How do you use DV01 to hedge interest rate risk with swaps?

DV01 (Dollar Value of a Basis Point) measures how much the value of a position changes when interest rates shift by 1 basis point (0.01%). For hedging with interest rate swaps, the goal is to match the DV01 of your exposure with the DV01 of the swap so that the combined position has near-zero rate sensitivity.

Step-by-Step Mechanics

1. Calculate the DV01 of the exposure. Suppose Ridgeway National Bank has a $500 million fixed-rate loan portfolio with a modified duration of 4.2 years. The DV01 is:

DV01_portfolio = $500,000,000 x 4.2 x 0.0001 = $210,000

This means for every 1 bp rise in rates, the portfolio loses $210,000 in value.

1. Determine the swap DV01. A 5-year pay-fixed, receive-floating interest rate swap with $100 million notional might have a DV01 of roughly $45,000 (the fixed leg has duration exposure while the floating leg resets frequently and has near-zero duration).

1. Compute the hedge notional. You need enough swap notional so the swap DV01 offsets the portfolio DV01:

Hedge Ratio = DV01_portfolio / DV01_swap_per_unit

Notional needed = ($210,000 / $45,000) x $100,000,000 = $466.7 million

1. Execute the hedge. Ridgeway enters a $466.7 million pay-fixed swap. If rates rise 25 bps, the portfolio loses approximately $210,000 x 25 = $5.25 million, but the swap gains roughly the same amount.

Key Pitfalls:

• DV01 changes as rates move (convexity), so the hedge needs periodic rebalancing.
• Floating leg resets introduce basis risk if the loan portfolio reprices on a different index than the swap.
• Cross-currency swaps add FX DV01 that must be managed separately.

For more practice on swap hedging, check out our FRM Part I question bank.