An Introduction to Interest Rate Hedging for Banks

Uploaded by FINCADAnalyticsSuite on 15.09.2010

hello my name is Martin mcconnell
I'm a derivatives consultant with Provident Risk Management
a company providing turnkey outsourced interest rate hedging solutions
to community banks
today we're going to talk about
how all banks can manage interest rate risk using swaps
and caps
banks are in the business of managing interest rates
both on their balance sheet and for their customers
interest rate risk in loans
fixed income securities
often these interest rate risk challenges conflict
in the current environment
banks want to increase asset sensitivity by making variable rate loans
at the same time borrowers are keen to lock in longtime fixed rates
off balance sheet tools such as swaps and caps
allow banks to enhance thier traditional on balance sheet portfolio management
this presentation will introduce simple hedging concepts for banks
and the risk management solutions they need to support a hedging program
first we'll take a look at portfolio or asset hedging
This can cover hedging fixed-income securities
loan pools on mortgage backed securities
in this first example
A bank wishes to hedge a fixed-income securities
when we approach this problem
we follow four basic steps
Firstly we define the strategy
Then identify the most favourable accounting treatment
we manage the credit and documentation risk
and finally we analyze the market risk associated with the transaction
Here our strategy it to hedge the change in value of an asset
in response to changes
in a long time liable swap rate
we will qualify this swap as a value hedge to ensure changes in the market value
of the swap will not impact earning
we will do a pre-trade
and post analysis to ensure
the hedge will be highly effective and qualify under hedge accounting rules
then we will negotiate
credit terms and documentation
here you can see a screen of fair value insight
the notional amount of our hedge is twenty five million dollars
matching the principal amount on the bond
The term is ten years
Under the swap
will pay a fixed rate of three point two five
And thats paid semi-annually
matching the coupon on the bond
we will receive
one month libel plus a spread of thirty three basis points
the floating rate payments will be make monthly
The swap has effectively converted this fixed-income securities
to a variable rate basis
As libel increases
the cash flows on the swap will increase
at the same time
we've hedged the market value of the assets
any increase in term, libel, or swaps
Will cause the market value of the swap to go up
a decline in the market value of the bond
we mentioned earlier
four basic steps to building a hedge strategy
The fourth step was to analyze market risk
Here we will stress test the swap
Model changes in the fair value of the swap
under different market conditions
we can see
the changes in the value of this swap
As rates go down fifty basis points
up one hundred basis points or up two hundred basis points
for example
if rates move up one hundred basis points
the market value of the swap would increase by two point one zero eight
million dollars
if rates go down by fifty basis points
swap will lose one point one four two million dollars in value
next we're going to take a look at liability hedging
on the liability side of the balance sheet
we use swaps and caps
to manage funding costs on deposits
Home loan advantage
trust preferred securities
and CD's
in this example we will look at hedging a deposit program index to libel
our goal will be to limit the exposure to rising libel rates
to qualify for hedge accounting
we will identify a pool of deposits with uniform characteristics
that will allow us to create a highly effective hedge
in this example we have a pool of fifty million dollar in deposit
linked to libel
we will hedge the first twenty five million deposits in the pool
The hedge will qualify as a cash flow hedge
we model three different interest-rate caps
cap premium will be advertised in accordance with
The fas-b guidance
which will result in a back loading of the premium
focusing on three year cap
we have a strike rate of two point two percent
if libel rises above two point two percent
the seller of the cap
well reimburse our bank
for its monthly interest expense on twenty five million dollars
above two point two percent
the bank has essentially purchased insurance
against rates rising above two point two percent
At providence risk management
we do a lot of work to support
hedging programs for commercial loans
we use FINCADs fair value insight
and our own transaction manager system
to support two hedging program
firstly we support programs where banks use of back-to-back swapbook
To execute swaps with commercial borrowers
and then hedge the risks on those swaps
With dealers or Home loan banks
For those banks
we support sales and marketing
credit and operations
instant documentation
pricing execution
error reporting
for banks making fixed-rate loans and hedging those loans individually
we focus on hedge counting
loan documentation
pricing execution
As well as documentation and counterparty credit risk
most of our banks prefer to make a variable rate loan
some will not make any fixed rate commercial loans at all
in today's market many borrowers want to lock in a low long-term fixed-rate
in this example
we meet the objective of the bank and the borrower
by combining a variable rate loan with the swap
firstly we make a loan at libel plus four hundred basis points
the bank executes the swap with the borrower
under that swap the bank pays libel plus four hundred basis points
and the borrower paid a fixed rate of five eighty five
from the borrowers perspective
the libel plus four hundred payments
cancel out and he is left paying five eighty five
the bank passes five eighty five fixed from the borrower
To its hedge provider
and is left earning libel plus four hundred basis points
a few key points to notice
For commercial borrower swaps
The swap must match the principal amortization and payment terms of the
the two off setting all back-to-back swaps
eliminate market exposure for the bank
there is no hedge accounting designation
for the swamps
and accounting
Is very simple and straightforward 0:08:07.940,0:08:12.990 Banks use back to back swap programs To manage rate risk on larger commercial
to provide greater product flexibility to their commercial borrowers
to allow them to
support credit based loan pricing
and to generate free income
In the swap example we just saw
The swap was struck at a rate of five eighty five
we can see from this report
That the par or
Mid market swap rate was five points seven zero percent
this resulted in free income to the bank
of twenty three thousand five hundred ninety nine dollars or fifteen basis
In this example we use fair value insights credit value adjustment module to
ensure we meet fair value accounting rules
we adjust the market value of this swap for credit risk
here we can see a credit charge of two thousand one hundred and eighty eight dollars
is the credit charge we calculate for this particular interest rates swap
that calculation
is based on our internal credit grades
for this particular loan
we also use Fair Value Insight
to calculate
potential credit exposure to our borrower under this swap
here you can see we’ve calculated a maximum peak exposure
of two hundred forty one thousand
ninety six dollars
under this particular swap transaction
I’d like to take a minute to talk about the importance of independent valuation
independent market valuations
Allow a bank
to verify deal of pricing
to carry out independent analysis of
credit market risk
also to model potential strategies and to meet auditor requirements
an independent pricing service
should use standard models
provide for open access to models documentation and data
should be able to meet fad-133 and 157 requirements
A system should support credit exposure calculations
and should provide for reporting on demand
to calculate a swap rate
A dealer will look at the following components
the treasury curve, swap shreds
Internal credit charges for the counterparty
and then of course a dealer markup or dealer revenue
each component of a swap price
can be calculated and should be verified
A bank considering using interest rate swaps
Faces many new challenges
Hedge accounting
Instant documentation
credit risk management
provident risk management and FINCAD’s Fair value insight
together address all of these challenges
banks should not reinvent the wheel when they begin an interest rate edging
they should adopt proven best practices to provide for policies and procedures
independent valuations
Credit and documentation management
and independent analysis and advice
That brings our introduction to hedging to An end
please look out for upcoming webcast
which will provide a step-by-step review of commercial loan swaps
balance sheet hedging and hedge accounting issues
and credit adjusted evaluations
in credit exposure calculations
for more information you can contact FINCAD at
you can contact providence risk management at
Or you can call me directly, Martin McConnell
704 552 3881
If you have any comments we look forward to receiving them and getting back at you