Question: Why do you believe institutions might want to consider hedging interest rate risk using derivatives? What are some factors we should consider when deciding to hedge with derivatives?
Our philosophy at ALM First is rooted in risk management. As part of the broader risk management process, hedging is the action of adjusting, reducing or mitigating the adverse impact of a potential market fluctuation. Hedging strategies are implemented under a risk management process to adjust risk to a desirable level; it’s not just about playing defense, it is about targeting an appropriate level of risk.
At ALM First, we have found learning to manage IRR is a far superior solution than avoiding it. Although derivatives can receive a “scary” connotation of sorts, they really should not. Derivatives are simply very effective and capital-efficient tools to control risk. To successfully make use of derivative hedging, an institution should consider the following categories: policies, analytics/modeling, training/education, and operations.
Frequently coming from the board, policies help guide management’s activities through stating goals, objectives and risk tolerances. The first step towards implementing a derivatives program is to ensure ALM, investment and hedging policies reflect the objectives of the board in relation to the use of derivatives for hedging.
The next step is to establish thorough analytic and modeling procedures, which involves the vital need to understand and quantify risk. Without strong modeling procedures, you are doomed to the life of the proverbial blind squirrel that finds a nut only every now and then. Effective risk managers have a solid understanding of the risks embedded within the balance sheet, regardless of whether they decide to hedge. Figure 1 below shows an example of assessing the equity exposure to changes in interest rates. To hedge equity at risk, an institution would need to determine the appropriate hedge instruments and hedge ratios to mitigate or alter the risk as deemed appropriate.
Figure 1: Interest Rate Risk—Measuring Equity at Risk
It is critical, however, that the board and management both have a comprehensive understanding of how derivatives work. Education and training are very important to the due diligence process of establishing a derivatives program. Regardless of the intention to use derivatives, building the knowledge of both your board and risk management team empowers them to make a difference in your institution. It allows the board to continue its contribution to the strategic direction of the institution, and to assess current risk management practices. It also enables management to effectively perform its role of measuring and managing risk exposure. You may have the best model in the world, but models are only as good as their users and their inputs. What use is a Ferrari if you don’t know how to drive one?
Lastly, operational and regulatory considerations are not to be underappreciated when building a derivatives hedging program. A big part to a derivatives program is the accounting. According to the Financial Accounting Standards (FAS) No. 133 and its subsequent amendments, derivatives can receive special (hedge) accounting treatment if they are tied to a specific hedged item, and a highly effective hedging relationship is documented. Ongoing assessments of hedge effectiveness are required quarterly, at the least. Additionally, operations needs to be prepared for the added responsibility of booking and settling trades, position reconciliation, daily P&L calculations and other supporting functions. While economic performance may be great, any weaknesses in disclosure and documentation place the institution at risk.
In sum, hedging with derivatives can be a very effective tool for risk management. Whether an institution decides to hedge with them or not, the most important factor is ensuring a robust risk management process. We advise our clients in this process, with the ultimate goal of delivering high-quality information allowing for a strong approach to strategic decision making. Doing so can allow them to deliver superior financial services and products, and meet the financial needs of the members or customers, whether they are borrowers or depositors. Ultimately, we believe focusing on a disciplined risk management process, and not on the direction of rates, is truly being ahead of the curve.
The Investment Management Group can be contacted at [email protected]