To Hedge or Not to Hedge

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Discussions around liability hedging have never been so topical.

Notwithstanding the selloff in real and nominal interest rates seen since January of this year, rates are still at very low levels and many question whether now is the right time to hedge. Apart from the economics there are also behavioural aspects in play, most notably regret risk, the regret that if interest rates rise more quickly than the market is currently pricing in, liabilities will fall and offer better opportunities to buy hedging assets. Expensive prices and regret risk have tipped the scale in favour of under-hedging for many pension schemes. While this is a reasonable approach there are two important questions to be considered before deciding to under-hedge:

  1. How much to under-hedge?
  2. How long to under-hedge?

Under-Hedging Carries Risks

Every investment decision demands a disciplined approach with firm rules and limits around opening and closing positions. Hedging activity should be no different. A wait and see approach where an increase in hedging only occurs if yields increase beyond a certain level runs the risk that rates stay low for a long time. The scheme would miss out on the benefits of hedging and never move towards its strategic hedging level. For example increasing the hedge ratio by 30% can reduce funding level volatility by approximately one third1.

This blog is the first in a series that explores some of the features and drivers of the term structure of interest rates and how they can influence the hedging question. Over the next series of blogs we will explore the following items:

  1. Forward curve
  2. Term premium
  3. Level of carry

The series will conclude that the hedging question is about ‘right sizing your risk’. It’s about ensuring the size of the position is commensurate with your conviction that interest rates will rise faster than what the market is currently pricing in. And finally it’s about having a timeline for the under hedged position from the outset and a planned route to exit if yields don’t move as expected.

1Based on a sample scheme with 20 year duration liabilities, 50% real/50% nominal and a total portfolio return target of gilts + 2.5% p.a. Russell Capital market Assumptions as at 31.12.2014.

Crevan Begley, Client Strategy & Research, EMEA

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