Evaluating Derivatives―Part IV: The Relationship Between Value and Cash Flow
February 19, 2015
Our last post on derivatives explored the relationship between rate shocks and changes in value. Inherent to this was a caution that improvement in value due to changes in the implied path of interest rates doesn’t guarantee cash flows will be positive in the future.
The economic value analysis is typically limited to assuming an implied path. When performing cash flow tests (earnings), however, that limitation is not necessary or warranted. Since there are virtually an unlimited number of paths that can occur, consider paths that could expose risk. Recent history has demonstrated that the risk of rates remaining flat should not be ignored.
Forward curve analytics provided by The Yield Book® Software.
For each rate environment, communicating the potential of rates going to that level and staying there can often expose potentials that won’t be seen from the economic value. Note that in this example, while rates change instantly, the earnings lag the initial year due to the quarterly reset.
Note: $s in 000s
It can also be beneficial to understand the impact of rates changing over time. Consider the difference of a 12-month rate change.
Note: $s in 000s
Note in this example that, if rates ramp up 200 bps over 12 months and stay at that level, the credit union earnings from the derivative do not break even until the 6th year. This is in contrast to the +200 instant change showing a break even in the 3rd year.
In order to reduce the risk of being blindsided from an earnings perspective, institutions should review the earnings potential of rate shifts that hold steady at the simulated level. Institutions should also understand the potential impact of slower rate changes.
Compare this to the economic value displayed in the previous blog where there is no hurt in the current environment and there are material gains in the other environments.
Derivatives analytics provided by The Yield Book® Software.