When credit unions consider engaging in hedging activity, they need to get board approval. This can be challenging as many board members do not fully understand what it means to use derivatives for hedging purposes. Below are some distinctions that can be presented to your board to help them understand what it really means to hedge.
Probably the most important distinction that the board needs to understand is that hedging is not speculation. When introduced to hedging interest rate risk with derivatives, some will mistake this activity as speculation. When hedging you are not betting on the direction of interest rates. Instead you are mitigating the risk of loss should interest rates move in a direction that negatively impacts your institution’s net interest margin or capital ratios. In fact, not hedging that risk is considered speculation by seasoned risk managers. Speculators engage in derivatives activity with the expectation that an asset or liability will change in value in a way that will be profitable to the speculator.
By communicating the following five points, you will have a board that is better positioned to make informed hedging decisions:
Hedging is for preventing an existing risk from impacting an institution’s earnings due to changes in interest rates. Speculation is “betting” on the direction interest rates will move and engaging in derivatives activity, or non-activity, with the hope of earning profits.
Hedging is a means to manage the volatility of interest rates. Speculation depends on interest rate volatility, and trades in and out of underlying assets whose values are impacted by interest rate volatility.
Hedging offers protection against undesired fluctuation of values. Speculation is risk seeking to generate profits from changes in values.
Hedging is an activity taken on by institutions that are risk adverse – they secure their net interest income or margins through hedging. Speculators are risk takers – they take risks deliberately with the hopes to earn profits.
Not hedging interest rate risk is often considered speculation. You (board member) may be expecting interest rates to fluctuate reasonably and in a manner tolerated by the institution’s risk appetite; the reality could be far less accommodating.
HedgeStar provides interest rate risk management services with a focus on accounting for derivatives. HedgeStar also provides training on a wide array of risk management topics and is a provider of CPE credits for CPAs. Please contact HedgeStar today if you would like to learn more on how we can provide training to get your board and staff up to speed on what it means to hedge interest rate risk.