Macrohedging for Financial Institutions: Beyond Duration

9 Pages Posted: 6 Jan 2005

See all articles by Iraj Fooladi

Iraj Fooladi

Dalhousie University - School of Business Administration

Gordon S. Roberts

York University - Schulich School of Business

Abstract

This article proposes two extensions of current practice in applying duration gaps for macrohedging the equity position of a financial institution against interest rate risk. The first adjusts for the relative convexities of the asset and liability portfolios, which we call the convexity gap. When the second-order (convexity) condition is not satisfied, satisfying the first-order (duration) condition is not sufficient to achieve a perfect hedge against interest rate risk. The second extension shows how to modify duration gaps recognizing that banks and other financial institutions hold assets that are not default-free. Numerical examples demonstrate that ignoring this adjustment introduces considerable hedging error.

JEL Classification: G20

Suggested Citation

Fooladi, Iraj and Roberts, Gordon S., Macrohedging for Financial Institutions: Beyond Duration. Journal of Applied Finance, Vol. 14, No. 1, Spring/Summer 2004. Available at SSRN: https://ssrn.com/abstract=561002

Iraj Fooladi (Contact Author)

Dalhousie University - School of Business Administration ( email )

Halifax, Nova Scotia B3H 4R2
Canada
902-494-1843 (Phone)
902-494-1107 (Fax)

Gordon S. Roberts

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada
416-736-2100 x77953 (Phone)
416-736-5687 (Fax)

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