Q. What is the most effective way to hedge interest rate risk?
A.
Last week, for the zillionth time, I was asked whether
community institutions should use SWAPs to hedge their interest rate risk. “After all, the big banks use them, shouldn’t
we?” Let’s review for a second what a
SWAP is and why big banks use them.
Like community institutions, big banks need to do a reasonable job of matching the duration of their funding to the duration of their assets. Say you need to hedge a book of five-year duration assets. You could go out and attempt to raise five-year duration funding. If that funding was five-year CDs, you’d have two problems.
First, customers don’t want to go long at the bottom of the rate cycle. So you’d need to bribe them with rates, which may be significantly above wholesale funding rates. Second, your early withdrawal penalties are probably insufficient to hold onto that funding in a rising rate environment of any significance. So we’re paying above wholesale rates for deposits that may not provide the hedge when we need it the most.
Like community institutions, big banks need to do a reasonable job of matching the duration of their funding to the duration of their assets. Say you need to hedge a book of five-year duration assets. You could go out and attempt to raise five-year duration funding. If that funding was five-year CDs, you’d have two problems.
First, customers don’t want to go long at the bottom of the rate cycle. So you’d need to bribe them with rates, which may be significantly above wholesale funding rates. Second, your early withdrawal penalties are probably insufficient to hold onto that funding in a rising rate environment of any significance. So we’re paying above wholesale rates for deposits that may not provide the hedge when we need it the most.
Big banks realize this, so they look for where deposit funding is cheap relative to the wholesale curve. Say that’s at the one-year point of the curve. Then they execute an interest rate swap to move the duration of that one-year funding out to five years. The swap pays the institution the one-year rate and charges the institution the five-year rate, locking in that rate for five years. The institution pays a fee for the swap based on the notional principal amount of the SWAP. It also pays (or receives) the difference between the one- and five-year rate. The penalty problem with the five-year CD goes away as early withdrawals on one-year CDs are less frequent and less painful than early withdrawal penalties on five-year CDs.