Assumptions

Projected interest rate assumptions are a critical part of measuring IRR and may be generated from internal analysis and/or external sources. Internal interest rate forecasts, which may be derived from implied forward yield curves, economic analysis, or historical regressions, should be documented to support the assumptions used in the analysis. Key rate assumptions that should be considered include relevant market rates, repricing rates, replacement interest rates, and discount rates.

Assumptions are postulations about interest rates, member behavior, and economic factors that are used in IRR measurements. Assumptions used to assess the interest-rate sensitivity of complex instruments (such as those with embedded options) and instruments with uncertain maturities (such as NMS) should be subject to rigorous documentation and review, as appropriate for the level of risk and the size and sophistication of the credit union. IRR measurements rely on assumptions about key parameters, such as:

• Projected balance sheet volumes

• Prepayment rates for loans and investment securities

• Repricing sensitivity

• Decay and Beta rates of NMS

• Projected interest rates

• Discount rates versus offering rates relationships

NMS decay rates and repricing sensitivity (Rate Sensitivity Factors or Beta) are commonly the most difficult assumptions that management makes when measuring IRR exposure. These assumptions are critical, particularly in market environments in which member behaviors may not reflect long-term economic fundamentals, or in which credit unions are subject to more competition.

These assumptions can have a significant impact on the measurement system’s output, so it is crucial that they be reasonable and supportable.

It is important that material assumptions be updated regularly to reflect the current market and operating environment and in response to sensitivity analysis. Furthermore, the process for developing material assumptions should be formalized and periodically assessed (at least annually for critical assumptions). This periodic assessment of the information and processes used to generate assumptions may prompt management to reevaluate its assumptions to better reflect current strategies or member behaviors.

However, before changing key assumptions that can materially alter measurement results, management should conduct thorough due diligence. Key assumption changes should be properly documented and reviewed by the board of directors and/or ALCO.

Last updated on December 06, 2024