Hedging a Bank's Negative Repricing Gap with OIS
A mid-sized bank has ₹800 crore of five-year fixed-rate loans at 8.90% and funds them with one-year retail deposits currently at 7.10%. The deposits reprice annually and the bank expects deposit rates to rise by 100 bps over the next year. The treasury's ALM report shows a negative gap: rate-sensitive liabilities reprice within one year while assets are fixed for five years. The treasurer proposes paying fixed on a five-year OIS at 6.95% for ₹800 crore notional. The risk committee suggests instead a one-year OIS rolled annually, or a forward-starting strip, to match the deposit repricing. The bank's net interest margin is 1.80% and its capital is tight. The OIS is cleared through a central counterparty with daily mark-to-market margin, and the loan book is illiquid and cannot be sold. The bank follows hedge accounting and must test effectiveness quarterly.
1. Quantify the bank's NIM exposure to a 100 bps deposit-rate rise and evaluate the treasurer's ₹800 crore five-year pay-fixed OIS.
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Annual NIM exposure = ₹800 crore × 100 bps = ₹8 crore pre-tax, assuming a 100% deposit beta. The five-year OIS has modified duration of about 4.5, so its DV01 is roughly ₹800 crore × 4.5 × 0.0001 = ₹36 lakh per bp. A 100 bps rise would produce a mark-to-market gain of about ₹36 crore - 4.5 times the NIM exposure. The treasurer's full-notional hedge overhedges the one-year repricing gap. To match ₹8 crore with a five-year OIS, the notional should be about ₹800 crore × (8/36) ≈ ₹178 crore. Alternatively, a one-year pay-fixed OIS of ₹800 crore has DV01 of about ₹7.68 lakh per bp and a 100 bps gain of about ₹7.68 crore, which closely matches the annual gap but must be rolled. The five-year trade also has more mark-to-market volatility and collateral calls. The right answer is a hedge sized to the gap and the deposit beta, not the full loan book.
2. Compare the five-year OIS, a rolling one-year OIS and a forward-starting strip for this bank, including hedge accounting and liquidity.
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A five-year OIS fixes the hedge cost for five years but mismatches the one-year deposit repricing; if deposit rates rise less than forward rates imply, the bank loses on the hedge. A rolling one-year OIS matches the annual repricing and has low duration, but the bank faces rollover risk: if rates rise, each new one-year OIS locks a higher fixed rate, which is exactly when deposit costs are also rising, so the economics can work, but the hedge is not a perfect lock. A strip of one-year forward-starting OIS covering years one to five matches the repricing ladder better and reduces roll risk, at the cost of complexity and bid-offer. For hedge accounting, the designated relationship must be documented; a five-year hedge against one-year deposits is likely to fail the effectiveness test because the critical terms differ, while a rolling one-year or a strip is easier to support. Liquidity matters: the full-notional five-year swap requires large daily margin; a ₹178 crore five-year hedge or a smaller strip uses less collateral. The bank should choose based on deposit beta, capital and accounting, not just the lowest fixed rate.