This series investigates the most important considerations for developing successful LDI strategies. Article two covers dynamic interest rate hedging.
Even though the past 20 years have seen a significant downward trend in interest rates, the trend was not one-way. There have been some significant and repeated rises in rates against the background downward trend or, put another way, we have found that interest rates often oscillate around a longer-term trend.
If interest rate oscillates, investors can benefit by applying a dynamic interest rate hedging strategy. With a dynamic hedge, the hedge level is lower for interest rate increases than for similar decreases.
This article analyzes dynamic interest rate hedging strategies. We find that such strategies can add expected returns, but at the expense of higher funding ratio risk. However, the level to which a dynamic hedge strategy can add value – and the optimal width and midpoint for the hedge levels, and the number of interest rate triggers – depends strongly on the characteristics of the investor and their investment beliefs with respect to interest rate risk.
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