Many risk managers try to prepare for things going wrong.Google tackled the problem of protecting itself if things goright—if the global economy turns around and interest rates headhigher. The company had invested in agency mortgage-backedsecurities (MBS) because of the relatively attractive yields(1.5%-2%) and if rates rise, it was looking at a potentially largedrop in the value of those investments.

“When the Fed raised the overnight borrowing rate from 3% to5.5% in 1994,” notes Hui-Chien Chang, director of the portfoliomanagement group, “the Barclays' U.S. aggregate bond index had adismal return of -2.94%.” That was not the kind of loss Googlecould accept.

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Like any fixed-income security, MBS prices move inversely tointerest rates, so rising rates depress prices. Agencymortgage-backeds have little perceived credit risk because they areissued by agencies of the U.S. government, but they have prepaymentrisk. The securities are backed by home mortgages and homeownerscan pay off their mortgages at any time, so the duration is notfixed. Higher rates would discourage prepayments, lengthening theduration of the securities and making their price drop even more.Google needed a hedging strategy and an appropriate hedginginstrument.

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It found its hedge in the to-be-announced (TBA) market, which isliquid and transparent. In a TBA trade, a buyer and seller agree ongeneral terms such as the type of security, the coupon, face valueand price, but not the specific pool of mortgages. Trades settleonly once a month. Until two days before settlement, sellers arefree to choose which pool of mortgages to offer, so naturally theypick the worst-performing pool. This worst-to-deliver option isunderstood and priced into the trade.

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TBA contracts work as hedges because if rates rise and mortgageprepayments slow, the value of the underlying MBS pool would dropbut the payoff from shorting TBA contracts would generate positivereturns to offset that drop, explains Aditya Agrawal, asenior portfolio analyst. Google also mitigates credit risk bynegotiating collateral postings with its counterparties, headds.

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While this approach creates good economichedges, they don't qualify for hedge accounting treatment, Agrawalexplains. As a result, the mark-to-market value change of theTBA hedges flows through the income statement without any offsetfrom the changes in the underlying MBS portfolio, which arerecorded on the balance sheet. Thus, a key constraint is “to managethe risk of the hedging program and control the accountingmark-to-market volatility associated with it,” he says.

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Google also hedges by selling forward specified pools ofmortgages that are revealed to the buyer before the sale. Becausespecified pools are usually of better quality than pools deliveredto settle TBA contracts, they are priced at a premium over TBAprices, Chang says.

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Because Google's investment strategy is a hybrid of relativevalue and absolute return, having a hedging tool “helps us managethat dual mandate in a rising interest-rate environment,” saysassistant treasurer Tony Altobelli. For operational efficiency,treasury systems helped the hedgers build a fully integrated userportal.

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“During a rising rate environment, it becomes critical toprotect our portfolio returns,” Chang says. “Our hedging strategyalready proved invaluable during several instances when marketswere volatile and we needed to tactically manage our risk.”

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See a slideshow of the 2012 Alexander Hamilton Award winnershere.

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Read about the Microsoft project that won the Silver in theFinancial Risk Management category here, the Ford Motor project that won the Bronze here, and the FLIR Systems project that won the Editors' ChoiceMiddle Market Excellence Award here.