Many years ago, when I was trading swaps, we received some unusual enquiries from a certain type of bank. This led to many swap transactions, most of which were medium to long-term. The interesting part was that these trades were equal and opposite. What do I mean by this? They simultaneously bought and sold the swap, creating pairs that effectively hedged each other, with the only cost being the bid-offer spread.
This seemed strange, so we invited them to our office to learn more. They explained that swaps were excellent because, at the end of the year, they could review the pairs and find that one would be in profit and the other in loss. The profitable swap would be moved to the trading account, where the profit was recognised immediately. The losing swap was held in an accrual account, where the loss was spread over several years. This was attractive because dealers' bonuses were based on year-end profits.
This story may make you smile, but it's true. Of course, today, this wouldn't be allowed. Items for trading are marked to market, and items for hedging are held in accrual accounts. Moving items from one to the other would raise questions.
I share this story because, while you might think this doesn't happen anymore, similar issues still exist. So, what’s going on?
You are likely familiar with using swaps to hedge fixed-rate products like mortgages and savings. For less sophisticated organisations, each swap matches a specific part of the retail product exactly. There are accounting rules to ensure this if you're holding items long-term in an accrual environment. More sophisticated organisations interpret this more broadly, taking an overall view of the balance sheet risks and hedging accordingly. This is called balance sheet hedging. Initially, things look balanced, no matter the measure—simple gap reports or more complex delta reports.
But over time, things change.
Hedged products often decrease in size faster than the derivative due to prepayment risk. This generally happens, leading to an over-hedged position, which causes problems. In theory, the over-hedged position needs trimming to keep risks neutral. But there's reluctance because of the early redemption cost.
Consider why customers repay their mortgage or withdraw fixed deposits—it’s often because better rates are available. If so, the underlying hedge is likely underwater, and breaking it incurs a penalty. Here’s the dilemma: do we break the swap and incur the penalty, or use it as a hedge in our business? The choice has significant consequences. Breaking the swap now sends the cost to the P&L account immediately. Keeping it spreads the cost over the transaction's maturity, accruing the cost.
Many managements keep the excess hedge, spreading future costs. Does this matter?
It’s a moot point. Either you accept the loss upfront or spread the identical cost over time. There’s little to choose from—it impacts either this year’s profit and loss heavily or future years lightly, but it totals the same. So why spread it out? It appears more acceptable. But is it good management?
I argue it isn’t. Here’s why: the retail products being sold have underlying options where the customer is long, and you are short.
This is fine if you price it into the product and are aware. But spreading things out makes the losses from granting customer options seem smaller than they are and we become more tolerant of the situation.
This isn’t the only example. Pipeline hedging for mortgages or fixed-rate deposits can lead to similar problems if expected business volumes don’t materialise.
A related issue is thinking an over-hedged position is manageable as a directional play on interest rates. But we know predicting rates is risky.
An excess hedge can lead to behavioural risk, supporting a risky stance on rates that has proven detrimental to numerous traders.
What can we learn?
Regularly rebalancing hedge portfolios is essential. If this causes pain, ask why and what can be done to avoid it in the future. Otherwise, you repeat the same mistake.
The story of banks doing mirrored swaps is amusing, but similar issues persist, and we often fool ourselves by ignoring them.
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