Wednesday, July 1, 2009

Earnings at Risk (EAR) from the beginning

As we have been discussing, EAR is a measure of interest rate risk that measures the effect that interest rate changes might have on your next year's income.

If we look at the measure a little closer, we realize that it more accurately can be said to be a measure of the effect on net interest income, or financial margin. That is because the main things that effect EAR are those balance sheet items with interest rates. So, non interest expenses and revenues (like salary expense or fee revenue) usually do not impact on the calculation of EAR.

There are two measurement tools for EAR - gap and income simulation.

Income simulation is the better of the two approaches, but it is more complicated and asumption bound. Income simulation works by modelling the income statement and then seeing how the chnaging of rates affects the bottom line. It's a superior approach because it takes into account current yield curves and product growth. Obviously, both of those involve assumptions - what rate do you apply to mortgages maturing 6 months from now? Or how fast do you assume your premium savings account is going to grow. The answers will impact on your interest rate risk.

One of the problems with income simulation is that you can assume your interest rate risk away. For instance, assume you are exposed to falling rates. Falling rate exposures can be corrected by increasing the amount of fixed term mortgages (long assets) or variable deposits (short liabilities). So, if your model assumes a fast growth rate in these items - presto, no interest rate risk.

Income simulation assumptions are also work intensive. Every product must be mapped to how interest rate chnages affects that product's rate. Also you must specify that product's gowth rate and it's rollover assumptions. When a product like a fixed term mortgage matures, what term does the borrower renew at? One year? Five years? You must specify. Its very labour intensive.

Gap calculations were the financial industry's initial approach to interest rate risk. Gap is income simulation, without the growth rate, interest rate, and rollover assumptions. So its much simpler to calculate. That is actually a strength over income simulation, because you can't assume your interest rate risk away with gap.

However, gap's assumptions are pretty extreme. Gap assumes no growth and it assumes that anything that matures will rollover to the same maturity and to the term. So a mortgage with a remaining term of 3 months and a rate 3% over the current market is assumed to rollover to a three month term with the same very high rate (plus or minus the shock rate). Those are the exact assumptions that get corrected by using income simulation. Taht is why income simulation is the stronger approach.

There is an expression - Gap is crap - and there certainly is some truth to that expression. However, if done correctly, gap provides a very useful answer. We'll explore both opinions (useful or crap) in the next few posts.

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