Derivatives are financial contractsthat have a value derived from the performance of another security. An interestrate derivative’s value is based upon the movements of an interest rate index. Interestrate indexes include U.S. Dollar Prime, LIBOR, Fed Funds, and Treasury yields.
There are two categories of derivatives the first being exchange-tradedproducts which are often used by traders and speculators, are standardizedcontract sizes and terms and are not typically used as customized hedgingsolutions. The other derivatives are Over-the-Counter (OTC) products which aredeveloped to meet the hedging demands by a company and investor and arecustomized contracts between two counterparties (Wintrust, 2012).Commonly usedderivatives are options, futures, forwards, and swaps. Options allow one partyeither Call or Put. Buyers of call options have the right to buy an asset atthe strike price at a future date. Sellers have the obligation to sell an assetat the strike price if the buyer calls the option. A buyer of a put option hasthe right, but not the obligation, to sell the asset at the strike price at afuture date.
A seller has the obligation to repurchase the asset at the strikeprice if the buyer exercises the option (NAPF, 2013). Futuresare exchange-traded standard contracts for an asset to be delivered at an agreedfuture time at a present price agreed upon. Forwards are non-standardizedcontracts between two parties to buy or sell an asset at a future time at aprice agreed today (NAPF, 2013).An OTC InterestRate Swap is an agreement between two parties in where one party agrees to paya fixed rate of interest and the other pays a floating rate and LIBOR is thefoundation of the swap market.
An interest rate swap allows borrowers to set aninterest rate on an existing rate. The benefits of interest rate swaps includeflexibility, duration, certainty and a current rate (Wintrust, 2012). Othertypes of hedging products include interest rate cap and collar. A capguarantees that the borrower a maximum rate and a floor guarantees the borrowera minimum rate. The borrower pays apremium up front in this case. An interest rate collar guarantees the borrowera maximum fixed rate and requires them to pay a certain minimum rate.
Thishelps to offset the cost of a cap by a borrower selling a floor to the bank(Wintrust, 2012). WintrustFinancial Corporation uses derivatives to manage risks such as interest raterisk or market risk. Wintrust’s policy does not allow using derivatives forspeculative purposes.
Management of the derivatives evaluateswhether the instrument effectively reduces the risk associated with that item.To decide if a derivative instrument continues to be an effective hedge, Wintrustmust make assumptions and judgments about the continued effectiveness of thehedging strategies and the nature and timing of forecasted transactions(Wintrust, 2017). As of December 31,2016, the Wintrust had two interest rate swap derivatives designated as cashflow hedges of variable rate deposits and mature in July 2019 and August 2019.They also had two interest rate caps designated as hedges of the variable cashoutflows both maturing in September 2017. Along with interest rate derivatives,Wintrust also uses mortgage banking derivatives, foreign currency derivatives,and will periodically sell options to a bank or dealer for the right to buycertain securities held within the banks’ investment (Wintrust, 2017).