Pub. 8 2018-2019 Issue 2

O V E R A C E N T U R Y : B U I L D I N G B E T T E R B A N K S - H E L P I N G C O L O R A D A N S R E A L I Z E D R E A M S September • October 2018 19 5 4 3 2 for every decision and compare alternatives across this same set of scenarios to determine when and where one choice will turn out more favorably, and by how much. This goes a long way towards eliminating surprises. Once you have your choices laid out across multiple scenarios, resist the very natural desire to “average” these outcomes into a single ranking “number.” This common misstep eliminates nearly all the value you’ve gained with multiple scenarios. Net Future Value is What Matters Time’s passage is inevitable and the key ingredient of net interest income. For this reason, net future value is far more important than net present value. Yield, internal rate of return, and duration are all calculations for the present, not the future. Do you realize that if a 30-year mortgage’s duration is 5.5 years today, in twelvemonths, it is likely to be 5.5 years? Isn’t that a future value you want to be alert to? Assets earn money over time, and they can also evolve through time. Looking to what that asset will provide in accumulated earnings and residual value at some reasonable future date would be more telling than its nature today, which is, after all, something you already know. Finding a Common Denominator is Essential Longer cash flow instruments offer more reward, and carry more risk, than shorter cash flows. But how does one compare the risk versus reward trade-off of two unlike things? All cash flows, both before and after your selected future date, must be accounted for. These cash flows – and those of any alternatives –must be treated on the same terms in order to adequately make comparisons. In ALM, we are required to evaluate income simulation over a year or two, and EVE based on an instantaneous rate shock. The former ignores later cash flows that are already set, and the latter makes no provision for the passage of time. Did you ever wonder why it is im- possible to reconcile these two metrics? The answer is that they have no common denominator. A total return analysis to a future date is one approach to resolving this. Combinations Reveal Potential Opportunity If we make every decision on a stand-alone basis, we are sentencing ourselves to mediocrity. If no line item on our balance sheet can ever look bad, they’ll never look good, either. Sometimes, two risks make a reward. Consider the barbell strategy: in some yield curve envi- ronments, a combination of short and long assets will deliver more return together across multiple scenarios than will intermediate maturity choices. The challenge is that depending on rate moves, one of these strategy legs – long or short – could wind up looking worse than the intermediate option. Only by understanding that the combination of short and long can still outperform the intermediate in this case couldwemake a better decision. Appropriate Confidence is Key Inappropriately low confidence leads to inaction and missed opportunity. Inappropriately high confidence In ALM, we are required to evaluate income simulation over a year or two, and EVE based on an instantaneous rate shock. The former ignores later cash f lows that are already set, and the latter makes no provision for the passage of time. Did you ever wonder why it is impossible to reconcile these two metrics? The answer is that they have no common denominator. A total return analysis to a future date is one approach to resolving this.