Presented By

MANAGING INTEREST RATE RISK

THROUGH HEDGING WITH DERIVATIVES2014 NASCUS Summit September 10, 2014

Travis Goodman, CFA

Managing Director, Advisory Services

Hedging Overview

• History

• Duration dilemma

• Hedging

– Swaps

– Caps

2

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%

3

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

4

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

5

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

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

7

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

8

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

9

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

10

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

11

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

12

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

13

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

14

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

15

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%

16

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

17

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

18

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

19

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

20

-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

21

-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

22

-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

23

-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

24

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

25

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

26

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

27

Interest Rate Swap Diagram

28

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

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%

29

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

30

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%

31

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

32

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

Swaps

If rates move up 300 basis points, net rate would be 4.93%

33

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

34

Interest Rate Swap ($10 million)

35

-

$(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

-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

36

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

38

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

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

39

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

40

Interest Rate Cap

• Cap term – 5 years

• Cap strike – 4%

• Cap index – 1mo LIBOR

41

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

42

Interest Rate Cap

Floating Rate10% (No insurance)

8% Interest Rate

4%

2%

1 month2% 4% 6% 8% 10% LIBOR

43

6%Cap

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)

44

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%

45

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

46

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

-

$(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)

47

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%

48

49

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

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

50

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

51

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

52

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Suite 500

Dallas, Texas 75219

Phone: 800.752.4628

Fax: 214.987.1052

www.almfirst.com