One of the features of this advance is that the member sells options to the FHLBI in return for a lower cost of funds. Financial institutions routinely sell options. Whenever mortgage-backed securities or other bonds with embedded call options are purchased, options are sold in exchange for higher initial asset yields. With the putable advance the member sells the option on the liability side of the balance sheet to reduce the institution's borrowing cost. The important aspect of selling options is that the seller understands the risks and has evaluated whether those risks are acceptable within the asset/liability structure of the institution.  

The putable advance is a fixed rate product that provides a low-cost funding alternative to FHLBI members. The advance rate is typically priced below current Treasury levels. These rates are achieved through the sale of put options to the FHLBI. The put options allow the FHLBI to convert the advance from a fixed rate loan to a LIBOR floating rate loan. One of the most popular advances is the three-year nonput one-year putable (3/1) described in Exhibit 1.

One of the most frequently asked questions about a putable advance is, When will the advance convert? Generally the advance converts when the market value is less than par or the price is less than 100. When the price is below 100, that indicates the advance can be reissued at a higher rate than the current rate on the advance, and the FHLBI will most likely exercise the option to convert the advance.

Some institutions have assumed that if the advance rate were below LIBOR, the FHLBI would convert the advance to receive the higher rate. This would not necessarily trigger the conversion as the value of the advance may still be below par. A better indication of whether the advance will convert is to compare the interest rate on the outstanding advance to the rate on a new advance with the same remaining maturity, lockout, and put option frequency. If the interest rate on the existing advance is less than the interest rate on the new advance, the existing advance will probably convert.

For example, on August 18, 1997, a three-year nonput one-year special was priced at a rate of 5.57 percent. As the end of the lockout period of August 18, 1998, approaches, an institution that borrowed this advance wants to know whether to expect this advance to convert. The remaining term on the advance is two years and the conversion dates occur quarterly after August 18, 1998. To project whether the advance will convert, an institution compares the rate on a new two-year nonput three-month advance to the rate on the advance outstanding. As of Feb. 13, 1998, a two-year nonput three-month advance is priced at the two-year Treasury less 14 bps, which equates to a rate of 5.20 percent. Since the rate is below the rate on the outstanding advance, it is not projected to convert on August 18, 1998, if that date’s interest rate environment is similar to the current environment. This is illustrated in Exhibit 2 below. 

There are three major factors which affect whether an advance is converted or not. These are interest rates, swap spreads, and volatility.

In general, if interest rates rise the putable advance is likely to convert, and if interest rates decline the advance tends not to convert. In the following example, a projection was made, using the 3/1 putable special above, on how much the two-year rate would have to fall for the term of the fixed rate to extend to maturity. A parallel shift in rates is assumed and all other market factors remain the same. The two-year rate was chosen as a benchmark because the first conversion option occurs when the advance has two years remaining. On the pricing date of August 18, 1997, the two-year rate was 5.80 percent.

In general, if swap spreads widen the advance converts, and if swap spreads narrow, assuming all other market factors remain constant, the advance tends not to convert. Swap spreads are a factor in whether an advance converts or not because the FHLBI creates the funding for the putable advance using interest rate swaps. As Exhibit 4 shows, the rate on a putable advance is derived from the rate on a bullet advance with the same maturity as the putable final maturity, less the value of the options sold. When swap spreads widen, the bullet advance, which is funded with a combination of a swap and a consolidated obligation, becomes more expensive, creating a higher cost putable advance.

The swap dealer generally initiates the conversion of the advance. When the advance is originally issued the institution sells the FHLBI the option to convert the advance. The FHLBI subsequently sells the option to a swap dealer in order to offset the risk of the advance. The swap dealer starts the conversion process by terminating the option with the FHLBI, which will trigger the FHLBI to convert the advance that the institution has borrowed. This process is illustrated in Exhibit 5.

Volatility measures the expected variance of interest rates. The recent stock market activity is an example of a market experiencing high volatility. If the stock market typically varies by no more than 100 points from day to day, that is a measure of volatility. If the market environment changes such that the day-to-day variations are less than 50 points, that indicates a reduction in volatility.

Volatility is an essential element in the pricing of options. If volatility is high, the value of the put options within the advance increases, and the period during which the rate is fixed tends to extend because the FHLBI desires to keep the options. If volatility is low, the value of the options decreases, and the FHLBI is more likely to convert the advance to LIBOR adjustable.

When will volatility have the greatest effect on the advance? Volatility affects the advance most when the interest rates are on the cusp or borderline of causing the advance to convert. For example, referring to Exhibit 2, when nine months remain on the three-year nonput one-year special, the rate on a new nine-month nonput three-month advance is projected to be about 5.57 percent, the same as the existing three-year nonput one-year advance. If interest rates were similar to the current environment, a rise in volatility would tend to cause the advance not to convert and the fixed rate would remain. Likewise, a fall in volatility would tend to cause the advance to convert. When the disparity between the interest rates on an existing advance and a new advance with the same maturity and call provisions is very large (i.e., 100 bps), volatility generally has very little effect on the conversion decision.  

How does the putable advance compare to other advance products? On a pricing basis the putable advance typically carries a lower rate than a bullet advance and a three-month LIBOR advance. Exhibit 7 provides indications on advances that are typically available to institutions. Two different sets of indications are provided to illustrate how the rates and spreads might look in different rate environments. The August 18, 1997, indications were priced in a typical upward sloping yield curve environment. Since that time, rates dropped 46 basis points, but also the curve flattened and inverted relative to LIBOR causing the spreads to Treasury to compress.  

The putable advance has a lower rate the longer the maturity and shorter the lockout. The lower ate reflects the additional uncertainty as to when the advance may convert. On a ten-year nonput one-year advance the rate is 4.83 percent, but this rate may discontinue after one year, it may remain outstanding for ten years, or it may convert sometime within that time period. The FHLBI is generally able to customize the maturity and lockout to meet the asset/liability requirements of the institution if the advance amount is $10 million or more.

Many institutions borrow the putable advance as an alternative to bullet advances. If the institution is liability sensitive, borrowing putable advances can reduce the overall interest rate exposure in the portfolio. An institution with long-term fixed rate assets that are funded primarily by overnight to three-month liabilities might consider a putable to extend the duration of the liabilities. The key to this decision is understanding how the putable behaves in different interest rate scenarios.

The benefits to the member are the following.

• The putable advance provides an interest rate that is typically a sub-treasury and sub-LIBOR funding level.

• Borrowers can customize the final maturity to meet their funding strategies. The FHLBI has funded structures from two-year nonput one-year putable advances to ten-year nonput five-year putable advances at the request of members.

• The putable advance provides a funding alternative to bullet advances to extend the duration of the liabilities in a liability sensitive portfolio.

The risk is that the advance may convert to LIBOR at some point in time between the lockout and final maturity, and the institution does not know when this conversion will occur. Exhibit 8 summarizes the market factors and how they influence the conversion decision.

With each funding decision, an institution must evaluate the different alternatives available and the market environment at the time. The putable advance is a new product with unique risk/return characteristics. It is the first product offered that allows the institution to sell options to the FHLBI in exchange for a lower funding cost. For this reason it is important that an institution understand how the putable advance performs in different interest rate environments, and use its professional experience and knowledge to determine if the advance meets its needs and objectives.