Swaps are largely used to hedge specific cashflows against floating rate exposure. Since banks make money out of the intr rate differential on their assets against liabilities (thats their main busn) they will tend to move both depo rates n lending rates in tandem with mkt rates.

However if such a bank takes a long term loan or issue a note or bond on a floating rate, they enter into a swap to hedge should rates rise.

If rates fall, a fixed rate payer will still be comitted at the fixed rate but will register a negative mark to market (loss on revaluation)

My 2 cts

Hi Emlyn,

All derivatives can be used to hedge interest rate risk exposure. Swaps are however preferred, as opposed to other derivatives, due to the fact that the major players in the market (and their customers as well) have a role in setting the benchmark rate (the LIBOR).

In the case of KCB, the interest rates on the loans are mainly floating rates. The base rates for the loans do fluctuate depending on various factors like the cost of getting deposits in the market and the CBR rate. So the use of swaps would best manage the exposure as you have intimated – but on its net exposure.

The impact of a decline in interest rates to KCB largely depends on the change in the shape of the yield curve and its net interest rate exposure. (I’ll use the table on Page 93 of the 2011 Annual Report).

A parallel reduction in interest rates could reduce the bank’s net income this year. A casing point is that the interbank rate in December was 27% while the current interbank rate is around 20% (as of 22 June 2012).

But the real impact of the reduction depends on what KCB is doing to manage its net exposure like reducing its loan book and increasing its investment in government securities.

And yes, the swaps are usually marked to market.

Hope this helps.

Regards

Yeah they are, since theyre usually longterm and in line with ias'

My thinking of marking to market implies that

1.There must be a clearing house for that pupose (SWAPS dont have a clearing house)

2.SWAPS are generally unregulated and the marking to market feature applies to regulate markets such as FUTURES.

kindly fill me in as to marking to market feature for swaps?

rgds

@ Emyln,

I think anyone can benefit by undertaking some form of risk management, hedging in a key risk management technique and swaption is one form of managing risk however the decision that goes into deciding whether to pursue these techniqueS depend alot on the business and the underlying exposures. Otherwise hedging could turn into a big lose!

Having say that, most Kenyan bankS have net liability exposure to the Euro Market so not hedging against the Euro is a good strategy at the moment.


Drunkard!

It took me a few minutes to understand your question so maybe you want to re-read and correct it.

First you explain a situation where the bank is recieving a fixed rate for loans issued and paying variable rates for deposits. In a situation like this swaption is not the best risk management technique the spread between the spot rate and the rate the bank give for deposits very much absorb the short term rate risk.
But if this is a textbook question then anyone can scratch some simple to complex risk management techniques but under normal business sense Swap will not come into the picture because of so many other factors.

Emlyn, Under the exact hypothetical scenario you presents, swap is not viable.

An interest rate swap for KCB seems somewhat unnecessary given it pays zero interest rate for its deposits

Not sure you understand the purpose of an interest rate hedge especially in the Kenyan context i.e. you only do search a hedge if you believe that interest expense on a given a loan will be higher than interest received. Hardly likely to happen for most banks. Except HF which has a serious mismatch between deposits and loans

Hi Emlyn,

A hedge is essentially taken to protect against market risk. Deposits rates on the other hand are not really mkt rissk but determined by the management of a bank based on various facters such as theeir liquidity, asset growth plans, cbr rate etc.

An interest rate swap will be used to hedge against adverse movement in a mkt traded benchmark such as libor. Some facilities / bonds issued at libor + spread will be at the mercies of libor movements (for a moment ignoring the manipulation scandal for sm london banks), should such a rate rise in future.

So essentiialy it boils down to: will u take A swap to hedge against a management decision or market risk (which the bank wont have control). Thats why it may not apply in the scenario u describe