A Guide to Managing Interest Rate Risk Plans: Rational - and Irrational - Decision Making; It's Tough to Know When to Change Course, When to Panic, When to Call for Help

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Today's volatile and uncertain financial environment demands, and indeed some regulatory bodies require, boards of directors and other management to develop policies and procedures for managing interest rate risk. Within an overall interest rate risk management program, the decision-making process reinfluenced by two distinct, yet coexisting, sets of factors. Both eventually demand attention from the decision-making body.

The more obvious of the two is the set of financial, or market-related, factors. Ideally, all interest rate risk management decisions should be based on fundamental economic analysis and social and political factors.

Together, these two factors may be useful in setting longer-range goals and objectives of the interest rate risk management process as well as longer-range management policies. Other factors influencing management decisions include balance sheet (gap) analysis and risk quantification.

Rate adjustment interval and maturity mismatches and balance sheet risk centers are identified. Then, given alternative interest rate scenarios, the risks and rewards associated with maintaining a particular balance sheet structure can be quantified.

If management and the board are bothered by the risk/reward Tradeoffs, alternative strategies for managing those risks should be identified and evaluated based on the relative merits of each and the ability of management to implement each strategy.

Technical analysis of individual financial markets on an on-going basis as selected risk management strategies are actually implemented.

Accounting and reporting requirements may influence the timing and implementation of specific hedge strategy decisions. The recent release by the Financial Accounting Standards Board (FASB) of its Statement of Financial Accounting Standards (SFAS) No. 80 creates the need to carefully consider this factor.

Management's consideration and analysis of these market-related factors will often result in the development an on-going evaluation of an overall interest rate risk management program. Euphoria and Panic

However, the second set of factors influencing interest rate risk management decisions is typically not addressed until risk management strategies are actually being implemented.

This set concerns nonmarket, and often nonrational, issues. Primarily, these include the emotional reactions of board and management to rapid, and often adverse, changes in the financial environment, especially as they affect past and present interest rate risk management decisions.

It is very easy to second guess decisions when one has the benefit of hindsight. Too often there is the temptation to say "If only we had done this..." or "If only we had waited..."

It is critical to remember that each interest rate risk managment decision is based on the information at hand at that point in time and that each is based on the most acceptable combination of risk/reward tradeoffs and their associated probabilities of occurrence. There are no zero-risk alternatives.

Perhaps the most difficult environment for a risk manager to deal with is one in which the futures hedge position has an unrealized loss that, at the moment, exceeds the change experienced in the cash item being hedged. It is at this point that board and management begin to almost exclusive focus on the loss in the futures position in much the same way a speculative trader would.

As a result, the institution loses its overall interest rate risk management perspective. Unfortunately, discomfort often peaks at the financially worst moment to make a hedge strategy management decision.

In this kind of environment the risk manager must constantly remind himself of his hedging objectives. It is prudent to review the factors that prompted an expansion of conventional asset and liability management activities to include an interest rate risk management process. …