Question

Describe the difference between a stack hedge and a strip hedge. What are the advantages and disadvantages of each?

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Answer 1

A stack hedge is a hedging technique and a front load hedge which involves concentrating most of the futures contracts used to hedge an interest rate swap in specific contract months in order to improve the overall hedge potential by using a number of futures of a single delivery month to hedge exposures with different delivery months. Therefore, it helps keep the hedge in the more liquid front month futures. The stack hedge is repeated at each resetting or fixing date until the whole position is closed out.

A strip hedge is also a hedging technique which involves using a series (or rolls) of interest rate futures to hedge an interest rate swap. The futures will match the resetting dates of the interest rate underlying the swap. The swap is, thus, theoretically divided into and hedged by rolls corresponding to the futures where the settlement dates coincide with or closely relate to the interest rate settlement dates (fixing or resetting dates) of the hedged swap.

So the differences as well as the advantages and disadvantages are as follows :

In short, a stack hedge stacks the entire futures position in the front month and then rolls forward into the next font month contract, while a strip hedge establishes the futures positions in a series of futures that have successively further expiration. The former has lower liquidity costs (due to the active trading of its underlying futures), but it is associated with a higher tracking error. The opposite is true for the latter as strip hedges are usually associated with a lower tracking error, but have higher liquidity costs due to the probability that the more distant contracts would be thinly traded (not as active). Furthermore, their trade-execution risk may be high and as a result its bid-ask spreads may also be high.