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Measuring and Monitoring Interest Rate Volatility

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BY ALEC HOLLIS

A vital component in managing your credit union’s balance sheet is measuring and monitoring interest rate volatility. But that task can be more complicated than it sounds thanks to widely varying perspectives of market volatility. Experts on the subject break the matter down for your CU.

2015 has been tumultuous for financial markets, with significant volatility occurring in the interest rate, equity and commodity markets.Substantial uncertainty over China’s persistent weakening economy and its impact on the United States led to a miniature market shock in the third quarter, palpable in the market volatility it caused during that time frame. Market volatility is a symptom of stress in financial markets,so understanding how to measure and monitor volatility, particularly interest rate volatility, yields important insight necessary for managing a balance sheet.

There are two primary perspectives of market volatility: implied and historical.Implied volatilityis the volatility assumption based on an option’s market price.It is a forward-looking measure, representing an expectation of future volatility.To calculate implied volatility,the market price of the option is entered into an option-pricing model, and the volatility assumption that yields that market price is outputted.Monitoring implied volatility is vital to determining the richness or cheapness of an option; greater implied volatility indicates a richer valuation and vice-versa.

Historical volatility refers to ex-post, or after the fact, volatility.It is realized, actual volatility and therefore is backward-looking.It is typically measured in annualized standard deviation based on continuously compounded daily changes in yield, using the convention of 250 trading days.It gives no insight into directional movement; however, increases in historical (and implied) volatility tend to represent market stress.

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