| |
Interest-rate risk is the potential impact to a financial institution's future earnings and capital that may occur through changes in market interest rates. Interest-rate risk arises when an institution's principal and interest cash flows, both on- and off-balance sheet, have mismatched pricing.
Total balance-sheet management routinely involves decisions about the pricing and duration of loans, investments and their funding counterparts. These decisions affect the profitability of credit unions, adding to or subtracting from their capital. Substantial swings in interest rates can be a boon to credit unions, or a bust. To mitigate these interest-rate swings, credit unions have three options:
- Avoid risk altogether, an impractical goal that is also inconsistent with a credit union's charter.
- Modify the balance sheet, which is not always an easy task.
- Hedge the risk by transferring it to a third party through the use of derivatives.
The foundation of ALM First's hedging program is the analysis of a client credit union's balance sheet and the subsequent identification of its inherent market risk. Derivative instruments are used to realign risk to internal tolerance levels.
The models that ALM First uses in this program analyze the volatility of earnings (short-term perspective) and the [net] economic value of capital (longer-term perspective). The decision to hedge a portion of a credit union's balance sheet will rely on the results of the initial and ongoing NEV analyses, incorporating our knowledge about the credit union and its market, with our experience and understanding of valuing and managing option-embedded cash flow instruments.
|
