Evaluating Derivatives—Part I: Earnings
December 12, 2014
While derivatives can be a good tool for mitigating interest rate risk, it is important for credit unions to understand the cost of the protection they are purchasing. This example uses an interest rate swap with the following terms to illustrate:
- 7-year term
- Notional amount: $100 million
- Credit union pays fixed rate of 2.00%
- Credit union receives 3-month LIBOR (~0.25%)
The basic workings of the swap are pretty straightforward. If rates do not change, the swap will be a hit to earnings because the credit union will pay a higher fixed rate than the variable rate it will receive; however, if rates increase, the credit union could benefit and this can help to mitigate interest rate risk. In evaluating the decision, it is critical that the credit union understand just how much the swap could cost over its life if rates do not change and how high rates would have to increase before the swap helps.
As shown in the table below, if interest rates do not change the credit union will pay out $1,760K per year, or $12,320K over the term of the swap. For some credit unions, this can be expensive insurance. Note that it takes rates increasing more than 300 bps – assuming an instantaneous rate change, which is an optimistic assumption when evaluating a derivative – before the net benefit to the credit union would offset the potential cost, if rates do not change.
Note: $s in 000s
Again, derivatives can be an effective tool for mitigating interest rate risk, but the credit union should do a thorough analysis of the financial impact and compare it to other risk-mitigating actions to determine the best route.