Derivatives are financial contracts
that have a value derived from the performance of another security. An interest
rate derivative’s value is based upon the movements of an interest rate index. Interest
rate indexes include U.S. Dollar Prime, LIBOR, Fed Funds, and Treasury yields.
There are two categories of derivatives the first being exchange-traded
products which are often used by traders and speculators, are standardized
contract sizes and terms and are not typically used as customized hedging
solutions. The other derivatives are Over-the-Counter (OTC) products which are
developed to meet the hedging demands by a company and investor and are
customized contracts between two counterparties (Wintrust, 2012).
derivatives are options, futures, forwards, and swaps. Options allow one party
either Call or Put. Buyers of call options have the right to buy an asset at
the strike price at a future date. Sellers have the obligation to sell an asset
at the strike price if the buyer calls the option. A buyer of a put option has
the right, but not the obligation, to sell the asset at the strike price at a
future date. A seller has the obligation to repurchase the asset at the strike
price if the buyer exercises the option (NAPF, 2013).
are exchange-traded standard contracts for an asset to be delivered at an agreed
future time at a present price agreed upon. Forwards are non-standardized
contracts between two parties to buy or sell an asset at a future time at a
price agreed today (NAPF, 2013).
An OTC Interest
Rate Swap is an agreement between two parties in where one party agrees to pay
a fixed rate of interest and the other pays a floating rate and LIBOR is the
foundation of the swap market. An interest rate swap allows borrowers to set an
interest rate on an existing rate. The benefits of interest rate swaps include
flexibility, duration, certainty and a current rate (Wintrust, 2012).
types of hedging products include interest rate cap and collar. A cap
guarantees that the borrower a maximum rate and a floor guarantees the borrower
a minimum rate. The borrower pays a
premium up front in this case. An interest rate collar guarantees the borrower
a maximum fixed rate and requires them to pay a certain minimum rate. This
helps to offset the cost of a cap by a borrower selling a floor to the bank
Financial Corporation uses derivatives to manage risks such as interest rate
risk or market risk. Wintrust’s policy does not allow using derivatives for
Management of the derivatives evaluates
whether the instrument effectively reduces the risk associated with that item.
To decide if a derivative instrument continues to be an effective hedge, Wintrust
must make assumptions and judgments about the continued effectiveness of the
hedging strategies and the nature and timing of forecasted transactions
As of December 31,
2016, the Wintrust had two interest rate swap derivatives designated as cash
flow 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 cash
outflows 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 buy
certain securities held within the banks’ investment (Wintrust, 2017).