Money
Issue No. 12 - August/September 2003
Interest Rate Hedging — A Structured Approach
by Mark Day
“Interest rates have bottomed; hedge now, hedge long.”
“Interest rates have not bottomed; stay short and variable.”
“Not sure on where interest rates are going; do nothing just yet…”
Given ANY interest rate environment and a room full of economists/bankers/financial consultants and there is no doubt that these are three gems of advice you will receive when trying to determine where interest rates will go.
Given time, each one will prove correct. That, however, does not help the decision of when, how and how much to hedge.
Take recent times for instance. In May this year cash rates were within coo—ee of historical lows (4.75%), we were some way through a global economic downturn and presumably before long, interest rates would go up. Right? Wrong, said the market on the whole.
The overall view of interest rate direction for Australia is best embodied by the 90 day bank bill futures market (‘Bill Futures’). The rate at which the Bill Futures trade is the market’s best estimation of the average cash rate for a 90—day period at a future time. As at 2 May 2003 the September 03 futures were trading at a yield of 4.50%, December 03 at 4.47% and the March 04 at 4.56%. What this means is that by December this year, the market (these days, the global investment community) considered that the Reserve Bank of Australia would be forced to lower interest rates (presumably as a response to a weaker domestic economy) by 0.25%. Hence our original observation that at around historically low cash rates we should be hedging our interest rate exposure (possibly with our ears pinned back) is not quite as clear as it was.
If we look back a year to May 2002 a very different but equally perplexing environment prevailed. Cash rates were lower, at 4.25%, but the expectation was that they had bottomed and were about to significantly increase. This was reflected in the September 02 Bill Futures trading at 5.01%, the ...
