Key Takeaways:
- Understanding swap use in today’s landscape
- Remaining competitive in the lending space despite a flatter curve
- Maintaining a lower cost of funds in a rising rate environment
- Protecting against the risk of unrealized losses in the investment portfolio
Swaps Today
In Q2 2021, the National Credit Union Administration board approved a ruling making it easier than ever for federal credit unions to utilize derivatives to manage interest rate risk. The final ruling removed the application process for federal credit unions greater than $500 million in assets with a CAMEL rating of 1 or 2. This also applies to state-chartered credit unions if their state follows parity with federal law. As a result, derivative interest across the industry has picked up – and for good reason. Having derivatives in the toolbox allows institutions to adapt to changing market environments while staying true to day-to-day balance sheet management. In any rate environment, a well-designed hedging program in conjunction with strong funds management can increase opportunities for institutions to add more profitable assets on the margin while managing risk exposure.
Introduction to Swaps
An interest rate swap is a financial instrument in which two parties agree to exchange interest rate payments. There are two main types of interest rate swaps that can have varying structures. The first which would be utilized by an institution protecting against rates rising is a pay fix – receive float interest rate swap. In this structure (Figure 1) the financial institution agrees to pay 5 years fixed at the current 5-year swap rate. In exchange, the financial institution receives a floating payment from the counterparty – typically a bank, at an agreed upon index (effective fed funds in Figure 1). If rates increased the fixed leg would stay the same, but the receive leg would increase with the index, thus making interest rate swaps an effective tool to manage the asset/liability duration gap. Interest rate swaps can also be used to protect against rates falling. To accomplish this, the financial institution would take the opposite side of the agreement and agree to pay a floating rate and receive a fixed rate. As rates decrease, the institution’s payment to the counterparty would decrease while receiving the higher fixed rate. The two structures of interest rate swaps can be used to manage interest rate risk in any rate environment.
Pay Fix – Receive Float Swap Valuation
At time zero the interest rate swap starts at a zero value. When rates rise, the value of the swap increases as the receive leg of the instrument increases. The opposite is true when rates decrease as the receive leg moves down with market. This makes fixed-to-floating interest rate swaps a great hedge for assets which decrease in value as rates increase and conversely increase in value as rates decrease. Entering into a swap agreement can help make changes in economic value more stable in different rate environments.
Pricing a Pay Fix – Receive Float Interest Rate Swap
The fixed rate of an interest rate swap is derived from the index forward curve at the start date of the contract. Over the life of the swap the cash flows of all the fixed and floating payments will net to zero. In other words, the starting present value of the instrument is zero. Figure 2 depicts this relationship between the fixed and receive leg of a 10 year fed funds indexed interest rate swap. The horizontal line represents the fixed 10-year swap rate. As time goes on the fed funds futures curve eventually breaks even with the fixed swap rate and then goes higher based on the slope of the curve when the swap is originated. The big caveat with this is that rates rarely (if ever) follow the forward curve exactly. To demonstrate this, a 25bps flattening and steepening of the curve is shown on the graph. If the forward curve steepens, the breakeven point occurs sooner than the base curve creating more value for the instrument. The opposite is true with a flatter curve. Therefore, it is important to monitor the swap position on a regular basis to ensure the hedge is still effectively meeting the intended risk management goals. One important note to add is that the counterparty will set the cost of the contract, which will usually include a spread over mid-market rates to account for credit risk, profit, etc.
Risks
As with any balance sheet activity, there are risks involved. However, the risks involved with interest rate swaps are generally considered low to moderate. The over-the-counter derivative market is massive, with the majority being interest rate contracts. This makes the OTC market extremely liquid. Counterparty risk does exist, but each interest rate swap contract must be backed by collateral. Collateral can be either cash or securities. In the case of securities, haircuts are applied meaning at least 100% of the interest rate swap is collateralized. As the market fluctuates up and down, the parties must post collateral to cover the swap. The shape of the yield curve is another risk. If there is a steepening of the yield curve, the market value loss of the asset could be greater than the gain on the hedge. Depending on the institution’s hedging goals, this could lead to rebalancing of the hedge to align it more closely with the asset. Continuously monitoring the swap is important to ensure it is meeting the hedging goals and to help you manage these risks.
Remaining Competitive and Managing Loan Growth
In any market rate environment, both sides of the balance sheet will usually have differing desires (Figure 3). In times of low interest rates, borrowers will look to capitalize on cheaper long-term debt. On the other hand, depositors want to keep their money as liquid as possible to obtain the highest possible savings rate should rates rise.
This dilemma between the wants of borrowers and depositors creates a mismatch in duration between both sides of the balance sheet leading institutions to potentially avoid interest rate risk. The use of derivatives allows financial institutions to synthetically change their interest rate risk profile without affecting both borrowers and depositors. By removing the interest rate risk component of lending, institutions can remain competitive and lend to all parts of the yield curve.
An example of this could be a market in which commercial lending has become competitive. This competition has led to borrowers wanting longer term commercial loans that may be too far out on the yield curve for an institution. Introducing derivatives in this scenario allows the institution to remove the interest rate risk component and focus on other risk components such as liquidity and credit. In doing so, they can compete in this space and bring in higher yielding loans to bolster the performance of the institution.
At the end of the day, depositories are in the business of risk management – not risk avoidance. Derivatives offer a way to efficiently manage interest rate risk so institutions can remain competitive and manage the balance sheet.
Managing Cost of Funds
Funding has remained extremely cheap in the current market rate environment; however, as mentioned previously, the duration of on-balance sheet funding tends to be short. Obtaining longer core deposit funding may require institutions to offer promotions at the expense of the bottom line. Wholesale borrowings are another option to extend duration of liabilities, however, doing so comes with term premiums when compared to the swap market.
An alternative option is to fund the assets with a short-term borrowing position and hedge the funding using a fixed-to-floating interest rate swap (Figure 5). By entering this swap contract, the institution pays a fixed-rate interest payment on a notional amount over the contractual period while receiving a floating interest-rate payment from its counterparty. The floating payment is used to offset the floating cost of rolling the short borrowing position, while locking in a fixed expense on the borrowing cost equal to the fixed leg rate and stabilizing the spread to the asset being funded. The swap synthetically extends the borrowing to the term of the swap contract, offsetting interest-rate risk at a much lower cost than a duration-matched term borrowing.
A risk that is introduced with this strategy is basis risk: the risk that the rolling borrowing rate increases faster than the floating leg of the interest rate swap. In that scenario, the basis risk is the difference between the funding cost and the receive leg of the swap.
Protecting Against Potential Unrealized Losses
In a low-rate environment, investment portfolios are faced with the potential of unrealized losses if spreads widen, or rates rise. This may lead to difficult conversations with Boards in the future. While spread risk cannot be hedged against, institutions can use derivatives to proactively protect the portfolio against rates rising. In a rising rate environment, the investment portfolio will lose value leading to unrealized losses. By hedging with a fixed-to-floating interest rate swap, institutions can create another line item showing an offsetting gain. Removing the interest rate risk allows management to focus on monitoring spreads. In addition, using derivatives as a form of insurance against this event allows for a different conversation with the Board in the future.
Conclusion
Interest rate swaps are an excellent tool to have at an institution’s disposal to assist in managing the balance sheet. There are several ways derivatives can be used to solve the challenges institutions may face. Whether it involves remaining competitive in the market, obtaining lower costs of funds, or protecting against unrealized losses, derivatives have a place on the balance sheet of many well-run institutions. Leaders, and their boards, must understand these instruments and the associated risks to utilize them efficiently.
ALM First offers a turnkey solution designed to provide the specific support your institution needs, from creating an investment policy to developing appropriate strategies and monitoring collateral on a daily basis. Contact us today at almfirst.com/contact or learn more at www.almfirst.com/hedging.
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Disclosure
All investing is subject to risk, including the possible loss of the money you invest.
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