Evaluating Derivatives―Part VI: Why Use Derivatives?
April 9, 2015
With the derivatives rule that went into effect in 2014, NCUA gave credit unions access to a new tool to help mitigate interest rate risk. Although a derivatives pilot program has been around since 1998, derivatives are still a relatively new thing to the industry. Past blogs in this series have provided the reader with important things to consider about the cash flows and economic value of interest rate swaps. All this, and more, should be carefully evaluated if your credit union is considering derivatives.
So, with all these things to consider, why might a credit union enter into a derivatives contract? The answer is simple: to hedge interest rate risk. As with other hedging techniques, a derivative will cost something today, but will help if rates increase. Think of it like an insurance policy.
For example, let’s suppose a credit union’s ALCO has decided it would be desirable to reduce interest rate risk and has established an internal goal of remaining Well Capitalized if rates increase 500 bps, and maintaining an NEV volatility of not greater than 40%. However, as shown below, an interest rate risk simulation indicates that if rates increase 500 bps, the credit union is positioned to put net worth of 3.64% at risk, leaving 6.56% net worth remaining. In addition, net economic value volatility is 55.55% and the resulting net economic value is 6.08%.
In evaluating ways to reduce its risk, the credit union runs a what-if scenario on the following interest rate swap:
- 7-year term
- Notional Amount: $50 million
- Pay Fixed Rate: 2.00%
- Receive Floating Rate: 3-month LIBOR
The results are shown below.
An interest rate swap is expected to provide protection, or insurance, against a rising rate environment. As noted above, the cost of this insurance in terms of annual ROA is 13 bps in the current environment. The benefit shown is the improvement in long term net worth at risk. The simulation including the impact of the swap shows that:
- Current ROA is reduced by 13 bps
- Long-term net worth not at risk improved by 78 bps to 7.34%
- The point at which the financial structure could now be positioned to fall below Well Capitalized has improved from when short-term rates are at 5% to when they now reach 6%
Note: $s in 000s
Derivatives analytics provided by The Yield Book® Software.
The NEV results both with and without the impact of the derivatives are shown above. Notice that the resulting NEV ratio after layering in the derivatives has improved in the +500 shock from 6.08% to 8.24%. Similarly, NEV volatility for that rate environment has been reduced from 55.55% to 38.31%. The ALCO has achieved their desired results.
While there are many things to consider about derivatives, they can be a good tool for mitigating interest rate risk. The more analysis that is done and the better your credit union’s unique risks and risk tolerances are understood, the better equipped you will be to decide if derivatives are a good choice for your credit union.