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'In a rising rate environment, the asset-sensitive bank reaps the benefits of its posture. Unfortunately, though, as rates decline, so do earnings'
Many community banks are asset sensitive and consequently exposed to declining interest rates. An asset sensitive bank has more repricing interest income than interest expense because of a high volume of variablerate loans, significant callable bond positions or a high volume of mortgage-backed securities and loans, for example.
During declining rates, not only do variable-rate loans reprise with the lower prime rate, but also callable and mortgage-backed securities prepayments increase, exacerbating the volume of downward repricing cash flows. In a rising rate environment, the asset sensitive bank reaps the benefits of its posture. Unfortunately, though, as rates decline, so do earnings.
To eliminate the volatility of earnings, an asset sensitive bank can purchase an interest rate floor contract to insure or hedge against unfavorable low rates. The interest rate floor contract is an effective and affordable method to hedge bank earnings. Moreover, setting the correct hedge is easy, once you are confident of your fully optioned interest rate risk exposure. We call this a macrohedge since we are hedging the entire balance sheet cash flows.
Interest rate floor contracts
An interest rate floor contract is an easy-to-use hedge but first we must become familiar with a few simple terms: (a) notional value refers to the amount on which interest is earned; (b) strike rate refers to the point at which the floor contract begins to pay (normally based on three-month LIBOR); and (c) interest rate risk exposure refers to the amount of earnings loss for a 2 percent market rate shock. The interest rate floor contract pays the owner a floating rate of interest on a specified notional value once interest rates decline below the strike rate. A correctly hedged position requires the notional value to correspond with the amount of income or interest rate risk...