Sources of Interest Rate Risk

Sources of IRR include:

Mortgage-Related Products

Mortgage-related products potentially create price risk within a loan pipeline, on a balance sheet portfolio of loans and investments, and in mortgage servicing rights. Interest rate changes affect not only current values, but also future lending volumes and related fee income. Some examples of the types of these activities are:

  • Long-term, fixed-rate mortgage loans

  • Long-term, fixed-rate investments (for example, MBS)

  • Variable-rate loans where the rate is based on a market index

  • Variable-rate loans with caps and floors

  • Asset-backed securities where the cash flows and maturity of the security vary as market rates change

See NCUA Letter to Credit Unions 10-CU-03, Concentration Risk , which discusses the evaluation of concentration risk as it relates to a credit union’s current balance sheet, how strategic plans may affect the level of concentration risk, and how to determine if risk management practices are commensurate with the level of risk.

Embedded Options

Embedded options associated with assets and liabilities can create IRR. Embedded options are features that provide the holder with the right, but not the obligation, to buy, sell, pay down, payoff, withdraw, or otherwise alter the cash flow of an instrument. Embedded options can create various risks, such as prepayment risk, extension risk, and negative convexity.

  • Prepayment and call risk increases when rates decline and borrowers can refinance at a lower rate, requiring a credit union to reinvest maturing proceeds at the lower current market rates.

  • Extension risk describes the increase in expected average life that results from a rise in market rates that, in turn, diminishes the incentive to call, refinance, or make other unscheduled principal payments. Higher rates will change the forecasted amount of call and prepayment options and lead to a longer expected average life than previously estimated. The lengthening of expected average life is called “extension.”

  • Negative convexity causes the duration of an option-based investment to lengthen when rates rise and shorten when rates fall. A negatively convex financial instrument’s price increases at a decreasing rate when rates decline; when rates rise, the price of a negatively convex instrument will decline at an increasing rate.

The holder of the option may be the credit union, credit union member, the issuer, or a counterparty. Many instruments contain embedded options that can alter cash flows and impact the IRR profile of the credit union. Here are some examples:

Instrument Details
Non-maturity shares Member depositors have the option to withdraw funds at par any time
Callable bonds The issuer has the option to redeem at a stated price all or part of a bond before maturity (based on contractual call dates)
Structured notes Options can vary by the type of instrument and may include step-up or step-down features, interest rate caps and floors, call features, and rules that change the priority and timing of cash flows received by different classes of investors within the deal structure
Wholesale borrowings Market lenders may have a right to call an advance before its stated maturity (requiring credit unions to repay the funding amount), or the borrowing credit union may have a right to prepay an advance early (allowing it to “put” back the funds before scheduled maturity)
Derivatives Purchasers of interest rate caps or floors
Mortgage loans Borrowers may have the option to prepay the loan partially or fully at par
Mortgage-backed securities Borrowers’ options to prepay individual mortgage loans included in an MBS loan pool can shorten the life of a tranche of loans within a security; some MBS are issued as structured instruments that add additional optionality

Non-Maturity Share-Based Funding Sources

Non-maturity share-based funding sources, which are a significant source of funding for credit unions, may increase IRR, especially when matched to a longer-term asset portfolio. For example, long-term, fixed-rate loans funded by member shares may involve repricing risk, basis risk, or yield curve risk. As a result, certain interest rate changes could increase funding costs while the yields on fixed-rate assets remain unchanged.

Derivative Contracts and IRR Hedging

Approved federal credit unions (and some state-chartered credit unions) can use interest rate derivatives to hedge IRR. Depending on the specific structure of the derivative, the instrument may create repricing, basis, yield curve, option, or price risk. Although derivatives can be used to mitigate IRR, they potentially expose a credit union to basis risk because the spread relationship between the cash instrument (that is, the hedged item) and the derivative instrument may change. For example, a credit union using interest rate swaps (priced off Libor or SOFR) to hedge its Treasury securities portfolio may face basis risk because the spread between the swap rate and Treasuries may change.

A credit union using derivative instruments, such as interest rate futures, swaps, and options, to hedge or alter the IRR characteristics of on-balance-sheet positions needs to consider how the off-balance-sheet contract’s cash flows may change with changes in interest rates and in relation to the positions being hedged.

Fee Income Businesses

Fee income businesses may be influenced by IRR, particularly mortgage origination and credit card servicing. Fluctuating interest rates can affect the volume and returns of these activities.

Product Pricing

Product pricing may introduce IRR, particularly basis risk or yield curve risk. Basis risk exists if funding sources and assets are linked to different market indices. Yield curve risk exists if funding sources and assets are linked to similar indices with different maturities.

Last updated on December 06, 2024