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Best Online Savings & Money Market Account Rates 2024

Best Online Savings & Money Market Account Rates

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Financial Institutions: Complexity of Financial Risk Modeling

Complex financial modeling is at the heart of risk management and dictates how much capital banks, insurance companies, pension funds, corporations, and individuals need to hold in order to meet all of their financial liabilities. This topic is important to understand because it played an integral part in the massive financial destruction that was 2008.

Now before you run away from a seemingly boring and incredibly technical topic, I want to at least relay the importance of it. Complex financial modeling is at the heart of risk management and dictates how much capital banks, insurance companies, pension funds, corporations, and individuals need to hold in order to meet all of their financial liabilities. This topic is important to understand because it played an integral part in the massive financial destruction that was 2008. I would not be able to write a comprehensive article on financial modeling without approaching the size of a book, but what I will try to do is explain the principal components (no pun intended) of complex financial modeling and why it has to be so complicated.

The first and most important principal in financial valuations is that everything in the financial world is viewed as a stream of cash flows. The only thing that distinguishes between securities is how those cash flows are derived. The simplest type of securities from a valuation perspective are fixed income bonds. A coupon bond has a series of payments each year related to the coupon and one final payment of principal on the final maturity date:

BondCashFlow

Coupon Bond Cash flows (Assume 10% interest paid semi-annually)

The coupon bond is easy to value because all you have to do is discount the fixed cash flows at current interest rates to come up with the current value. Instruments become difficult to value when their cash flows are unknown and/or variable.

Equity prices can be considered the discounted value of both variable and unknown cash flows. A stock’s value is nothing more than the discounted value of all free cash flows that the company produces from now until infinity (assuming the company survives). Equity analysts spend incredible amounts of time forecasting cash flows and growth rates for individual companies going forward, just so that they can come up with what they believe is a discounted free cash flow “fair value”.

It might have seemed like I went off on a bit of a tangent with simple bonds and equities, but it is important to understand those concepts before we leap into the more complicated. The more complicated items include equity options, mortgage backed securities, collateralized debt obligations, etc. There are many hundreds of ways I can dice up the categories, but nearly every one of them has a common a element – Optionality.

Options, in this definition, make the value of the security depend upon some future observation of a market. I probably lost just about everyone with that statement, but give me a chance to explain. What if I said you needed to value a variable annuity in which the contract provides the policy holder a fixed stream of cash flows 20 years in the future and the size of those cash flows depends upon the level of the S&P 500 in 20 years? This might seem complicated, but in reality this is on the simpler side of options. What if the cash flows did not depend upon the return of the S&P 500 from now until year 20, but instead it was a series of resetting options for 20 years in which every year the gain was locked in and the option was reset? Even better, what if the options depended upon the average performance of multiple indices such as the S&P 500, Eurostoxx 50, and FTSE 100?

The bottom line is that there is no simple way of valuing complex options. It is not as if there is a simple equation defined for each exotic contract, therefore modern mathematical finance has used “stochastic” processes. A stochastic process is a set of random variables over time. In our case we consider the different markets that we trade in random processes with certain characteristics. By defining these markets as random processes, we can randomly draw an infinite number of paths for each market which allows us to value these “path-dependent options” across all possible market outcomes. As a result, we have a set of valuations across all possible market paths and if we discount all of those valuations to today and average the discounted cash flows we come up with the expected value of this complex option. This simulation process is called a Monte Carlo method.

The above rhetoric might be too much to grasp, but the bottom line is that complex options are valued by looking at the payout over a large number of theoretical market outcomes and then taking the average of those payouts.

A naive monte carlo simulation showing possible stock price paths

A naive monte carlo simulation showing possible stock price paths

I consider the above monte carlo simulation naive because it simply draws its returns from a normal distribution with mean 8% and standard deviation 20%. With a normal distribution I would never see a return as largely negative as 2008 at about -40%. Therefore there are many refinements that are done to the process to try to account for fat tails. Some have “regime switching” methods in which the model will flip from say an 8% return with 20% standard deviation world to a -10% return 30% standard deviation world. Other models will draw from actual historical observations to account for the actual tail returns.

Simple two regime switching equity model

Simple two regime switching equity model

It is not important to get into the details, but very important to point out some of the flaws. No model is perfect in producing returns that are real world equity returns. Likewise, it is even more difficult to produce random interest rate yield curves that are perfect Now let us take it one step further, how do you create random economic environments that are realistic?

This brings us to the real heart of what we are trying to achieve, and that is a measure of economic capital. How much capital does a firm need in the real world to cover losses under extreme economic environments? This question can only be answered by valuing both assets and liabilities through some sort of monte carlo simulation so that you know what the tail distribution looks for worst case asset/liability ratios. In order to do this, a firm must develop an economic scenario generator. Now we are getting complicated.

An economic scenario generator is just a complex multi-dimensional monte carlo simulation. I explained how important it was to have the correct assumptions and chosen model so that the simulation accounts for fat tails in equity returns, now we not only need fat tailed equity returns, but realistic assumptions for inflation, credit spread movement, interest rate curves and the correlations and interactions amongst all of these factors. Now you can see that the sort of difficult problem just became extremely difficult. This is an area of finance that is under heavy development but still in its infancy.

This complexity should segue into the bank failures during this last credit crisis. How could their models not have told them that the risks on their balance sheets were too much for the capital that they held? The answer is multi-faceted with reasons stemming from compensation plans to stockholder interests, but on the financial risk modeling side it was simple: they did not model it completely and if they thought they were modeling it well they either did not believe it or did a shoddy job of modeling. The underlying instruments such as the highly leveraged CDO’s were complicated enough to value by themselves, but when you put the whole mess together it was even more hopeless.

The positive spin is that 2008 has provided real world extreme market conditions that show just how terrible things can get. Previous to 2008, all financial companies relied upon rather muted historic data to “stress test” their balance sheets. In retrospect, we all know that using historic data did not show them the extreme stress test that these financial institutions would endure during 2008. Going forward, the banks will be sure to run their “2008 Scenario” first and foremost to test the strength of their balance sheets.


Savings, CD, and Mortgage Rates Hit Record Lows - Weekly Rate Update

Rate information contained on this page may have changed. Please find latest savings rates.

Savings rates stayed at the 52-week low last week, holding steady at 1.61% APY. One year CD rates took the steepest dropped by 1 basis point to a new BestCashCow low of 2.00% APY. According to the BestCashCow mortgage rate tables, the average 30-year fixed rate mortgage is below 5% at 4.957%. The fifteen-year fixed-rate mortgage average is 4.4%.

The Labor Department provided an early Holiday present today, providing a job's report that was far better than anyone expected. Yes, the economy still shed jobs, but only a seasonlly adjusted 11,000 in November versus projections of 100,000. The unemployment dipped for the first time in months, going from 10.2% to 10%. The employment news caused the dollar to strengthen and gold to plunge on expectations that the Fed may begin raising rates sooner than expected. Ironically, this has happened at the same time that savings rates, cd rates, mortgage rates, and muni bond rates are hitting multi-year lows. Coincidence? Probably not. The economy seems to have bottomed and rates are a lagging indicator. For savers, the night is darkest just before the dawn, and we may be seeing the faint glimmers of sun. For borrowers, the golden days may be coming to an end. If you were thinking of refinancing or buying a home, now is the time. Mortgage rates are at record lows and if the economy continues on its current trajectory, will begin rising soon.

CD and Savings Rates

Savings rates stayed at the 52-week low last week, holding steady at 1.61% APY. One year CD rates took the steepest dropped by 1 basis point to a new BestCashCow low of 2.00% APY. Three year rates actually rose by 8 basis points from 2.72% APY to 2.8% APY due to the addition of several new banks to the rate tables with aggressive pricing. Five year rates also increased by 2 basis points to 3.35% APY.

Looking at the yield ratio we have developed for deposit accounts, the spread the spread between savings rates and 36-month CDs reached a new all-time high. As we discussed, 3 year (36 month) CD rates rose due to aggressive pricing from several banks new to the rate tables. Nevertheless, the fact remains that longer-term CD continue to inch up even as savings rates remain steady or decline. If the economy continues to firm up, look for 3 and 5 year CD rates to continue rising and the ratio to go even higher.

It's still hard to recommend putting money into anything longer-term than a 12-month CD, especially with soaring equity markets and signs that the economy may be coming back to life. For those worried about interest rate risk, cd laddering may be a good way to smooth out the return you receive from your CD portfolio.

Mortgage Rates

Once again, savers' pain is a borrower's gain. Mortgage rates again hit record lows over the past week. According to the BestCashCow rate tables, the average 30-year fixed rate mortgage is below 5% at 4.957%. The fifteen-year fixed-rate mortgage average is 4.4%.

MortgageRateAnalysis

You can compare the best mortgage rates in BestCashCow's new mortgage section.


Savings Rates and Mortgage Rates at Record Lows - Weekly Rate Summary

Rate information contained on this page may have changed. Please find latest savings rates.

Savings rates hit a new 52-week low last week, falling by 1 basis point from 1.62% APY to 1.61% APY. One year CD rates took the steepest drop, falling by 7 basis points to 2.01% APY. Both three year and five year CD rates fell slighly, by 3 and 2 basis points respectively. The slow, painful downward trend continues.

This past week the discussion was on turkey and the start of the Holiday shopping season. Over the next couple of weeks we will see if consumer spending is as buoyant as the stock market. The early indications from Black Friday and the first shopping weekend is that consumers are out in force, but are not spending that much. According to data from the National Retail Federation Weekend Survey:

"...195 million shoppers visited stores and websites over Black Friday weekend, up from 172 million last year. However, the average spending over the weekend dropped to $343.31 per person from $372.57 a year ago. Total spending reached an estimated $41.2 billion.

“Shoppers proved this weekend that they were willing to open their wallets for a bargain, heading out to take advantage of great deals on less expensive items like toys, small appliances and winter clothes,” said Tracy Mullin, NRF President and CEO. “While retailers are encouraged by the number of Americans who shopped over Black Friday weekend, they know they have their work cut out for them to keep people coming back through Christmas. Shoppers can continue to expect retailers to focus on low prices and bargains through the end of December.”

Of course, comparing sales to last year is like comparing an ocean liner's maiden voyage to that of the Titanic. Everything is going to look better in comparison. I was out today at Best Buy and the store was busy, but not frenzied. The women at the cash register told me that there had been a steady stream of customers all day. We'll see if consumers are as ebbuliant as the markets and the Wall Streeters who are getting record bonuses this year.

The other big news for the week was the potential default of the Dubai World Fund on its $59 billion in debt. Now, let's put that into perspective. $59 billion is not that much money on a global basis and it will certainly be backed up by the United Arab Emirates. But it shows the fragility of the once high-flying emerging markets. If Dubai can get into trouble, it raises questions about other Gulf countries and other regions of the world with high debt ratios - what region besides Asia doesn't have high debt ratios? As revenue and collateral values plummet anyone can be exposed. The tied has gone out and now we're seeing who's left stranded on the beach.

Against this backdrop we did see some good news on the real esate front - I think. Home prices showed sustained improvement in the third quarter. That marks three straight quarters in which prices didn't fall as fast as they did in the past. Or in real esate parlance: The annual rate of return has improved from a -14.7% decline in the second quarter to a -8.9% decline in the third quarter." You can read the whole article here.

Existing homeprices also rose 10% in October according to the National Association of Realtors. But as Sam Cass notes in his article Existing Home Sales Rise 10% in October - Break out the Bubbly, be very suspicious of that number. Government steroids may be responsible for much of that gain.

It is against that backdrop that we dive into a review of Savings, CD, and Mortgage Rates:

CD and Savings Rates

Savings rates hit a new 52-week low last week, falling by 1 basis point from 1.62% APY to 1.61% APY. One year CD rates took the steepest drop, falling by 7 basis points to 2.01% APY. Both three year and five year CD rates fell slighly, by 3 and 2 basis points respectively. The slow, painful downward trend continues.

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Looking at the yield ratio we have developed for deposit accounts , we see that the spread between savings rates and 36-month CDs remains close to its 12 month high. While it has come slightly in the last few weeks, the ratio is still elevated relative to earlier in the year. This reflects the rate stability in longer term CD rates even as savings rates continue their glacial descent. The story is really the weakness in savings rates and the continued 0% Fed rate policy. That's driving the ratio. Banks are still awash in cash and cheap money from the Fed and the Fed's policy of keeping rates low for an extended period of time is going to drive this ratio higher.

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It's still hard to recommend putting money into anything longer-term than a 12-month CD, especially with soaring equity markets and signs that the economy may be coming back to life. For those worried about interest rate risk, cd laddering may be a good way to smooth out the return you receive from your CD portfolio.

Mortgage Rates

Savers' pain is a borrower's gain. Mortgage rates again hit record lows over the past week. According to the BestCashCow rate tables, the average 30-year fixed rate mortgage is now below 5% at 4.893%. The fifteen-year fixed rate mortgage average is 4.362%, at an all-time low.

You can compare the best mortgage rates in our new Mortgage section.