Interest Rates – Hedging Versus Speculation
By: John Trefethen, Director & Co-Founder
As a reminder from an earlier HedgeStar article, there are four primary types of risks inherent to interest rates: 1) repricing risk, 2) basis risk, 3) yield curve risk, and 4) option risk. This article will discuss hedging interest rates in broad terms to help illustrate the difference between hedging and speculation. At its core, a hedge is a mechanism that reduces an institution’s exposure to risk. A hedge is done to minimize the possibility that an entity’s assets will lose value, or that expected cash flows will be less than expected. Consider it a form of insurance. Most homeowners know the importance of purchasing insurance to protect them from a financial loss due to an unexpected event, such as a fire. Putting a hedge in place to protect an institution from an event that may cause financial loss is no different. Many entities have become complacent when it comes to managing interest rate risk. In part, this is driven by the extended low-rate environment we have been in. As of this writing, the 10-year US Treasury Note is yielding a historically low 0.928%. Institutions should evaluate if this current rate environment creates an opportunity to 1) lock in a low borrowing / funding rate, or 2) lock in net interest margin where rates are a component of margin, such as with financial institutions. Executing an appropriate hedge can accomplish these strategies. An important distinction that should be understood is that hedging is not speculation. In fact, not hedging can often be viewed as speculation. Take for example a financial institution that holds short-term liabilities (deposits from customers) and long-term assets (fixed-rate mortgages with customers). In a rising interest rate environment, financial institutions will see their margin erode as they pay more to their depositors but continue to receive the same from their mortgagees. Not putting in place a hedge to lock in that margin can be viewed as speculation (taking on more risk), by essentially speculating that short-term rates will remain low and margin will be preserved. When considering interest rates, the four key differences between hedging and speculation are the following:
In summary, hedging activity mitigates risk – speculative activity takes on risk. And not hedging, when risk exists, is just one more form of speculation.
For more information contact John Trefethen, Director & Co-Founder
Phone: 952-746-6040 Email: jtrefethen@hedgestar.com