The Hedge That Stopped Working When Rates Moved

Two distinct problems have been blended together by the effectiveness test.

The first is a basis and funding mismatch. The institution funds fixed-rate mortgages with short-term deposits. The swap pays fixed and receives floating, which hedges the asset's fixed-rate exposure but does nothing about the deposit side. When deposit costs rise faster than the floating leg, the spread between what the institution pays for funds and what the swap receives narrows. The swap is doing what it was designed to do; the design did not cover the funding cost risk. Net interest margin compression of 0.8 percentage points on a $600 million book is a real economic loss, not an accounting artefact.

The second is a duration mismatch caused by prepayment. The swap notional of $400 million was matched to expected duration. When borrowers refinanced, the actual portfolio shortened. The institution is now paying fixed on $400 million of notional against a mortgage book that is shorter and smaller in duration terms than assumed. That is over-hedging: the swap's fixed payments continue while the asset that justified them has partly disappeared. This creates exposure to falling rates, precisely the opposite of the original intent.

The effectiveness test is the reason nobody noticed. Testing the swap against a hypothetical derivative measures whether the swap behaves like a generic swap. It will pass almost always, because the swap is a generic swap. It says nothing about whether the swap offsets the actual portfolio. A test that cannot fail is not a control. The committee was told the position was hedged because the test passed, but the test was never designed to answer the question the board asked.

The report to the committee should start by correcting the framing. The position is not "hedged" in the sense the committee understood; it is partially hedged against one risk while exposed to two others.

What the report should contain:

1. Decompose the margin move. Show how much of the 0.8 point compression came from deposit repricing, how much from the swap's floating leg, and how much from prepayment-driven over-hedging. The committee needs the attribution, not a single number.
2. Quantify the over-hedge. State the current notional versus the duration-equivalent notional of the remaining portfolio, and the loss sensitivity to a rate fall of 100 basis points. If the over-hedge is material, the committee should consider unwinding or restructuring part of the swap, and should see the cost of doing so.
3. Retire the misleading test. Replace the hypothetical-derivative comparison with a test against the actual portfolio, including a dollar-offset or regression approach that captures prepayment behaviour. Report the results in plain terms: what fraction of the portfolio's rate sensitivity is offset.
4. Model prepayments explicitly. The original duration match assumed a prepayment speed. Build a range of prepayment scenarios and show the hedge ratio under each. If the hedge only works at one prepayment speed, that is the finding.
5. Address the funding side. The deposit repricing risk is not hedged by the swap. Consider whether the institution should hedge margin directly, lengthen funding, or reprice assets. Present the options with their costs.

Framework changes: require hedge documentation to state which risk is being hedged and which is not; require effectiveness testing against the actual hedged item; set a tolerance band for hedge ratio drift with a mandatory review trigger; and require the treasurer to report hedge performance in economic terms alongside accounting effectiveness. The committee should also be told, explicitly, that "temporary" is not an analysis. If margin compression is expected to reverse, the report should say why, over what horizon, and what would falsify that view.