In an ever-volatile environment, banks can have tremendous losses if they don’t hedge against the risks. Against the frequent changes of interest rates by the central bank, banks are left with no choice but to adopt various strategies for immunization of it’s profitability margin.If a bank doesn’t hedge it’s risks, it can lead to massive bankruptcy.
Hedging is defined as an activity of creating a reverse position in balance-sheets of a possible gain or loss. There are various tools which banks use to hedge their risks.It all depends whether a bank is primarily an asset-sensitive bank or liability sensitive bank. An asset-sensitive bank is one where assets (eg.loans) reprice faster than liabilities(eg.deposits). A liability sensitive bank is one where liabilities reprice faster than assets.The methodology of hedging is different for both type of banks.
For an asset sensitive bank, where assets are majorly on floating rates and mature faster than liabilities, any fall in the interest rates will reduce it’s profitability margin(NIM).The asset-sensitive bank can buy futures and gain from the fall in interest rates by the rise in futures’ value from the predicted falling interest rate environment.Another strategy which the asset-sensitive bank can use is investing in interest rate floor’s where the asset sensitive bank can create a deal whereby by paying premium the bank can hedge against the falling interest rates by preventing a further fall in interest than the minimum interest rate floor as that might harm it’s sensitive asset portfolio.The asset- sensitive bank can also buy forwards whereby if as predicted if the rates fall, then the forward payer will gain more than the forward receiver.
Considering a bank which is a liability sensitive bank where liabilities mature faster than assets, the bank can hedge against it’s risks by adopting securitization.Securitization is a method whereby all the illiquid assets on it’s balance sheet can be guaranteed by an entity and the bank can transfer the duration gap of it’s illiquid assets by forming a special purpose vehicle and transferring them to another originator.
Another tool for hedging against rising interest rates for a liability sensitive bank is buying a interest rate cap whereby by paying premium the liability sensitive bank can prevent the payments on it’s liabilities by not paying more than the maximum ceiling of interest cap in case of rising interest rates.Further, the liability sensitive bank can become the receiver of a forward contract if it expects the interest rates to rise.The liability sensitive bank can sell futures if it expects interest rates to rise.Another strategy could be engaging in swaps.The liability sensitive bank can convert it’s fixed rate assets into floating rate assets and gain from the rising interest rates case.
Banks are not allowed to deal in options except over the counter options to hedge its foreign exchange risk based on stipulated Rbi guidelines.Another wing or offshoot of the bank engages in Shadow-Banking and can gain from the Option trading.Option trading on Stock Exchange depends on the difference between actual market price and the price at which the option was purchased at mark to market gains or losses.
If the entity expects the Stock Market to go up, then it can buy call option and pay premium for it.If the stock market actually went up then the bank can benefit from the difference in the margin of what it bought the option for and the strike price of the option.If the bank expects the market to fall, banks can buy put option i.e a right to sell the option at a higher price.If the markets actually fall, the bank can benefit from the mark to market profit by the margin money from what it bought the put option for and what is the actual strike price in the market.Incase, the reverse situation holds, all what’s lost is the option premium I.e the price paid to not exercise the decision.
