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A Practical Guide to Using Receive-Fixed Interest Rate Swaps to Reduce Asset-Sensitivity and Benefit Current Period Earnings

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Banks use several techniques to convert some of their asset-sensitivity to current period earnings. Traditional non-derivative approaches, including using the loan portfolio or the investment portfolio, take time and can create capital implications for the bank. They may be better left out of the equation as they are used to pursue longer term bank objectives. A better approach involves the use of derivatives – specifically, receive-fixed, pay-floating interest rate swaps. The bank can quickly reposition its interest rate sensitivity and dial in a specific net interest income target with this efficient, competitively priced approach. A receive-fixed swap can immediately create the desired impact on the bank's interest rate risk position without grossing up the balance sheet or forcing recognition of unrealized gains or losses that are common side effects of using the bank's investment portfolio and wholesale funding to achieve the same objective. Sizing the Transaction Structuring an interest rate swap to convert some of the bank's asset sensitivity to current period earnings is simple. Using proforma cash flows, the three key variables of swap notional, swap tenor, and swap rate can be used to define a set of instruments that will achieve the bank's objectives. Importantly though, swaps of different tenors will expose the bank to different points on the forward curve, so one instrument may be favored over another, depending on the bank's objectives. Swap Tenor (years) Rec-Fixed Swap Rate Swap Notional per $1mm increase NII Initial Positive Carry (Swap Rate – 1mL) 3 yr 0.90% $133,000,000 75 bps 5 yr 1.65% $67,000,000 150 bps 7 yr 2.15% $50,000,000 200 bps 10 yr 2.60% $41,000,000 245 bps Table 1: Example Receive-Fixed Swap Rates vs. 1m LIBOR Table 1 shows current swap rates where the bank can receive-fixed and pay 1-month LIBOR. For the spe- cific swap rates, Table 1 also shows how much notional is required for each swap tenor in order to increase Net Interest Income by $1 million. The initial positive carry is the difference between the swap rate and the current period 1-month LIBOR reset, which is presently 0.152%. The longer the tenor, the greater the swap rate, and the greater the initial positive carry, generally. This means that for longer-term swaps, it takes less swap notional to accomplish the same NII objective than it would for a shorter term transaction. The other factors that influence the ideal transaction size, then, are the desired overall change in the bank's interest rate risk position, and the size of the available underlying hedged items, assuming the bank wishes the swap to qualify for hedge accounting. A Practical Guide to Using Receive-Fixed Interest Rate Swaps to Reduce Asset-Sensitivity and Benefit Current Period Earnings PG1

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