Abstract
The marketization of interest rate is an inevitable requirement for China’s financial reform and joining the WTO to connect with the international financial market. It is also an important link to improve the marketization degree of China’s financial system. The marketization of interest rate in China is gradually advancing according to its preset mode. In the process of interest rate marketization, an unavoidable problem is that while the interest rate marketization gives the commercial banks the autonomy of capital pricing, the fluctuation of interest rate is more and more frequent. However, due to the fluctuation of interest rate, the loan as the main assets of commercial banks will be prepayed by borrowers, and the time deposit as the main liabilities of commercial banks will be withdrawn by depositors in advance; that is, embedded options are implied in asset liability items, which makes it difficult for commercial banks to accurately calculate the actual interest margin of deposits and loans and manage the interest rate risk. Therefore, it is of great significance to identify and price such embedded option value. On the basis of identifying and decomposing the embedded options in deposit and loan of commercial banks, according to the change characteristics of deposit and loan interest rate of Chinese commercial banks, this paper chooses jump-diffusion interest rate model to describe the change of benchmark interest rate of deposit and loan in China and demonstrates the advantages of this model compared with other models. Based on Monte Carlo simulation technology, the embedded options of five-year fixed deposit and ten-year prepayable loan in China are priced. On this basis, it points out that the real interest margin of commercial bank’s deposit and loan should be the nominal interest margin minus the value of deposit and loan’s embedded options. In the process of interest rate risk management, we should pay attention to the existence of embedded options and carry out effective management.
Highlights
Embedded options refer to the options embedded in bank assets and liabilities
Time deposits can be divided into a fixed claim and several American interest rate call options. e necessary condition for the execution of the embedded option in deposit is that the interest rate rises, and the more the interest rate rises, the greater the possibility of the option execution
The possibility of option execution decreases with the passage of time, generally only in the early implementation
Summary
Embedded options refer to the options embedded in bank assets and liabilities. When the interest rate fluctuates greatly, the customers of the bank will exercise the option implied in the assets or liabilities for the purpose of selfinterest (such as prepaying the loan or withdrawing the time deposit in advance), bringing uncertainty to the bank’s income [1]. is uncertainty obviously constitutes a source of risk, which is called “embedded option risk.” With the advancement of interest rate marketization in China, financial derivatives with interest rate as the subject matter are increasing. Erefore, it is of great significance for China’s commercial banks to study the pricing technology of embedded option implied in the assets and liabilities of banks and other financial institutions in terms of product development and risk management. Zheng and Lin [14] proposed a new standard to measure the impact of embedded options on bond interest rate risk and used the binary tree model to make an empirical analysis on the callable and resolvable financial bonds issued by China Development Bank. Yang [16] focused on the effective duration and effective convexity model based on embedded option and option-adjusted spread and studied its specific application in the interest rate risk management of commercial banks in China. Xia et al, [23] priced the deposit and loan with embedded options, and on this basis, they analyzed the impact of embedded options on the interest rate risk management of commercial banks. Based on its own advantages, the Monte Carlo simulation method can solve multidimensional securities pricing, which will become the development trend of this kind of financial product pricing
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