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Hedge accounting advisory
Guide

Hedge accounting advisory for financial institutions

  • Authors

    Eri Panoti

    Director
    Accounting Advisory

    Financial Institutions | Kennett Square, PA

Summary

Hedge accounting can be challenging to “get right” and tough to apply, so designing an effective hedging strategy and achieving the intended results is important for financial institutions.

It’s critical that it’s right

Hedge accounting can be challenging to “get right” and onerous to apply. Designing an effective hedging strategy and achieving the intended accounting results over time can be a difficult task ­— especially considering the need to accomplish it in a way that satisfies the concerns of key stakeholders including, management, the board of directors, auditors, and regulators. A financial institution needs to understand the economic and accounting nuances of each hedging strategy and to efficiently administer the program during its lifetime.

Why work with Chatham?

Chatham provides technical accounting consulting, analysis, technology, education, and key hedge accounting deliverables.

  • Accountants with deep technical and practical expertise are on call to help.
  • Chatham technology is a practitioner-developed technology and provides efficiencies in administering your program.
  • Transparent valuation methodologies and calculations drive better insight into the amounts recorded in your financial statements.

Case study

Problem

A liability sensitive financial institution is looking to reduce its sensitivity to rising interest rates. The entity has to mitigate liability sensitivity and does not want to borrow wholesale funds to point a pay-fixed swap against.

Goals
  • Convert fixed-rate assets to floating
  • Minimize income statement volatility caused by a change in value of a derivative transaction
Solutions

Chatham structures a pay-fixed vanilla interest rate swap and helps the financial institution minimize income statement volatility by designating the swap as a fair value hedge of a closed portfolio of prepayable fixed-rate loans as shown below:

  • Originate fixed rate loans to create a hedgeable portfolio
    • Loans do not need to have the same maturity or coupon
    • Loans required to be prepayable
  • Determine size and duration of risk exposure and compare to average retention period of loans
  • Designate the last layer of a closed portfolio of fixed-rate loans (i.e. $40M portion that is not expected to prepay of a $100M portfolio)
  • Execute a plain-vanilla swap with the same notional as the last layer and a duration that address the risk exposure
  • Changes in fair value of the swap are offset by changes in fair value of the hedged last layer of the designated prepayable fixed-rate loan portfolio — mismatches are reported in interest income
  • Any partial or full prepayments that occur up to the undesignated portion of the closed pool will be ignored for hedge accounting purposes
  • Stop hedge accounting once prepayments exceed undesignated portion of the closed pool and encroach into the designated last layer amount
  • Consider redesignation of the swap to a new portfolio

Ready to learn more?

Contact a Chatham advisor today.

About the author

  • Eri Panoti

    Director
    Accounting Advisory

    Financial Institutions | Kennett Square, PA


Disclaimers

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 chathamfinancial.com/legal-notices.

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. All rights reserved.

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