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

By Robert B. Perry and Hafizan G. Hamzah

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

Many financial executives agree the goal of most liability hedging transactions is to effectively reduce the variability of future interest expense and obtain hedge accounting treatment under FAS 133. This article explores such an option and shows how an interest-rate swap affects a financial institution’s balance sheet, interest-rate risk profile, and net interest margin.

Consider this scenario: XYZ Financial Institution would like to hedge a bucket of six-month time deposits that are characterized by an average duration of three months. The principal value of this bucket is $75 million.

The institution would like to synthetically extend the duration of this bucket to five years using a pay fixed/receive floating interest-rate swap. More demand for fixed-rate commercial real estate loans has created the need for longer duration funding to better finance (match) the new asset growth.

XYZ has had little luck attracting five-year time deposits through pricing and promotions. For simplicity, its balance sheet consists of one bucket of assets and one bucket of liabilities.

The bucket of assets is $75 million of fixed-rate, commercial real estate loans that balloon in five or seven years and amortize over 25 years. The liability funding these loans is the bucket of six-month time deposits. The time deposits reprice every six months with one-sixth of the bucket rolling monthly.

The following exhibits describe the balance sheet, interest-rate risk and net-interest margin sensitivity.

Exhibit 1 [pdf] shows XYZ’s market value sensitivity to changes in interest rates. Pre-swap, XYZ exhibits an average sensitivity, or effective duration, of 4.32% for rates up and down 100 basis points (bp).

Overlaying the swap’s market value sensitivity onto XYZ’s balance sheet decreases the measure to 0.04%. The sensitivity is reduced by extending the duration of the bucket of six-month time deposits synthetically.

Exhibit 2 [pdf] describes the difference in effective duration (elasticity) of XYZ’s liabilities pre- and post-swap. The duration is extended by 4.27%, from 0.29% to 4.56%.

Exhibit 3 [pdf] shows XYZ’s net interest margin (NIM) sensitivity to changes in interest rates. Pre-swap, XYZ’s NIM for parallel rate shifts up and down 100 bp has a range of 137 bp, from 4.27% in the down 100 bp shift to 2.9% in the up 100 bp shift.

After overlaying the sensitivity of the interest-rate swap, the variability in NIM decreases to 16 bp. Post-swap in the down 100 bp, NIM is 3.18%, while in the up 100 bp shift, it is 3.02%. This is a difference in variability of 121 bp.

XYZ’s NIM changes from 3.59% to 2.21% [pdf] with a 200 bp increase in rates pre-swap. Post-swap, the change is 3.1% to 2.93% with the same change in rates.

Through the up and down 200 bp shifts, pre-swap XYZ’s NIM has a range of 275 bp. Post-swap, that range is reduced to 32 bp.

The difference in base NIM pre- and post-swap of 49 bp is greater than would be expected in an average institution. XYZ’s duration gap between assets and liabilities is larger than that of a normal institution because of the simplicity of its balance sheet.

Next: Maintaining hedge accounting treatment

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.