Hedging interest rate risk to earn T-bill return return

Muddahudda

Hello, can someone help me understand how you earn the T-bill return when you hedge interest rate risk? In volume 4 page 169 of CFAI texts it states "By hedging interest rate risk, a manager synthetically creates a Treasury bill and therefore earns the return on the Treasury bill."

Any clarification would be extremely helpful. Thank you.

Analti_Calte

The single most important factor that explains bond returns is interest rates. Duration measures the sensitivity of a bond or bond portolio to changes in interest rates (i.e. a small parallel change in the yield curve). If you neutralize this factor on your bond portfolio by shorting the appropriate number of US treasury bond futures, you will earn the risk-free rate (no risk premium). This is the same concept as hedging an equity portfolio with equity futures, you neutralize beta and receive the risk-free rate as return.

You will learn more about this subject when covering the Fixed Income Session dealing with Asset Liability Management, and when studying the Derivatives Session.

Good luck!

Chuckrox

I seem to remember from a derivatives class that there is complicated mathematical proof behind this concept but is out of the scope of the material..

Windjam

"The single most important factor that explains bond returns is interest rates. "

And once we have eliminated this risk, it almost becomes like a risk free investment.

And a risk free investment will ALWAYS give a risk free rate of return, (which is the return from a T-Bill) or else there will be an arbitrage opportunity.