Risk-Adjusted Pricing of Bank's Assets Based on Cash Flow Matching Matrix

Abstract

To price bank’s assets correctly, it is important to know cost of funds. But funding cost calculation is complicated due to the fact that banks fund long term assets through short-term liabilities. As a result, assets with a given time to maturity are usually financed by several liabilities with different maturities. To calculate funding cost it needs to know how cash flows are matched between assets and liabilities. For this it`s used cash flow matching matrix or funding matrix. In the paper, a new algorithm of filling of a two-dimensional funding matrix that is based on the golden rule of banking and modified RAROC approach is proposed. It provides positive definiteness and uniqueness of the matrix. The matrix shows terms to maturity and amounts of liability cash flows which fund the asset cash flow with a given term to maturity. Examples of partially and fully filled matrices are presented. It is proposed an approach to risk-adjusted pricing that is based on this funding matrix and RAROC-approach adapted to cash flows. The developed approach to pricing integrates organically credit and liquidity risks. It takes into consideration expected credit losses and economic capital (unexpected credit losses) for all lifetime of asset cash flows and not one-year period traditionally used in RAROC.