how to Hedge? problems, interest, receive

rohitdoshi

I have some problems on the concept of hedge?

For example, if i enter a interest rate swap (long fixed, short floating), so i am exposed to the risk of interest rate decline. RIGHT? then i need to hedge. how to do it? easy, enter another swap (pay floating, receive fixed). Ok. I finish hedge. I think this kind of hedge is perfect, but it is one hedge method.

Also i can purchase put option on interest rate as another way of hedging interest rate decline risk? right? when interest rate goes down, i will gain from put option on interest rate to offset the loss from swap.
So my question is, actually, i can make hedge via any financial products that can gain from interest decline, in this case. for instance, a call on fixed income securities. Right?

Swanand

i think the question here is not about long and short. it is about hedge, i can make hedge via any financial products that can gain from interest decline, in this case. for instance, a call on fixed income securities.?

but thx anyway

RMontgomery

I find that the easiest way to get your head around hedging is to draw yourself a little diagram. It is soooo easy to get mixed up with long and short calls or puts on rates or on bonds that a diagramm is the safest and easiest option.

If you are long a swap, you receive fixed and pay floating. You are therefore exposed to the risk of rates going up, which would mean that you are paying more than you are getting. If you were to enter into an offsetting swap, then you would effectively terminate your swap - you are left with no exposure at all. You could, however, hedge your risk by buying an interst rate call or a cap - both of which pay off when rates rise. Alternatively, you could also buy a put on a bond, which will fall in value when rates go up (as you buy the put, you profit).

Again, I can only encourage diagramms....by tests are littered with them and I end up making a lot less mistakes :-)