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SVB just went bankrupt pursuing that strategy... That being said, I don't think it's possible for all banks to hedge interest rate risk. The risk, to the syste

by runeks 4y ago

SVB just went bankrupt pursuing that strategy... That being said, I don't think it's possible for all banks to hedge interest rate risk. The risk, to the system as a whole, doesn't go away just because it's transferred to someone else.

m3kw9 4y ago
So their bond prices went down and made them bankrupt, how does the math work in simple terms?
- runeks 4y ago
  In simple terms, a bond is a piece of paper that pays a dollar amount per year to the holder for N number of years, after which the initial price paid for the bond is returned to the holder. For example, a 10-year bond that pays $2 per year costs $100 today. That is, a piece of paper that pays $2 to the holder every year for 10 years, after which the holder gets its $100 back. Now, some time passes and the market thinks the above bond is too expensive. Instead, the market will only pay $50 for the above bond, ie. $50 to get $2 per year. This means that the price of another bond: the bond that pays $4 per year will now cost $100. This is the case because holding two bonds that cost $50 each and pay $2 per year is exactly equivalent to holding a single bond that pays $4 per year and costs $100. If the market price of a 10-year bond that pays $4 per year costs $100 then we say that the current rate of interest for the 10-year bond is 4%. If this rate of interest falls to 2%, it simply means that the market is now willing to pay $200 per year for a bond that pays $4 per year — or, equivalently, $100 for a bond that pays $2 per year.
  - tome 4y ago
    > after which the initial price paid for the bond is returned to the holder Probably better to say "face value". The initial price paid for the bond may well not be its face value.
- shagie 4y ago
  (as I understand it, and I could be wrong... and if so, please correct me) The difference between the 10 year and 3 month bonds - https://ycharts.com/indicators/10_year_3_month_treasury_spread https://ycharts.com/indicators/10_year_3_month_treasury_spre... You'll note that you can get more money buy buying a 3 month bond rather than a 10 year bond. So, now if you want to sell a 10 year $100 bond, you'll need to sell it for less than what a 3 month $100 bond costs to buy... which is $100. https://ycharts.com/indicators/3_month_t_bill https://ycharts.com/indicators/3_month_t_bill (look at 3 year chart range) and https://ycharts.com/indicators/10_year_treasury_rate https://ycharts.com/indicators/10_year_treasury_rate (again, look at 3 year range). The 10 year $100 bond is still going to pay out at a profit... in 10 years. But there's more valuable things that one can do with $100 in the shorter term so any sales of that before it pays out will be done at a loss.
tel 4y ago
Swaps do indeed transfer that risk to other parties, at a premium because those other parties are more able to absorb the risk. While, sure, there are systematic stresses across the whole financial system, it doesn't mean that there aren't counterparties more capable of managing interest rate risk and willing to do so for a fee. This can be done by just having a larger balance sheet, or blending durations. Seems like SVB wasn't willing to pay the premium, though.
- runeks 4y ago
  Who are these counterparties that can absorb trillions of dollars in interest rate risk? My amateur understanding is that this counterparty would need to be short long bonds, ie. be a bond issuer. And they would need to be interested in exchanging their fixed interest rate for a variable one. If the above is correctly understood I don't see how banks can find issuers of trillions of dollars worth of bonds that want a variable interest rate in a rising interest rate environment.
  - tel 4y ago
    It’s very expensive to buy hedges when the event they’re protecting against is actively happening. The point would have been to find that counterparty ahead of the time and still pay a hefty premium. If I’m taking the variable end of a swap and expecting interest rate hikes, I can use the spread I’m gaining to offset the damage to a portfolio I already have of shorter duration (thus: less interest rate sensitive) bonds. Overall, the USG issuing trillions of dollars of low interest bonds and then raising rates is going to cause losses for bond holders throughout the system, but as long as those bonds are held, in aggregate, in portfolios and entities which won’t face liquidity crises until they mature, the loss can be borne. There may also be more sophisticated ways of offsetting bond exposure, but I’m not familiar. I’m appealing more to the idea that this impact by the Fed is easy to predict, indeed exactly the point. Bond valuations drying up will reduce the multiplier and take money out of circulation. The system is supposed to remain capitalized (and/or hedged) to survive the stress and the Fed would be watching. Apparently some parts of the system weren’t. And there are calls for the Fed to slow down. And probably more evidence that banking regs need to remain strong.
spacebanana7 4y ago
The system risk can be reduced when someone who’s positively exposed to rising rates trades exposure with someone who’s negatively exposed to rising rates. For example, pension funds often benefit from rising rates because they plan on paying out future liabilities with current assets and landlords are negatively exposed to rising rates because they own a stream of income in the future. The trade of interest rate exposure between these parties helps both achieve more stability. A real world example would be taxi drivers trading weather risk with ice cream vans. One party benefits from wet weather that stops people walking outside and the other benefits, so they can trade exposure in a way that makes the system more stable.

by runeks 4y ago

m3kw9 4y ago

So their bond prices went down and made them bankrupt, how does the math work in simple terms?

runeks 4y ago
In simple terms, a bond is a piece of paper that pays a dollar amount per year to the holder for N number of years, after which the initial price paid for the bond is returned to the holder. For example, a 10-year bond that pays $2 per year costs $100 today. That is, a piece of paper that pays $2 to the holder every year for 10 years, after which the holder gets its $100 back. Now, some time passes and the market thinks the above bond is too expensive. Instead, the market will only pay $50 for the above bond, ie. $50 to get $2 per year. This means that the price of another bond: the bond that pays $4 per year will now cost $100. This is the case because holding two bonds that cost $50 each and pay $2 per year is exactly equivalent to holding a single bond that pays $4 per year and costs $100. If the market price of a 10-year bond that pays $4 per year costs $100 then we say that the current rate of interest for the 10-year bond is 4%. If this rate of interest falls to 2%, it simply means that the market is now willing to pay $200 per year for a bond that pays $4 per year — or, equivalently, $100 for a bond that pays $2 per year.
- tome 4y ago
  > after which the initial price paid for the bond is returned to the holder Probably better to say "face value". The initial price paid for the bond may well not be its face value.
shagie 4y ago
(as I understand it, and I could be wrong... and if so, please correct me) The difference between the 10 year and 3 month bonds - https://ycharts.com/indicators/10_year_3_month_treasury_spread https://ycharts.com/indicators/10_year_3_month_treasury_spre... You'll note that you can get more money buy buying a 3 month bond rather than a 10 year bond. So, now if you want to sell a 10 year $100 bond, you'll need to sell it for less than what a 3 month $100 bond costs to buy... which is $100. https://ycharts.com/indicators/3_month_t_bill https://ycharts.com/indicators/3_month_t_bill (look at 3 year chart range) and https://ycharts.com/indicators/10_year_treasury_rate https://ycharts.com/indicators/10_year_treasury_rate (again, look at 3 year range). The 10 year $100 bond is still going to pay out at a profit... in 10 years. But there's more valuable things that one can do with $100 in the shorter term so any sales of that before it pays out will be done at a loss.

tel 4y ago

Swaps do indeed transfer that risk to other parties, at a premium because those other parties are more able to absorb the risk. While, sure, there are systematic stresses across the whole financial system, it doesn't mean that there aren't counterparties more capable of managing interest rate risk and willing to do so for a fee. This can be done by just having a larger balance sheet, or blending durations. Seems like SVB wasn't willing to pay the premium, though.

runeks 4y ago
Who are these counterparties that can absorb trillions of dollars in interest rate risk? My amateur understanding is that this counterparty would need to be short long bonds, ie. be a bond issuer. And they would need to be interested in exchanging their fixed interest rate for a variable one. If the above is correctly understood I don't see how banks can find issuers of trillions of dollars worth of bonds that want a variable interest rate in a rising interest rate environment.
- tel 4y ago
  It’s very expensive to buy hedges when the event they’re protecting against is actively happening. The point would have been to find that counterparty ahead of the time and still pay a hefty premium. If I’m taking the variable end of a swap and expecting interest rate hikes, I can use the spread I’m gaining to offset the damage to a portfolio I already have of shorter duration (thus: less interest rate sensitive) bonds. Overall, the USG issuing trillions of dollars of low interest bonds and then raising rates is going to cause losses for bond holders throughout the system, but as long as those bonds are held, in aggregate, in portfolios and entities which won’t face liquidity crises until they mature, the loss can be borne. There may also be more sophisticated ways of offsetting bond exposure, but I’m not familiar. I’m appealing more to the idea that this impact by the Fed is easy to predict, indeed exactly the point. Bond valuations drying up will reduce the multiplier and take money out of circulation. The system is supposed to remain capitalized (and/or hedged) to survive the stress and the Fed would be watching. Apparently some parts of the system weren’t. And there are calls for the Fed to slow down. And probably more evidence that banking regs need to remain strong.

spacebanana7 4y ago

The system risk can be reduced when someone who’s positively exposed to rising rates trades exposure with someone who’s negatively exposed to rising rates. For example, pension funds often benefit from rising rates because they plan on paying out future liabilities with current assets and landlords are negatively exposed to rising rates because they own a stream of income in the future. The trade of interest rate exposure between these parties helps both achieve more stability. A real world example would be taxi drivers trading weather risk with ice cream vans. One party benefits from wet weather that stops people walking outside and the other benefits, so they can trade exposure in a way that makes the system more stable.