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The Twisted Yield Curve Scenario: A building block to better balance sheet management

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BY BRITTANY ROLLEK

A base ALM model is useful, but it doesn’t give credit unions the full market rate picture. That’s where the twisted yield curve steps in and fills the gaps. Keep reading to learn how such sensitivity analysis can help your CU comprehensively manage its balance sheet.

Apart from being a common regulatory request, modeling the balance sheet’s sensitivity to the yield curve via a “twisted yield curve” scenario is a valuable analysis for comprehensive balance sheet management. While the base ALM model assesses present value, projected earnings and their volatility in parallel shocks to market rates, a twisted yield curve scenario measures the sensitivity of the risk position when interest rates move in a non-parallel fashion. Because actual market rates typically don’t move in parallel shifts, modeling this kind of change helps illustrate how the interest rate risk position might look in a different economic landscape, all else being equal. It can also highlight how different financial instruments are affected by movements in specific sections of the yield curve. Understanding yield curve sensitivity is essential to the greater task of strategy development. It’s also critical to building a balance sheet that doesn’t leave the institution exposed to one directional risk.

The shape of the yield curve at any given time expresses market expectations of both the macroeconomic outlook and the future path of interest rates. In a normal market environment with an upward sloping yield curve and strong growth expectations, the opportunity cost of investing long versus holding cash is relatively high, pushing demand into short-term instruments and widening the spread between short- and long-term yields. In market environments where this spread tightens, there is either a lack of confidence in long-run economic growth, or short-term rates have increased relative to long-term rates, driven by events such as a tightening in monetary policy. In some cases when the future economic outlook is very poor, long-term yields can drop below short-term yields. Extreme demand for long-term investments under the expectation that rates will be much lower in the future precipitates such a downturn. Typically, this type of environment is corrected back to a normal rate environment, albeit usually at lower overall yield levels.

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