Series: Ask ALM
Depositories hedge for a variety of reasons, including locking in potential profits, managing risk, attracting more business or extending the duration of their liabilities.
At ALM First, we’ve always encouraged institutions, whether they’re hedging or not, to look closely at their balance sheet and price their assets in a risk adjusted framework. This requires using financial models to identify the components of an asset’s yield to ensure accurate pricing, hedging and capital allocation.
The first question to ask before embarking on a hedging program is whether hedging would be beneficial. If an institution can see a benefit from hedging, the next step is to determine whether to work with an investment manager, and then to lay the proper groundwork for success.
When to Consider Hedging
If a depository is pricing assets in a risk-adjusted framework, hedging should be a normal part of the conversation. If loans can be naturally funded and hedged with deposits, then hedging using derivatives doesn’t come into the equation. However, retaining longer duration assets or more term loans, such as 30-year mortgages or commercial loans, in the portfolio may result in a higher level of interest rate risk. When assets don’t fit well with the rest of the balance sheet, that’s the time for an institution to consider hedging with derivatives.
When Hedging Won’t Help
If assets are poorly priced and have a low marginal expected return, hedging won’t help. High performing institutions price assets accurately and are likely to use hedging to protect their positive margins from interest rate risk. Other risks, such as credit risk, can be managed at the portfolio level through diversification while liquidity risk exposure can be a positive as a portion of a depository’s profits come from being a liquidity provider.
Encourage Participation and Preparation
There is a potentially profitable side to risk management. Robust models, the right technology, and accurate data, can help institutions identify the assets that make sense to hedge. Over time, effective risk management and hedging can help make a depository’s profits more stable and predictable.
The most common hedging instrument is a plain vanilla interest rate swap, which allows an entity to pay fixed and receive a floating rate. An interest rate swap is a way to synthetically extend the duration of a short-term funding source and is well-suited for a mortgage or longer duration commercial loan. Although the interest rate risk is coming from the asset, it’s often easier to hedge the liability. New rules have made it easier for institutions to address mismatches between their assets and liabilities by bringing the economics and the accounting for hedging mortgages closer together at the portfolio level.
Other Common Hedging Instruments
Back-to-back swaps are another common hedging strategy, which passes the cost of hedging on to the borrower. Institutions can also trade interest rate caps and floors, however, those aren’t as common.
Swaptions, which are options on a swap, are popular with mortgage hedgers and asset managers who are evaluating the market in real time. If rates rise significantly and the mortgage portfolio duration extends, it can either be rebalanced through re-hedging or rebalancing, or an institution can put on a swap and a swaption, which is an agreement to enter into more swaps as rates go up to hedge convexity risk.
Best Practices for Hedging Programs
There are several best practices successful hedgers and successful hedging programs share:
- The ability to identify the hedgeable risk inside an asset or liability. Understanding the risk profile of the hedged asset or liability is critical for successful hedging.
- Routine analytics to ensure instruments behave as expected. For example, ALM First’s team runs weekly analytics on 17,000 bonds. We’re constantly seeing whether each one is doing what we thought it should do as interest rates and other market factors move. Frequent analytical runs are necessary to create a feedback loop that refines future modeling.
- Robust ex-post performance evaluation to refine pricing. If there’s not enough profit in an asset after hedging it, the pricing may need to be adjusted.
Whether institutions choose to work with a provider or manage a hedging program internally, the difficult part is laying the groundwork at the beginning. Fine-tuning on the front-end is especially important when hedging a complex asset.
The Potential Institutional Benefits
When institutions put the profitable side of risk management into practice, all the pieces start working together and everyone understands the way assets are priced given allocated capital. It can alleviate many of the conflicts that may arise between marketing and finance regarding product pricing, for example. Analytics, modeling and hedging can change the whole nature of internal discussions by allowing the team to identify new ways the institution can expand the product mix to better serve their customers or members. This opens the door to becoming a high-performing institution.
Want to learn more? Contact ALM First.
