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Hedging Deposits to Reduce Liability Sensitivity

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chathamfinancial.com 2 The fixed-rate CD, issued and reissued every 90 days, can establish a variable rate pattern that is suitable for hedging. Any CD program of satisfactory size is a candidate for this type of term deposit hedging. Short-term (30- or 90-day CDs) are typical, although longer maturity CDs out to one year can also work, but may offer less benefit. In this type of hedging transaction, the CD rate and the equivalent period LIBOR index rate are expected to be different every period. This creates a basis between the CD and the index that can be estimated from an historical perspective, but that can be different from history and change throughout the life of the hedge. As long as the FI can get comfortable with this basis risk, a rolling term deposit hedge can be highly effective and beneficial to the FI in managing the interest rate risk position. Managed deposits hedge. The vast majority of financial institution deposits are managed non- maturity deposits. Figure 2 shows the historical relationship between NMDs and 1-month LIBOR over the past 10 years. Not surprisingly, on average, the rates on these managed deposits lag LIBOR, and never quite approached the full index value throughout the period in question. This behavior is not only common among individual FIs, but it is also market driven in most cases and can be determined in a way that can be "indexed" and therefore, hedged effectively. The FI need not hedge the current rate or the full index to take advantage of this behavior. It is critical for the FI to commit to maintaining the relationship between the given accounts, pools, or tiers and the index that it identifies and agrees to hedge at the inception of the hedge. Only then will the hedge function properly, minimize ineffectiveness, and be in good standing to receive cash flow hedge accounting throughout the life of the trade. The FI should also be mindful of issues related to maintaining deposit account balances. A properly constructed rate will not cannibalize other deposits in the bank, nor will it push deposits to other products or competitors as a result. Challenges notwithstanding, this strategy is a viable approach to deposit hedging, once other forms of deposit hedging have been considered. 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 3/2005 3/2006 3/2007 3/2008 3/2009 3/2010 3/2011 3/2012 3/2013 3/2014 3/2015 3m LIBOR 3m CD Figure 1: CD rates vs. 3-month LIBOR

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