Projecting future net income as a financial management device has been around for a long time. Measuring option risks, and thus the market value of portfolio equity, as a distinct financial management benchmark emerged only in the mid-1980s.
Financial institutions still tend to favor using net interest income simulation to formulate financial decisions, although it does not rigorously capture option values.
It is easy to understand this preference.
*Financial managers, board members, stock analysts, and shareholders understand net interest income clearly. They are conditioned to think about income relative to equity and assets as the keys to success or failure.
*Held-to-maturity accounting prohibits selling financial assets before maturity.
*Bonuses are almost always based on some variant of income performance.
With these incentives, many financial institution managers allow themselves to argue, "I am holding this bond to maturity; all that matters is net interest income."
They need to understand that measuring market value of portfolio equity allows better management of such income.
Market-value portfolio equity is the option-adjusted discounted present value of future cash flows under a wide variety of market scenarios. It takes into account market volatility, implied forward rates, and correlation between cash flows and changes in forward interest rates.
This approach measures true economic value, including the value or cost of embedded options.
Net interest income, a conceptual and data subset of this approach, is derived from zero-volatility projection of cash flow. However, volatility is not zero!
Net interest simulation lacks the analytical rigor to evaluate the economic consequences of volatility-sensitive cash flows. This technique usually makes currently high-yielding instruments look more attractive and lower-yielding investments less attractive, since high yields often come as compensation for selling options (assuming yield-curve risk or negative convexity).
On average, the investor will pay later for risk assumed today. The question is, how much?
Asset-liability managers, treasurers, and CFOs do themselves and their companies a great disservice by failing to integrate net interest income and market value of portfolio equity. It is simply wrong thinking to view market value merely as "something we do for the regulators."
Overreliance on net interest income to the exclusion of market- value analysis leads to performance problems - in particular, paying too much for assets that create short options positions. The institution in this case is like an insurance company whose premiums are too low for its risks.
Consider a simple case:
During a positively sloped yield curve, many institutions use one-year borrowings to purchase longer-duration mortgage-backed securities and callable notes to enhance income. Wall Street is willing to help lever this bet by providing repo funding to purchase even more long-duration assets.
Net interest income simulation would portray good results for this strategy for at least the next year, regardless of what interest rates do. And management bonuses will look good.
However, if rates rise, reduced or negative income will result. If rates fall, assets prepay and income also falls. In these cases, interest rate volatility can lead to career volatility.
Market-value analysis would provide a warning of impending problems by showing shrinking profits in mark-to-market terms. Rigorous market- value analysis as the "central theme" for financial modeling provides a means to optimize investment, funding, and hedging strategies from an economic perspective. Combining the market value and net interest income approaches matches risk premiums received to risk assumed over time.
Financial institutions today are making decisions in an environment with two major trends:
*Accounting rules pressuring full market-value disclosure.
*Intense competition and consolidation creating unrelenting earnings pressure.
An essential part of any financial management plan should be simultaneously and consistently measuring and managing net interest income and the market value of portfolio equity.
Mr. Moore is executive vice president and treasurer of the Federal Home Loan Bank of Chicago.
Mr. Colvin is president of Pinehurst Analytics, Chapel Hill, N.C., a consulting and software firm. The bank and the firm have developed an automated system that combines the analytical techniques discussed in this article.