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Hedging Against an Economic Upturn: Google

Hui-Chien Chang, director of the portfolio management group
Many risk managers try to prepare for things going wrong. Google tackled the problem of protecting itself if things go right—if the global economy turns around and interest rates head higher. The company had invested in agency mortgage-backed securities (MBS) because of the relatively attractive yields (1.5%-2%) and if rates rise, it was looking at a potentially large drop in the value of those investments.  

“When the Fed raised the overnight borrowing rate from 3% to 5.5% in 1994,” notes Hui-Chien Chang, director of the portfolio management group, “the Barclays’ U.S. aggregate bond index had a dismal return of -2.94%.” That was not the kind of loss Google could accept.

Like any fixed-income security, MBS prices move inversely to interest rates, so rising rates depress prices. Agency mortgage-backeds have little perceived credit risk because they are issued by agencies of the U.S. government, but they have prepayment risk. The securities are backed by home mortgages and homeowners can pay off their mortgages at any time, so the duration is not fixed. Higher rates would discourage prepayments, lengthening the duration of the securities and making their price drop even more. Google needed a hedging strategy and an appropriate hedging instrument.

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