There is now a wide range of interest rate derivatives available in most developed markets. These derivatives provide bank treasuries with tools to change their exposure to shifts in interest rates without having to act to change the composition of the banks’ balance sheet directly. The latter is difficult to achieve quickly and efficiently in practice.
Derivatives are not recorded on the bank’s balance sheet and are hence described as “off-balance sheet”. Over the years most regulators have acted to force greater disclosure of these off-balance sheet items and their related exposures.
Banks have resisted this trend to greater transparency arguing that by providing more information they risk giving commercially sensitive information to competitors that will be able to exploit perceived weaknesses in balance sheet structure at an individual bank. There is little merit to this argument.
We now need to look at some of these derivatives in order to show how a bank can use them to adjust its exposure to shifts in the yield curve.