Wednesday, June 17, 2009

Interest Rate Risk - From the beginning

Let's step back and review interest rate risk from the beginning.

There are two types of interest rate risk measurements - Earnings at Risk (EAR) and Economic Value at Risk. In some ways they are polar opposites to each other, and yet they are also good complements of each other. A strength in one measure is a weakness in the other and vice-versa.

Both measures work with an assumed change in interest rates. There are numerous ways to do this, but the most common (and easiest) method is to assume that all interest rates change at once by exactly the same amount. That's called a parallel shock in interest rates.

The next question is how big a change? A one percent change is kind of the standard. Shocks greater than are pretty rare, but two percent is sometimes used as a worse case scenario. Many credit unions use smaller shocks for reporting to their regulators. 25 and 50 basis point parallel rate shocks are pretty common.

Other common rate changes include 'ramps' which mean a constant and steady change of rates over a period of time. 'Tilts' are like ramps, but the shorter rates move at a different pace or direction than the longer rates, resulting in a tilting of the yield curve. Ramps and shocks imply all rates move the same way - this assumption can also be relaxed. In fact, the possibilities are infinite - it's deriving some meaning from the results that frequently means using simple parallel shocks, or perhaps ramps.

Earnings at Risk (EAR)
This is the simpler of the two measures to understand. It measures how many profits the organization will make or lose for a given change in interest rates. The results from an EAR analysis are quite simple to understand. If rates move like this, profits over the next year will rise (or fall) by this many dollars. That kind of statement hits home to many credit union managers.

The measurement process is relatively simple, and closely related to doing a margin budget. Calculate how much you will earn/pay on each asset/liability based on current or forecasted interest rates. The total of earnings less payments is net interest income. (So far, that's analogous to a margin budget.) Now assume those rates change and recalculate net interest income. The difference between the two results is the EAR in dollar terms.

Economic Value at Risk (EVR)
Unfortunately, this form of interest rate risk has many names and even different methods of calculating it. Having stated that, they all ultimately translate into pretty much the same thing. So, to keep it simple, we'll just stay with EVR.

Economic value is somewhat similar to other valuation terms of an organization - market value or stock price, book value, liquidation value, going concern value. Basically you are trying to derive the value of the credit union. Subtracting liabilities from assets is one technique - that's the accounting book value. Economic value goes one step - it is calculated by subtracting the present value of all the liabilities less the present value of all the assets.

An EVR measurement states how much the economic value of the credit union will change for a given change in rates. Taking the present value involves an interest rate - in this case the rate on the specific asset or liability. And like EAR, you calculate a new economic value after changing the rates by a given amount. The difference between the two economic values is your EVR.

Comparison of EAR and EVR
EAR is concerned with risks to the next year's net interest income. EVR is concerned with risks to economic value of the credit union. It's something like owning a stock or bond. EAR is similar to a concern about risks of loss on interest or dividends. EVR is similar to a concern about risks of loss on the market price of the stock or bond.

EAR only considers the next year's income, so items with a maturity beyond 1 year have no effect on EAR. Variable items have the biggest effect on EAR. The shorter the term of a fixed item, the bigger the effect on EAR. The longer the term of a fixed item, the smaller the effect, such that after one year there is no effect on EAR.

EVR considers all items on the balance sheet, but variable items have almost negligible effect. The longer the term of a fixed item, the bigger the effect on EVR. The smaller the term of a fixed item, the smaller the effect on EVR.

So, to properly consider all the terms exposed to interest rate risk, you need to use both measures.

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