get longer, and all of a sudden you've got a duration mismatch between assets and liabilities. Your problem isn't a rates problem per se, it's a duration problem. If you're locked into enough long resi paper, it could even be a liquidity problem. A significant move in rates could mean less cash in the short term so you can't pay your liabilities as they come due. In this case, buying a cap wouldn't be sufficient because if you've got a liquidity problem, no matter how much it has increased in value the only way to realize that value on a cash basis is to sell it, which would leave you unhedged in the event rates continued to move against you. So the best hedge would be a product that pays a regular stream of straight cash in the event of a rate widening. The floating leg of a LIbor swap comes to mind as a pretty liquid product that meets this requirement, so that's probably what you'd want to buy to cover the cash impact, and to cover the duration impact... you have a lot of options as an insurance company - you could always dream up some new type of complex policy that lengthens when rates widen, but if you were one of those goodie two shoes types that isn't comfortable ripping off retail players, you have the choice of either buying a product that shortens portfolio duration in the event of a rate shock or selling a product that lengthens liability duration in the event of a rate shock.

2. Imagine your equity was in some kind of back door consumer finance company that takes some market risk between originating collateral and selling ABS into the capital markets. Like if you were an auto company or a timeshare company or something. If you originate loans at S+500 bps or whatever, with the intention to fund them at S+300 in the ABS markets and pocket the excess spread, if your cost of funding via the ABS markets blows out to S+600 due to rate moves and you've got a big chunk of collateral sitting on your B/S, you're all of a sudden 100 bps underwater on the entire notional value. Plus those businesses can't finance their day to day operations unless they can monetize their paper up front, so they'd be what they call "proper fucked." This one is a real rates problem, and it's a doozy. Sure you could rate lock the ABS during the origination period, but that would be extraordinarily expensive and if you blow your entire profit hedging, then what's the point of the whole endeavor? And if you can't sell the collateral to bring in cash, your business collapses. Really the best way to hedge in this type of scenario would be to write hedges into the revolving warehouse facilities you get from the bankers to fund the collateral as its originated. Structure the warehouses such that in the event you can't term out the collateral due to rates moving against you, you can continue to warehouse it without taking a major economic hit. Might have to slap a banker or two, but eventually someone will fold to lock in your underwriting fees.

3. Let's say your equity is in a major American global corporate with massive overseas operations. Higher rates in USD implies a stronger dollar (ignoring the whole flight to quality issue for simplicity's sake) and therefore makes their revenue from overseas operations appear relatively weaker just because they report in dollars. It's not really a rate problem, it's a currency problem. The proper hedge would be a currency forward, not a rate product.

So look - I'm tired of coming up with examples and I haven't even begun to touch on the liability side of balance sheets. Long story short a rate increase has broad implications across the financial space, so theres no single best way to hedge. Know what you're hedging against before you construct the hedge, because hedges can eat up a trade's profitability very quickly. The proper hedge depends on what kind of company you own equity in.

My view: betting on rates rising is not a hedge for an equity portfolio. I don't think you'll see a strong relationship between rates and stocks over most meaningful time periods. Generally, people think of stocks as an inflation hedge and bonds as a deflation hedge. To hedge interest rate risk, you have to short bonds in some fashion. So, if you short bonds against your equity portfolio, you're long inflation (through stocks) and short deflation (short bonds) which is closer to doubling down on your risks than to hedging.

Your risks with stocks are much greater with a host of other factors besides interest rates. I would focus on those.

Martinghoul:

What if them bonds were TIPS?

The reason I would not use TIPS to hedge an equity portfolio is because there are two components of the return of TIPS: the interest rate component and the inflation component. How to separate them and size the positions vs. equities is close to pure guess work (in my opinion).

If I want to hedge equities, I'm basically selling the position or buying puts because those are the only ways to directly reduce your exposure.

How about you?

SirTradesaLot:

My view: betting on rates rising is not a hedge for an equity portfolio. I don't think you'll see a strong relationship between rates and stocks over most meaningful time periods. Generally, people think of stocks as an inflation hedge and bonds as a deflation hedge. To hedge interest rate risk, you have to short bonds in some fashion. So, if you short bonds against your equity portfolio, you're long inflation (through stocks) and short deflation (short bonds) which is closer to doubling down on your risks than to hedging.

Your risks with stocks are much greater with a host of other factors besides interest rates. I would focus on those.

I disagree with this - certainly you see a strong historical correlation between rates and GDP growth, and I think most people would figure that GDP growth has a positive impact on stocks, so therefore rates up should mean equities up all else equal.

I agree that betting on rate increases isn't really a proper hedge for an equity portfolio, but I feel like common sense says in a base case type scenario high rates implies a stronger macro environment, which implies better performance in equities, and that has been the case historically.

NYCbandar:

I agree that betting on rate increases isn't really a proper hedge for an equity portfolio, but I feel like common sense says in a base case type scenario high rates implies a stronger macro environment, which implies better performance in equities, and that has been the case historically.

SirTradesaLot:

NYCbandar:

I agree that betting on rate increases isn't really a proper hedge for an equity portfolio, but I feel like common sense says in a base case type scenario high rates implies a stronger macro environment, which implies better performance in equities, and that has been the case historically.

That's sort of the point: hedging interest rates rising is a double down of your bet, not a hedge to your equity portfolio.

Touché

Great thread, we need more of these on WSO.

NYCbandar:

I think most people would figure that GDP growth has a positive impact on stocks

Empirically there is little to no correlation between GDP growth and equity returns...

http://www.businessinsider.com/benjamin-inker-on-stock-market-returns-2…

equities and rates often rise together and so yes it is true that often a short in bonds is the same as a stock long. howveer there are moments, very scary moments, where the bond market threatens the stock market with rapid and discontinuous rate rises. A couple of weeks ago when a blow-off in the us bond market was rippling thru EM i can assure you that for that moment stocks and rates were engatively correlated and if rates had kept rising it would have hurt the stock market badly. At those moments it might make sens to try to sell som bonds against a long in stix, but generally i find in these moments its better to make a decision on the original trade as opposed to trying to hedge it...

Generally, I think of it like this:

If stocks are absolutely melting down, Treasuries are one of the best things to own because they are usually appreciating significantly. So, normally I think of owning treasuries as the hedge against declining stock prices.

If rates are rising, initially I expect quick increases in interest rates to negatively effect the prices of almost everything. (discount everything at a higher rate). (however, it is hard for people slicing data to look for this to see it in the data because you'll need to slice the data pretty finely) Longer term, higher interest rates usually mean the environment is better for stocks in general. So, I don't think it's crazy for someone holding stocks to short bonds for short periods of time. But, for the person looking to set a year long hedge against their equity portfolio, shorting bonds is not something I would do.

Going Concern:

Great thread, we need more of these on WSO.

NYCbandar:

I think most people would figure that GDP growth has a positive impact on stocks

Empirically there is little to no correlation between GDP growth and equity returns...

http://www.businessinsider.com/benjamin-inker-on-s...

Ha, yeah... You realize that the Inkler guy they're talking about is just some assclown that ended up on the wrong side of history trying to talk his book, right?

Look I guess we can just agree to disagree - go ahead and short broad equity indices during macro growth periods. Sounds absolutely retarded to me personally, but I guess if it weren't for guys like you, the rest of us wouldn't be able to find counterparties, so keep on fighting the good fight.

NYCbandar:

Going Concern:

Great thread, we need more of these on WSO.

NYCbandar:

I think most people would figure that GDP growth has a positive impact on stocks

Empirically there is little to no correlation between GDP growth and equity returns...

http://www.businessinsider.com/benjamin-inker-on-s...

Ha, yeah... You realize that the Inkler guy they're talking about is just some assclown that ended up on the wrong side of history trying to talk his book, right?

Look I guess we can just agree to disagree - go ahead and short broad equity indices during macro growth periods. Sounds absolutely retarded to me personally, but I guess if it weren't for guys like you, the rest of us wouldn't be able to find counterparties, so keep on fighting the good fight.

LOL, I just gave one example, there are plenty of others. I'd love to see some actual evidence of GDP growth causing equity outperformance broadly instead of just the good ol' 'agree to disagree' copout. Some bullshit textbook equations don't count (obviously).

Also I'm not too sure where you see me saying to short broad equity indices, may want to brush up on that reading comprehension.

I agree with your other post though, the bottom line is that the OP is asking a loaded question...he's assuming that specifically interest rates have a tangible influence on equities. This may or may not be true depending on thousands of variables, it is fairly impossible to generalize. The hard part is actually isolating this relation for some sort of equity subset at some period of time at some point in some market cycle. Once you have done that with confidence then expressing the hedge should be fairly trivial, just use swaps or futures or some shit like that.

My last point on this subject... This is from the horse's mouth, so to speak: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1476376

Martinghoul:

My last point on this subject... This is from the horse's mouth, so to speak:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id...

Thanks for sharing. And yes, I was following your posts on the subject matter in other two forums.

zee4:

Martinghoul:

My last point on this subject... This is from the horse's mouth, so to speak:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id...

Thanks for sharing. And yes, I was following your posts on the subject matter in other two forums.

What I'm getting from this discussion is that even if I were to hedge myself against interest rate risk, I'd just be exposing myself to an equal model risk. Am I wrong?

Hot dang. This is going to kill my interns tomorrow. Thanks for bringing this up as we were discussing this a few weeks ago on my desk.

<span class=keyword_link><a href=/resources/skills/finance/going-concern>Going Concern</a></span>:

NYCbandar:

Going Concern:

Great thread, we need more of these on WSO.

NYCbandar:

I think most people would figure that GDP growth has a positive impact on stocks

Empirically there is little to no correlation between GDP growth and equity returns...

http://www.businessinsider.com/benjamin-inker-on-s...

Ha, yeah... You realize that the Inkler guy they're talking about is just some assclown that ended up on the wrong side of history trying to talk his book, right?

Look I guess we can just agree to disagree - go ahead and short broad equity indices during macro growth periods. Sounds absolutely retarded to me personally, but I guess if it weren't for guys like you, the rest of us wouldn't be able to find counterparties, so keep on fighting the good fight.

LOL, I just gave one example, there are plenty of others. I'd love to see some actual evidence of GDP growth causing equity outperformance broadly instead of just the good ol' 'agree to disagree' copout. Some bullshit textbook equations don't count (obviously).

Also I'm not too sure where you see me saying to short broad equity indices, may want to brush up on that reading comprehension.

I agree with your other post though, the bottom line is that the OP is asking a loaded question...he's assuming that specifically interest rates have a tangible influence on equities. This may or may not be true depending on thousands of variables, it is fairly impossible to generalize. The hard part is actually isolating this relation for some sort of equity subset at some period of time at some point in some market cycle. Once you have done that with confidence then expressing the hedge should be fairly trivial, just use swaps or futures or some shit like that.

Well, to give the most obvious example that's fresh in everybody's mind, look to the most recent "great recession." GDP retracted and equities got smashed.

Even look at tiny macro data points that imply stronger GDP growth - when they get announced better than expected, implying higher GDP growth, equities rally. Like, when a stronger than expected new jobless claim data point gets released, all else equal, equities rally. The reason I didn't want to get into a big argument is because its just a factual point. To prove your "GDP growth is unrelated to equity markets" point to be true, you've got a tall mountain to climb. Show me the better than expected macro data release that caused equities to sell off without some other element in the background and I'll eat my hat.

Look, here's what might be confusing you - GDP is a lagging indicator relative to asset prices. Markets respond to changes in expectations rather than historical GDP swings. Oftentimes the big moves are already priced in by the time the general population can see them, so to the untrained eye it looks like no move.

I'm sure some econ professor who had no idea how financial markets function published some paper that a similarly ignorant Econ professor made you read or whatever that appeare to show no connection between GDP growth and equity prices, but they're just wrong. In this world, truth isn't a democratic decision. Sometimes no matter who's on your side, you're just fucking wrong.

These economists, what was their independent variable? GDP growth? Clearly that's an idiotic paper because growth is already priced into equity values and GDP is a lagging indicator. If their independent variable is GDP, obviously they won't see a correlation, because equity markets don't respond to the official government GDP that gets published months after the trades have been made.

Look, historicals prove you wrong beyond a shadow of a doubt. In strong macro environments, equities tend to do well. Show me your proof for the opposite. And as far as the shorting equity indices comment, it's not a reading comprehension issue, that would be the logical trade if you truly believed that economic growth is uncorrelated with equity price increases. Like... as a trader, you don't get to just make far fetched claims like that and walk away from them. The next logical question is going to be "so what's the trade?."

Also, interest rates certainly do have a tangible impact on equity prices, dont put words in my mouth. Just look at the banks during the financial crisis, or the effect of Fed tapering commentary today. My only point was that different businesses have to hedge against different impacts of rate moves, that's not the same as saying rate moves are meaningless.

So yeah, to sum up, I disagree with you, and I had hoped to just leave it at that.

NYCbandar:

Look, here's what might be confusing you - GDP is a lagging indicator relative to asset prices. Markets respond to changes in expectations rather than historical GDP swings. Oftentimes the big moves are already priced in by the time the general population can see them, so to the untrained eye it looks like no move.

These economists, what was their independent variable? GDP growth? Clearly that's an idiotic paper because growth is already priced into equity values and GDP is a lagging indicator. If their independent variable is GDP, obviously they won't see a correlation, because equity markets don't respond to the official government GDP that gets published months after the trades have been made.

I'm not confused, broski. This was exactly my point. GDP growth has little to no impact in equity prices, it's the leading indicators that have the impact on asset pricing. But that is NOT what you said earlier. Maybe just semantics, but still worth highlighting.

NYCbandar:

In strong macro environments, equities tend to do well. Show me your proof for the opposite.

I never said otherwise. I'm simply pointing out that "strong macro environments" isn't judged by what GDP growth is, it's judged by the factors leading up to it that actually affect asset pricing.

NYCbandar:

And as far as the shorting equity indices comment, it's not a reading comprehension issue, that would be the logical trade if you truly believed that economic growth is uncorrelated with equity price increases. Like... as a trader, you don't get to just make far fetched claims like that and walk away from them. The next logical question is going to be "so what's the trade?."

I don't believe that "economic growth" is necessarily uncorrelated with equity price increases. Rather, I'm highlighting the fact that the "economic growth" that actually affects equity price movements isn't determined by looking at GDP growth, which as you already admitted, is a LAGGING indicator. That is all.

I thought buying bank equities is a good hedge against interest rate. Since loans will have higher interest rate and banks will rake in more money.

TBT would be a good way to hedge against rising interest rates and is by far one of my favorite investments for 2014. TBT is a 2x leveraged ETF that is short 20 yr bonds. Which obviously means when interest rates rise, bonds go down and this ETF goes up (short 20 yr bonds).

In light of the two years that have passed, what an interesting question, still.

What about shorting guvies and buying a swap?

in