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However, it is still difficult to accurately measure the full exposure of prepayment or
option risk with income simulation. In addition, it does not fully address the effect on
net worth (value). Income simulation is highly dependent upon assumptions. The
longer the time frame, the more the results are influenced by these assumptions. Users
must specify what will happen to all the cash flows they receive in future periods. They
must incorporate their reinvestment decisions. In short, user bias can increasingly
affect the results.
In addition to measuring the short-term effect of interest rate changes on income, it is
equally important to measure the long-term effect on capital. Just as changes in
interest rates will cause stock and bond prices to fluctuate, changes in interest rates
will also affect the fair value of your credit union’s balance sheet. As noted earlier, an
increase in interest rates will typically cause a credit union’s existing loans (and
investments) to decline in value. The present value of your balance sheet
represents an estimate of the fair value of your credit union’s future earnings
over the life of the holdings (long-term measure). Credit unions should understand
this relationship. NCUA expects credit unions with greater risk to have more
sophisticated techniques for quantifying this relationship on their balance sheets.
Managing value in relation to risk will increasingly become more important and
significant as NCUA implements the system of “prompt corrective action (PCA),” as
promulgated by the Credit Union Membership Access Act.
Asset Valuation:
For credit unions lacking advanced ALM models, there are additional methods for
measuring interest-rate risk in mortgage loans. Using mortgage-backed securities as a
proxy, credit unions can obtain estimates of risk exposure on their mortgages. One
public source of this information is the The Asset & Liability Price Tables on the Office
of Thrift Supervision Website at http://www.ots.treas.gov/quarter.html. These tables
provide mortgage pool security prices at 100, 200, 300 basis point shock scenarios.
Industry recognized information providers also provide estimated price sensitivity of
individual securities.
Net Economic Value:
Net Economic Value (NEV)
3
measures the effect of interest rate risk on capital. NEV is
a solvency measure, but is also an estimate of the balance sheet’s future earnings
capacity. It measures the balance sheet’s value at a fixed point in time. Proper NEV
models capture principal and interest cash flows and provide an analysis of option risk.
Managing NEV reduces the volatility of earnings and net worth.
In short, NEV equals the fair value of assets minus the fair value of liabilities. NEV
calculations must also include the value of embedded options. Models that calculate
NEV compute the value of capital under current interest rates (no rate change) and
then under a “shocked” interest rate scenario. The variance between these two NEV
calculations represents the potential impact on capital if rates were to change. The
3. For a more extensive discussion of net economic value and the risk of mortgage-related assets, see the NCUA
Corporate Examiner’s Guide under Reference information at NCUA’s Website at http://www.ncua.gov.