Using Futures Contracts To Hedge ARMs

[Bryan Hancock]

Has anyone out there in creative land used futures contracts to hedge interest rate risk on your ARM? I am wondering what futures to use for commercial loans with floaters past year 5 or so. Selling eurodollar futures to hedge LIBOR floaters may make sense.

Does anyone have experience implementing something like this? Is basis risk the main thing to account for?

[Eric M.]

I looked into this a couple of years ago and found it much harder in practice than it seems in theory. (and I am a futures trader by trade!)
This pretty complicated stuff and I never found anyone who had actually done it on an individual basis.

It all looks perfectly straightforward on paper. But then I would do a "paper trade" and use real examples and prices to put the hedge on and then create scenarios and prices in the future to simulate different outcomes. Then tally up how effective the hedge was. I kept coming out on the losing end in these scenarios and finally figured out why.

The problem occurs when you see that the futures market already has priced in certain expected rate increases over the coming years. (look at the Euro$ futures going out a few years).
So let's say you see that 1 yr LIBOR is 1% (just using round numbers for example. Future price would be 99.00) and you want to hedge for an adjustment that will occur in 2 years. You are thinking to yourself "I want to lock in that 1% rate". So to do this you have 2 basic choices. Sell contracts dated 2 years in the future, or sell the nearest contract and keep rolling that nearest contract each expiration (sell a new on every 3 months or so). Most people would sell the 2 year future. The problem is that the 2 year future is not priced at 1%. It is priced at 2% (price of 98.00) because the market is expecting that rate rise over 2 years. (again, example pricing)
So you are not actually locking in a 1% rate, you are locking in a 2% rate. This is fine as long as you understand that.
So then create a scenario to check if your hedge worked.
The easiest scenario is let's say rates stay exactly the same as they are now for the next 2 years. In a "hedge" situation, you would expect to make no gain or loss ignoring commission costs. However, in this case you would lose because that 2 year contract you bought that is now coming to expiration is now priced at the current rate of 1%. So you sold it 2 years ago at 98.00 and now you will have to close the hedge by buying it back at 99.00. You have lost $2500 per contract hedged but your rate on your mortgage is unchanged.
Hope that makes sense.
NOw, in other scenarios the market may have gone your way or it may also go the other way but in all cases you will have that 1% difference between what you thought you were locking in and what you actually locked in. So let's say the market does indeed do as expected and the current rate is 2% in 2 years. You will have no gain or loss on the hedge but your mortgage will adjust up a percent and you will pay more interest costs so you will be a net loser.

If you choose the other strategy of selling the closest month and rolling often, your outcome is a little better but the same scenario happens on a smaller scale each rollover plus you have greater transaction costs. So instead of losing $2500 on 1 contract, you might lose $200 each rollover for 2 years. Still $1600 plus 8 commissions.

The basic idea is that when you hedge you are not locking in "today's rates" as most people think of today's rates. You are locking in today's rate expectations for the future. And the market has already priced in the expectation of a rise. If the market rises MORE than is expected today, then you will benefit by that extra amount. But if the market rises less than the expected amount (as in the scenario where rates stay the same) then you will lose that amount.

If you are happy to lock in that expected rate because you think the expectation is too little and it will be even worse in reality, then go ahead, it works. Just realize exactly what you are locking in.

The moral is to make a timely hedge you must hedge not before the rate move happens, but before the EXPECTATION of the rate move is priced in to the futures. We are in a scenario now where the rate move has not actually happened but enough people think it will happen that an increase is already priced in.