Evaluating Derivatives―Part V: Economic Value Declines Over Time
March 5, 2015
Credit unions purchase derivatives to receive value: interest rate risk protection. This blog series set out to help decision makers understand the variety of outcomes they could observe over the life of a derivative, and how those outcomes will ultimately determine the value realized.
Over its life, derivative economic value is impacted by two forces:
- Changing rate environments – which can increase or decrease economic value
- Time – which continuously decreases economic value gains
Prior blog articles discussed the impact of changing rate environments on economic value. Regardless of the rate environment, economic value of a derivative will converge to zero at maturity. The value of the protection diminishes as the remaining time to maturity becomes less. Using our prior example of the 7-year swap, the chart below shows the economic value on day 1 and each year thereafter:
Note: $s in 000s
Derivatives analytics provided by The Yield Book® Software.
The chart demonstrates the economic values for the various rate shocks as the time until maturity shortens. Compare the highest shocked environment shown, +500, the initial value of $26.4 million to the year 1 shocked value of $22.8 million. The year 1 value is materially lower because the swap only offers 6 remaining years of protection. Independent of the rate environment, by the end of year 7 the swap no longer has value since it matures.
Why is this important? If the swap was originally purchased to address a volatility issue in the credit union’s financial structure and that volatility persists, then over time the credit union will need to either adjust the underlying structure or will need to purchase additional swaps to maintain the same level of protection. It can be important to be clear about the objectives of the derivatives. Is the purchase designed to offset an existing risk and buy time until the root interest rate risk can be addressed? On the other hand, is the intent to, ongoing have, a business model incorporate additional interest rate risk and perpetually utilize derivatives to offset the risk?