BY ALEC HOLLIS
If the mere mention of the word derivative sends you hiding under the covers, it’s time to set aside your fear. Far from being the boogey man in the closet, derivatives are a friendly ghost when it comes to managing a credit union’s interest rate risk. Keep reading for a shift in scare-tactic perspective.
I can’t tell you how many times I hear clients mention they are slowing down loan production or altering product offerings in the name of interest rate risk (IRR). While altering product offerings is one method of influencing IRR, in a way it contradicts the idea of serving members and providing them what they need. Interest rate risk (IRR) is a normal part of a depository’s business model, and managing it is vital to profitability. To some, the word “derivative” may have negative connotations and sound scary or daunting, especially in light of the oft-referenced financial crisis of 2008. However, it really shouldn’t. Derivatives are nothing more than capital-efficient tools for managing this risk. The essential idea is to shift IRR to a targeted or desirable level. IRR is typically viewed from two predominant perspectives: the “earnings” perspective and the “economic value” perspective. The use of derivatives can help alleviate both. Ultimately, there is a profitable side to risk management and being hedged.
The first step to hedging using derivatives involves understanding the exposure. Typically, analysis for derivatives involves calculating exposure under very small changes in interest rates, such as 10 basis points (bps). Exposure is frequently viewed in dollar amounts, such as the dollar value of a one basis point shift in rates (DV01). Figure 1 below shows the equity exposure to changes in interest rates from a total balance sheet perspective; the same analysis also can be done for a single asset or liability or a portfolio of either. To hedge the equity at risk, a derivative contract matching the average dollar exposure between 10 bps shifts would be selected.