Consulting Corner

Adjusting Assumptions to Market Conditions
    By Lily H. H. Chu

In an environment plagued by unprecedented low interest rates, record prepayment speeds and new and untested investment structures, the risk of trading losses and mis-statement of portfolio values is at an all-time high. While there are state-of-the-art analytic and system tools to monitor these investment risks, the complexity of these systems can lead to costly misapplications. As the market environment changes, the systems and analyses upon which investment and risk managers rely must be kept up to date and their applicability ensured.

Shortfalls that most commonly occur with investment systems are threefold:
    1. Use of inappropriate analytical approach
    2. Use of inappropriate analytical tools
    3. Improper use of analytics, reliance on bad assumptions

Significant changes in the market environment have increased the potential for the third shortfall to occur. The risk of using out of date assumptions and system defaults can be costly. Oftentimes, reports and analyses are set up such that they may be run on a regular basis, as mechanically and simply as possible. This means having systems flexible enough to allow for changes to assumptions, but facilitating running the analyses by setting up default levels for those assumptions. However, once market conditions change, those default levels may no longer be applicable. In times such as these, with interest rates well in the single digits across the curve, and short volatilities hitting 60%, the setups and assumptions underlying those reports must be reviewed for currency.

Small changes in assumptions that underlie analyses, such as volatilities, prepayment speeds and interest rate models, can have a dramatic impact on asset and hedge valuation. Following are some examples of how changes in assumptions can impact risk and return analyses.

Volatility

For securities with option components, the volatility assumption is a key factor in valuation. >>>