Explaining Hedging to your Board
By: John Trefethen, Director & Co-Founder
When credit unions consider engaging in hedging activity, they need to get approval from their board of directors. This may pose a challenge as many board members do not fully understand what it means to use derivatives for hedging purposes. Their understanding of derivatives often stems from what they have seen or read in media outlets. Stories of the Orange County bankruptcy in 1994 and the financial crisis of 2008 both being fueled by derivative use rightfully causes concern. However, the derivative strategies employed in those cases do not resemble what a credit union would do, or is allowed to do, for hedging purposes. In both instances, derivatives were used as tools for speculation. Put simply, they were being used by investors to chase above-market yields. The hedging credit unions’ objective is the opposite of speculation. Credit unions hedge to manage risk and create more certainty with financial outcomes. 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 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. By not hedging, your credit union is speculating on what interest rates will do and how that will impact your credit union’s financial performance.
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 is trading on potential increases or decreases in interest rate volatility for the purpose of producing meaningful returns.
Hedging offers protection against undesired fluctuations in value. 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 realize a margin over and above the average market participant.
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.