INTERMEDIATE DERIVATIVE ANALYTICS CUNA CFO Conference May 19, Presented by: Emily Moré Hollis, CFA Founding Partner

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1 INTERMEDIATE DERIVATIVE ANALYTICS CUNA CFO Conference May 19, 2015 Presented by: Emily Moré Hollis, CFA Founding Partner

2 Agenda Derivative terms and definitions Derivative process and analytics Identification of risk and key rate durations Accounting requirements Back office 2

3 Are My Identified Risks: Hedgeable, Diversifiable or Unhedgeable? Are we hedging for a disaster or day to day operations? Be careful when constructing disaster hedges it may be too late when they finally pay off! Also, don t define risks too narrowly building hedging strategies solely around regulatory definitions of economic value sensitivity would be remiss Some risks should simply be diversified that s why we have a balance sheet credit risk + other idiosyncratic risks Understanding unhedgeable risk and basis risk is very important when evaluating hedge performance 3

4 Can We Measure The Basis Risk And Is It Reasonable? Most interest rate swaps and caps that you will consider for hedging are LIBOR-based Many assets and liabilities that are hedged are not Basis risk is the risk that arises between hedges and hedged items when their market value changes are based on different underlying drivers Example: I grow #1 grade corn and hedge it in the futures market with a corn contract that is based on #2 grade corn I have hedged my corn crop, but still have basis risk between the valuation of my #1 grade and the market s valuation of #2 grade Hedging mortgages with interest rate swaps hedges interest rates and swap spreads (LIBOR/Treasury spreads), but it doesn t hedge mortgage spreads to swaps 4

5 Key Terms and Definitions Interest rate swap an agreement between two parties, where a stream of interest payments is exchanged for another based on a specified notional amount Interest rate cap an agreement in which payments are made when the reference exceeds the strike rate Notional principal amount the principal amount that the interest payments in an interest rate swap are based Fixed rate the rate that a party agrees to pay in swap, this rate remains the same for the life of the swap Floating rate the rate that a party agrees to pay, this rate is tied to an index and resets throughout the life of the swap 5

6 Key Terms and Definitions (continued..) Underlying index the rate that the floating leg of a swap is tied to Strike the rate at which the reference rate is compared to Maturity the length of time until the swap or cap expires Reset frequency how often the floating rate changes Payment frequency how often payments are made Day count convention a convention for determining the number of days between two dates and the number of days in a year 6

7 Key Terms and Definitions (continued..) Duration Measures the sensitivity of a bonds price to changes in interest rates, taking into account that expected cash flows will change as rates change Convexity Measures how the duration of a bond changes as interest rates change Repricing risk Risk associated with liabilities and assets having different fixed terms. i.e. long term assets funded with short term liabilities. As rates rise margins will compress, as liabilities reset higher. Net Economic Value (NEV) The economic value of capital as measured by netting the economic value of assets against the economic value of liabilities 7

8 Key Terms and Definitions (continued..) NEV Sensitivity The volatility in the net economic value of capital. Interest Rate Risk Risk to earnings or market value due to uncertain interest rates. Basis Risk - Risk that offsetting segments of a hedging strategy will not experience price changes in equal amounts. This imperfect correlation creates the potential for excess gains or losses Idiosyncratic Risk Risk that is specific to an asset or a small group of assets. 8

9 DERIVATIVE PROCESS AND ANALYTICS 9

10 Derivative Analytics Interest rate swaps receive periodic payments based on all LIBOR rates until maturity Interest rate caps only receive payments when LIBOR is above the strike A zero strike cap and a swap are economically the same the user just pays for them differently 10

11 Derivative Analytics The valuation of interest rate swaps is relatively simple, one only needs a forward curve to determine the fair value. Interest rate caps are more complex and require more analytically rigorous models as there are more moving parts; like volatility and time 11

12 IDENTIFICATION OF RISK AND KEY RATE DURATION ANALYTICS 12

13 Swap Notional Amount of $10,000,000 Purchase $10 million of seven year interest rate swap: Pay 1.50% in today s market for seven years Receive one month LIBOR at 0.25%. The expense is a 125 basis point effect on the trade, so dollar for dollar hedged 4.00% mortgages will be yielding a net 2.75%. (4.00% %) Should rates rise by 300 basis points, the swaps will gain $1.558 million 13

14 Cap Notional Amount of $10,000,000 Purchase $10 million of 3% seven year out-of-the-money caps: Assume cost of the cap is $ , an expense of $50,400 per year. This cost is the CU s maximum exposure. The expense is a 60 basis point effect on the trade, so dollar for dollar hedged 4.00% mortgages will be yielding a net 3.40%. (4.00% %) Should rates rise by 300 basis points, the caps will gain $1.012 million 14

15 Derivative Income Comparison Income Sample Swap vs. Cap 10,000,000 Credit Union Asset 500,000,000 7 Year Swap 1.50% 7 Year Cap, Strike of 3.00% Cap starts generating income when LIBOR is greater than 3.00% Cap Income , ,000 Cap Expense - (50,400) (50,400) (50,400) (50,400) (50,400) (50,400) Net Cap Income - (50,400) (50,400) (50,400) (50,400) (25,400) 74,600 Swap Income (150,000) (150,000) (125,000) (25,000) 75, , ,000 Swap starts generating income when LIBOR is greater than 1.50%. Up 200 swap earns 75 bps (2.25%-1.50%). 15

16 Derivative Market Value Comparison Starting NEV % Change of Negative 25% $484,673 gain $474,000 gain 16

17 Identification of Risk Process Credit union owns $20mm of fixed mortgages Identify loans that have the most advantageous characteristics to hedge away Individual loan characteristics determine the amount of interest rate risk which needs to be hedged Run loans at the record level to depict an accurate effective duration profile Calculate key rate durations of the pool to determine mortgage pool sensitivity to each point along the yield curve Build hedge ratios 17

18 Key Rate Duration Yield curves rarely move in parallel fashion Key rate durations identify sensitivity of portfolio to each point on the yield curve Portfolios are more sensitive to some portions of the yield curve than others 2 main strategies using key rate duration Position portfolio at specific points on the yield curve to take advantage of shape / shift changes Extinguish a liability with your investments 18

19 Key Rate Duration Key rate durations are computed by decreasing and increasing each individual key spot rate by some number of basis points (e.g., up or down 50bps) and re-computing the asset s (or liability s) price given that shift, holding all other spot rates along the term structure constant. The average percentage change in the asset s value resulting from a given pair of these up and down key rate shifts is its key rate duration for that point on the curve. The sum of these partial durations is the asset s overall effective duration. 19

20 Key Rate Duration 2.00% 1.50% 1.00% Rate Adjusted Rate 0.50% 0.00%

21 Key Rate Duration - $20 Million of Loans $600,000 Loans $500,000 $400,000 $300,000 $200,000 $100,000 $- $(100,000) $(200,000) $(300,000) $(400,000) $(500,000) $(600,000)

22 Dollar Duration with Swaps Hedging $20 mm of Loans $600,000 Swaps $400,000 $200,000 $- $(200,000) $(400,000) $(600,000) $600, Loans $400,000 $200,000 $- $(200,000) $(400,000) $(600,000)

23 Swap Options Swap Tenor Allocation 1 Allocation 2 Allocation 3 Swap Notional 2 Year 5,937, Year 4,930, ,288, Year 2,437, ,453, ,774, Year 8,353, ,866, ,866, Year 4,669, ,669, Total Swaps 21,658, ,277, ,310, Mortgages 20,025, ,025, ,025,

24 Swap Options Scenario Allocation 1 Allocation 2 Allocation 3 Net Hedge Position -100 (251,940.78) (296,469.33) (299,006.41) -80 (110,472.86) (128,645.29) (130,049.22) -60 (21,810.73) (26,123.86) (26,775.13) -40 (9,654.31) (11,369.99) (11,608.18) -20 (20,017.74) (20,497.69) (20,591.93) , , , , , , , (444.80) 80 (7,415.02) (16,089.59) (18,124.22) 100 (25,802.53) (39,140.85) (42,291.43) 24

25 Net Hedge Positions Scenario Allocation 1 Allocation 2 Allocation 3 % Hedged % 129% 129% % 114% 114% % 103% 104% % 102% 102% % 109% 109% 0 0% 0% 0% % 104% 104% % 102% 102% % 100% 100% 80 99% 98% 98% % 97% 97% 25

26 Hedging Benefit 1,500,000 1,000, ,000 - (500,000) (1,000,000) (1,500,000) Loan Value Swap Value Net 26

27 Swap Income & Expense At Execution Up 300 Mortgage Income Mortgage Income Loans Hedged Rate Income Loans Hedged Rate Income 20,000, % 800,000 20,000, % 800,000 Interest Expense Interest Expense Derivatives Expense Derivatives Expense 16,277, % (325,556) 16,277, % (325,556) Interest Income Interest Income Derivatives Income Derivatives Income 16,277, % 40,694 16,277, % 529,028 Net Income 2.58% 515,139 Net Income 5.02% 1,003,472 27

28 ACCOUNTING REQUIREMENTS 28

29 Hedge Accounting Flowchart ASC 815 (FAS 133) Fair Value Summary Qualifies Fair Value Cash Flow Change in Fair Value of Derivative offsets hedged item (Runs through P&L) Change in Fair Value recorded in OCI (equity) 29

30 Hedge Accounting Qualification Accounting Requirements Formal documentation at hedge inception Execute a hedging strategy that qualifies for hedge accounting Obtain pre approval from your auditor Hedging relationship expected to be highly effective Changes in cash flows that could affect earnings 30

31 Hedge Accounting Service Initial Hedge designation memorandum and effectiveness analysis Ongoing Periodic hedge effectiveness testing Monthly: credit unions and other financial institutions Quarterly: regulatory requirement Required journal entries Hedge Memo (6-10 pages) 31

32 BACK OFFICE 32

33 Weighted Maximum Fair Value Loss Options Swaps Futures Total Gross National (Step #1) 100,000,000 50,000,000 5,000, ,000,000 Adjustment Factor 33% 100% 100% Adjusted Notional (Step #2) 33,000,000 50,000,000 5,000,000 88,000,000 Weighted Average Remaining Maturity (WARM) (Step #3) Weighted Average Remaining Maturity Notional (WARM) (Step#4) 68,112,000 (77.4% of Step #3) Notional Limit Authority (65% of net worth) 65,000,000 Under (Over) Notional Limit Authority - (3,112,000) 33

34 Back Office Credit union will consult with accounting vendor on hedge effectiveness tests and finalize accounting hedge types and entries Hedge review with each trade Dealers will credit union on notifications of rate resets and interest payments when applicable Daily Calculate prices notifying dealer if collateral should be called Deliver and receive collateral to and from safekeeping agent 34

35 Back Office Collateral Movement Zero threshold $250 collateral margin Next day delivery of collateral Collateral can consist of cash, Treasuries, Agencies, MBS Safekeeping agent for credit union is FHLB Safekeeping agent for dealer is JP Morgan 35

36 Back Office Collateral Movement Day One Credit union enters into an interest rate swap No collateral action Day Two Market value of swap is $200,000 No collateral action Day Three Market value of swap is $500,000 CU calls dealer to deliver $500,000 to the FHLB Day Four Market value of swap is $450,000 $500,000 of collateral is received into the FHLB Day Five Market value of swap is $200,000 Dealer calls CU to deliver back $300,000 of collateral Day Six Market value of swap is $200,000 Collateral is sent to dealer for $300,000 36

37 Back Office Collateral Movement Day One Credit union purchases an interest rate cap for $500,000 No collateral action Day Two Market value of cap is $550,000 $500,000 of collateral is received into the FHLB Day Three Market value of cap is $600,000 No collateral action Day Four Market value of swap is $800,000 CU calls dealer to deliver $300,000 to the FHLB Day Five Market value of swap is $800, ,000 of collateral is received into the FHLB Day Six Market value of swap is $300,000 Dealer calls CU to deliver back $500,000 of collateral 37

38 Back Office Monthly Price volatilities in up and down 300 basis point scenarios Distribute monthly reports as outlined in the derivative policy Receive derivative pricing and accounting entries from accounting vendor Prepare NEV with and without the derivatives trades Monthly Reports Areas of noncompliance Limits List of individual positions and aggregate current fair values and notional amounts Net economic value with derivatives included and excluded Evaluation of effectiveness of the hedge relationship and reporting in compliance with GAAP 38

39 Back Office Quarterly Work with accounting vendor to calculate hedge effectiveness tests on derivatives Prepare quarterly derivative analytical reports as outlined in the derivative policy Distribute quarterly reports as outlined in the derivative policy Annual Updated names of officials who are authorized to conduct derivatives transactions to dealers or / and advisors Financial audit Internal controls review is required for the first two years by and internal auditor 39

40 Key Takeaway Risk management is superior to risk avoidance Taking A systematic approach to derivatives use is a best practice for addressing risk management needs 40

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