Pub. 7 2019 Issue 4

ISSUE 4. 2019 23 estimate the weighted average time until principal and interest are received. The calculation is based on the time value of money concept, which holds that a dollar today is more valuable than a dollar received in the future. In other words, the sooner a cash flow is received, the more valuable it is. Macaulay’s duration proved to be very useful in measuring price volatil- ity; however, it was proven to work only for instruments with fixed cash flow streams. This wasn’t a major concern until the ad- vent of option-related investments such as collateralized mortgage obligations (CMOs), mortgage-backed securities, and callable investments, which contain cash flows streams that can be dramatically altered by interest rate movements. These optionable investments can harbor a signifi- cant amount of duration uncertainty, which can then lead to an enhanced interest rate risk profile. To overcome this shortcoming, economists created the “modified duration” and, more recently, “effective duration” methods. Effective duration is the most ap- propriate when analyzing these option-re- lated instruments, but it’s far too complex to cover in this article. It was discovered that Macaulay duration could be modified to show the approx- imate percentage price change of a fixed-income investment when interest rates (yields) change. There are several properties of modified duration that are important to note. If all other factors re- main constant, the longer the maturity of a bond or loan, the greater the modified duration. Modified duration is important because it provides a convenient way to approximate portfolio price risk. For example, if your aggregated investment portfolio has a modified duration of 2.8%, this means that when rates go up or down 100 basis points (bps), the total value of the portfolio will depreciate or appreciate 2.8%. This example is provided for con- text and does not take into account the convexity profile of your balance sheet. In my prior life as an asset liability manage- ment consultant, I focused on creating duration (cash flow) certainty on both sides of the balance sheet for my clients. The first step in this process was typically to join a Federal Home Loan Bank. The reasons for doing so were innumerable, but one of the most important factors was the cash flow certainty of a FHLB bullet advance. In other words, the Macaulay duration is known at origination of the advance, and it only changes due to the expiration of time, not due to the movement of interest rates. Creating cash flow certainty on the liability side of the balance sheet, if properly struc- tured, should allow a bank to add some cash flow volatility (optionality) on the asset side to enhance return without adding unnecessary risk. Banks can purchase CMOs, MBSs and callable investments to improve investment portfolio yields. They can also begin offering longer-term loan products with variable options and terms to attract more residential and commercial real estate loan business. At a recent con- ference, I heard a speaker make a simple and important observation: “Yields are estimates, but cash flows are facts.” Duration is the catalyst behind the market value of equity (MVE) method of approx- imating interest rate risk that so many of you are familiar with. The principal be- hind the MVE calculation revolves around taking your entire balance sheet to market. The calculation is designed to approxi- mate the deterioration in a bank’s finan- cial condition due to an adverse movement in interest rates. Effective interest rate risk management requires managing duration of the loan and investment portfolios, as well as the funding base. The Member Solutions and Member Strat- egies teams at the FHLB Des Moines have powerful analytical tools that can assist your institution in evaluating strategic funding decisions and mitigating unwant- ed interest rate risk. They also have an extensive product knowledge base that can be leveraged to illustrate the benefits of us- ing specific advances to maximize income and hedge risk. The key is actively measur- ing and monitoring asset and liability cash flows to complement funding decisions that are based on scenario analysis and net interest margin management. n To discuss funding options and strategies, please do not hesitate to call your VP/Relation- ship Manager or email the Member Strategies team at: strategies@fhlbdm.com . Brad Spears is SVP/Director, Member Relation- ships for the Federal Home Loan Bank of Des Moines. Mr. Spears joined the Bank in 2015 and oversees a team of 10 relationship managers covering 13 states and over 1,350 members. Prior to joining FHLB of Des Moines, Mr. Spears was VP/Senior Portfolio Strategist at CNBS, LLC, a regional broker dealer locat- ed in Overland Park, KS where had worked since February 1997. While at CNBS, he was directly responsible for managing client fixed income portfolios on a non-discretionary basis. He developed investment policies, formulated strategies, determined appropriate asset alloca- tion and monitored client portfolios. Brad also conducted both economic and market research and presented the results to clients through original articles for publication and presenta- tion to various audiences. Brad earned a B.S. in Business Administration from Kansas State University in Manhattan, KS. Mr. Spears also previously held NASD series 7 and 66 registrations. Many prudent investment and asset- liability managers use “duration” to measure weighted average time of portfolio cash flows and the aggregate level of price risk harbored in their investment or loan portfolios.