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  • Writer's pictureWilliam Webster

Hedging Mortgages with Swaps: Cash Flow Hedging vs. Basis Point Value Hedging

Updated: Jan 13


Hedging mortgages with swaps is a common practice for financial institutions looking to manage interest rate risks associated with their mortgage portfolios. When hedging mortgages, two primary strategies emerge: cash flow hedging and basis point value (BPV) hedging. These strategies are influenced by the accounting method employed, with accrual accounting favouring cash flow hedging and mark-to-market accounting favouring basis point value hedging. It is important to understand how these approaches impact the hedge ratios of a mortgage book.


Cash Flow Hedging and Accrual Accounting: Cash flow hedging involves aligning the cash flows from the mortgage portfolio with the cash flows on the swap thereby hedging interest rate risk as fixed rate interest is converted to variable rate. Accrual accounting, which focuses on recognizing revenue and expenses when they are earned or incurred, is typically used to account for cash flow hedges.

Under accrual accounting, the objective is to hedge the future cash flows of the mortgage portfolio, ensuring that the income generated from the portfolio remains relatively stable despite fluctuations in interest rates. This approach allows financial institutions to match the interest income received from the mortgage portfolio with the interest payments made on the swap contract.


The hedge ratio for cash flow hedging is determined based on the projected future cash flows of the mortgage portfolio and the swap contract. It aims to offset changes in interest rates by ensuring that the interest income and interest expense remain closely aligned. This approach provides a level of predictability and stability in cash flow generation, thereby reducing the impact of interest rate movements on the financial institution's earnings.


Basis Point Value (BPV) Hedging and Mark-to-Market Accounting: Basis point value hedging focuses on managing the market value of the mortgage portfolio relative to changes in interest rates. This approach is often employed when mark-to-market accounting is used, which involves valuing assets and liabilities based on their current market prices.


With basis point value hedging, the hedge ratio is determined based on the BPV of the mortgage portfolio and the swap contract. The BPV measures the sensitivity of the mortgage portfolio's value to changes in interest rates. By actively adjusting the hedge ratio, financial institutions aim to offset the impact of interest rate fluctuations on the market value of the mortgage portfolio.


Mark-to-market accounting provides a real-time view of the market value of the mortgage portfolio and the swap contract. This approach enables financial institutions to assess the effectiveness of their hedge positions and make adjustments as necessary. By managing the risk through basis point value hedging, financial institutions can protect the market value of their mortgage portfolios and mitigate potential losses arising from interest rate movements.


The choice between cash flow hedging and basis point value hedging for hedging mortgages with swaps depends on the accounting method used and the specific objectives of the financial institution. Accrual accounting favours cash flow hedging, which emphasizes stable cash flow generation, while mark-to-market accounting favours basis point value hedging, which focuses on managing market value and potential losses.


Financial institutions must carefully evaluate their risk management objectives, regulatory requirements, and accounting practices when determining the most suitable hedging strategy for their mortgage portfolios. By understanding the nuances and implications of cash flow hedging and basis point value hedging, institutions can effectively manage interest rate risks and optimize their overall portfolio performance.


Perspective

The first time I encountered a variation on this risk was in the early 1990s, while working at a bank, I faced an unusual situation while hedging fixed-rate bonds with swaps. The challenge emerged because we were hedging bonds issued by Brazil and Mexico, which traded on a higher yield curve due to their credit risk.


The bank's system recommended a hedge ratio of $10m bond to $7m swap, deviating from the conventional 1:1 ratio that aligned cash flows on an equal basis. This unexpected result gave two different but potentially correct hedge ratios depending on the purpose of the hedge.


A 1:1 ratio was appropriate for a buy and hold, accrual investment and a 1:0.7 ratio was suited to a traded mark-to-market situation. It should be noted that this latter dynamic hedge would need constant rebalancing as a result of changing interest rates.

At first sight, this may appear a million miles from mortgage hedging but the challenges encountered in hedging these bonds bore similarities to those faced in mortgage hedging, requiring financial professionals to manage interest rate risks and balance cash flows or market values effectively. This is brought home by a more recent encounter with mortgage hedging.


In this situation, the mortgages had uncertain maturities, although they were predominantly long-dated. The bank, under regulatory pressure, was required to mark-to-market (MTM) the mortgages using a yield curve that reflected the relevant credit risk. Similarly, the swaps were also marked-to-market.


Despite employing cash flow hedging with a 1:1 basis for the swaps to hedge the mortgages, significant profit and loss fluctuations occurred. As interest rates fell, the basis point values of the swaps increased at a faster pace than the mortgages due to differences in convexity. Since the bank paid a fixed rate on the swaps, it experienced increasing losses as interest rates declined. This situation presented a dilemma: should the bank shift from managing the risk through cash flow hedging to basis point value hedging?


This dilemma consumed considerable management time as they grappled with finding the optimal solution. Ultimately, a compromise was reached, acknowledging the imperfect nature of the situation. The chosen hedge ratio fell between the two extreme scenarios. This compromise recognized that hedging is not a black and white issue. Real-world factors such as regulation, accounting practices, capital requirements, and management perceptions all play significant roles in shaping the approach to hedging.


By understanding the nuances and trade-offs involved, financial professionals can navigate the complexities of hedging in a more informed manner. Balancing the objectives of risk mitigation, accounting requirements, and capital optimization is key to achieving successful hedging outcomes in the real world.

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