Since January 2009, the average level of the effective federalfunds rate has been approximately 0.18% with a standard deviationof 0.14%. This data emphasizes information already known throughoutthe financial industry: Interest rates have been flat for a long,long time.

For the eight years prior to 2009, effective federal fundsaveraged 3.27% with a standard deviation of 1.87%. From 1990 to2009, the average rate was 4.26%, with 1.89% standard deviation,indicating that rate volatility has declined significantly in thepast seven and a half years.

Until recently, the average effective federal funds rate hasbeen flat – and had been for a very long time. Credit unions andother depositories have been attempting to estimate the path offuture interest rates to protect their balance sheets from adverserate movements. It's imperative to assess interest rate riskappropriately because it is one of the most critical variables invaluing a credit union's balance sheet. At a minimum, it would beprudent for institutions to project performance assuming ratesreturn to historical tendencies.

Ultimately, institutions fail because they can't project therisk inherent in the portfolio. Financial modeling is central tomanaging any financial institution, but inadequate modelsophistication and poor assumptions can significantly underestimaterisk. Although financial models can't completely insulate a creditunion from risk, sound modeling can greatly reduce the potentialfor catastrophic failure.

Using Modeling Tools

The first step in protecting the credit union is to select anappropriate risk model. Management should strive for modelcomplexity that is equal to the institution's balance sheetcomplexity. For credit unions with a significant residentialmortgage portfolio, it's especially important to consider adoptinga stochastic model to calculate optionality. Residential mortgageborrowers possess a valuable call option on rates, which isn't asprevalent in other loan products. Given the market rates, the valueof a mortgage option may not be significant as the refinanceincentive is low for most newly originated mortgages. This maydeter some institutions from taking steps to calculate a moreprecise option value; however, capturing optionality is a criticalcomponent in the design of hedging strategies.

Beyond offering the ability to perform intricate calculations toensure more precise analytics, an advanced model can provide creditunions with significant resources to aid in strategic planning. Inaddition to interest rate risk, they face credit and liquidityrisk, as well as a multitude of esoteric factors. An advanced modelwill project credit losses for the life of a loan to estimate thecredit risk inherent in a portfolio. These assumptions will alsoaid in projecting an institution's liquidity for a more holisticview of the major risks facing any depository.

Sophisticated modeling software can also be used to estimateprobability of rate movements, allowing balance sheet strategies tobe adaptive toward the market environment. Stochastic modeling usesMonte Carlo simulations (originally developed by gamblers) toproject the path of interest rates through time. While thesesimulations are necessary to value optionality in a portfolio,Monte Carlo simulations can be expanded to provide an estimate ofthe progression of interest rates. With a well-calibrated model,the Monte Carlo simulations will project the path of interest ratesover multiple iterations through time. This enables a credit unionto discern the assumed probability of a specific index increasingor decreasing a particular amount at a given time.

The reliability of the Monte Carlo simulations in such cases isdriven by the underlying assumption of the model. For example,assumptions ranging from the number of iterations each simulationperforms to the model's volatility surface can influence theresults of the simulation. Since assumptions can have such animpact on results, it is critical to frequently validate the modelbeing used. If the underlying assumptions are deemed reasonable, aninstitution can use the results of the probability estimation toinform balance sheet strategy to mitigate interest rate risk.

Reporting Interest Rate Risk

Many metrics are used to report interest rate risk, but one thatis most frequently referenced is effective duration. Effectiveduration is the price sensitivity of a security, given a change inunderlying interest rates. However, the calculation for effectiveduration, while commonly referenced, has some flaws. Thecalculation itself is precise when the observed rate changes haveonly small variances. As market rates become more volatile,duration analytics lose precision.

Another shortcoming of effective duration is the assumption thatmarket rates move in parallel fashion, which can be a significantshortcoming when trying to develop a hedging strategy. Since ratesrarely, if ever, move in a parallel fashion and long-term assetscan be sensitive to multiple points along a yield curve, key rateduration analytics are more appropriate to understand the truenature of a portfolio's sensitivity.

Key rate duration reports a security's sensitivity along theentire yield curve by isolating each point along the curve andvaluing the security as a single point is adjusted up and down.This results in a significant amount of processing time,emphasizing the need for a sophisticated model. With the resultingkey rate durations, a credit union can more efficiently hedge thebalance sheet. Key rate duration analytics guide the institution tothe appropriate notional allocation for interest rate swaps. Bydoing so, the balance sheet is better protected against parallelinterest rate moves and changes in the slope of the yieldcurve.

Many factors can affect a credit union's capital position, andinterest rate risk is only a single factor. However, it's one thatmay be mitigated easier than in the past and shouldn't beoverlooked. Instruments like interest rate derivatives are moreprevalent and accessible today than in previous years. Suchproducts are available as tools to manage an institution's interestrate risk. The first step to hedging risk is to understand thecredit union's risk position. Understanding and trusting theaccuracy of risk reporting will not occur unless a well-rounded ALMprocess is developed with a model that matches the institution'sbalance sheet complexity.

Thomas Griswoldis Director, Strategic Solutions Groupfor ALM First Financial Advisors. He can be reachedat 214-451-3491 or [email protected].