The Art of Interest-Rate Swaps

When hedging forward repricings of short-term liabilities, one approach is to use an interest-rate swap.

May 26, 2011
KEYWORDS duration , hedge , swap
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Maintaining hedge accounting treatment

To obtain hedge effectiveness under FAS 133 for an interest-rate swap with the goal of synthetically extending the duration of short-term liabilities, follow a four step process.

Step 1: Correlate

When accounting for interest-rate swaps, marginal repricings of the hedged liability should show high correlation with the floating leg of the interest-rate swap.

The method for performing Step 1 is to capture historical data on marginal liability rates, and then compare this data against a market interest rate (three-month LIBOR generally works for this analysis) using a simple linear regression.

A correlation coefficient of 0.80 or greater is desired. This step will ultimately help determine the interest-rate swap’s floating rate.

Step 2: Create

Step 2 involves creating a “hypothetical” perfect hedge. This will produce a benchmark that the actual interest-rate swap will be compared with regularly.

The hypothetical hedge should have characteristics needed for balance-sheet management that are more desirable than those in the unhedged liability. Some features may include longer duration, different rate structures, call features, or resets and repricing dates.

Step 3: Execute

In Step 3, the actual swap is executed and should contain as many of the parameters of the hypothetical perfect hedge as possible. Executing an interest-rate swap that closely compares with the hypothetical hedge should help maintain hedge accounting treatment under FAS 133.

In the example of XYZ, the hypothetical perfect hedge and the swap being considered for execution are identical.

Step 4: Compare

Generally, to maintain hedge accounting treatment under FAS 133, a re-evaluation of the interest-rate swap should be performed at least quarterly. Step 4 is accomplished by updating the marginal liability repricing rates, re-regressing them against updated market interest rates, and re-evaluating the correlation.

Next, confirm that the notional value of the liability is greater than or equal to the notional value of the swap and, finally, compare the mark-to-market value of the actual interest-rate swap and the present value of the hypothetical perfect hedge.

Differences in the actual swap’s market value change and the hypothetical perfect hedge’s computed market value change are generally considered ineffective.

Adding a pay fixed/receive floating interest-rate swap to XYZ’s balance sheet reduces interest-rate risk by extending the duration of the institution’s existing bucket of six-month time deposits. Market value and net interest margin sensitivity measures are both reduced.

Performing these steps and consulting an accountant and financial advisor for institution-specific requirements should help maintain hedge accounting treatment under FAS 133.

Robert B. Perry is a financial advisor with ALM First in Dallas. He advises multiple financial institution clients on asset/liability management and investment strategy.

Hafizan Hamzah is a financial analyst with ALM First, responsible for asset/liability analysis for financial institutions.

Contact them at 800-752-4628.

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