Use Cash to Hedge Interest Rate

Photo by Tim Evans on Unsplash

It’s common knowledge that when it comes to the protection, cash never hurts. But do you know cash is a key ingredient in managing the risk of any investment. Let’s jump into it.

Here the cash isn’t just the money in your hand. It needs to be deposited in a bank which pays you the current interest rate, say 3%.

The interest rate used to be negligible, but it’s not that case any more. Something paying you 3% without you doing anything probably is more important than any other investment.

This cash is fluid, you can use it anytime you want. Moreover, the interest rate is also fluid, it can go up and down. If the rate were zero as two years ago, it wouldn’t generate anything by sitting in the bank. In case you need to spend it, it will lose value. On the other hand, if the interest rate goes up in the future, it can generate extra cash as expected.

Now let’s turn to any other investment, say you purchased a 30-year bond, and it pays you a fixed coupon every six month. This steady income stream will be pretty nice for 30 years. Except the price of the bond could under extremely high pressure when the interest rate goes up.

It’s not uncommon to lose 50% of your long-term bond value when the interest rate jumps 3% up. This just happened in front of us, so it’s not a myth.

But I thought if I hold the bond till mature, I won’t lose anything. That’s true, but 30 years is a long time, within 30 years, you can’t withdraw any money from it, especially when the interest rate goes up. Can you do that?

Since cash generates more when the interest rate goes up, it becomes a natural hedge to protect the rising interest rate environment where most of the investment suffers.

Here’s how it works. Your portfolio susceptible to the interest rate can be decomposed by multiple parts. Say the bond part has 30 years to mature which works against the interest rate, whereas the cash part has 0 years to mature and work favoring the interest rate. So there must exist a balanced ratio in between if I invest x% to bond and (1-x%) to cash so that they can cancel each other out from the interest rate fluctuation. This is referred as Immunization Strategy.

We will not go into this strategy in detail, except just reveal some discovery using it. For instance, it has been tested: holding 100% of bond and 100% of cash will both lose value along the way, 50% chance of all the possible future environments. This line might be a bit over-simplified, because it can’t cover all investment scenarios, however, it does deliver the message quite well. It’s totally not guaranteed, in case you decide to withdraw the money in the future, you won’t hurt the investment value.

But if you invest 30% in cash instead, the chance to lose money reduced to 10% of all the possible future environments. By keeping some cash in the pot, you can sustain the value of the investment as much as possible, as long as possible. Isn’t this interesting?

Conclusion

It’s my guts feeling that cash is helpful to survive our current environment. However putting everything in cash also sacrifice the return for the long run. This article suggests that a magic ratio can exist in between so that you can formulate a risk-hedged plan for your portfolio that generates the agreed-upon withdrawn without squeezed in any way by the interest rate change.

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#OpenToWork Front-end Engineer, book author of “Designing React Hooks the Right Way” sold at Amazon.

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Fang Jin

#OpenToWork Front-end Engineer, book author of “Designing React Hooks the Right Way” sold at Amazon.