Hedging the Interest Rate Risk of Brady Bonds
26 Pages Posted: 7 Nov 2008
Date Written: July 1996
While there is significant interest in investing in Brady bonds, the source of attraction is often the exposure to sovereign risk (and its yield compensation), while the exposure to U.S. interest rate risk is a â¬Snecessary evilâ¬?. This paper addresses the problem of determining the interest rate sensitivity of Brady debt. WE show that the most relevant state variables in determining the duration of a Brady bond are U.S. interest rates and the bondâ¬"s strip spread. Motivated by the difficult of using structural models to price and hedge Brady debt, we provide a model-free approach to estimating the hedge ratio. Using our approach to hedge the Argentinian Par and Discount Brady bonds, we find that only a small fraction (15% or so) of the total risk is hedgeable, but our hedged portfolio exhibits little covariation with U.S. interest rates.
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