A strip is a type of interest rate derivative that allows the holder to hedge against changes in interest rates. It consists of buying or selling a series of futures contracts with different maturities, such as three-month or six-month contracts. The term “strip” comes from the idea of stripping the interest rate exposure into different time periods.
A strip can be used to hedge the interest rate risk of a loan or a deposit that has a variable interest rate that resets periodically. For example, suppose a borrower takes out a two-year loan with a variable interest rate that is based on a benchmark rate plus a fixed premium, and the interest rate resets every three months. The borrower faces the risk that the interest rate will increase at each reset date, which will increase the interest payments.
To hedge this risk, the borrower can sell a strip of futures contracts that match the reset dates of the loan. For example, if the loan starts in March, the borrower can sell a strip of eight three-month futures contracts, starting from June and ending in December of the following year. By selling the futures contracts, the borrower locks in the interest rate for each period, and any increase in the interest rate will be offset by a gain in the futures position. Conversely, any decrease in the interest rate will be offset by a loss in the futures position.
A strip can also be used to hedge the interest rate risk of an investment that earns a variable interest rate that resets periodically. For example, suppose an investor deposits money for two years with a variable interest rate that is based on a benchmark rate plus a fixed premium, and the interest rate resets every six months. The investor faces the risk that the interest rate will decrease at each reset date, which will reduce the interest earnings.
To hedge this risk, the investor can buy a strip of futures contracts that match the reset dates of the deposit. For example, if the deposit starts in March, the investor can buy a strip of four six-month futures contracts, starting from September and ending in March of the following year. By buying the futures contracts, the investor locks in the interest rate for each period, and any decrease in the interest rate will be offset by a gain in the futures position. Conversely, any increase in the interest rate will be offset by a loss in the futures position.
A strip is a simple and effective way to hedge the interest rate risk of variable rate loans or deposits. However, it may not provide a perfect hedge, as there may be differences between the futures contracts and the underlying loans or deposits, such as the contract size, the settlement date, the interest rate calculation, and the credit risk. Therefore, the hedger should monitor the hedge performance and adjust the hedge ratio if necessary.
Basic Theory:
Interest rate risk arises when changes in interest rates impact the value of fixed-income securities. STRIPs allow investors to isolate the interest rate component, providing a tool for directly hedging interest rate risk. By holding a combination of principal STRIP and interest STRIP positions, investors can effectively protect themselves from fluctuations in interest rates.
Procedures:
- Identify the Risk Exposure: Determine the exposure to interest rate risk in your portfolio. This could be the result of holding fixed-rate bonds or other interest-sensitive instruments.
- Understand the STRIP Components: A principal STRIP represents the future principal repayment, while an interest STRIP represents the future interest payments. By holding both, you can replicate the cash flows of the original bond.
- Calculate the STRIP Positions: Use Excel formulas to calculate the amount of principal STRIPs and interest STRIPs needed to offset the interest rate risk. The formulas involve the present value of future cash flows, taking into account the current interest rate environment.
- Implement the Hedge: Execute the calculated positions in principal and interest STRIPs to hedge against interest rate risk.
Scenario:
Let’s consider a scenario where an investor holds a $1,000,000 face value 10-year bond with a 5% coupon rate. The investor wants to hedge against potential interest rate increases.
Calculation in Excel:
| Periods | Cash Flow from the Bond | Present Value of Cash Flow at Current Rate | Principal STRIP | Interest STRIP |
|---|---|---|---|---|
| 1 | -1,000,000 | =B1/(1+$G$2)^A1 | =IF(A1=$G$1, C1, 0) | =B1-E1 |
| 2 | 50,000 | =B2/(1+$G$2)^A2 | =IF(A2=$G$1, C2, 0) | =B2-E2 |
| 10 | 50,000 | =B10/(1+$G$2)^A10 | =IF(A10=$G$1, C10,0) | =B10-E10 |
In this scenario, set cell G1 as the maturity period (10 years), and G2 as the current interest rate. Adjust these variables based on your specific scenario.
Result:
After calculating the principal and interest STRIP positions, the investor would have a hedged portfolio that is less sensitive to interest rate changes.
Alternative Approaches:
- Duration Matching: Instead of using STRIPs, match the duration of the bond with another fixed-income security to reduce interest rate risk.
- Options Hedging: Utilize interest rate options to hedge against adverse interest rate movements.
- Dynamic Hedging: Continuously adjust the hedge based on changes in interest rates to maintain an effective risk mitigation strategy.
