managing interest rate risk through hedging with derivatives · managing interest rate risk through...
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Presented By
MANAGING INTEREST RATE RISK
THROUGH HEDGING WITH DERIVATIVES2014 NASCUS Summit September 10, 2014
Travis Goodman, CFA
Managing Director, Advisory Services
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Hedging Overview
• History
• Duration dilemma
• Hedging
– Swaps
– Caps
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Introduction and History
• Over the counter derivative contracts have their origins in the
exchange traded markets
• Notional amount of OTC contracts as of June 2012
– $708 trillion
• Interest rate contracts make up the lions share of OTC
derivatives
Hedging Interests
Interest Rate 67%
Credit Default (CDS) 8%
Foreign Exchange 9%
Commodity 2%
Equity 1%
Other 12%
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To Put it in Perspective
• Market size
– Treasuries $10 trillion
– Agency debt $2 trillion
– MBS $8 trillion
– OTC derivatives $708 trillion
• The outstanding notional principal in the OTC derivatives
market dwarfs the large primary fixed-income markets
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Terms and Definitions
• Interest rate swap – an agreement between two parties, where a stream of interest payments is
exchanged for another based on a specified notional amount
• Interest rate cap – an agreement in which payments are made when the reference exceeds the
strike rate
• Notional principal amount – the principal amount that the interest payments in an interest rate
swap are based
• Fixed rate – the rate that a party agrees to pay in swap, this rate remains the same for the life of
the swap
• Floating rate – the rate that a party agrees to pay, this rate is tied to an index and resets
throughout the life of the swap
• Underlying index – the rate that the floating leg of a swap is tied to
• Strike – the rate at which the reference rate is compared to
• Maturity – the length of time until the swap or cap expires
• Reset frequency – how often the floating rate changes
• Payment frequency – how often payments are made
• Day count convention – a convention for determining the number
of days between two dates and the number of days in a year
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6
Derivatives Are Not New to NCUA
NCUA
Rules
Pilot
Program
ANPR
6/11, 1/12
NPR
5/13
Final Rule
1/14
• Part 703 prohibits
the use of
derivatives
• Makes exceptions
for specific loan
pipeline hedging
needs
• Permitted a limited
number of
approved FCUs to
enter into
derivatives with
approval
• Powers extended
through direct and
vendor programs
• Imposed standards
for counterparty
credit worthiness
• Limits based on
NW, earnings
• Should derivatives
activity permit third
party experience
• What control
standards should
be required?
• What products and
limits should be
allowed?
• Demonstrate
material IRR
exposure
• Permit swaps and
caps to mitigate
IRR exposure
• Establish product
limits using a
tiered structure
• Specify third party
roles
• Limit
counterparties to
dealers, CFTC
approved swap
dealers
• Require personnel
with years of
experience
• Expand products
to include floors, T
futures, and basis
swaps
• Modify limits for
maximum
allowable loss and
notional
• Streamline
experience
requirements
• Align counterparty,
margin
requirements with
CFTC regs
• Streamline the
application
process
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Derivatives Update
• NCUA voted to approve the use of derivatives on
January 23, 2014
• Eligible derivatives
– Interest rate swaps
– Interest rate caps
– Interest rate floors
– Treasury futures
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Risk Avoidance
• Limits investment opportunities
• Ignores market preferences and relative value
• Asset allocation and balance sheet mix decisions can be
clouded by duration constraints
• Institutions “chase” similar assets (autos) to unprofitable
pricing levels based on their attractive duration characteristics
• While leaving some wider spreading and more potentially
profitable assets (mortgages) out of the mix
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Why Don’t More Institutions Hedge?
• They may not understand their exposures to:
– Interest rate moves
– Yield curve shape / slope
– Options implied volatilities
• They may understand these risks, but do not know how to
hedge
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Can We Measure The Basis Risk And Is It Reasonable?
• Most interest rate swaps and caps that you will consider for
hedging are LIBOR based
• Many assets and liabilities that are hedged are not LIBOR
based
• Basis risk is the risk that arises between hedges and hedged
items when their market value changes are based on different
underlying drivers
– Hedging mortgages with interest rate swaps hedges interest
rates and swap spreads (LIBOR / Treasury spreads) but it
doesn’t hedge mortgage spreads to swap
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Other Barriers to Consider
• Institutions with poor market value don’t want to lock in low
value
• Managers are often evaluated against (unhedged) peer group
• Hedging is likely to expose poor asset allocation decisions
• Hedging increases regulatory scrutiny
• Ambiguous rules create accounting risks
• As rates have fallen, most hedges observed have losses
when viewed in isolation
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The Duration Conundrum
• Financial institutions all need:
– Stable and liquid sources of duration
• From –
– Deposits
– Borrowings
– Hedges
• To fund and hedge different types of assets
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Borrowers vs. Depositors – The Dilemma
Depositors and borrowers maximize their own utility
4.0%
1.5%
Low Rate Environment
Balance Sheet is Net Long
Liability Sensitive
Ra
te
Maturity
Borrowers
Depositors
9.0%
6.0%
High Rate Environment
Balance Sheet is Net Short
Asset Sensitive
Rate
Maturity
Depositors
Borrowers
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Opportunities Lie Along The Entire Yield Curve
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
Yie
ld
Maturity
Institutions that can’t hedge compete for assets in the crowded short duration space
Institutions that can hedge select assets along the entire curve
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Deposit Strategies
• Financial institutions usually “pay-up” to interest rate swap
rates to attract long term deposits
CDs Swaps Spread
3m 0.55 0.24 0.31
6m 0.80 0.33 0.47
1yr 1.40 0.57 0.83
2yr 1.70 0.73 0.97
5yr 2.50 1.88 0.62
10yr 3.75 2.70 1.05
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Withdrawal Penalties
• Theoretical values of early withdrawal penalties vary with the
level of rates
– 5 year CD
– Penalty = 6 months of interest
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
Penalty
Rate
Rate Penalty
1% 0.5%
2% 1.0%
3% 1.5%
4% 2.0%
5% 2.5%
6% 3.0%
7% 3.5%
8% 4.0%
9% 4.5%
10% 5.0%
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Convexity
• Be careful when assessing the hedging benefit of liabilities
that can be called away
-6.00
-4.00
-2.00
0.00
2.00
4.00
6.00
8.00
10.00
12.00
-200 -100 Base 100 200 300 400
Price C
hange
CD - High Penalty CD - Low Penalty
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Borrowing Strategies
• FHLB advances:
– FHLB advance structures generally have better hedging benefits
than term deposits because of the lack of an early withdrawal
penalty
– Pricing can still be “expensive” versus longer term interest rate
swap ratesFHLB Swaps Spread
3m 0.23 0.24 -0.01
6m 0.25 0.33 -0.08
1yr 0.32 0.57 -0.25
2yr 0.79 0.73 0.06
5yr 2.12 1.88 0.24
10yr 3.24 2.70 0.54
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Borrowing Strategies – Pros and Cons
• FHLB advances:
– Pros:
• Duration hedging benefits without risk of early withdrawal
• Stable long-term funding source for longer duration assets
– Cons:
• Stock investment earns a “sub” market return and increases all in
funding costs
• Liquidity is poor and getting true “mark to market” payouts for
liquidations is virtually impossible
• Increase leverage when institution may not need it
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Interest Rate Risk Insurance
Primary derivative instruments
• Swaps
– No upfront cost; gains when rates rise and losses when rates fall
– Effectively change short term liabilities into fixed term funding
• Caps
– Premiums can be high, and accounting is more difficult
– Up front cost is maximum you can lose, gains in value when
rates rise
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-7.00%
-6.00%
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
-200 -100 Base 100 200 300
Asset - % change in MV
Asset
Balance Sheet Risk
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-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
4.00%
-200 -100 Base 100 200 300
Liability - % change in MV
Liability
Balance Sheet Risk
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-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
-200 -100 Base 100 200 300
Combined
Asset
Liability
Balance Sheet Risk
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-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
-200 -100 Base 100 200 300
Capital - % change in MV
Capital
Balance Sheet Risk
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Insurance
Risk Profile
• NEV percent change in up 300 = negative 35%
• NEV ratio in up 300 = 5.00%
Situation
• If rates rise by over 100 basis points, the credit union’s
interest rate risk will be outside of risk tolerance levels
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Insurance
Options – On balance sheet
• Sell loans
• Extend duration of liabilities (borrow)
• Decrease duration of assets
Insurance Options – Off balance sheet
• Enter into an interest rate swap
• Interest rate caps
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On Balance Sheet vs. Off Balance Sheet
• On balance sheet
– Decreases capital ratio
– Usually more expensive
– Identical NEV percent change impact to off balance sheet
– No hedge effectiveness testing or additional accounting cost
• Off balance sheet
– Little to no impact on capital ratio
– Usually less expensive
– Identical NEV percent change impact to on balance sheet
– Hedge effectiveness and accounting cost
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Interest Rate Swap Diagram
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Financial
Institution
Depositor
Borrower
Swap
Flo
ati
ng
Flo
ati
ng
Fix
ed
Fixed
2.25%
Fixed Rate
4.25%
Fixed Rate
0.25%
Floating
0.05%
Floating
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Swaps
Pay fixed swap rates as of Aug 25, 2014
• 2 year 0.72%
• 5 year 1.81%
• 7 year 2.07%
• 10 year 2.54%
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Swaps
Insurance with swaps
• Credit union issues $10 million of 15year real estate loans
• Credit union buys insurance by entering into a seven year
swap to pay 2.07% and to receive a one month variable rate
(LIBOR + 0 = 0.25%) on $10 million for seven years
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Swaps
• The Financial Institution (FI)
– Earns 3.75% fixed rate 15 year mortgage loan
– Pays 2.07% on a fixed rate 7 year swap
– Receives one month LIBOR flat (0.25%) floating rate on swap
• The FI receives a net amount of LIBOR plus 1.68% for seven years
• LIBOR + (3.75% - 2.07%) = LIBOR + 1.68%
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Swaps
Application – Swaps
• Credit Union earns 3.75% on mortgage loan
• Credit Union pays 2.07% on swap
• Credit Union receives 0.25% on swap
• Credit Union receives a net amount of 1.93% on mortgage loans
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Mortgages 3.75%
Fixed Swap Payment -2.07%
Net…..…………… 1.68%
Floating Swap Receipt 0.25%
Net on Transaction 1.93%
Becomes a floating rate asset at LIBOR plus 168 basis point
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Swaps
If rates move up 300 basis points, net rate would be 4.93%
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Net Interest Margins
-
1.00
2.00
3.00
4.00
5.00
6.00
-200 -100 Base 100 200
Net
Inte
rest
Marg
in (
%)
Interest Rate Scenario
Pre Swap
Post Swap
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Interest Rate Swap ($10 million)
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-
$(1,500,000.00)
$(1,000,000.00)
$(500,000.00)
$-
$500,000.00
$1,000,000.00
$1,500,000.00
$2,000,000.00
-200 -100 Base 100 200 300
15yr Mtge
7yr Swap
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-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
4.00%
-200 -100 Base 100 200 300
Liability
Liability
Remember Balance Sheet Risk
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Swap Impact to Capital
37
-
$(1,500,000.00)
$(1,000,000.00)
$(500,000.00)
$-
$500,000.00
$1,000,000.00
$1,500,000.00
$2,000,000.00
$2,500,000.00
-200 -100 Base 100 200 300
Capital Impact
Net
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7r Swap vs 7yr Borrowing
38
-
$(1,500,000.00)
$(1,000,000.00)
$(500,000.00)
$-
$500,000.00
$1,000,000.00
$1,500,000.00
$2,000,000.00
-200 -100 Base 100 200 300
7yr Swap
7yr Swap
$(1,500,000.00)
$(1,000,000.00)
$(500,000.00)
$-
$500,000.00
$1,000,000.00
$1,500,000.00
$2,000,000.00
-200 -100 Base 100 200 300
7yr Borrowing
7yr Swap
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Interest Rate Cap
• A cap is a derivative which protects the buyer from interest
rates rising
• Cap term = Length of time between initial agreement and
termination of contract
• Cap index = Rate type on which the contract will be based –
most likely LIBOR
• Cap strike = Maximum rate to which the underlying index can
increase
• Cap premium = Cost to purchase cap; can be amortized over
the life
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Interest Rate Cap
• A cap’s payout is based upon the strike of the cap (a rate
agreed upon at the inception of the agreement, i.e. 4.0%)
relative to an underlying index
• If the underlying index exceeds the cap strike, the buyer of a
cap receives a payment equal to the index minus the cap
strike rate times the notional amount of the cap
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Interest Rate Cap
• Cap term – 5 years
• Cap strike – 4%
• Cap index – 1mo LIBOR
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Cap Payout
• Payout = NP[max(0, LIBOR – strike rate)(days/360)]
• NP = notional principal
• Strike rate = cap rate or max LIBOR rate
• Days = days between each caplet (3 months)
• Example
– $10 million Cap
– LIBOR = 6% - for the entire year
– Strike Rate = 4%
– 10,000,000 x (6%-4%) x (360/360) = $200,000
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Interest Rate Cap
Floating Rate10% (No insurance)
8% Interest Rate
4%
2%
1 month2% 4% 6% 8% 10% LIBOR
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6%Cap
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Cap – Economic Value
Eff. Duration -200 -100 Base 100 200
Fixed Rate Asset 2.78 107,421 106,996 105,778 101,118 95,861
Market Value Sensitivity Pre-Hedge 2.78 1,643 1,218 - (4,660) (9,917)
Interest Rate Cap (4,546) (2,681) - 3,924 8,954
Market Value Sensitivity Post-Hedge 2.78 (2,903) (1,463) - (736) (963)
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Cap – Income
LIBOR 0.25% 1.25% 2.25% 3.25% 4.25% 5.25% 6.25%
Floating Rate Liability 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00%
Expense (Pre Cap) 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00%
Cap 0.00% 0.00% 0.00% 0.00% 0.25% 1.25% 2.25%
Expense (Post Cap) 1.00% 2.00% 3.00% 4.00% 4.75% 4.75% 4.75%
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Interest Rate Cap
• Cap cost are based on expected future interest rates
• Cap cost increase as terms increase
• Cap cost decrease as cap strike increase
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Per $10,000,000 trade Term
Total Cost
(all up front) 7yrs 10yrs
Cap Strike
1.50% $ 512,000.00 $ 1,063,000.00
2.50% $ 333,700.00 $ 717,000.00
3.00% $ 268,000.00 $ 582,000.00
5.00% $ 130,400.00 $ 275,000.00
Bps / Year cost
Cap Stike
1.50% 78bps 116bps
2.50% 51bps 78bps
3.00% 40bps 64bps
5.00% 19bps 30bps
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-
$(1,500,000.00)
$(1,000,000.00)
$(500,000.00)
$-
$500,000.00
$1,000,000.00
-200 -100 Base 100 200 300
15yr Mtge
Cap
Interest Rate Cap ($10 million)
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The Cost of Hedging Assuming Rates Do Not Move
• Unhedge 4.50% mortgage
• Hedge by selling mortgage and invest in a 1-year security at
0.50%
• Hedge with a 10-year borrowing at 3.50%
• Hedge with a 10-year swap to pay 2.75% and receive 0.25%
• Hedge with a 10-year 4% cap at an annualized cost of
0.627%
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The Cost of Hedging Assuming Rates Do Not Move
49
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
One YrInvestment
Unhedged Hedged with 10 yrBorrowing
Hedged with 10 yrSwaps
Hedged with 10 yrout of the money
cap
0.50%
4.50%
1.00%
2.00%
3.87%
-
100,000
200,000
300,000
400,000
500,000
One YrInvestment
Unhedged Hedged with 10 yrBorrowing
Hedged with 10 yrSwaps
Hedged with 10 yrout of the money
cap
50,000
450,000
100,000
200,000
387,300
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Risks to Transaction
• Why shouldn’t you do this…What are you missing?
• Insurance decreases gains on loans in downward rate
environments
• Perfect hedges are difficult to achieve and are not cost
effective
• Insurance can be expensive
• Insurance requires a greater amount of education
• Insurance can be abused by being used for speculation
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Risks to Transaction
• Basis risk between hedged item and derivative
• Counterparty risk in the amount of marked-to-market
thresholds (usually $250k or less)
• Liquidity risk in the event a counterparty goes under and trade
needs to be transferred
• Political risk due to lack of examiner knowledge and
experience
• Could be re-pricing risk if using swaps and rates decline
causing mortgages to prepay
• Ineffectiveness in accounting hedge causes income volatility
to financial statements
• Unclear impact to RBC at this time
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Conclusion
• Risk management requires the use of hedging – always!
• Hedging can be as simple as selling assets or using
derivatives
• Institutions should take market risk they are being paid for and
avoid market risk they are not being paid for
• Derivatives sound scary but are very common and effective
tools for risk management
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2911 Turtle Creek Blvd.
Suite 500
Dallas, Texas 75219
Phone: 800.752.4628
Fax: 214.987.1052
www.almfirst.com