Derivatives Overlay Risks
Investment managers often use a derivatives overlay when managing a portfolio against a liability structure. While a derivatives overlay strategy provides considerable flexibility and allows hedging risk that would otherwise be difficult to hedge, there are also risks associated with using a derivatives overlay.
On this page, we discuss the risk associated with using a derivatives overlay. These risks are present when investors use interest rate swaps or swaptions to hedge a duration gap, i.e. a difference in the duration of the assets versus the duration of the liabilities.
Risks when using a derivatives overlay
The following risks are present when using a derivatives overlay to hedge liabilities:
- Hedge amounts are approximations based on assumed durations and ignore convexity. Convexity matters for large-rate movements.
- Duration assumes parallel shifts in the curve.
- Twists in the yield curve can create substantial structural risk and immunization may fail to replicate the immunizing zero-coupon bond. Setting asset convexity somewhat higher than liability convexity creates net positive convexity while limiting the dispersion of asset cash flows in relation to liability flows to minimize structural risk
- Model risk can be significant in some cases.
- Measurement error when weighted average characteristics of the portfolio assets and liabilities are used instead of portfolio statistics based on portfolio cash flows and yield (IRR).
- Futures BPV calculations are based on an assumed CTD bond. That bond can change, changing the futures duration and BPV.
- Portfolio yield and liability discount rate may differ, reflecting different risk levels. This creates spread risk.
- Traditionally, OTC derivatives have counterparty risk. The move towards requiring collateral reduces the counterparty risk, but creates cash flow risk.
- Asset liquidity risk exists if positions cannot be quickly adjusted with reasonable transaction costs.
We discussed the risks that are present when investors use a derivatives overlay to hedge a duration gap.