INTEREST RATE RISK

What is the Risk?

Interest rate risk is the risk that arises for bond owners from fluctuating interest rates.

How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market. The sensitivity depends on two things, the bond's time to maturity, and the coupon rate of the bond. It also impacts the present value of income or payment streams due lenders.

The interest rate risk is the risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any other interest rate relationship..

What is a 'Yield Curve?'

A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year and 30-year U.S.Treasury debt.

This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is used to predict changes in economic output and growth.


INTEREST RATE RISK

Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (such as through an interest rate swap).

BREAKING DOWN 'Interest Rate Risk'

Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall, and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases, since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease, since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.

Cash Flow valuation risk: It is the risk of the present value of the cash flows falling by the reduction of the flows and / or the change in the discount rate; the market rate for discount changes such as changes in the prime rate or interbank rate.

Interest rate risk exposure arises when a change in interest rates has the potential to affect the value of a company's assets and liabilities.

Market Interest Rates exposure is the danger of reduced cash flow, either in the form of diminished Interest rate risk is most relevant to fixed-income securities whereby a potential increase in market interest rates is a risk to the value of fixed-income securities.

When market interest rates increase, prices on previously issued fixed-income securities as traded in the market decline, since potential investors are now more inclined to buy new securities that offer higher rates. Only by having lower selling prices can past securities with lower rates become competitive with securities issued after market interest rates have turned higher cash inflows or increased cash outflows.

For example, if an investor buys a five-year bond that costs $500 with a 3 percent coupon, interest rates may rise to 4%. In that case, the investor may have difficulty selling the bond when others enter the market with more attractive rates. Older bonds look less attractive as newly issued bonds carry higher coupon rates as well. Further, lower demand may cause lower prices on the secondary market, and the investor is likely to get less for the bond on the market than he paid for it. 

Measuring Interest Rate Risk

The Full Valuation Approach

The full valuation approach to measuring the interest rate risk is to re-value the bond or portfolio for a given interest-rate change scenario. This rate change can be parallel or non-parallel. It is also referred to as a scenario analysis because it involves the way in which your exposure will change as a result of certain interest rate scenarios. For example, an investor may evaluate the portfolio based on an increase in rates of 50, 100 and 200 basis points. Each bond is valued and then the total value of the portfolio is computed under the various scenarios.



Example: Compute the Interest-Rate Risk Exposure

Let's take an option-free bond with an 8% coupon, ten-year bond with a price of 125. Yield to maturity is 7% 

Answer:

Scenario 1 is an increase of 50bps that drives the price down to 120 (this is just an estimate). To see the percentage change you take the new price after the yield change and subtract it from the initial price after the change divided by the initial price.

120 - 125 / 125 = -.04 = a 4 % decrease in the price of the bond due to a 50 bps change

Scenario 2 is an increase of 100 bps that drives the price down to 114.

114 - 125 / 125 = - .088 = an 8.8% decrease in price due to a 100 bps change.

You can use this for any type of scenario concerning a change in yields.

The Duration/Convexity Approach

In contrast, the duration/convexity approach just looks at one time parallel move in interest rates using the properties of price volatility.

Duration and Convexity

Bond Duration

In finance, the duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received. 

The formula is complicated, but what it boils down to is: Duration = Present value of a bond's cash flows, weighted by length of time to receipt and divided by the bond's current market value. For example, let's calculate the duration of a three-year, $1,000 Company XYZ bond with a semiannual 10% coupon.

Duration is a measure of a bond's sensitivity to interest rate changes. The higher the bond's duration, the greater its sensitivity to the change (also known as volatility) and vice versa.

HOW IT WORKS (EXAMPLE):

There is more than one way to calculate duration depending on one’s compounding assumptions.

The Macaulay duration (named after Frederick Macaulay, an economist who developed the concept in 1938) is the most common. The formula is:

INTEREST RATE RISK
where:

t = period in which the coupon is received

C = periodic (usually semiannual) coupon payment

y = the periodic yield to maturity or required yield

n = number periods

M = maturity value (in $)

P = market price of bond

The formula is complicated, but what it boils down to is: Duration = Present value of a bond's cash flows, weighted by length of time to receipt and divided by the bond's current market value. For example, let's calculate the duration of a three-year, $1,000 Company XYZ bond with a semiannual 10% coupon.

INTEREST RATE RISK
Notice in the table above that we first weighted the cash flows by the periods in which the occurred and then calculated the present value of each of these weighted cash flows (also, a measure of 5% is used instead of 10% because payments are semiannual). 

To calculate the Macaulay duration, we then divide the sum of the present values of these cash flows by the current bond price (which we are assuming is $1,000):

Company XYZ Macaulay duration = $5,329.48 / $1,000 = 5.33

As mentioned earlier, duration can help investors understand how sensitive a bond is to changes in prevailing interest rates. By multiplying a bond's duration by the change, the investor can estimate the percentage price change for the bond. For example, consider the Company XYZ bonds with duration of 5.53 years. If for whatever reason market yields increased by 20 basis points (0.20%), the approximate percentage change in the XYZ bond's price would be:

-5.53 x .002 = -0.01106 or -1.106%

Note that this is an approximation. The formula assumes a linear relationship between bond prices and yields even though the relationship is actually convex. Thus, the formula is less reliable when there is a large change in yield.

In general, six things affect a bond's duration:
  • Bond's Price: Note that if the bond in the above example were trading at $900 today, then the duration would be $5,329.48 / $900 = 5.92. If the bond were trading at $1,200 today, then the duration would be $5,329.48 / $1,200 = 4.44.
  • Coupon: The higher a bond's coupon, the more income it produces early on and thus the shorter its duration. The lower the coupon, the longer the duration (and volatility). Zero-coupon bonds, which have only one cash flow, have durations equal to their maturities.
  • Sinking Fund: The presence of a sinking fund lowers a bond's duration because the extra cash flows in the early years are greater than those of a bond without a sinking fund. 
  • Call Provision: Bonds with call provisions also have shorter durations because the principal is repaid earlier than a similar non-callable bond.

WHY IT MATTERS: Duration is a measure of risk

Understanding the duration formula is not nearly as important as understanding that duration is a measure of risk because it has a direct relationship with price volatility. The greater duration of the bond, the greater its percentage price volatility.

By providing a way to estimate the effect of certain market changes on a bond's price, duration can help you choose investments that might better meet your future cash needs.

Duration also helps income investors who want to take on minimal interest rate risk (that is, they believe interest rates might rise) understand why they should consider bonds with high coupon payments and shorter maturities.


INTEREST RATE RISK

Bond Convexity

In finance, bond convexity is a measure of the non-linear relationship of bond prices to changes in interest rates, the second derivative of the price of the bond with respect to interest rates (duration is the first derivative).

Convexity in Fixed Income Management

Unfortunately, duration has limitations when used as a measure of interest rate sensitivity. The statistic calculates a linear relationship between price and yield changes in bonds. In reality, the relationship between the changes in price and yield is convex.

In Figure 1, the curved line represents the change in prices given a change in yields. The straight line, tangent to the curve, represents the estimated change in price via the duration statistic. The shaded area shows the difference between the duration estimate and the actual price movement. As indicated, the larger the change in interest the larger the error in estimating the price change of the bond.


INTEREST RATE RISK

Convexity, which is a measure of the curvature of the changes in the price of a bond in relation to changes in interest rates, is used to address this duration error. Basically, it measures the change in duration as interest rates change.

Convexity helps to approximate the change in price that is not explained by duration. If you go to the property of a bond's price volatility you will see that when there is a large change in rates, the duration measure can be way off because of the convex nature of the yield curve. 


INTEREST RATE RISK

Let's now calculate convexity and the convexity adjustment. The formula for convexity is:


INTEREST RATE RISK

P(i decrease) = price of the bond when interest rates decrease

P(i increase) = price of the bond when interest rates increase

FV = face value of the bonds

dY = change in interest rate in decimal form

In general, the higher the coupon, the lower the convexity, because a 5% bond is more sensitive to interest rate changes than a 10% bond. Due to the call feature, callable bonds will display negative convexity if yields fall too low, meaning the duration will decrease when yields decrease. Zero-coupon bonds have the highest convexity. These relationships are only valid when comparing bonds that have the same durations and yields to maturity.

A high convexity bond is more sensitive to changes in interest rates and should see larger fluctuations in price when interest rates move.

The opposite is true of low convexity bonds; their prices don't fluctuate as much when interest rates change. When graphed on a two-dimensional plot, this relationship should generate a long-sloping U shape (hence, the term "convex").

Low-coupon and zero-coupon bonds, which tend to have lower yields, have the highest interest rate volatility. In technical terms, this means that the modified duration of the bond requires a larger adjustment to keep pace with the higher change in price after an interest-rate move. Lower coupon rates lead to lower yields, and lower yields lead to higher degrees of convexity.

Use duration and convexity to measure bond risk

A coupon bond makes a series of payments over its life, and so fixed-income investors need a measure of the average maturity of the bond's promised cash flow to serve as a summary statistic of the effective maturity of the bond. Such investors also need a measure that can be used as a guide to the sensitivity of a bond to interest rate changes, since price sensitivity tends to increase with time to maturity.

The statistic that aids investors in both areas is duration, which along with convexity can help fixed-income investors gauge uncertainty when managing their portfolios

Because duration is so important to fixed-income portfolio management, it is worth exploring the following properties:

  • The duration of a zero-coupon bond equals its time to maturity.
  • Holding maturity constant, a bond's duration is lower when the coupon rate is higher. This rule is due to the impact of early higher coupon payments.
  • Holding the coupon rate  constant, a bond's duration generally increases with time to maturity. This property of duration is fairly intuitive; however, duration does not always increase with time to maturity. For some deep-discount bonds, duration may fall with increases in maturity.
  • Holding other factors constant, the duration of a coupon bond is higher when the bond's yield to maturity is lower. This principle applies to coupon bonds. For zero-coupon bonds, duration equals time to maturity, regardless of the yield to maturity.
  • The duration of a level perpetuity is (1 + y) / y. For example, at a 10% yield, the duration of perpetuity that pays $100 once a year forever will equal 1.10 / .10 = 11 years, but at an 8% yield it will equal 1.08 / .08 = 13.5 years. This principle makes it obvious that maturity and duration can differ substantially. The maturity of the perpetuity is infinite, whereas the duration of the instrument at a 10% yield is only 11 years. The present-value-weighted cash flow early on in the life of the perpetuity dominates the computation of duration.
    INTEREST RATE RISK
Duration for Gap Management in Fixed Income

Many banks have a natural mismatch between asset and liability maturities. Bank liabilities are primarily the deposits owed to customers, most of which are very short-term in nature and of low duration. Bank assets by contrast are composed largely of outstanding  commercial  and consumer loans or mortgages. These assets are of longer duration and their values are more sensitive to interest rate fluctuations. In periods when interest rates increase unexpectedly, banks can suffer serious decreases in net worth if their assets fall in value by more than their liabilities.

Understanding Gap Management

One way to view gap management is as an attempt by the bank to equate the durations of assets and liabilities to effectively immunize its overall position from interest rate movements. Because bank assets and liabilities are roughly equal in size, if their durations are also equal, any change in interest rates will affect the value of assets and liabilities equally. Interest rate changes would have no effect on net worth. Therefore, net worth immunization requires a portfolio duration, or gap, of zero

As interest rates fluctuate, both the value of the assets held by the fund and the rate at which those assets generate income fluctuate. The  portfolio manager , therefore, may want to protect (immunize) the future accumulated value of the fund at some target date against interest-rate movements. The idea behind immunization is that with duration-matched assets and liabilities, the ability of the asset portfolio to meet the firm's obligations should be unaffected by interest rate movements.

The Bottom Line

Interest rates are constantly changing and add a level of uncertainty to fixed-income investing. Duration and Convexity allow investors to quantify this uncertainty and are useful tools in the management of fixed-income portfolios.

Price Sensitivity

The value of existing fixed-income securities with different maturities declines by various degrees when market interest rates rise. This is referred to as price sensitivity, meaning that prices on securities of certain maturity lengths are more sensitive to increases in market interest rates, resulting in sharper declines in their security values.

For example, suppose there are two fixed-income securities, one maturing in one year and the other in 10 years. When market interest rates rise, holders of the one-year security could quickly reinvest in a higher-rate security after having a lower return for only one year. Holders of the 10-year security would be stuck with a lower rate for 9 more years, justifying a comparably lower security value than shorter-term securities to attract willing buyers. The longer a security's maturity, the more its price declines to a given increase in interest rates.

Maturity Risk Premium

The greater price sensibility of longer-term securities leads to higher interest rate risk for those securities. To compensate investors for taking on more risk, the expected rates of return on longer-term securities are normally higher than on shorter-term securities. This extra rate of return is called maturity  risk premium, which is higher with longer years to maturity. Along with other risk premiums, such as default  risk  premiums and  liquidity risk  premiums, maturity risk premiums help determine rates offered on securities of different maturities beyond varied credit and liquidity conditions.

Interest rate risk exposure arises when a change in interest rates has the potential to affect the value of a company's assets and liabilities. ... In either case, interest rate exposure is the danger of reduced cash flow, either in the form of diminished cash inflows or increased cash outflows.

Expected vales of cash flows due over time can change with interest rate changes which would change the present value of the expected cash flows as well as changes in the discounting rate so applied.

Duration risk is the name economists give to the risk associated with the sensitivity of a bond’s price to a one percent change in interest rates.

Generally speaking, a duration of 10 would mean for every 1% rise in interest rates your bond investments value would fall by 10%. A duration of five would equate to a 5% drop in value for each 1% rise in rates, and so on. As you can see, the higher the duration, the higher the risk level of your bond holdings and vice versa.

In a rising rate environment you typically want your bond holdings to have the lowest duration possible to protect the value of your principal from potentially precipitous declines if interest rates rise quickly. Of course, this works the other way around, too. If interest rates fell, your bond price would likely go up.

Hedging the Risk

Shorter-term bonds have a lower interest rate risk, since there is a shorter period of time within which changes in interest rates can adversely impact the bonds. Conversely, there is a higher interest rate risk associated with longer-term bonds, since there may be many years within which an adverse interest rate fluctuation can occur. When a bond has a higher level of interest rate risk, its price will fluctuate more when there is an adverse change in the interest rate.

Interest rate risk can be mitigated, either by diversifying one's investments across a broad mix of security types, or by hedging. In the latter case, an investor can enter into an interest rate swap agreement with a third party, thereby offloading the risk of rate fluctuations onto the other party.

Interest Rate Swap

An interest rate swap is a customized contract between two parties to swap two schedules of cash flows. The most common reason to engage in an interest rate swap is to exchange a variable-rate payment for a fixed-rate payment, or vice versa. Thus, a company that has only been able to obtain a floating-rate loan can effectively convert the loan to a fixed-rate loan through an interest rate swap. This approach is especially attractive when a borrower is only able to obtain a fixed-rate loan by paying a premium, but can combine a variable-rate loan and an interest rate swap to achieve a fixed-rate loan at a lower price. A company may want to take the reverse approach and swap its fixed interest payments for floating payments. This situation arises when the treasurer believes that interest rates will decline during the swap period, and wants to take advantage of the lower rates.

The duration of a swap contract could extend for anywhere from one to 25 years, and represents interest payments. Only the interest rate obligations are swapped, not the underlying loans or investments from which the obligations are derived. The counterparties are usually a company and a bank. There are many types of rate swaps; we will confine this discussion to a swap arrangement where one schedule of cash flows is based on a floating interest rate, and the other is based on a fixed interest rate.

For example, a five-year schedule of cash flows based on a fixed interest rate may be swapped for a five-year schedule of cash flows based on a floating interest rate that is tied to the London Interbank Offered Rate (LIBOR).

A swap contract is settled through a multi-step process, which is:

Calculate the payment obligation of each party, typically once every six months through the life of the swap arrangement.

Determine the variance between the two amounts.

The party whose position is improved by the swap arrangement pays the variance to the party whose position is degraded by the swap arrangement.

Thus, a company continues to pay interest to its banker under the original lending agreement, while the company either accepts a payment from the rate swap counterparty, or issues a payment to the counterparty, with the result being that the net amount of interest paid by the company is the amount planned by the business when it entered into the swap agreement.

Several larger banks have active trading groups that routinely deal with interest rate swaps. Most swaps involve sums in the millions of dollars, but some banks are willing to engage in swap arrangements involving amounts of less than $1 million. There is a counterparty risk with interest rate swaps, since one party could fail to make a contractually-mandated payment to the other party. This risk is of particular concern when a swap arrangement covers multiple years, since the financial condition of a counterparty could change dramatically during that time.

If there is general agreement in the marketplace that interest rates are headed in a certain direction, it will be more expensive to obtain a swap that protects against interest rate changes in the anticipated direction.

Compensating Balance

In theory, a hedge must correlate exactly with the change in value of the asset being hedged. Either in actual market value changes or changes in the discounted value of cash flows as the asset hedged. The idea is to create a compensating balance that can be reported in real time or accounted for in the balance sheet and income statement.

Actual cash additions or reduction from the hedged asset or hedge instrument should exactly match the change in value of the asset or hedge in cash or hedged market values marked-to-market; values should exactly match.

The simplest hedge example would be corn stored in a silo where by the farmer sells corn futures contracts against his corn held in the silo and then lifts the hedge when the corn is sold into market. He might in fact deliver his corn against his futures contracts to close out the hedge. 

Financial instrument or cash flow hedges are or can be “infinitely” more complex in identifying compensating balances; actual or discounted cash flows.  Just what are the compensating balances against either the asset of cash flows hedged?

To arrive at the perfect “financial” hedge, may involve a combination of hedge instruments and could be adjusted over time. There are algorithmic computer based decision models addressing these adjustments. These are referred to as dynamic optimal hedges or protocols or routines. There are complex rules in accounting that must be met to qualify as an “Effective Hedge” with regulators.

Hedge effectiveness relates to the capability of the derivative instrument to originate gains and losses that counteract losses and gains on the hedged item.

One might have to meet margin calls on the hedge instrument that must be settled in cash when there is no cash coming from the asset being hedged; only a positive market value change. Thus, no equivalent cash compensation available to meet the call.

Strategies

Shorter Maturities

Investors can adjust their bond holdings to bonds of shorter duration. Shorter-term bonds are less susceptible to negative value impacts from rising rates, since interest rates do not generally change significantly over the short term. Bonds with shorter durations afford investors the opportunity to cash in their bonds and reinvest within a shorter span of time, when negative effects from rising rates should be minimal. As rates do gradually rise, investors can regularly reinvest in new bonds offered at higher interest rates.

Floating Rate Bonds or Bond Funds

Another alternative strategy to use in a rising rate environment is to invest in floating rate bonds or bond funds. The interest rates for floating rate bonds are periodically adjusted, typically somewhere between every 30 to 90 days, in accord with an interest rate benchmark such as the prime rate or LIBOR. These types of bonds often offer somewhat higher yields with minimal additional risk.

Investors must always consider the total picture when making fixed income investments. Beyond simply taking into account Interest rates and available yields, the ultimate focus is a bond's total return on investment (ROI), which includes the interest earned over the time period that the bond is held and any capital gains or losses resulting from any price change in the bond that has occurred between the purchase date and the date when the bond is sold.

Avoid Negative Bond Returns

When it comes to financial markets, investors can be sure of three things: that markets will rise, fall and at times remain the same. Everything else is essentially up to chance, though investors can employ a mix of strategies to attempt to prudently navigate the ups and downs in the markets.

Maintain Individual Bond Positions

The simplest way to avoid losses in your bond portfolio in a period of rising interest rates is to buy individual bonds and hold them to maturity. With this method, an investor is reasonably assured to receive principal back at maturity, and this method eliminates interest rate risk. The current bond price may decline when rates rise, but the investor will receive his or her original investment back at the defined maturity date of the bond.

In a period of declining interest rates, the one risk that cannot be eliminated is reinvestment risk, because the funds received at maturity will need to be reinvested at a lower coupon rate. However, this is a favorable outcome in a period of rising rates.

Stay Short when Rates Rise

In a rising interest rate environment, or period where rates are projected to rise in the future, staying invested in bonds with nearer-term maturity dates can be important. Fundamentally, interest rate risk is lower for bonds that have closer maturity dates. Bond duration, which measures the sensitivity of a bond price to changes in interest rates, demonstrates that prices change less for closer maturity dates. Overall, staying on the shorter end of the maturity schedule can help the bond investor avoid negative bond returns, and provide for a pick-up in yield during a period of rising rates.

Sell Short Your Bonds

For more adventurous investors, there are some opportunities to short bonds. As with any security, going short means borrowing the security and anticipating a fall in price, after which the investor can buy it and return what has been borrowed. The market for shorting an individual bond is not large or liquid, but there are plenty of opportunities for individual investors to invest in short bond mutual funds and exchange-traded funds.

Other Considerations

There are, of course, many other strategies and combinations to employ to try and avoid negative bond returns. This includes hedging techniques, such as:

Using  futures options  and  swap  spreads to speculate on rising (or falling) rates along certain parts of the yield curve, or on specific bond classes or credit ratings. 

Inflation rates and expectations for future inflation are also important considerations when investing in bonds. Inflation-adjusted bonds, such as  Treasury Inflation Protected Securities, can help investors reduce the damage that inflation can do on real bond returns.

Investing in bond funds can be tricky in a period of rising rates, but they do have benefits in that the investor is outsourcing his or her capital to a bond professional that should have a fair level of expertise in specific bond strategies in a mix of interest rate environments.

The Bottom Line

Despite the nearly infinite combination of strategies that can be employed to speculate on rising or falling rates as well as try and eliminate the key risks to investing bonds identified above, the best approach to investors may be to hold a diversified mix of bond classes across a wide array of maturity dates.

As with any asset, speculators will try and predict the market's direction, but most investors would sleep better at night by simply buying bonds at existing interest rate levels and holding them until maturity. The hiring of a bond professional or investing directly in bond funds can also make sense in certain circumstances.

It is most difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses of principal and minimize the hit to your current bond portfolio. At the end of the day, higher rates are better for your portfolio as they increase portfolio income levels, but investors should work to make as smooth a transition as possible to eventually benefit from the increase in yields.

Accounting Issues

Accounting for Derivatives and Hedges

Derivatives and hedges have a well-earned reputation for arcane accounting rules.

Proper accounting of hedges emphasizes cash flow hedges and fair value hedges.

Accounting for Derivatives and Hedging Activities The main issue in accounting for derivatives is the treatment of the gains and losses resulting from the change of the derivative’s carrying value to fair value since all derivatives are reported on the balance sheet at fair value and fair value can change from period to period.

Furthermore, since the main objective of hedging is to secure the income statement from the impact of opposed changes in prices, interest rates, or currency exchange rates, companies exercising derivatives for hedging would like to use an accounting approach that causes the gain or loss from the derivative to impact earnings in the equivalent period as the gain or loss resulting from the risk being hedged.

This accounting approach is referred to as hedge accounting. Hedge accounting is allowed only if several conditions are met.

The three most important of these conditions relate to (1) “the nature of the hedged risk”, (2) “the hedge effectiveness”, and (3) “documentation”.

If any of these conditions is not met, hedge accounting is not allowed, and any change in the carrying value of the derivative must be recognized immediately in earnings.

Hedge Effectiveness: Hedged risks that allow a derivative to qualify for hedge accounting include (1) interest rate risks, (2) price risks, (3) foreign currency exchange rate risks, and (4) credit risks.

Derivatives used to hedge these risks can be designed as hedges of three types of risk exposures: (1) fair value exposure, (2) cash flow exposure, and (3) exposure to changes in the value of a net investment in a foreign operation.

For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value.

For a derivative designed as hedging the exposure to variable cash flows of a forecasted transaction referred to as a cash flow hedge, “the effective portion of the derivative’s gain or loss is initially reported as a component of other comprehensive income (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings.

The ineffective portion of the gain or loss is reported in earnings immediately.

Hedge effectiveness relates to the capability of the derivative instrument to originate gains and losses that counteract losses and gains on the hedged item.

For hedge accounting to be used, a company must anticipate that the hedge will be highly effective in offsetting for changes in the value of the hedged item or changes in cash flows connected to the hedged item.

After the hedge is in place, it must practically be highly effective to continue the use of hedge accounting.

Effectiveness tests can be based on changes in the value of the complete hedged instrument or can omit changes in the value related to course of time. For example, futures and forward prices can be viewed as the total of the current spot price plus a forward discount or premium. The change in forward discount or premium is unrelated to any changes in an item where futures are used to hedge, so a valid approach is to exclude the changes in discount or premium from the measurement of hedge effectiveness. In this case, hedge effectiveness would be evaluated by comparing changes in the spot rate component of futures prices to changes in the value of the hedged item.

Accordingly, the company must select a method to measure the portion of the change in the value of the derivative intended to offset changes in the hedged exposure and to evaluate hedge effectiveness (1) at the inception of the hedge and (2) on an ongoing basis while the hedge is in place

The Financial Accounting Standards Board issued on November 6, 2008 an exposure draft of the proposed amendment of FASB Statement No. 133.

This proposed Statement would amend the hedge effectiveness guidance in Statement 133 to no longer require (a) that a hedging relationship be highly effective, (b) a quantitative assessment of the effectiveness of a hedging relationship, or (c) ongoing effectiveness testing.

This proposed Statement would require that a hedging relationship be “reasonably effective” and not “highly effective”. The Board decided to amend the hedge effectiveness specifications in Statement 133 to diminish the complication of qualifying for hedge accounting, make it simpler for entities to regularly execute hedge accounting, and furnish comparability and uniformity in financial statement results.

It would also require a qualitative assessment of the hedging relationship’s effectiveness at inception of the hedging relationship and only in specific conditions, would require a quantitative assessment to illustrate that changes in fair value of the hedging instrument are anticipated to be reasonably effective in offsetting changes in fair value of the hedged item or variability in cash flows of the hedged transaction.

Finally, entities after inception of the hedging relationship would need to qualitatively or quantitatively reevaluate effectiveness only if incidents evoke that the hedging relationship may no longer be reasonably effective (FASB Exposure Draft amendment of SFAS No. 133, 2008).

Methods of Testing Hedge Effectiveness

As Trombley (2003) states, the hedge must be expected to be highly effective in achieving gains and losses that offset gains and losses on the hedged risk at the inception of the hedge.

The two acceptable approaches for assessing expected effectiveness are “critical terms analysis” and “statistical analysis”.

Critical term analysis assesses the critical terms including the nature of the underlying, the notional amount of the derivative, and the actual amount of the hedged item, the delivery date, and the settlement date. If the critical terms of the hedged item and the hedging instrument match, effective hedging can reasonably be assumed.

If critical terms analysis fails because the critical terms of the hedged item and the hedging instrument do not match, the alternative is statistical analysis (regression).

There are two primary methods of testing the hedging effectiveness of forwards, futures, and swaps when the critical terms of the hedging derivative and the hedged item are not identical: (1) “the dollar-offset method”, and (2) the “regression method”

Dollar-Offset Method: Determines that the dollar-offset method evaluates the fair value or cash flow changes of the hedged item and the derivative. The change in the value of the derivative closely counteracts the change in the value of the hedged item under a highly effective hedge.

Consequently, in a highly effective hedge the ratio of the lump sum of the intermittent changes in the value of the derivative and the hedged item would equal one “after multiplying the ratio by negative one to adjust for the two sums having opposite signs in a hedging relationship”.

Trombley (2003) explains that the cumulative dollar-offset method has emerged as a standard practice and it calculates the delta ratio on a quarterly basis using cumulative changes in the value of requires the derivative and the value of the hedged item.

In conformity, entities should use either a “period-by-period” approach or a “cumulative” approach retrospectively every quarter to assess the effectiveness of a fair value hedge or a cash flow hedge to achieve offsetting changes in fair values or cash flows under the dollar-offset approach.

The “period-by-period” approach contrasting the changes arise throughout the assessed period of the hedging instrument’s fair values or cash flows to the changes in the hedged item’s fair value or hedged transaction’s cash flows attributable to the hedged risk that have occurred during the same period.

 The “cumulative” approach entails comparing the cumulative changes in the hedging instrument’s fair values or cash flows to the cumulative changes in the hedged item's fair value or hedged transaction’s cash flows attributable to the risk hedged from the inception of the hedge until today.

Regression Method: Regression analysis is a statistical method that grants quantitative information about the relationship between two or more variables. The necessity to prove that a derivative will be highly effective transcribes to display that the price or interest rate or currency exchange rate connected with the hedged item sustains closeness to the price corresponding with the hedging derivative.

Simple regression furnishes a summary statistic, the correlation coefficient, which quantifies the proximity of the relationship. Correlation coefficients may range in value from −1.0 to +1.0, where 1.0 is expressive of a perfect correlation between the two respective variables. A related statistic to the correlation coefficient is the coefficient of determination, or the R-Squared. The R-Squared is found simply by squaring the correlation coefficient, so the possible range of the R-Squared statistic is from zero to one.

Hedge Documentation:

At the inception of a fair value or cash flow hedge entities must provide formal documentation of the “hedging relationship, the entity's risk management objectives and strategies for undertaking the hedge, including identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and the method of assessing the hedging instrument's effectiveness” in reference to designating hedging relationships.

The Financial Accounting Standards Board (FASB) requires concurrent designation and documentation of a hedge to prevent management’s intent to attain a preferred hedge accounting result by prohibiting reviewing transactions with “hindsight” and making retroactive decisions after hedge results are acknowledged.

Specifically, at the inception of a cash flow or a fair value hedge, Statement 133 requires entities to provide documentation to indicate the period they anticipate the forecasted transaction to transpire. After the date of initial application the designation and formal documentation of a hedging relationship accomplish hedge accounting only prospectively with any gain or loss on the derivative recognized currently in earnings prospectively from the date of initial application.

Bond Laddering and interest rate risk

A bond ladder staggers the maturity of your fixed-income investments, while creating a schedule for reinvesting the proceeds as each bond matures. Because your holdings are not "bunched up" in one time period, you reduce the risk of being caught holding a significant cash position when reinvesting is less optimal—for instance, if rates on current bonds are too low to generate sufficient income.

Laddering is particularly useful for trying to create a predictable income stream. Laddering, however, can require a substantial commitment of assets over time, and the return of principal at maturity of any bond is not guaranteed.

Your exposure to interest rate volatility is reduced because your bond portfolio is now spread across different coupons and maturities

Allocating only part of your fixed-income portfolio in longer-term bonds can help reduce the risk associated with rising rates, which tend to have a greater impact on the value of longer maturities.

By buying bonds at different times and during different interest rate environments, you are hedging interest rate risk

Bradley Needham can assist institutional clients in structuring simple to very complex derivative structures with algorithmic dynamic adjustments to optimize hedge performance. 

Contact Us to discuss your interest rate risk exposure