Academic journal article Review of Business

Futures versus Swaps: Some Considerations for the Thrift Industry

Academic journal article Review of Business

Futures versus Swaps: Some Considerations for the Thrift Industry

Article excerpt

Futures Versus Swaps: Some Considerations for the Thrift Industry


Studies have shown that financial managers often lack an understanding of the mechanics of hedging, lack the expertise to construct and manage hedges, or simply fail to appreciate the benefits of hedging [2,3,11]. Thrift managers are not an exception, and historically, thrifts have been reluctant to hedge. The experiences of the industry over the last decade, however, have forced thrifts to re-examine their risk management practices, and many are now struggling to understand hedging concepts and hedging tools.(1)

Prior to the introduction of swaps, the principal instruments for hedging interest rate risk were interest rate futures contracts. Thrifts were never big users of futures. The studies noted above have shown that managers mistakenly regard futures as "speculative" in nature or only suitable for hedging short term risk exposures. Swaps, on the other hand, have been widely embraced during the last few years as an effective long term risk management tool.

In this article, the source of a thrift's long term interest rate risk are examined, and swaps and futures hedging strategies for the management of this risk are compared. The argument is that while swaps hedges can be very effective, they are not necessarily superior to futures hedges when cost is considered.

Thrifts and Interest Rate Risk:

The Problem

Consider the case of a thrift institution which acquires, either by origination or assignment, conventional fixed rate mortgages using funds obtained from the sale of three month certificates of deposit (CDs). To make the example concrete, suppose the thrift purchases $25 million of newly originated 20 year mortgage debt having a coupon of ten percent and yielding ten percent - thus the mortgages are priced at par. The mortgagors will make payments to the thrift on a quarterly basis.(2) The thrift funds the mortgages by selling $25 million of three month (90 day) CDs. The plan is to refund the mortgage assets every three months by selling replacement CDs. This process would be continued until the mortgages mature. At the time of the initial CD sale, the three month CD rate is eight percent.

The example is complicated a bit by the amortizing nature of mortgage debt. At each refunding, fewer CDs need to be sold to carry the mortgage assets. Consider the first three and the last three payments in the amortization schedule. These are depicted in Table 1 on page 16.(3) Notice that, after the first CD cycle matures, the thrift only needs to raise $24.90 million from the sale of replacement CDs. After the 78th cycle matures, the thrift will only need to raise $1.40 million from the sale of replacement CDs.

Table : Table 1

Amortization of Mortgage Debt

                      Principal   Remaining
Payment    Payment    Component   Book Value
Number    (thous $)   (thous $)    (mil $)
  1         725.65      100.65      24.90
  2         725.65      103.17      24.80
  3         725.65      105.75      24.69
 78         725.65      673.84       1.40
 79         725.65      690.68       0.71
 80         725.73      708.03       0.00

In a stable interest rate environment, the thrift would simply carry the mortgages unhedged and enjoy a rate spread of two percent, which is the differences between the ten percent the thrift receives on its mortgage assets and the eight percent the thrift pays on its CD liabilities. The first set of cash flows is illustrated in Figure 1 on page 17. The exhibit depicts the initial exchange of principals between the thrift and the mortgagors on the one hand and the thrift and the third party lenders (CD purchasers) on the other.

The CDs mature at the time the first mortgage payment is made, and the thrift must refund its mortgage assets with the sale of replacement CDs. The thrift will receive a payment of $725. …

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