Hedging the interest rate risk of Bradys: the case of Argentinian fixed and floating-rate bonds

While there is significant interest in investing in Brady bonds, the source of attraction is often the exposure to sovereign risk (and its yield compensation), while the exposure to US interest rate risk is a 'necessary evil'. This paper addresses the problem of determining the interest rate sensitivity of Brady debt. We show that the most relevant state variables in determining the duration of a Brady bond are US interest rates and the bond's strip spread. Motivated by the difficulty of using structural models to price and hedge Brady debt, we provide a model-free approach to estimating the hedge ratio. Using our approach to hedge the Argentinian Par and Discount Brady bonds, we find that only a small fraction (15% or so) of the total risk is hedgeable, but our hedged portfolio exhibits little covariation with US interest rates.