In anticipation of rising interest rates, banks last year began adjusting their risk management strategies, and dramatically reduced holdings of interest rate options and futures to hedge their portfolios.

To help them weather the coming bear market, banks stuck with interest rate swaps as a means of keeping their own portfolios hedged.

In a survey of the 260 largest banking companies released last week, the Bank Administration Institute found that the major objective at most U.S. banks last year was the management of interest rate risk.

In contrast, two years earlier, the same survey found that most banks were concerned with the liquidity of their portfolios.

The study confirmed what bankers have been saying this year as the derivatives market erupted in controversy --that they anticipated the change in interest rates and handled their investments more responsibly than many of the corporations, municipalities, and other investors whose derivative . investments soured as rates rose.

The BAI study found that 90% of the responding banks used derivatives last year. More than 80% of the banks said they used derivatives predominantly as a hedge.

Only 5% of the respondents said they used derivatives as an investment within their portfolios. Leslie Rahl, co-principal of Capital Market Risk Advisors, a New York risk management consultancy, said the survey "confirms some fairly consistent growth" in derivatives over the last three years, but pointed out that growth has since tapered off.

"The growth in some options is trailing off a bit because of the. change from a bull market to a bear market," Ms. Rahl said.

She noted. that derivatives products created during the bull market to hedge portfolios in a stable interest rate environment are virtually useless to banks now that interest rates are spiking upward, causing a Slowdown in the use of options and futures.

Indeed, the BAI study shows such a slowdown was already under way in 1993.

In 1990, 48% of banks said they used interest rate options to hedge their portfolios. In 1991 44% said they used options. Last year, only 8% of banks said they used options as a hedge.

Interest rate futures likewise declined. In 1990 41% used them to hedge their portfolios. In 1991, that number declined slightly to 40%. But last year, only 8% of banks said they used interest rate futures as a hedge. "In the spring people got hurt by bull market instruments," Ms. Rahl said. "The change in the market now has made them put the brakes on."

An interest rate swap is a fixed-rate or floating-rate swap of a single currency.

An interest rate option is the right, but not the obligation, to pay or receive a specific interest rate on a predetermined principal for a set amount of time.

An interest rate future is a standardized contract that obligates one party to buy and the other to sell a specific asset at a specified price and time in the future.

Amortizing interest rate swaps were popular hedges among banks with less than $10 billion in assets. The survey found that 60% of them used amortizing swaps as a hedge.

An amortizing interest rate swap is a swap with a declining notional principal amount reflecting the amortization of an underlying fixed-rate or floating-rate instrument, such as a mortgage obligation.

If the amortization schedules of the swap and underlying instrument are not set at the same levels, the fixed-rate receiver can face significant prepayment or extension risk.

Amortizing swaps should not be confused with index amortizing swaps, which also have been used by regional banks.

An index amortizing swap features a notional principal that declines at short-term money rates, such as the London interbank offered rate. The instruments have created problems for a number of banks, industry observers say privately.

The use of the index is supposed to protect the fixed-rate payer from prepayment risk. However, since the underlying instruments usually are mortgages, the payer faces significant prepayment risk if rates are low.

According to Capital Market Risk Advisors co-principal Tanya Styblo Beder, index amortizing swaps are highly complex structures, but they are no more risky than other derivatives if handled properly.

"They are a challenge to hedge," she said. "Some risk models don't handle them well." But, Elliot A. Rosen, president and chief operating officer of Sendero Corp. based in Arizona, said index amortizing swaps are not hard to model at all. "The rules on how they cash flow are pretty basic," he said. "But how they are set up is different for each institution. They were created to get the extra yield on mortgage-backed securities of CMOs??'

Mr. Rosen said Sendero is now testing new asset liability management software that can effectively model the risks involved with index amortizing swaps.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.