How can interest-rate derivatives be used in abond portfolio?
What will be an ideal response?
Interest-rate derivatives can be used in a bond portfolio to hedge or immunize against interest-rate risk resulting in adverse change in the funding gap using a bond-only portfolio.For example, the duration of the liabilities can be more than 20 while, in contrast, the duration of Treasury bonds and high-grade corporate bonds is not close to 20 . Thus, it is difficult to obtain the necessary dollar duration to hedge interest-rate risk. The solution to address this issue is to use interest-rate derivatives such as futures and swaps to "extend" dollar duration. Consequently, a pension plan sponsor seeking to duration match all or part of the interest-rate risk must be prepared to authorize the use of interest-rate derivatives.
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