Throwing away a billion yuan, real or rand: the cost of sub-optimal hedging in high interest-rate environments

Abstract

Interest-rate volatility is known to be positively level dependent, i.e., to correlate positively with interest rate levels. However, recent research has provided compelling evidence that as interest rates rise, the amount of level dependence decreases. We advance this line of research by investigating the amount of volatility level dependence in an emerging market with high interest rates, and find no evidence for the positive level dependence implied by the popular log-normal forward-LIBOR market model. This has important consequences for the hedging of interest-rate derivatives: when hedging caps, using the log-normal market model can be worse than not hedging at all and it is significantly outperformed by its normally distributed counterpart, which exhibits no level dependence.

Keywords: hedging, interest-rate derivatives, interest-rate volatility, LIBOR market model

JEL Classification: C5, G11, G12, G13