What if Rates Go to Zero? Strategies for Survival

Transcription

1 What if Rates Go to Zero? Strategies for Survival Monday 6/26/2017 3:45 PM 4:45 PM Presented by: Todd Cuppia Managing Director Balance Sheet Strategies Chatham Financial 235 Whitehorse Lane Kennett Square, PA P: E:

2 Is a conversation around the potential for negative rates even relevant in today s market? A solid maybe

3 Those Pesky Demographic Trends Source: Brookings The long-term decline in both the nominal effective fed funds rate and inflation expectations, in the U.S. and abroad, may indicate that brushes with the zero lower bound are more frequent than the past (and may have longer durations)

4 The market is pricing in extremely low risk of unexpected inflation 10-yr Term Premium The term premium embedded in Treasury yields is a good estimate of the market s assessment of the risk of unexpected inflation over the term of an investment i.e. the amount of inflation risk above what the market is has priced in for future loss of purchasing power Source: FRBNY

5 Researchers increasingly considering a protracted low rate environment Source: FRB San Francisco where rates could be very close to zero 30 40% of the time Source: Brookings. Kiley, Roberts, Bernanke

6 Hedging demand has increased for low rate protection 24 3 Month Options on 10-year Swaps (Skew) Source: Tullett Prebon, Chatham Financial * Lower readings imply that supply/demand in the markets are tilted towards hedgers paying for protection against falling rates.

7 Low Strike Floors Implied Probability of Exercise Important to keep the risk in context Source: Author s calculations

8 A near zero experience The brush with the potential for negative rates in the US, in addition to the experience of other developed economies where rates actually went negative, has brought the risk to the front of mind of risk managers, auditors and regulators. Very low strike options are still relatively illiquid, and pricing can vary meaningfully by counterparty Many lenders are now including floor language in floating rate loans The existence of floors matters, even if rates stay positive! but how are they valued?

9 Models for the forward rate don t worry there won t be a quiz In order to construct a volatility surface it is necessary to choose a model for the underlying forward rate. The three most common models are: The lognormal model (rates are bound by zero, i.e. the zero lower bound) The normal model (no boundaries to negative rates but perhaps rates can fall further than is practical given boundaries to the effective lower bound on rates (ELB)) The shifted lognormal model (The addition of a shift parameter to the lognormal model bridges the gap between the benefits of a lognormal model, and the practical reality that there is likely to be a boundary to how low rates can go)

10 The Hull-White model can handle negative rates Short Rate - Interest Rate Simulation under Hull-White 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% -0.50% -1.00% -1.50% Simulation Period But since calibration statistics are based on non market observables analysts prefer more robust models

11 The LIBOR Market Model is lognormal Short Rate - Interest Rate Simulation under LMM 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Simulation Period To compensate for the lognormality of the model, and to adjust for the possibility of negative rates, a shift parameter is typically applied (not shown)

12 Shifted Lognormal Model achieves superior fit to quoted prices

13 Zero strike floors, a practical example Example: Debt, Swap, No floor Positive Rates Fixed Borrower (Example: Your Bank) Floating Swap Counterparty Floating Loan Lender (Example: Brokered MMDA Provider) Absent the existence of any floor to the floating rate, the index (+/- spread) is free to move into negative territory

14 Zero strike floors, a practical example Example: Debt with 0% Floor, Swap without floor Negative Rates Fixed (+ Negative Spread) Borrower (Example: Your Bank) Floating Swap Counterparty Floating Loan 0% Floor Language and such rate will never be below 0% Lender (Example: Brokered MMDA Provider) In the case where there is a floor in the funding agreement, and the all-in floating rate is negative, the lender will not pay the negative floating rate. If the floor is not mirrored in the swap, any difference between the index and the 0% boundary would typically be added to the fixed leg of the swap.

15 Comparison with Example Example: LIBOR = 1.2% Example: LIBOR = (0.50%) Debt Swap Debt Swap Float (1.2%) 1.2% Float 0.0% 0.0% Fixed (2.0%) Net (2.0%) Fixed (2.0%) (0.50%) Net (2.5%)

16 Zero strike floors, a practical example Example: Debt with 0% Floor, Swap With 0% floor Negative Rates Borrower (Example: Your Bank) Fixed Floating Swap Counterparty Floating Loan Purchasing an equal and offsetting floor embedded in the swap eliminates the risk of a cash flow/value mismatch Lender (Example: Brokered MMDA Provider) The price of the insurance will fluctuate with the probability of a negative index setting. Critically, the economic / accounting risk due diligence associated with the decision to purchase the floor (or leave that risk unhedged) is a function of the overall level of, and variance in, the probability of negative rates so rates do not need to actually go negative for all this to matter!

17 Hedge Accounting Framework Derivative Subject to Topic 815 (carried on balance sheet at fair value) Does NOT Qualify for Hedge Accounting Qualifies for Hedge Accounting Mark-to-Market Through P&L Fair Value Cash Flow / Net Investment Change in FV offsets hedged item (through P&L) Change in FV recorded in OCI (equity)

18 Hedge Accounting Criteria Obtaining hedge accounting is a special election Qualify for hedge accounting only if all of the following criteria are met: Formal documentation at inception of the hedging relationship Forecasted transactions must be probable of occurring The hedge is considered highly effective The hedged item presents an exposure that could affect reported earnings The designated risk must be allowed under hedge accounting

19 Cash Flow Hedges (Current GAAP) A hedging relationship where the variability of the hedged item s cash flows are offset by the cash flows of the hedging instrument Hedged item is a forecasted transaction or balance sheet item with variable cash flows Earnings recognition matches timing of hedged transaction Forecasted transactions must be probable of occurring Effective Portion OCI Derivative in FV OCI Reclassification Align gains / losses on hedge with P&L recognition of hedged transaction Ineffective Portion Earnings Helpful changes are coming to the accounting standard!

20 Calculating OCI and Ineffectiveness (Current GAAP) Actual Trade Hypothetical Trade Current Period Clean Value $1,000,000 A $900,000D Inception Clean Value $0 B $0 E "Unrealized" gains/(losses) $1,000,000 $900,000 Cumulative Change in Value $1,000,000 C = A - B $900,000 F = D - E Cumulative OCI $(900,000)Deferred (Gain)/Loss (B/S) Lesser of C and F. Deferred gain (B/S) Cumulative Ineffectiveness $(100,000) (Gain)/Loss (I/S) If C > F, cumulative ineffectiveness = C F (overhedged) Otherwise, cumulative ineffectiveness = 0 (underhedged)

21 New Hedge Accounting Standard Available Soon Under existing hedge accounting guidance, changes in fair value are deferred in OCI and derivative payments are recognized in NII. Any mismatches are recorded as ineffectiveness in non-interest income/expense. The proposed changes to ASC 815 no longer require ineffectiveness to be separately measured and reported in financial statements. Any mismatch between the hedge and the hedged item will be reported in the income statement line item when the hedged item affects earnings.

22 Hypothetical Derivate Method Most common measurement testing method for cash flow hedges Based on a comparison of the change in value of the actual hedge and the change in value of a hypothetically perfect hedge that exactly matches the critical terms of the hedged transactions Must be updated whenever the best estimate of the hedged transactions change Basis for most cash flow hedge assessment methods (e.g., regression) Actual Derivative Hypothetical Derivative

23 Regression Refresher Robust method for assessing hedge effectiveness Regression is a statistical technique used for determining whether and by how much a change in one variable (the independent variable) will result in a change in another variable (the dependent variable) Regression analysis graphs a best fit line through historical value changes of the independent and dependent variables Data that fits closely to the best fit line indicates a strong relationship between the variables, while scattered data indicates a weaker relationship The algebraic equation representing the regression is: y = a + bx + e Where y is the dependent variable, x is the independent variable, a is the intersection on the y-axis, b is the slope of the line

24 Hedge Change Hedge Change Regression Refresher Passing slope and R-squared Evaluating Regression Results Regression analyses produce a series of statistical measures Auditors focus on certain measures deemed most relevant and have established minimum / maximum values that are acceptable for those measures R-squared (> 0.80) Slope coefficient (between 0.80 and 1.25) F-statistic (>4.13) y = 0.988x R 2 = y = x R 2 = REGRESSION ANALYSIS 200, , ,000 50, , ,000-50, , , , ,000-50, , ,000 Hypothetical Derivative Change REGRESSION ANALYSIS 200, , ,000 50, , , , , , , , , ,000-50,000 Failing slope and R-squared -100, ,000 Hypothetical Derivative Change

25 What s your delta? 5 Year 0% Floor Cost / Delta

26 What s your delta? 10 Year 0% Floor Cost / Delta

27 Quarter 1 Quarter 2 Quarter 3 Quarter 4 Quarter 5 Quarter 6 Quarter 7 Quarter 8 Quarter 9 Context 300,000 Simulated Hedge Ineffectiveness on $100mm USD LIBOR Swap (0% floor mismatch Current GAAP) 200, ,000 - (100,000) (200,000) (300,000) Ineffectiveness Recognized in Earnings (400,000) (500,000)

28 Ok, great, so what do I do Not purchasing the floor and embedding it into the swap is a source of hedge accounting ineffectiveness Modifying the loan agreement by removing the floor or modifying it is possible (spread concession) Given that the threshold for qualifying for hedge accounting, and the potential impact of any ineffectiveness is quantitative, mismatches in the hedging relationship are possible. There are a number of strategies to maximize economic benefit in the context of what is allowed by the accounting standard Ultimately however, hedge ineffectiveness results in earnings volatility, which may be significant, and should be quantified ahead of time What about back-to-back swaps? What about loan pricing strategies / documentation / system readiness? Are there implications for the bond portfolio?

29 The fine print CHATHAM HEDGING ADVISORS, LLC (CHA) IS A SUBSIDIARY OF CHATHAM FINANCIAL CORP. AND PROVIDES HEDGE ADVISORY, ACCOUNTING AND EXECUTION SERVICES RELATED TO SWAP TRANSACTIONS IN THE UNITED STATES. CHA IS REGISTERED WITH THE COMMODITY FUTURES TRADING COMMISSION (CFTC) AS A COMMODITY TRADING ADVISOR AND IS A MEMBER OF THE NATIONAL FUTURES ASSOCIATION (NFA); HOWEVER, NEITHER THE CFTC NOR THE NFA HAVE PASSED UPON THE MERITS OF PARTICIPATING IN ANY ADVISORY SERVICES OFFERED BY CHA. FOR FURTHER INFORMATION, PLEASE VISIT TRANSACTIONS IN OVER-THE-COUNTER DERIVATIVES (OR SWAPS ) HAVE SIGNIFICANT RISKS, INCLUDING, BUT NOT LIMITED TO, SUBSTANTIAL RISK OF LOSS. YOU SHOULD CONSULT YOUR OWN BUSINESS, LEGAL, TAX AND ACCOUNTING ADVISERS WITH RESPECT TO PROPOSED SWAP TRANSACTION AND YOU SHOULD REFRAIN FROM ENTERING INTO ANY SWAP TRANSACTION UNLESS YOU HAVE FULLY UNDERSTOOD THE TERMS AND RISKS OF THE TRANSACTION, INCLUDING THE EXTENT OF YOUR POTENTIAL RISK OF LOSS. THIS MATERIAL HAS BEEN PREPARED BY A SALES OR TRADING EMPLOYEE OR AGENT OF CHATHAM HEDGING ADVISORS AND COULD BE DEEMED A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION. THIS MATERIAL IS NOT A RESEARCH REPORT PREPARED BY CHATHAM HEDGING ADVISORS. IF YOU ARE NOT AN EXPERIENCED USER OF THE DERIVATIVES MARKETS, CAPABLE OF MAKING INDEPENDENT TRADING DECISIONS, THEN YOU SHOULD NOT RELY SOLELY ON THIS COMMUNICATION IN MAKING TRADING DECISIONS