Understanding Policy Measures

Earnings at Risk Short term measure The change in the 12-month forecast financial margin including derivatives resulting from a 2 standard deviation change in interest rates where the base forecast is held constant. Recommended: The Earnings at Risk tolerance is limited to 6% of the book value of Capital. Roughly $1.5 million given current capital levels Currently risk level stands at 0.2% Approximately zero.

Earnings Risk 300 Interest Rate Paths

Earnings Risk 300 Interest Rate Paths

Earnings Risk 300 Interest Rate Paths

Earnings Risk 300 Interest Rate Paths

Duration or Market Value Risk Long Term Measure

Value at Risk – Long term risk The value of a fixed income security is inversely related to changes in interest rates. Intuitively, earning 5% on a security is more valuable in a 3% environment than it is at 7%. Therefore, the value (or price) of a 5% security would be higher than par (at a premium) if valued in a 3% environment, and less than par (at a discount) if 7%. The challenge with this concept is that it represents relative value unless the security is actually sold. In other words, the 5% is earned (excluding events of default) if held to maturity, thus, any loss measured at 7% need not be realized.

Value at Risk – Long term risk For a liability (deposit) the principles for determining value are the same as for assets in that price and rate are inversely related, but because liabilities are debt obligations, higher prices are not desirable. Paying 5% on a deposit is relatively more costly in a 3% environment than it is at 7%. In this case, a premium represents a premium expense rather than premium value.

Value at Risk – Long term risk The Credit Union holds both financial assets and financial liabilities We calculate the market value of all financial assets and liabilities relative to current market rates. The difference between the market value of assets and the market value of liabilities is the market value of equity

Value at Risk – Long term risk Simulations are run to estimate the change in value of assets and liabilities as rates change. The change in market value of assets minus the change in market value of liabilities equals the change in the market value of equity for a given change in interest rates. This is the basis for your market value risk policy where the change in the market value of equity for a 1% change in interest rates may not exceed 10% of the market value of equity. Current measure: 1.1%

Value at Risk – Long term risk In simple terms, this measure approximates the average life for which the credit union has invested its capital. If the measure is high and positive when rates are shocked lower, capital has risk similar to longer term bond investments, suitable if interest rates are expected to fall, stay unchanged, or not rise by as much as implied. If the measure is low or negative when rates are shocked lower, the average life of assets is similar to or shorter than the average life of liabilities, suitable when rates are expected to rise rapidly.

Long Term Risk Mismatch Report Duration of Equity Core Deposit Assumption = 5yr Duration

Interest Rate Swaps An agreement between two parties to exchange cashflows on predetermined dates based on a notional amount. No principal is exchanged. One party agrees to pay a fixed rate while the other party pays a rate that resets periodically

Swaps

Forward Rate Example 1.00% X% 3.00% 1year 2year 2.00% 2year At what rate ‘x’ would you be indifferent to either strategy ? By simple arithmetic, the rate is calculated to be ~ 3.00%. If you believe that one year rates will be lower than 3.00% in one years time, you should invest for 2 years in order to effectively “lock in” this rate

Swap Yield Curve Source: PRO Financial Solutions - ProCad Beta

Implied Forward Swap Yield Curves Source: PRO Financial Solutions - ProCad Beta

Questions?