Cost-of-Funds Index Swaps

Overview

Cost-of-Funds Index (COFI) swaps play a unique role in the realm of interest rate derivatives. They’re commonly used by mortgage lenders and financial institutions that reference COFI-based adjustable-rate loans. COFI is basically a measure of what it costs these institutions to obtain funds—think of it as a weighted average of the deposit and borrowing rates. In some regions, such as parts of the United States, the Federal Home Loan Bank (FHLB) calculates a widely recognized COFI.

At first glance, COFI swaps might feel like a niche product. But in the mortgage world, they’re a big deal. Why? Because an entire branch of adjustable-rate mortgages (ARMs) sets borrowing rates according to this cost-of-funds measure. If a lender’s incoming mortgage payments hinge on COFI, it certainly helps to be able to hedge or manage risk using a swap that references the same index.

To set the stage, let’s clarify the big picture: A COFI swap is structurally similar to a plain-vanilla interest rate swap. One side pays a fixed rate, the other side pays a floating rate tied to COFI. The end goal is typically to manage interest rate risk by matching inflows and outflows to the same benchmark.

I vividly recall the first time I heard about COFI swaps. I was sitting in a training session where a longtime mortgage banker said, “Well, I used to trade LIBOR-based swaps, but now our entire portfolio is moving toward these cost-of-funds ARMs.” It dawned on me that for institutions specifically reliant on local deposit markets, COFI is more relevant than global benchmarks like LIBOR or SOFR. Anyway, let’s delve deeper.

Key Concepts and Mechanics

What Is the Cost-of-Funds Index (COFI)?

The COFI is a measure of the cost that financial institutions incur to raise funds—via deposits, borrowings, or alternative sources—over a specific period. For certain U.S. regions (like the 11th District in the Western U.S.), the COFI is published monthly by the Federal Home Loan Bank of San Francisco. Here’s the tricky thing: COFI is often influenced by local conditions, deposit competition, and regional economic factors, so it might not move in lockstep with widely used global benchmarks.

COFI in Mortgage Lending

Adjustable-rate mortgages often reference COFI as the underlying index that determines when and by how much the mortgage rate resets. If you’re a mortgage lender, your inflows—those monthly mortgage payments—are pegged to COFI plus a margin. If you’re also funding yourself at deposit rates broadly reflected in COFI, your net interest margin might stay stable. But in practice, deposit rates can shift quickly. If you want to ensure your interest income is more predictable, you might enter a swap to convert the floating COFI-based inflow to a fixed rate.

Basic Structure of a COFI Swap

A standard COFI swap involves two legs:

1. The fixed leg: The swap’s fixed-rate payer (often the mortgage lender who wants certainty) agrees to pay a pre-agreed fixed rate to the swap counterparty.
2. The floating leg: The swap counterparty pays a floating rate indexed to COFI, typically reset monthly or quarterly, depending on the contract terms.

The net swap settlement is usually computed on a notional principal. There may be netting provisions—the party owing the larger sum pays the difference, simplifying cash flows.

Below is a simple representation of the cash flow structure in a COFI swap:

    flowchart LR
	    A["Mortgage Lender"] -->|Pays Fixed Rate| B["Swap Counterparty"]
	    B["Swap Counterparty"] -->|Pays COFI-based Floating Rate| A["Mortgage Lender"]

In many cases, the mortgage lender is long COFI (since mortgage receipts come in at COFI + a margin), so they become a fixed-rate payer in the swap, receiving the same COFI-aligned floating rate from the counterparty.

Rationale and Use Cases

For a mortgage lender with significant COFI-based ARMs on their balance sheet, the following scenarios often arise:

• They want to lock in a steady net interest margin. If mortgage rates on their portfolio are floating but deposit rates might also float (not always perfectly in line with COFI), the lender can swap its floating exposure to a fixed rate.
• Alternatively, an institution might pay floating (COFI) and receive fixed, depending on the mismatch in its overall asset-liability structure.

These swaps can also be used by real estate investment trusts (REITs) and other financial entities that want to hedge exposures related to COFI-based mortgage products or instruments.

Construction of the COFI Forward Curve

Valuing a COFI swap requires forecasting future COFI resets. However, unlike major benchmarks such as USD LIBOR or SOFR—which have deep futures and forward markets—COFI lacks a highly liquid standard forward curve. So how do practitioners estimate forward COFI rates?

1. Historical Analysis: Observing historical COFI movements relative to factors like local deposit rates, interest rate trends, and money market conditions.
2. Economic Forecasts: Incorporating macroeconomic expectations—think of central bank policy, regional economic indicators, and deposit competition.
3. Observing Marginal Cost of Funds: Analyzing deposit flows and short-to-medium term borrowing rates in local markets.

In practice, dealers might build a synthetic forward curve by splicing together deposit rate expectations, interest rate swap curves for more liquid benchmarks, and historical differentials. It can feel a bit like patchwork, but the goal is a best estimate of how COFI might evolve.

Valuation Methodology

Conceptually, COFI swaps are valued much like other interest rate swaps: each floating payment is discounted back using an appropriate discount factor. The difference is that the floating leg is pegged to COFI, so we plug in the estimated forward COFI rates.

Let’s denote:

• \( L(t_i, t_{i+1}) \) as the expected COFI rate for the reset period \([t_i, t_{i+1}]\).
• \( \delta_i \) as the appropriate day-count fraction for the accrual.
• \( D(t_i) \) as the discount factor to time \(t_i\).

If the notional is \(N\), then a single floating leg payment at time \( t_{i+1} \) is typically \( N \times L(t_i, t_{i+1}) \times \delta_i \). Summing all expected discounted floating payments minus the sum of the discounted fixed leg payments gives you the net present value (NPV) of the swap from the perspective of the fixed-rate payer or receiver (depending on which side you’re on).

Quick Mathematical Sketch for Valuation

The present value of the swap to the fixed-rate payer can be written as:

where

In an efficient market, at initiation for a par swap, \(\text{PV}_{\text{swap}} = 0\). Over time, changes in the forward COFI rate curve, discount rates, or credit risk perceptions will shift the swap’s fair value.

Real-World Example

Let’s do a quick scenario:

• You’re a mortgage lender, HelloBank, with $50 million worth of adjustable-rate mortgages, paying you COFI + 2.50%. So if COFI is 3% in a given month, you collect 5.5%.
• You’re worried that if COFI drops, your mortgage yields drop too. You want to lock in, say, a 5% yield for the next five years.

So you enter a COFI swap with a dealer:

• You pay a fixed 3% on $50 million notional.
• You receive COFI (currently around 3%) on the $50 million.

Result? Combined with your mortgages, you effectively lock in a 2.5% spread on top of your fixed 3% outflow, i.e., 5.5%. If COFI falls to 2.5%, you lose on the mortgage side, but you gain on the swap’s floating leg because you receive COFI (2.5%) while paying a fixed 3%. If COFI rises, the mortgage yield climbs, but you’re paying more via your swap. Net effect? More stable income, with minor basis risk if actual deposit costs differ from COFI.

Liquidity Considerations and Market Risk

COFI swaps lack the deep liquidity of mainstream interest rate swaps. This means:

• Wider bid-ask spreads: The difference between the price you pay to open or close a COFI swap can be costly.
• Limited secondary market: It might be trickier to offload or restructure a COFI swap partway through the contract.
• Possibly fewer dealers: Not all major banks actively make markets in COFI swaps.

This can be a big deal for hedge managers. If you’re used to large, liquid markets like SOFR, you might find the COFI space somewhat more “locals only.” On the bright side, for local or regional banks that consistently use COFI-based products, the smaller pool of counterparties still meets most of their needs.

Risk Management and Hedging

From a risk management perspective, a COFI swap helps isolate or mitigate interest rate mismatches. But it doesn’t solve every issue:

1. Basis Risk: Actual deposit costs might deviate slightly from published COFI, especially if your institution offers promotional deposit rates or has different funding sources.
2. Counterparty Risk: Like all swaps, you face the possibility that your swap counterparty might default. Clearing mechanisms or collateral agreements can mitigate this risk.
3. Regulatory and Capital Requirements: Regulators typically watch such swaps for potential systemic risk, requiring capital or margin if the swap is uncleared.

Example of a Simple Python Approach to Forward COFI Estimation

Below is a toy snippet to illustrate how you might build a forward curve for COFI using historical trends plus an economic shock factor. (Note: This is simplified and hypothetical.)

 1import numpy as np
 2import pandas as pd
 3
 4past_cofi = pd.Series([2.5, 2.6, 2.55, 2.7, 2.72, 2.65, 2.67, 2.70, 2.80, 2.90, 3.00, 3.05])
 5
 6np.random.seed(42)  # for reproducibility
 7future_cofi = []
 8last_value = past_cofi.iloc[-1]
 9for i in range(12):
10    shock = np.random.normal(0, 0.05)
11    next_val = last_value + shock
12    future_cofi.append(next_val)
13    last_value = next_val
14
15print("Projected COFI for next 12 months:", future_cofi)

In the real world, you’d incorporate macroeconomic forecasts, official rate guidance, deposit market conditions, and more to derive a forward curve in a coherent, intricately calibrated manner.

Common Pitfalls and Best Practices

• Ignoring basis risk: Even if your mortgages pay COFI + 2.50%, your actual cost of funding might not match COFI. It’s easy to underestimate how deposit competition can push your real funding costs away from the index.
• Overlooking liquidity conditions: If you decide to exit or restructure your swap early, you might get hammered by wide bid-ask spreads.
• Misaligned maturities: The maturity of your swap should match—or closely approximate—the maturity or reset profile of your COFI-based mortgage portfolio. A mismatch can introduce new exposures you didn’t intend.
• Credit concerns: Conduct an appropriate credit check on the counterparty. Even if the swap notional is large, you can mitigate risk with appropriate collateral or by using a central clearinghouse (if available).
• Operational complexity: You’ll need a robust back office to track monthly COFI resets, update valuations, manage collateral calls, and handle potential netting or tear-ups.

Regulatory and Reporting Considerations

In many jurisdictions, regulators have guidelines for how swaps, including COFI swaps, must be reported and margined. Institutions often come under:

• Collateral requirements: Uncleared derivatives might need initial and variation margin, especially for large exposures.
• Hedge accounting rules: IFRS or US GAAP might allow a special hedge accounting designation, but only if strict criteria are met (documentation, effectiveness testing, etc.).
• Qualified hedge treatment: For many mortgage lenders, achieving hedge accounting can smooth out earnings volatility. But any slip-up in the documentation or mismatch in hedge effectiveness can result in unwanted mark-to-market swings.

Exam Tips and Real-World Guidance

For exam success, particularly at the advanced levels, you’ll want to:

• Understand how a COFI swap is analogous to an interest rate swap but with a different floating index.
• Be able to explain how the forward COFI curve is built, especially given that it does not have broad liquidity.
• Evaluate basis risk and how it differs from a typical LIBOR- or SOFR-based swap.
• Remember the key formula for swap valuation. You’ll often see a question on test day about computing present values of fixed vs. floating legs—especially if you’re given a hypothetical COFI scenario.
• Show that you comprehend the credit and regulatory considerations around these swaps.
• Time management on an exam question might be crucial. They could present a scenario with a mortgage portfolio, a COFI-based ARM, and a potential swap transaction. You’ll need to quickly identify the type of exposure, propose the hedge, and do a partial valuation or a demonstration of the hedge’s net effect.

On a personal note, I once had a colleague who spent hours perfecting his answer to an exam question about a mortgage lender’s COFI mismatch, only to run out of time for the next constructed-response item. Don’t let that happen to you! Practice quickly discerning which formula or approach to use and move on once you’ve shown your work.

References for Further Study

• Federal Home Loan Bank of San Francisco: Historical COFI Data.
• Fabozzi, Frank J. “The Handbook of Mortgage-Backed Securities.”
• CFA Institute Level III Curriculum—particularly the swaps and risk management readings.
• Financial regulators’ websites for updated guidelines on margin and clearing requirements.

Master Your Knowledge of COFI Swaps