MANAGING INTEREST RATE RISK THROUGH HEDGING WITH DERIVATIVES 2014 NASCUS Summit September 10, 2014

MANAGING INTEREST RATE RISK THROUGH HEDGING WITH DERIVATIVES 2014 NASCUS Summit September 10, 2014 Presented By Travis Goodman, CFA Managing Directo...
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MANAGING INTEREST RATE RISK THROUGH HEDGING WITH DERIVATIVES 2014 NASCUS Summit

September 10, 2014

Presented By Travis Goodman, CFA Managing Director, Advisory Services

Hedging Overview • History • Duration dilemma • Hedging – Swaps – Caps

2

Introduction and History • Over the counter derivative contracts have their origins in the exchange traded markets • Notional amount of OTC contracts as of June 2012 – $708 trillion

• Interest rate contracts make up the lions share of OTC derivatives Hedging Interests Interest Rate

67%

Credit Default (CDS)

8%

Foreign Exchange

9%

Commodity

2%

Equity

1%

Other

12%

3

To Put it in Perspective • Market size – – – –

Treasuries Agency debt MBS OTC derivatives

$10 trillion $2 trillion $8 trillion $708 trillion

• The outstanding notional principal in the OTC derivatives market dwarfs the large primary fixed-income markets

4

Terms and Definitions •

Interest rate swap – an agreement between two parties, where a stream of interest payments is exchanged for another based on a specified notional amount



Interest rate cap – an agreement in which payments are made when the reference exceeds the strike rate



Notional principal amount – the principal amount that the interest payments in an interest rate swap are based



Fixed rate – the rate that a party agrees to pay in swap, this rate remains the same for the life of the swap



Floating rate – the rate that a party agrees to pay, this rate is tied to an index and resets throughout the life of the swap



Underlying index – the rate that the floating leg of a swap is tied to



Strike – the rate at which the reference rate is compared to



Maturity – the length of time until the swap or cap expires



Reset frequency – how often the floating rate changes



Payment frequency – how often payments are made



Day count convention – a convention for determining the number of days between two dates and the number of days in a year

5

Derivatives Are Not New to NCUA

NCUA Rules

• Part 703 prohibits the use of derivatives • Makes exceptions for specific loan pipeline hedging needs

Pilot Program

• Permitted a limited number of approved FCUs to enter into derivatives with approval • Powers extended through direct and vendor programs

• Imposed standards for counterparty credit worthiness • Limits based on NW, earnings

ANPR 6/11, 1/12

NPR 5/13

• Should derivatives activity permit third party experience

• Permit swaps and caps to mitigate IRR exposure

• What control standards should be required?

• Establish product limits using a tiered structure

• What products and limits should be allowed?

• Specify third party roles

• Demonstrate material IRR exposure

• Limit counterparties to dealers, CFTC approved swap dealers • Require personnel with years of experience

Final Rule 1/14

• Expand products to include floors, T futures, and basis swaps • Modify limits for maximum allowable loss and notional • Streamline experience requirements • Align counterparty, margin requirements with CFTC regs • Streamline the application process

6

Derivatives Update • NCUA voted to approve the use of derivatives on January 23, 2014 • Eligible derivatives – – – –

Interest rate swaps Interest rate caps Interest rate floors Treasury futures

7

Risk Avoidance • Limits investment opportunities • Ignores market preferences and relative value • Asset allocation and balance sheet mix decisions can be clouded by duration constraints • Institutions “chase” similar assets (autos) to unprofitable pricing levels based on their attractive duration characteristics • While leaving some wider spreading and more potentially profitable assets (mortgages) out of the mix

8

Why Don’t More Institutions Hedge? • They may not understand their exposures to: – Interest rate moves – Yield curve shape / slope – Options implied volatilities

• They may understand these risks, but do not know how to hedge

9

Can We Measure The Basis Risk And Is It Reasonable? • Most interest rate swaps and caps that you will consider for hedging are LIBOR based • Many assets and liabilities that are hedged are not LIBOR based • Basis risk is the risk that arises between hedges and hedged items when their market value changes are based on different underlying drivers – Hedging mortgages with interest rate swaps hedges interest rates and swap spreads (LIBOR / Treasury spreads) but it doesn’t hedge mortgage spreads to swap

10

Other Barriers to Consider • Institutions with poor market value don’t want to lock in low value • Managers are often evaluated against (unhedged) peer group • Hedging is likely to expose poor asset allocation decisions • Hedging increases regulatory scrutiny • Ambiguous rules create accounting risks • As rates have fallen, most hedges observed have losses when viewed in isolation

11

The Duration Conundrum • Financial institutions all need: – Stable and liquid sources of duration • From – – Deposits – Borrowings – Hedges

• To fund and hedge different types of assets

12

Borrowers vs. Depositors – The Dilemma Low Rate Environment 4.0%

High Rate Environment 9.0% Depositors

Rate

Rate

Borrowers

1.5%

6.0% Depositors

Borrowers

Maturity

Maturity

Balance Sheet is Net Long Liability Sensitive

Balance Sheet is Net Short Asset Sensitive

Depositors and borrowers maximize their own utility

13

Opportunities Lie Along The Entire Yield Curve Institutions that can hedge select assets along the entire curve Institutions that can’t hedge compete for assets in the crowded short duration space 5 4.5 4 3.5

Yield

3

2.5 2 1.5 1 0.5 0

Maturity

14

Deposit Strategies • Financial institutions usually “pay-up” to interest rate swap rates to attract long term deposits CDs

Swaps

Spread

3m

0.55

0.24

0.31

6m

0.80

0.33

0.47

1yr

1.40

0.57

0.83

2yr

1.70

0.73

0.97

5yr

2.50

1.88

0.62

10yr

3.75

2.70

1.05

15

Withdrawal Penalties • Theoretical values of early withdrawal penalties vary with the level of rates – 5 year CD – Penalty = 6 months of interest Penalty

1%

0.5%

2%

1.0%

3%

1.5%

4%

2.0%

5%

2.5%

6%

3.0%

7%

3.5%

8%

4.0%

9%

4.5%

10%

5.0%

6.0% 5.0% 4.0%

Penalty

Rate

3.0% 2.0% 1.0% 0.0% 1%

2%

3%

4%

5% 6% Rate

7%

8%

9%

10%

16

Convexity • Be careful when assessing the hedging benefit of liabilities that can be called away 12.00 10.00 8.00

Price Change

6.00

4.00 2.00 0.00 -200

-100

Base

100

200

300

400

-2.00 -4.00 -6.00 CD - High Penalty

CD - Low Penalty

17

Borrowing Strategies • FHLB advances: – FHLB advance structures generally have better hedging benefits than term deposits because of the lack of an early withdrawal penalty – Pricing can still be “expensive” versus longer term interest rate swap rates FHLB

Swaps

Spread

3m

0.23

0.24

-0.01

6m

0.25

0.33

-0.08

1yr

0.32

0.57

-0.25

2yr

0.79

0.73

0.06

5yr

2.12

1.88

0.24

10yr

3.24

2.70

0.54

18

Borrowing Strategies – Pros and Cons • FHLB advances: – Pros: • Duration hedging benefits without risk of early withdrawal • Stable long-term funding source for longer duration assets

– Cons: • Stock investment earns a “sub” market return and increases all in funding costs • Liquidity is poor and getting true “mark to market” payouts for liquidations is virtually impossible • Increase leverage when institution may not need it

19

Interest Rate Risk Insurance Primary derivative instruments • Swaps – No upfront cost; gains when rates rise and losses when rates fall – Effectively change short term liabilities into fixed term funding

• Caps – Premiums can be high, and accounting is more difficult – Up front cost is maximum you can lose, gains in value when rates rise

20

Balance Sheet Risk

Asset - % change in MV

2.00% 1.00% 0.00% -200 -1.00%

-100

Base

100

200

300

-2.00% -3.00%

Asset

-4.00% -5.00% -6.00% -7.00%

21

Balance Sheet Risk

Liability - % change in MV

4.00% 3.00% 2.00% 1.00%

0.00% -200 -1.00%

Liability -100

Base

100

200

300

-2.00% -3.00%

22

Balance Sheet Risk

Combined

4.00%

2.00% 0.00% -200 -2.00%

-100

Base

100

200

300

Asset

Liability

-4.00% -6.00% -8.00%

23

Balance Sheet Risk

Capital - % change in MV

4.00% 2.00% 0.00% -200

-100

Base

100

200

300

Capital

-2.00% -4.00% -6.00%

24

Insurance Risk Profile • NEV percent change in up 300 = negative 35% • NEV ratio in up 300 = 5.00% Situation • If rates rise by over 100 basis points, the credit union’s interest rate risk will be outside of risk tolerance levels

25

Insurance Options – On balance sheet • Sell loans • Extend duration of liabilities (borrow) • Decrease duration of assets Insurance Options – Off balance sheet • Enter into an interest rate swap • Interest rate caps

26

On Balance Sheet vs. Off Balance Sheet • On balance sheet – – – –

Decreases capital ratio Usually more expensive Identical NEV percent change impact to off balance sheet No hedge effectiveness testing or additional accounting cost

• Off balance sheet – – – –

Little to no impact on capital ratio Usually less expensive Identical NEV percent change impact to on balance sheet Hedge effectiveness and accounting cost

27

Interest Rate Swap Diagram

Floating

Depositor

0.05% Floating

4.25% Fixed Rate

Fixed

0.25% Floating

Floating

Financial Institution

Fixed

Borrower

2.25% Fixed Rate

Swap

28

Swaps Pay fixed swap rates as of Aug 25, 2014 • 2 year 0.72% • 5 year 1.81% • 7 year 2.07% • 10 year 2.54%

29

Swaps Insurance with swaps • Credit union issues $10 million of 15year real estate loans • Credit union buys insurance by entering into a seven year swap to pay 2.07% and to receive a one month variable rate (LIBOR + 0 = 0.25%) on $10 million for seven years

30

Swaps • The Financial Institution (FI) – Earns 3.75% fixed rate 15 year mortgage loan – Pays 2.07% on a fixed rate 7 year swap – Receives one month LIBOR flat (0.25%) floating rate on swap

• The FI receives a net amount of LIBOR plus 1.68% for seven years • LIBOR + (3.75% - 2.07%) = LIBOR + 1.68%

31

Swaps

Application – Swaps • Credit Union earns 3.75% on mortgage loan • Credit Union pays 2.07% on swap • Credit Union receives 0.25% on swap • Credit Union receives a net amount of 1.93% on mortgage loans

Mortgages Fixed Swap Payment Net…..……………

3.75% -2.07% 1.68%

Floating Swap Receipt

0.25%

Net on Transaction

1.93%

Becomes a floating rate asset at LIBOR plus 168 basis point

32

Swaps If rates move up 300 basis points, net rate would be 4.93%

33

Net Interest Margins

6.00

Net Interest Margin (%)

5.00

4.00

3.00

Pre Swap Post Swap

2.00

1.00

-200

-100

Base Interest Rate Scenario

100

200

34

Interest Rate Swap ($10 million)

$2,000,000.00 $1,500,000.00 $1,000,000.00

15yr Mtge $500,000.00

-

7yr Swap

$-

-200 $(500,000.00)

-100

Base

100

200

300

$(1,000,000.00) $(1,500,000.00)

35

Remember Balance Sheet Risk

Liability

4.00% 3.00% 2.00% 1.00% 0.00% -200 -1.00%

Liability -100

Base

100

200

300

-2.00% -3.00%

36

Swap Impact to Capital

Capital Impact

$2,500,000.00 $2,000,000.00 $1,500,000.00

$1,000,000.00 Net

$500,000.00 $-

- $(500,000.00)-200

-100

Base

100

200

300

$(1,000,000.00) $(1,500,000.00)

37

7r Swap vs 7yr Borrowing

7yr Swap $2,000,000.00 $1,500,000.00 $1,000,000.00 $500,000.00 7yr Swap

$$(500,000.00)-200

-100

Base

100

200

300

200

300

$(1,000,000.00) $(1,500,000.00)

7yr Borrowing

-

$2,000,000.00 $1,500,000.00 $1,000,000.00 $500,000.00 7yr Swap

$$(500,000.00)-200

-100

Base

100

$(1,000,000.00)

$(1,500,000.00)

38

Interest Rate Cap • A cap is a derivative which protects the buyer from interest rates rising • 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

39

Interest Rate Cap • A cap’s payout is based upon the strike of the cap (a rate agreed upon at the inception of the agreement, i.e. 4.0%) 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

40

Interest Rate Cap • Cap term – 5 years • Cap strike – 4% • Cap index – 1mo LIBOR

41

Cap Payout • • • •

Payout = NP[max(0, LIBOR – strike rate)(days/360)] NP = notional principal Strike rate = cap rate or max LIBOR rate Days = days between each caplet (3 months)

• Example – – – –

$10 million Cap LIBOR = 6% - for the entire year Strike Rate = 4% 10,000,000 x (6%-4%) x (360/360) = $200,000

42

Interest Rate Cap

Floating Rate (No insurance)

10% Interest Rate

8%

Cap

6% 4% 2%

2%

4%

6%

8%

10%

1 month LIBOR

43

Cap – Economic Value

Eff. Duration

-200

-100

Base

100

200

Fixed Rate Asset

2.78

107,421

106,996

105,778

101,118

95,861

Market Value Sensitivity Pre-Hedge

2.78

1,643

1,218

-

(4,660)

(9,917)

(4,546)

(2,681)

-

3,924

8,954

(2,903)

(1,463)

-

(736)

(963)

Interest Rate Cap Market Value Sensitivity Post-Hedge

2.78

44

Cap – Income

LIBOR

0.25%

1.25%

2.25%

3.25%

4.25%

5.25%

6.25%

Floating Rate Liability

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

Expense (Pre Cap)

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

Cap

0.00%

0.00%

0.00%

0.00%

0.25%

1.25%

2.25%

Expense (Post Cap)

1.00%

2.00%

3.00%

4.00%

4.75%

4.75%

4.75%

45

Interest Rate Cap • Cap cost are based on expected future interest rates • Cap cost increase as terms increase • Cap cost decrease as cap strike increase Per $10,000,000 trade Total Cost (all up front) 1.50%

Cap Strike

Term 7yrs

10yrs

$ 512,000.00 $ 1,063,000.00

2.50% $

333,700.00

$ 717,000.00

3.00% $

268,000.00

$ 582,000.00

5.00% $

130,400.00

$ 275,000.00

1.50%

78bps

116bps

2.50%

51bps

78bps

3.00%

40bps

64bps

5.00%

19bps

30bps

Bps / Year cost

Cap Stike

46

Interest Rate Cap ($10 million)

$1,000,000.00 $500,000.00

-

15yr Mtge

$-200

-100

Base

100

200

300

Cap

$(500,000.00) $(1,000,000.00) $(1,500,000.00)

47

The Cost of Hedging Assuming Rates Do Not Move • Unhedge 4.50% mortgage • Hedge by selling mortgage and invest in a 1-year security at 0.50% • Hedge with a 10-year borrowing at 3.50% • Hedge with a 10-year swap to pay 2.75% and receive 0.25% • Hedge with a 10-year 4% cap at an annualized cost of 0.627%

48

The Cost of Hedging Assuming Rates Do Not Move

4.50% 3.87%

5.00% 4.00%

2.00%

3.00% 1.00% 2.00%

0.50%

1.00% 0.00% One Yr Investment

Unhedged

Hedged with 10 yr Borrowing

Hedged with 10 yr Swaps

Hedged with 10 yr out of the money cap

450,000 387,300

500,000 400,000 200,000

300,000 100,000 200,000

50,000

100,000 One Yr Investment

Unhedged

Hedged with 10 yr Borrowing

Hedged with 10 yr Swaps

Hedged with 10 yr out of the money cap 49

Risks to Transaction • Why shouldn’t you do this…What are you missing? • Insurance decreases gains on loans in downward rate environments • Perfect hedges are difficult to achieve and are not cost effective • Insurance can be expensive • Insurance requires a greater amount of education • Insurance can be abused by being used for speculation

50

Risks to Transaction • Basis risk between hedged item and derivative • Counterparty risk in the amount of marked-to-market thresholds (usually $250k or less) • Liquidity risk in the event a counterparty goes under and trade needs to be transferred • Political risk due to lack of examiner knowledge and experience • Could be re-pricing risk if using swaps and rates decline causing mortgages to prepay • Ineffectiveness in accounting hedge causes income volatility to financial statements • Unclear impact to RBC at this time

51

Conclusion • Risk management requires the use of hedging – always! • Hedging can be as simple as selling assets or using derivatives • Institutions should take market risk they are being paid for and avoid market risk they are not being paid for • Derivatives sound scary but are very common and effective tools for risk management

52

2911 Turtle Creek Blvd. Suite 500 Dallas, Texas 75219 Phone: 800.752.4628 Fax: 214.987.1052 www.almfirst.com

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