The Time Has Come: Interest Rate Modeling For Liability Cash Flow Analysis

Historically, interest rate models have largely been the domain of finance professionals with advanced quantitative degrees called “quants.” The mission of these financial engineers is often solely to accurately value interest rate sensitive instruments for the purposes of trading or risk management, usually within financial services firms. However, a frequently overlooked yet straightforward application of interest rate models is equally beneficial to those managing interest rate sensitive liabilities in the modern corporation.

Why interest rate models are not used more frequently is an interesting question with no clear good answers, though associated with some noteworthy observations. First, these models are largely misunderstood, described in antiseptic, stark, mathematical terms, and as such are thought of as inaccessible to most and generally too complex to use. In fact, those who understand these types of tools often possess an inherent bias against making them better known because that would only dilute the value of their hard won knowledge. Second, a model’s useful implementation often requires greater computing power and flexibility than the ubiquitous spreadsheet. Yet sadly for many finance professionals, the spreadsheet is the only flexible computational tool available. The third reason is more subtle and leads to an overlooked yet incredibly important simplifying assumption. This is explored in more detail below.

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