Hedging programs come in a variety of forms and are used in many industries. Hedging is defined as procedures that adjust, reduce or mitigate negative effects of possible market movements. Many financial institutions use hedging to manage risk, gaining them more control over the relationship between profitability and risk. In this article, we will discuss reasons to implement hedging programs and identify the foundational points of hedging.

Why use hedging programs?

Usually, hedging is an aspect of risk management. While there are numerous reasons to hedge, they can be broadly categorized. Virtually all banking organizations conduct business in lending and in deposits. So, choosing to hedge often involves the desire to mitigate interest-rate risk resulting from these products and services. Examples of hedging programs focusing on interest rate risk include:

• Core balance sheet hedging
• Portfolio’d mortgage and CRE loans
• Funding risk
• Mortgage banking
• Mortgage origination pipeline
• Mortgage servicing rights

Regardless of the specific application of the hedging program, the framework for identifying risk and developing procedures to mitigate the risk is the same.

How is interest risk quantified?

Bond traders have specific methods to quantify interest rate risk. Commonly used is DV01, or the dollar value of 1 basis point (bp). As a measure of interest-rate risk, it is basically a trader’s abbreviation for the dollar value change given a 1 bp change in interest rates. This concept is closely related to effective duration, which is the linear function of a bond’s price given a parallel shift in interest rates.

Take, for example, a \$1 million market value position in a security with a calculated effective duration of 3%. The DV01 of the position is simply the assumed dollar value of this effective duration figure in a 1 bp increment. According to the calculations in Figure 1 below, the DV01 of the position is \$300. This indicates if interest rates were to shift in either direction by 1 bp, an expected value change of \$300 would result. How is the hedge position size determined?

Calculating the hedge position size involves matching the hedge position DV01 with the calculated DV01 exposure. Different hedge instruments ultimately have different exposures; the hedge instrument used will drive the position size. For example, see Figure 2 below. The 10-year U.S. Treasury futures contract has roughly two times the exposure to interest rates as does the 2-year U.S. Treasury futures contract (DV01 of \$72.00 versus \$36.04). So, if hedging with the 2-year, the position size would be two times as large versus using the 10-year contract to hedge. Consider the previous example of a \$1 million market value position in a bond. Say a hedger wanted to remove the interest-rate exposure of this position using the 10-year futures contract. To calculate the required position size, divide the DV01 of the exposure by the DV01 of 1 contract, calculated in Figure 3 below. If the hedger decided to use the 2-year contract instead, the position size would be double, or eight contracts needed (\$300 divided by \$36.04, rounded down). Remember, the 2-year contract has a notional size of \$200,000 versus the \$100,000 notional on the 10-year, so this drives the DV01 higher than it would be if the notional sizes were the same. Actually, hedgers often use a blend of different maturity dates to match the exposure to specific points on the discount curve.

What other risk factors should be considered?

Many securities contain risk associated with aspects other than interest-rate risk. More complex assets with embedded options, like mortgage-backed assets, contain a variety of risk factors. Factor-based sensitivity analyses can illustrate the total risk position. At ALM First, we run multi-dimensional risk analyses (MDRAs) to assess the exposure to various risk factors, including exposure to interest rates, volatility, prepayments, and product spreads. This way, hedging programs can address a wider range of risk factors, and an analysis of basis point risk between the exposure and the hedging instruments can be performed.

In the above example in which a \$1 million market-value position was hedged using only the 2-year futures contract, the hedged position would still be subject to risk of changing discount curve shape, volatility, prepayments, etc.

For financial institutions to expand product and service offerings, hedging programs to control risk are essential. In the case of mortgage lending, proper pipeline hedging allows an institution to offer loans at attractive rates while still making a profit. Additionally, portfolio products that add too much term-risk to the balance sheet can be hedged so the aggregate balance sheet exposure remains within acceptable ranges. Basically, interest-rate risk should not be managed only with product offerings. # Alec Hollis, CFA

Director, ALM Strategy Group at ALM First # Michael Oravetz

Associate, ALM & Investment Strategy at ALM First