The Super Floater Is Back!

David Trinder, WesCorp
May 13, 2005

As Mr. Greenspan noted some months ago, “anyone who does not expect interest rates to rise is desirous of losing money!” Short-term interest rates have moved up steadily since June 2004 and there is nothing on the horizon to suggest that these increases will stop any time soon. With a relatively flat yield curve and low option volatility, the “Super Floater” certificate is starting once again to look like an attractive hedge instrument.

An Additional Hedge Alternative

A super floater certificate is a combination of a simple term floating rate certificate and a fixed-pay interest rate swap. The embedded interest rate swap acts as the hedge against the potential increase in short-term funding costs. When credit unions are faced with a higher than desired exposure to rising interest rates, they are somewhat limited in their corrective actions. One option would be to sell longer-term, fixed-rate loans or investments to reduce this risk. If the sale of target loans or investments would generate capital losses, however, credit unions will typically refrain making that choice and seek an alternative solution.

Another strategy might include the issuance of long-term, fixed-rate certificates to members; however, this usually requires the payment of a large rate premium and typically only generates limited volumes. Other credit unions might turn to long-term, fixed-rate borrowings as a solution, but this also can be expensive and balloons the balance sheet for credit unions that do not need additional liquidity. Financial derivatives are the most efficient tools for hedging interest rate risk, but they too have their drawbacks. It can take time to set up a derivative hedging program, implement new policies and procedures and train staff and the board. Also, the rigors of complying with FAS133 can be a significant burden. So what’s the major benefit of a super floater? The super floater certificate provides access to the interest rate swap derivatives market without the overhead of a stand-alone derivative transaction.

How Does a Super Floater Work?

As mentioned earlier, a super floater investment combines several individual elements. We start with a standard floating rate certificate with a final maturity appropriate for the desired hedging period. Then we embed a standard pay fixed / receive floating rate interest rate swap derivative transaction. At this point, the coupon to be paid on the certificate consists of the combination of the floating rate earned on the underlying floating rate certificate, plus the receive floating rate from the interest rate swap transaction less the fixed-rate payable on the interest rate swap transaction. This can be expressed as the following formula:

2 × floating rate – the term fixed rate

What happens if you apply different floating rates to this formula? If the floating rate is less than half of the set fixed rate, the coupon will go negative. To avoid this situation, an interest rate floor contract is typically added to the structure—whereby if the floating rate index is less than half of the fixed rate, the floor will pay the difference. An interest rate floor contract is an option product that commands an up-front option premium. To pay for this feature, some of the upside potential is surrendered by selling an interest rate cap. The strike rate on the interest rate cap is set such that the resulting option premium is sufficient to completely offset the option premium commanded by the interest rate floor contract. The final coupon formula can now be expressed as:

2 × floating rate – the term fixed rate,

provided the resulting coupon shall not be less than zero nor greater than (cap strike rate)

Table 1 shows how a super floater certificate will perform under different interest rate scenarios. In this example, the certificate is for $10 million and the coupon formula is:

2 × 3-month LIBOR – 4.40%,

provided the coupon shall not be less than zero or greater than 12.20%

Table 1

			CERTIFICATE: $10,000,000
	3 MOS		FLOATING	FIXED	ZERO COST COLLAR		NET	NET
QTR	LIBOR	PRINCIPAL	2 X LIBOR	4.40%	CAP	FLOOR	COUPON	YIELD
1	3.00	10,000,000	152,083	-111,528	0	-	40,556	1.60%
2	5.00	10,000,000	253,472	-111,528	0	-	141,944	5.60%
3	7.00	10,000,000	354,861	-111,528	0	-	243,333	9.60%
4	9.00	10,000,000	456,250	-111,528	-35,486	-	309,236	12.20%
5	7.00	10,000,000	354,861	-111,528	0	-	243,333	9.60%
6	5.00	10,000,000	253,472	-111,528	0	-	141,944	5.60%
7	3.00	10,000,000	152,083	-111,528	0	-	40,556	1.60%
8	1.00	10,000,000	50,694	-111,528	0	60,833	0	0.00%

As a result of the coupon formula, the yield changes by twice the amount of change in the underlying floating rate index in both rising and falling rate environments. You also can calculate that the maximum yield becomes effective when the three-month LIBOR exceeds 8.30 percent (2 × 3-month LIBOR at 8.30% = 16.60% − the fixed rate at 4.40% = 12.20%). The table is presented as an aid to understanding the dynamics of a super floater certificate. As an investor, you will see only the net coupon and net yield columns.

What Should You Invest?

Firstly, the super floater is an efficient interest rate risk management instrument that reduces a credit union’s risk exposure to rising interest rates. As the hedge transactions are embedded in a floating rate certificate, the investment is not subject to the FAS133 accounting rules. As there is no need to specifically identify target balance sheet items, the credit union is effectively undertaking a macro hedge on its risk exposure. Additionally, the floating index is not required to be tied to liability pricing—as is required by FAS133. The credit union retains complete flexibility in pricing products and can use the LIBOR market—the deepest and most efficient (least expensive) index.

Previously, we submitted the details of the super floater certificate, its structure, and application to the NCUA for review and believe that this is a legal investment transaction for credit unions. Indeed, many of you are already purchasing investments with embedded options through WesCorp structured certificates—callables, putables, indexed amortizing, capped floaters and the like. The super floater is no different in concept but is very different in application. It can be used as a risk reduction hedge instrument.

Impact to Balance Sheet?

Unlike the stand-alone interest rate swap, this hedge transaction is an investment and resides on the balance sheet. If term investment funds are not available, the credit union can always borrow term fixed-rate funds and use the proceeds to purchase a super floater certificate. Remember that borrowing term fixed-rate money is also a hedge, in which case the credit union would only have to borrow half the amount. Using the three-year illustration in Table 1 as an example, if the credit union does not have $10 million in available term funds to invest, it can borrow $5 million at a fixed rate for a three-year fixed term and then purchase a $5 million, three-year super floater certificate.

What Is the Operational Impact?

Accounting for a super floater certificate is extremely straightforward. The previous table shows that a simple Excel spreadsheet can easily calculate current and projected income that the certificate may generate. The credit union’s risk management process does need to be able to identify and quantify the impact of this transaction. Those with less sophisticated models may need to break the certificate into its components and then run the individual elements through their model. This, however, is a relatively minor overhead for such a powerful hedging tool.

Does This Negate the Need for Stand-Alone Derivatives Transactions?

No. The super floater is merely another hedging tool that a credit union should have in its toolbox. Stand-alone financial derivatives are still the most capital-efficient hedging tool. Credit unions with capital constraints or liquidity constraints should turn to stand-alone derivatives for hedging purposes. Those that need an immediate hedging solution can use the super floater while they put the necessary infrastructure in place to employ financial derivatives. Those credit unions that are smaller or have limited need and choose not to join our derivatives hedging program should look carefully at the super floater as a viable and practical alternative.

Will Rates Be Posted on WesCorp’s Website?

These are simple investments to purchase and operate but difficult to manufacture as there are four moving parts—the underlying term floating rate investment; the embedded interest rate swap; an interest rate floor contract, and an interest rate cap contract. Consequently, these will be available only through reverse inquiry. Given the complexity of manufacture, there is a minimum investment amount of $5 million. It should be noted also that the shape of the yield curve and/or interest rate option premiums may be such that this product cannot be manufactured.

That said, we could possibly aggregate smaller amounts to piggyback on a reverse inquiry for a larger transaction. Remember, this is an advanced hedging instrument and anyone using this needs to fully understand the potential risks.

David Trinder is vice president of balance sheet management for WesCorp www.wescorp.org . This article first appeared in the Winter 2004 issue of WesCorp's magazine on balance sheet management called InsideRISK. Contact Trinder at dtrinder@wescorp.org or 800-442-4366.