Hedging is the application of financial analysis the use of diverse financial instruments to control and often reduce different types of risk.
It sounds like a simple concept, but with today's complex bank portfolios, sophisticated computer simulations of nearly every possible market scenario must be run to come up with an effective hedge strategy. Even the smallest bank that handles retail deposits, home loans, and little more must employ risk management techniques to guard against the possibility of customers withdrawing their money and the effects of changing interest rates, to name only two risks.
To illustrate the variety of choices banks face, the American Banker today introduces as a regular feature the "Model Portfolio." The idea is to create a hypothetical financial institution and ask consultants and bankers to pitch hedge strategies for its portfolio.
Hopefully the portfolios will be unique enough to create interest but typical enough that some readers will recognize similarities to their own risk profiles.
The first model portfolio comes from Yield Curve Financial Corp., a fairly typical middle American institution that was created with the help of Heinz Binggeli, managing director of Emcor, a risk management consulting firm in Irvington, New York.
While the risk management consultants we spoke with said that they would need more time to do comprehensive computer modeling and that in real life they would have to know more details about our portfolio's makeup, they said they could make some basic assumptions with the information we provided.
Fred Price, principal of Sandler O'Neill & Partners, said he would not look to hedge Yield Curve Financial's portfolio as it stands.
"I'd rather take my lumps and some losses," he said. "A hedge says you're willing to lock in what you have. I'd diversify and acquire the instruments I'd rather own."
Mr. Price said he would replace YCFC's $700 million in inverse floaters with seasoned two- and three-year balloon-mortgage-backed securities and some adjustable-rate mortgages. He'd also divest some of the bank's Treasuries.
"I wouldn't necessarily hedge until I boiled it down to what I'd want to keep," noted Mr. Price.
Tanya Styblo Beder, co-principal of Capital Market Risk Advisors Inc., said that Yield Curve Financial's portfolio is highly sensitive to movements in the five-year Treasury rate.
Capital Market Risk Advisors vice president Thomas Riesing said that to get an accurate view of how to hedge the bank's portfolio, he and Ms. Beder had to assume that the inverse floaters would reset every six months. They also assumed the $1.5 billion in Treasuries consisted of: $300 of two-year notes, $200 million of three-year notes, $500 million of five-year notes, $300 million of 10-year notes, and $200 million of 30-year notes.
"Overall the portfolio has the risk profile of a five-year sensitivity," said Ms. Beder. "For a macrohedge you might consider going into the five-year OTC swap market or five-year securities."