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Case Study

Increasing margin while protecting against adverse rising rate scenarios

Summary

Chatham strategized and worked with a financial institution client who purchased a fixed-rate security and layered on a pay-fixed, receive-floating interest rate swap.

Impact to client

  • The strategy resulted in the client receiving ~0.49% + Fed Funds (9bps) for 14 years, at the inception of the trade, increasing the initial incremental yield by ~48bps, as compared to Interest on Excess Reserves (IOER) (10bps)
  • This approach allowed the financial institution to increase yields today, as compared to holding cash, and in potential rising rate scenarios while reducing excess liquidity
  • The trade structure and hedge accounting designation limited financial statement volatility, due to changes in interest rates, associated with the derivative and the Available-for-Sale (AFS) fixed-rate security

Scenario and goals

  • The client had surplus liquidity on their balance sheet and wanted to deploy cash to increase current yields above their current earning rate of IOER
  • They had executed strategies in the past hedging the liability side of the balance sheet, but they were unfamiliar with the process for hedging the asset side and needed expert hedge accounting guidance
  • Their goal was to shorten the duration of their fixed income portfolio and considered hedging both existing bonds in their portfolio and new purchases
  • The financial institution wanted to posture itself to benefit by receiving higher yields should interest rates increase
  • Due to the LIBOR transition, they wanted to limit their exposure to LIBOR in situations wherever feasible

Strategy details

  • The client collaborated with Chatham’s Balance Sheet Risk Management (BSRM) team to identify possible securities to hedge
  • The team also provided alternative methods to hedge the securities which contemplated their interest rate risk profile
  • The BSRM team structured the trade to ensure optimal hedge accounting results and minimize earnings volatility while also taking into account the bank’s need to maintain liquidity and balance sheet flexibility in the future
  • The client purchased a fixed-rate security, designated AFS, and executed a pay-fixed, receive-floating interest rate swap, synthetically transforming it into a floating-rate asset
  • The receive-floating leg of the interest rate swap was tied to Fed Funds, limiting their incremental exposure to LIBOR

Ready to take the next step?

The combination of a low interest rate environment and low loan demand has caused many financial institutions to find alternative methods to increase margin without adding interest rate risk to their balance sheet. We have helped our clients think through these circumstances and utilize different asset hedging strategies to help them achieve their goals. Contact Chatham if you are interested in discussing these strategies and the impact to your financial institution.

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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