Microsoft’s extraordinary cash position – more than $38 billion – is the envy of its competitors. But managing this in a highly volatile and generally poor investment environment is a major challenge. As the software giant’s shareholders and analysts debate whether and how the company should use that money, Microsoft has quietly distinguished itself by earning solid returns on the portfolio, using risk management and investment strategies worthy of the most sophisticated institutional investors. This is paying off. In its 2001 fiscal year (ending June 30) – a period when many portfolio managers were lucky to break even – Microsoft’s cash portfolio returned 9.42%.

Microsoft’s portfolio return target is around 9%, and its treasury has developed a risk management system, the Catastrophe Hedging Programme (CHP), to help reach this goal.

Jeff Scott, Microsoft’s assistant treasurer for portfolio management, oversees the CHP, version 2.5 of which was rolled out in 2001. He hedges out the portfolios’ interest rate exposures to improve the chances of them meeting their return targets. The fixed-income portion of Microsoft’s cash investments – roughly 85% – includes the full range of money market, Treasury, agency, corporate, mortgage-backed, municipal, high-yield and emerging market securities. The remainder of its portfolio is in equities.

The building block of the CHP system is simple PVO1 analysis: a calculation of the dollar effect on Microsoft’s portfolio of a 1-basis-point movement in interest rates. When it introduced the first version of the CHP in 1997, the PVO1 was less than $1 million. It is now more than $8 million.

Scott’s preferred hedging tools for Microsoft’s interest rate portfolios are swaptions. Microsoft typically creates a collar by buying and selling interest rate swaptions. It then models a hedged PVO1 and runs that model through historical stress tests to see how each portfolio would react under dramatic changes in interest rates.

“For each portfolio we look at historical and statistical modelling of extreme interest rate environments and forecast turnover rate for each asset class, because the turnover rate will directly affect our realised gain or loss,” says Scott. “We ensure each portfolio generates our income forecast by overlaying our swaption strategy on the overall portfolio based on swaption-adjusted PV01s and key-rate durations.”

Microsoft structures these hedges in-house, and its process has become more sophisticated in the past four years. The treasury team used to put on hedges when there was a predetermined standard deviation change in interest rates, but with CHP2.5 Microsoft can gain cost efficiencies using a calendar-based layered approach.

CHP2.5 offers a 30-day window in each quarter to decide upon, and implement, the interest rate hedging strategy. That period is usually at the same time in each business quarter, but Scott declines to reveal its exact timing.

After the hedging window closes, Microsoft is 100% hedged for the next quarter. The hedging programme is then split into four stages, within which Microsoft can judge the relative price efficiency of hedging its portfolio interest rate risk. For example, it will be hedged within a band of 65% to 85% of its interest rate exposure for the second quarter out from any given point in the business cycle; for the third quarter out Microsoft will be hedged between 40% and 60%; and it will have between 15% and 35% of its hedge in place for the fourth quarter.

Using a window rather than a set date allows the portfolio managers to be opportunistic when buying hedging instruments. In the last quarter, Microsoft bought payer swaptions at the end of October at a time when interest rates were at their lows for the implementation window. It paid approximately $10 million. The options are worth roughly $70 million today.

When dealers are unwilling to provide liquidity for a certain product, Microsoft will step in. “The most expensive hedges are the longer-dated ones, but you also get more efficient pricing because the short-dated three-month options are so far out-of-the-money that the investment banks don’t want to sell them – they call them lottery tickets,” explains Scott. His team manages to stimulate liquidity for these short-dated hedges by becoming a market-maker itself. Insights gleaned from the CHP have allowed Microsoft to put on some profitable hedges – in November alone, it had net profit of roughly $40 million on its derivatives positions.

The CHP programme has maintained the portfolios’ targeted returns over the past 12 months, even though interest rates have fallen more in that period than during 1982 – the period Microsoft used in its stress tests for a falling interest rate environment. The treasury uses percentage change in interest rates rather than actual basis-point declines to normalise the model’s forecasting ability.

The programme does allow for operational flexibility. “We are very active in managing the hedging programme,” says Scott. “In May and June this year [2001] we bought a lot of the receiver swaptions back because there was significant downside risk to falling interest rates.”

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