Rens Borsje: To hedge, or not to hedge, that's the question

January 2, 2024

^{This column was originally written in Dutch. This is an English translation.}

By Rens Borsje, Senior Risk Consultant at Probability & Partners

In addition to worrying in 2024 about climate risk, the Solvency II update, inflation, DORA, the Wtp, etc, there are also topics such as interest rate risk and expectations and volatility. I would like to take a closer look at those for the coming year.

It starts with your risk appetite. Do you have long-term obligations such as a life insurer or a pension fund? Then the past two years have been a welcome change from years of creeping interest rates down. However, after a strong rise in interest rates, we now see expectations that the front of the curve is already coming down and the 10-year point has also fallen about one percentage point in the past three months. Now you have to ask yourself, how comfortable are you with this open risk if we assume an interest rate scenario with interest rate levels like in 2021?

Lagarde and her fellow central bankers have already announced an end to interest rate hikes now that inflation has been curbed and the inflation target of around 2% will be reached in 2025. America is again slightly ahead, the United Kingdom may be slightly behind, but in Europe we are also expected to see the first falls in policy rates at the end of this year. This may be a bit premature, as Pim Poppe pointed out just over a month ago - after all, inflation does not yet seem to be completely under control - but this is the direction given. For the first time in a long time, there is room for divergence between the policies of the various central banks.

Volatility is the second part of this puzzle. Comparable to the interest rate itself, the volatility - realised and expected in the market - is considerably higher than during the stable interest rate declines up to and including 2021. This makes the importance of hedging clear because the shocks can be much larger and possibly more painful. The potential shocks and events already planned for this year are significant:

• Geopolitical uncertainty: Despite several ongoing wars and rising tensions, for example in Taiwan, the market has become fairly stable and accustomed. I think there is still room for a correction here.
• Trump 2024: The last word has not yet been spoken on this. Possibly another four years of Trump in America will in any case not reduce global volatility.
• European political climate: We see a lot of shifts, also in our country. It is still unclear what effect this will have on the economic climate and the stability of policy.
• Climate risk: In addition to possible climate-driven disasters - see the current high tide in our little country - the imposed regulations can also cause slowdown or divergence.
• ECB balance sheet: In addition to the policy interest rate, the ECB has another tool at its disposal. Little has been communicated about this so far, but accelerated or delayed reduction of the balance sheet can immediately have a major impact on the middle and back end of the yield curve.
• Credit crisis: Thanks to the almost inexhaustible corona stimulus packages, fewer companies than expected have collapsed. However, now that this support has been withdrawn and repayments must begin, it is becoming clear that there is room for correction here too.
• Generative AI revolution: I don't expect the world to completely change by 2024, but like many technological revolutions, it will undoubtedly happen faster than expected.

The above only describes risks and potential events that are currently known (to me), and therefore says nothing about additional surprises. Now the question remains how to deal with this. If you are satisfied with the current interest rate and you feel adventurous, you can sell some upside in the form of swaptions or caps. However, from a risk management perspective, I would pay attention to the following topics.

• Consider your RAS (risk appetite statement) and how it aligns with your current positions and sensitivities.
• View your balance sheet holistically, but also per component to get the right focus.
• Interest rate sensitivity: Parallel sensitivity and simple duration is not detailed enough. Look at your exposure per year or bucket in more detail.
• Convexity is very important, just like in previous years. Be aware of where these non-linear risks are located in your balance sheet and monitor this at a higher frequency than normal. A good example of this is your mortgage portfolio. Until 2022 and 2023, there were low repayments, but this turned into extra high repayments and a shorter interest rate sensitivity as a result of falling interest rates and more flow in the housing market.

All in all, 2024 seems to be a very interesting year. Also from a risk management perspective. To return to the title and the main question: the most important thing is that you have to determine what you feel comfortable with, or in other words what your risk appetite is. If you want to be less sensitive to potentially large and more shocks with a negative impact compared to previous years, then a little more hedging doesn't feel so bad.

Probability & Partners is a risk advisory firm offering integrated risk management and quantitative modelling solutions to the financial sector and data-driven enterprises.