Understanding the Basics of Hedging of HTM & AFS. Mechanics, Timing of Hedging and Hedging Coverage.

1. Introduction to Hedging in Banking Context

Hedging is a fundamental pillar of risk management within banking institutions, especially in the management of interest rate risk. When banks invest in fixed-income securities, such as those categorized under Held-to-Maturity (HTM) or Available-for-Sale (AFS), they expose themselves to interest rate fluctuations that can materially affect the value of these assets and, consequently, the bank's capital and earnings.

HTM securities are intended to be held until maturity and are reported at amortized cost. AFS securities, on the other hand, are marked-to-market, and changes in their fair value are recognized in other comprehensive income. Both types of securities, however, are vulnerable to interest rate movements, and it is critical for banks to manage these risks proactively. One of the most effective methods is through the use of hedging instruments such as interest rate derivatives.

2. The Mechanics of Interest Rate Hedging

Interest rate derivatives (IRDs) are financial instruments that derive their value from underlying interest rates. These include swaps, futures, forwards, and options. In a rising interest rate environment, the market value of fixed-income securities tends to fall. To offset this risk, banks may enter into receive-floating, pay-fixed interest rate swaps. This way, the gains from the derivatives can help compensate for the losses in their securities portfolios.

Similarly, in a declining interest rate environment, banks might enter into pay-floating, receive-fixed swaps to preserve or enhance income. Other hedging strategies may involve shorting Treasury futures or purchasing options that benefit from interest rate movements.

Importantly, these instruments are not just deployed randomly but are part of an overarching asset-liability management (ALM) framework. The purpose is to align the duration and repricing of assets and liabilities to mitigate net interest income volatility and economic value sensitivity.

3. Timing of Hedging: A Strategic Lever

The timing of hedging activities is as critical as the act of hedging itself. Research shows that banks adopt a discretionary and asymmetric approach to hedging. They intensify hedging activities as interest rate risk escalates, particularly when unrealized losses in HTM and AFS securities mount. Conversely, when interest rates fall and these securities gain in value, banks tend to scale back their hedging activities.

This behavior suggests a conscious cost-benefit analysis undertaken by risk managers. Since hedging is not free, due to transaction costs, basis risk, and capital implications under hedge accounting rules, banks prefer to hedge when the potential downside risk justifies the cost.

The discretionary nature of this timing is crucial. It indicates that hedging is not purely reactive but is instead a strategic response informed by forward-looking risk assessments, often aligned with macroeconomic indicators such as inflation trends, Federal Reserve signals, and forward rate curves.

4. Adequacy of Hedging: Not Just Coverage, But Relevance

While timing relates to when to hedge, adequacy addresses the scope and effectiveness of hedging. Adequate hedging means more than just the nominal amount of derivatives in place; it involves aligning the hedge's characteristics with the specific risk profile of the assets.

For example:

• A bank with a portfolio heavily invested in 10-year municipal bonds (HTM) may hedge with long-term receive-floating swaps to offset the duration risk.

• A bank holding AFS mortgage-backed securities (MBS) may use interest rate futures or call options to hedge against prepayment risk and valuation losses.

• A bank with significant exposure to callable agency debt may employ swaptions to protect against the embedded option risk.

• If the bank holds a laddered Treasury portfolio, it may use a combination of short- and long-duration swaps to match the average duration of the ladder.

• For banks with non-parallel yield curve exposure, customized strategies like flattener or steepener trades may be necessary.

This necessitates a deep understanding of duration, convexity, and optionality within the securities, and matching those characteristics with suitable hedge instruments.

Empirical studies indicate that many banks still underhedge, especially smaller banks with less sophisticated risk management infrastructure. According to FDIC Call Report data, only around 28.8% of U.S. banks with assets below $250 billion actively use interest rate derivatives for hedging.

The question of adequacy also touches on regulatory expectations. Basel III and guidelines from bodies like the BCBS and EBA emphasize not just the existence of hedging but also its effectiveness under stressed conditions. Hence, models such as Economic Value of Equity (EVE) and Net Interest Income (NII) sensitivity analysis are increasingly used to assess hedging sufficiency.

5. Discretionary Hedging and Risk Signaling

An important, often overlooked, aspect of hedging is its signaling effect. Market participants, including depositors and investors, may infer a bank's risk posture based on its hedging activity. A sudden cessation or unwinding of hedging positions during a volatile interest rate cycle can be perceived as a red flag, prompting questions about the bank's risk appetite, strategy, or solvency.

Therefore, discretionary hedging must be paired with strong communication, internally (to governance bodies) and externally (to analysts and rating agencies). Hedging decisions should be framed within a documented risk appetite framework and be subject to board oversight. Transparency, through disclosures in financial statements and regulatory filings, further builds stakeholder confidence.

This is particularly crucial for institutions with high levels of uninsured deposits or those whose business models rely heavily on long-duration assets, which are more sensitive to interest rate shocks. 

6. Conclusion: Hedging as an Integrated Risk Tool

In conclusion, hedging HTM and AFS securities is not just a tactical exercise but a strategic imperative in modern banking. The dual considerations of timing and adequacy form the crux of effective interest rate risk management. Banks that manage these two aspects well can safeguard not only their earnings and capital but also their reputation and depositor trust.

As the macroeconomic landscape continues to shift, with potential for more abrupt interest rate cycles, banks must move beyond compliance and adopt a proactive, well-documented, and transparent hedging framework that aligns with their broader risk management and governance structures.

**Disclaimer** - This article's views, opinions, and information are solely for educational, personal, and informational purposes. They are entirely independent and do not reflect or relate, directly or indirectly, to my current or previous employers.

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Babu Sathyanarayanan Moorad Choudhry Prateek Yadav CFA Institute Global Association of Risk Professionals (GARP) Claire Trythall Beata Lubinska, Ph.D Utkarsh Jain Ganesh Nayak Priyanshu Pandey Govind Gurnani Jakob Lavröd Glenn Handley Priyanshu Pandey Aswath Damodaran Ife Osakuade, MSc