Forward Curve Bias and Optimization Errors

12 Pages Posted: 12 Mar 2019 Last revised: 8 Apr 2019

See all articles by Camilo Sarmiento

Camilo Sarmiento

Inter-American Development Bank (IDB)

Date Written: February 21, 2019

Abstract

We derive optimal hedging ratios for interest rate risk under different assumptions that underpin the relationship between the forward rate and the expected future spot rate. In some instances, full hedging is optimal, and the conditions for the optimality of a partial hedge are identified. Less hedging (more floating debt in our model) is more optimal under the liquidity preference model than under the unbiased expectations hypothesis. This indicates that in times of higher preference for liquidity less hedging is optimal. Higher preference for liquidity correlates with larger term spreads (a steeper yield curve) and periods of monetary easing. Comparison of the analytical results with historical data indicates that partial hedging for interest rate risk is generally preferable over full hedging strategies with some exceptions. Lastly, the paper shows the role of market timing on hedging decisions.

Keywords: Hedge Ratios, Forward Rate, Expected Spot Rate, Profit Maximization, Expected Utility

JEL Classification: D81, D84, G14

Suggested Citation

Sarmiento, Camilo, Forward Curve Bias and Optimization Errors (February 21, 2019). Available at SSRN: https://ssrn.com/abstract=3339055 or http://dx.doi.org/10.2139/ssrn.3339055

Camilo Sarmiento (Contact Author)

Inter-American Development Bank (IDB) ( email )

1300 New York Avenue NW
Washington, DC 20577
United States

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