Why Use Derivatives & Balance Sheet Hedging?

There are multiple assets competing for a spot on an institution’s balance sheet, and interest-rate risk shouldn’t be grounds for exclusion. Instead, meet the demands of your market, and then manage the interest-rate risk through our proven hedging solution. Derivative hedging techniques can help your institution retain core, longer-duration assets by managing the interest-rate risk that accompanies them. With a robust risk management process, your institution can improve its safety and soundness and help broaden the spectrum of products and services offered.

Choosing ALM First

ALM First provides:

  • Proven Expertise: Our team of experts has deep experience utilizing derivative hedging for both banks and credit unions. In addition, we work with financial institutions on successful hedging strategies, and we participated in the NCUA Derivatives Pilot Program. ALM First also played an instrumental role in the final 2014 regulation.
  • Turn-key Hedging Solution: Our expert guidance, analysis, and industry experience enables us to effectively utilize hedge instruments and reduce interest rate risk for our clients. We offer a turn-key hedging solution including consulting and advisory services.

ALM First’s Derivatives and Hedging Expertise

ALM First’s team of experts will work with you to:

  • Develop strategies to optimize your risk profile through hedging with derivatives
  • Provide education and training
  • Navigate the regulatory approval process
  • Establish relationships with counterparties
  • Execute transactions without bias
  • Monitor, analyze, and report hedge positions on an ongoing basis
  • Implement hedge accounting
  • Protect against unlikely events and outlier interest rate scenarios
  • Increase net interest margin stability

Additional Advantages with ALM First

Avoiding sectors or specific assets is usually a sub-optimal approach to risk management when compared with hedging. By managing your risk more effectively through hedging with derivatives, your institution can benefit from:

  • Enhanced income (rates are lower relative to term borrowings)
  • More capital efficiency
  • Sophisticated, detailed analytics including performance feedback loops and comprehensive monthly reports
  • Trusted operations, monitored collateral, confirmed trades, and counterparty credit analyses
  • Decreased interest-rate risk and credit risk (gains are collateralized)
  • Greater liquidity

 

>> Contact us today to discuss our turn-key consulting and advisory service and the advantages derivatives can provide you.

Derivatives and Balance Sheet Hedging FAQs

When is it desirable to mitigate risk? When is it not?

An institution should mitigate risk when the cost to eliminate risk is cheap and when managing risk is a better option than avoiding risk. An institution should be careful without the necessary education or support, as improper risk mitigation can be expensive and therefore not cost-effective.

How do you recognize the cost of hedging?

It is important to consider and minimize hedging costs. Hedging costs can be in the form of:

  • Roll yield (cost of carry of the hedge instrument)
  • Transactions costs
  • Offset ineffectiveness (i.e., unequal market value movements)
Why hedge instead of borrow?

There are clear advantages to hedging:

  • Hedging does not decrease the capital-to-asset ratio for transactions that are off balance sheet.
  • Borrowings are not liquid, and if your institution needs to liquidate a position, it can be very costly. Interest rate swaps and caps are extremely liquid and can be sold for a gain or loss.
  • Borrowing brings hedging benefits to the balance sheet, but it also comes with the risks of investing or deploying the funds. Derivatives simply do not have these leverage and investment issues to contemplate.
  • Credit risk is mitigated via bilateral agreements requiring daily margin maintenance or via tri-party custody or via clearing.
What are factors that could contribute to imperfect tracking?

Tracking is partially based on model assumptions, and these can influence the results. Some examples include:

  • Duration estimates
  • Convexity estimates
  • Rebalancing (rate volatility)
  • Imperfect correlation
What are the components of an interest rate cap?

An interest-rate cap is a derivative which protects the buyer from rising interest rates.

  • 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


A Cap’s payout is based upon the strike of the Cap 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.