Swap Book Hedging using Stochastic Optimisation with Realistic Risk Factors

Sammanfattning: Market makers such as large banks are exposed to market risk in fixed income by acting as a counterparty for customers that enter swap contracts. This master thesis addresses the problem of creating a cost-effective hedge for a realistic swap book of a market maker in a multiple yield curve setting. The proposed hedge model is the two-stage stochastic optimisation problem created by Blomvall and Hagenbjörk (2020). Systematic term structure innovations (components) are estimated using six different component models including principal component analysis (PCA), independent component analysis (ICA) and rotations of principal components. The component models are evaluated with a statistical test that uses daily swap rate observations from the European swap market. The statistical test shows that for both FRA and IRS contracts, a rotation of regular principal components is capable of a more accurate description of swap rate innovations than regular PCA. The hedging model is applied to an FRA and an IRS swap book separately, with daily rebalancing, over the period 2013-06-21 to 2021-05-11. The model produces a highly effective hedge for the tested component methods. However, replacing the PCA components with improved components does not improve the hedge. The study is conducted in collaboration with two other master theses, each done at separate banks. This thesis is done in collaboration with Swedbank and the simulated swap book is based on the exposure of a typical swap book at Swedbank, which is why the European swap market is studied.