Managing Risk with Derivatives

Properly understood and used, derivatives can be an effective way to manage interest-rate risk.

June 12, 2014

Derivatives are instruments financial institutions use to manage interest-rate risk by decreasing risk exposure.

Today’s derivatives market is huge—$342 trillion for interest-rate swaps alone (in “notional” value). Banks have used derivatives extensively for many years. Approximately 28% of banks with assets between $250 million and $1 billion, and 57% of banks with assets between $1 billion and $5 billion use derivatives to guard against interest-rate risk. Essentially, derivatives have become standard practice for many banks.

NCUA has approved its final rule on the use of simple derivatives. This gives credit unions direct access to these risk management tools (albeit at a much simpler level than their banking counterparts). NCUA’s ruling makes about 400 credit unions eligible to apply for the authority to engage in derivatives. The agency estimates 30 to 60 credit unions will apply for the authority within two years.

SIDEBAR:

Derivatives can be complex, but they’re basically financial contracts between two parties that derive their value from an underlying asset, commodity, index, or currency. Interest-rate derivatives are used to customize cash flow needs, such as turning a fixed-rate asset into a floating-rate asset, or vice versa. Most credit unions engage in derivatives that gain value when rates rise. This can reduce fair-value losses on a credit union’s longer-term assets, such as mortgage loans.

To understand how derivatives work, consider a futures contract. For example, a producer of wheat might be trying to secure a price at which to sell next season’s crop, while a bread maker might be trying to lock in a price today to buy the wheat to estimate future costs and profits.

SIDEBAR:

The farmer and the bread maker would then enter into a futures contract requiring the delivery of 1,000 bushels of grain to the buyer in September 2014 at a price of $4 per bushel. By entering into this futures contract, the farmer and the bread maker secure a price that both parties believe will be a fair price in September. This contract can then be bought and sold in the futures market. Misconceptions

The primary misconception of derivatives is that they’re all risky. Derivatives, like most financial instruments, can be risky when viewed in isolation. Homeowners insurance never looks like a reasonable investment until you attach it to a house. Then the combination looks great.

The same goes for derivatives. They hardly ever look good by themselves, but they can look great as part of a portfolio or balance sheet. All derivatives contain some level of risk, but they can have strong risk-reducing characteristics at the portfolio level.

Another misconception is that the demise of some corporate credit unions was due solely to derivatives, which isn’t true. Credit losses on nonconforming securities, not basic derivatives, caused corporate failures.

When using derivatives as defined by NCUA’s ruling, credit risk is minimal due to the requirement of collateral postings. International Securities Dealers Association (ISDA) agreements state that collateral is supported by 100% of the market value gains with daily pricing.

From the credit union’s perspective, a market value gain will be covered by the posting of collateral from the dealer. A market value loss will require the credit union to post collateral to the dealer. The minimum transfer amount is $250,000, which means any movement over that amount will trigger movement of collateral. Exposure to the counterparty is limited to this $250,000 and any further daily market movement.

NEXT: Interest-rate swaps



Interest-rate swaps

The interest-rate swaps market began decades ago as a way for financial institutions—and corporations—to manage their debt. It has since grown into one of the most useful and liquid derivatives markets in the world.

An interest-rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a period of time. Swaps are useful when one financial institution wants to receive a payment with a variable interest rate, while the other institution wants to limit future risk by receiving a fixed-rate payment instead. Each group has its own priorities and requirements, so these exchanges can work to the advantage of both parties.

Because swaps are highly liquid and have built-in, forward rate expectations, as well as a credit component, the swap rate curve—the relationship between swap fixed rates of varying maturities—has become an important interest-rate benchmark for credit markets. In some cases, it has supplanted the U.S. Treasury yield curve.

NCUA permits credit unions to engage in the most commonly traded and liquid interest-rate swaps—known as “vanilla” swaps. Vanilla swaps exchange fixed-rate payments for floating-rate payments based on LIBOR (London Inter-Bank Offered Rate)—the interest rate high credit quality banks charge one another for short-term financing. LIBOR is set daily and it’s the benchmark for floating short-term interest rates.

Although there are other types of interest-rate swaps, such as those that trade one floating rate for another, plain vanilla swaps make up the vast majority of the market.

By convention, each participant in a vanilla swap transaction is known by its relation to the fixed-rate stream of payments. The party that elects to receive a fixed rate and pay floating is the “receiver,” while the party that receives a floating rate in exchange for a fixed rate is the “payer.” Both the receiver and the payer are known as “counterparties” in the swap transaction.

The counterparty that receives the floating “leg” will see the value of its swap transaction increase as rates move up, because it’s receiving higher interest payments. Payments are based on a “notional” amount and are off-balance sheet. The notional amount never exchanges hands between counterparties; the only exchange is the interest payments that are based on the notional principal. The notional value is the total value of a leveraged position’s assets.

Interest-rate caps

An interest-rate cap is a derivative for which the buyer pays a premium. In exchange, the buyer receives the right to payments at the end of each period for a specified amount of time in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month that the LIBOR rate exceeds 2.5% (the agreed upon strike) for a period of seven years. In other words, if rates move to 4%, the cap buyer will receive 1.5% (4 - 2.5) times the notional amount in interest payments.

The beauty of a cap is that the buyer can never lose more than the premium paid. The higher the agreed-upon strike rate, the lower the premium. This lower premium is like a high-deductible insurance premium—when rates move up, the cap buyer receives income, which will off set the locked-in, low rate it’s trying to hedge.

Managing interest-rate risk

Generally, financial institutions generate income by exposing their balance sheets to different types of risks (interest rate, convexity, liquidity) and through financial intermediation (gathering a portfolio of member deposits and building a portfolio of member loans). Understanding and applying strategies for managing these risks, and strategies for balance sheet construction, can enhance returns. But they also present risks if interest rates rise or liquidity spreads widen.

On the other hand, the often-used conservative practice of selling member-issued mortgages can negatively affect earnings. In this strategy, the interest-rate risk is removed, but so is the asset’s yield spread that institutions would rather retain.

Properly used, derivatives can offset interest-rate risk that is inherent within credit unions today. This is vital because as competition grows, derivatives can allow credit unions to compete more effectively. Credit unions that qualify should take the time to look into derivatives as instruments to put in their toolbox to help manage interest-rate risk (“NCUA’s derivatives ruling and CU eligibility”).

EMILY HOLLIS is a certified financial advisor and partner at ALM First Financial Advisors, LLC.