NEW ORLEANS—Credit union CFOs were offered new insights and some old reminders on how to use interest rate swaps and derivatives to hedge their portfolios during a one-hour discussion here.
Led by Emily Hollis, Founding Partner with Dallas-based ALM First Financial Advisors, the discussion at the CUNA CFO Council annual meeting was aimed at those with an “intermediate” knowledge of the subject matter.
“There are a lot of credit unions in this low-rate environment that don’t have a lot of interest rate risk right now,” acknowledged Hollis.
Nevertheless Hollis reminded her audience to understand effective duration means price volatility. “You have to know what type of derivatives to put on,” she said, adding, “Caps help with negative convexity. As asset duration extends and liability duration shortens, caps will kick in and help the effective duration come back into place.”
Emily Hollis, ALM First Advisors
Hollis urged CFOs not to define risk too narrowly, and to similarly be careful when constructing disaster hedges, as it may be too late when they pay off.
“Most interest rate swaps and caps that you will consider for hedging are LIBOR-based,” said Hollis. “Many assets and liabilities that are hedged are not.”
Another risk to keep an eye on, she added, is basis risk, which is the risk that arises between hedges and hedged items when their market value changes are based on different underlying drivers.
Three Points
Speaking to the issue of Derivative Analytics, Hollis offered three points:
- Interest rate swaps receive periodic payments based on LIBOR rates until maturity.
- Interest rate caps only receive payments when LIBOR is above the strike.
- A zero strike cap and a swap are economically the same, the user just pays for them differently.
“The valuation of interest rate swaps is relatively simple. One only needs a forward curve to determine the fair value,” Hollis said. “Interest rate caps are more complex and require more analytically rigorous models, as there are more moving parts, such as volatility and time.”
Speaking again to caps, Hollis reiterated, “Caps are used, again, for negative convexity. But if you have the choice of an effective duration mismatch today that needs to be fixed, you would always use a swap. You don’t want the cost of an at-the-money option to fix a duration mismatch, unless you know rates are going to fall. Unfortunately, in the CU movement we have regulations that provide a little more leeway to buy options, even though it may not be best to do that.”
As an example of how to hedge a balance sheet and identify the risk process, Hollis used a fictional CU with a $20-million portfolio of fixed mortgages. It would take these steps in this scenario:
- Identify loans that have the most advantageous characteristics to hedge away.
- Individual loan characteristics determine the amount of interest rate risk that needs to be hedged.
- Run loss at the record level to depict an accurate effective duration profile.
- Calculate key rate durations of the pool to determine mortgage pool sensitivity to each point along the yield curve.
- Build hedge ratios.
'Last Thing You Want'
“What happens in our hedges is that the yield curve very rarely moves in a parallel fashion,” she said. “So the last thing you want is to hedge 15-year mortgage with five-year swaps, and then the five year stays the same, the seven year backs up, and you’ve got a loss on your mortgages, and the swap doesn’t do anything.”
Hollis reminded the CFOs that key rate durations are computed by decreasing and increasing interest rates at key parts of the yield curve, most commonly at year two, five, seven, 10, 15, etc.
“You take your balance sheet and you shock not only the assets, but the liabilities,” Hollis said. “You might have liabilities that are hedging away at cash flows that you don’t even realize. So we’re trying to find spots that really need the hedges. Never let a hedge sit. Take off your hedges if your prepayments are coming off. They should never be put on and forgotten about.”