Interest Rate Risk Management Research Articles

Mind the Solvency II Gap: A Coherent Measure of Market Consistent Embedded Value to Interest Rate Risk in ALM

This paper derives Asset and Liability Management ('ALM') interest rate risk measures (i.e. duration and convexity gaps) applicable to Life insurance companies that are adequate such as asset and liability-driven strategies can be used within a mix of tactics and instruments to achieve financial objectives, for a given set of ALM interest rate risk indicator tolerances. The approach adopted relies on a half-way approach between immunization (i.e. duration match) and dedication (i.e. cash flows match) that consists to match both the duration and convexity of the market value of assets and best estimate liabilities as well as the inclusion of partial and key-rate duration and convexity matches. The recent changes in regulation through the adoption of a market consistent framework (i.e. MCEV) combined to distressed economic conditions with failing equity markets, brutal changes in interest rates and spreads further increase the motivation for a rigorous and coherent definition of ALM risk measures in order to manage appropriately interest rate risk of Life insurance companies. Through this paper, effective and key-rate duration (and convexity) gaps are derived based on the interpretation of ALM risk indicators as approximation of interest rate sensitivities within a market consistent framework. Those concepts are discussed with respect to their usefulness for ALM of Life insurance companies. This paper is of high interest in the context of Solvency II given the lack of guidelines provided by EIOPA regarding the treatment and management of interest rate risk from an ALM perspective.

Pre‐Issuance Hedging of Fixed‐Rate Debt

This article analyzes several corporate hedging strategies to manage interest rate risk on fixed‐rate debt prior to issuance. The authors start by considering these strategies using a highly stylized model: a binomial forward interest rate tree that, while simple in design, illustrates derivative pricing methodologies that are used in practice. Under a given rate volatility assumption, they demonstrate expected outcomes when entering a forward bond contract, a forward‐starting pay‐fixed interest swap, and a purchased option on that swap, as well as the “default” alternative of doing nothing. In principle, the decision of whether or not to hedge, as well as how to do so, depends on management's view of future interest rate volatility and degree of comfort with possible outcomes.The authors then assess the pros and cons of hedging strategies, with considerable emphasis on practical considerations. For example, while their theoretical model would allow an issuer to “lock” a specific debt issuance, in practice one can hedge only “benchmark” interest rate risk. The authors describe the use of both Treasury locks and forward‐starting swaps to address unexpected benchmark yield changes, and discuss how factors such as the time to issuance affect an issuer's choice of instrument. For instance, Treasury locks are typically used when the time to issuance is relatively short, while interest rate swaps are more common for longer times to issuance. The article also discusses circumstances in which a “do nothing” strategy may be preferable to other alternatives, as well as the disadvantages of issuing in advance. Finally, the authors describe the impact of financial accounting on different hedge strategies.

The Determinants of Treasury Bond Stripping Level

Several explanations of Treasury bond stripping have been proposed including interest rate risk management, taxes, and market completion. Our findings suggest that stripping is affected by each of these factors. First, we find that higher coupon and longer maturity Treasury bonds are more heavily stripped, consistent with the Interest Rate Risk and Tax hypotheses. Second, large gaps in the maturity spectrum of Treasury bonds induce stripping, in support of the Market Completion hypothesis. Third, the percent of individual bonds held as strips decreases when the yield curve is significantly inverted, consistent with the Tax hypothesis. Finally, patterns of coupon rates on adjacent maturity issues of Treasuries also have an impact on Treasury bond stripping.

Managing Interest Rate Risk

This is a Power Point presentation made to Banca d'Italia (Central Bank of Italy) workshop on Interest Rate Risk Management held on March 21, 2011, attended by more than 70 bankers from Europe. The topics include, i) threat of inflation, ii) multifactor models for managing interest rate risk, iii) interest rate risk of non-maturity deposit accounts, iv) a general framework for interest rate risk of derivatives, and v) what term structure models to use (fundamental, single-plus, double-plus, or triple-plus) for interest rate risk analysis?

How Useful Are Banks' Earnings-At-Risk And Economic Value Of Equity-At-Risk Public Disclosures?

This paper examines the information content and the usefulness of banks' interest rate risk public disclosures. ALM managers use Earnings at Risk ( EAR ) and Economic Value of Equity at Risk ( EVEAR ) as measures of the dollar amount of potential loss to net interest income and common shareholders' equity as a result of unforeseen interest rate changes. These two interest rate risk management metrics are now recognized benchmarks for measuring interest rate risk exposure, and its potential impact on a bank's financial position. At the explicit request of regulators, financial analysts and competitive pressures, more commercial banks are now reporting EAR and EVEAR numbers in their annual financial reports. To examine preliminary evidence on the information content of such public disclosures, we composed a sample of some of North America's largest commercial banks. The Canadian peer group is based on Canada's seven largest banks, and the U.S. peer group is composed of twelve of its largest banks. In particular, we investigate if "ex ante" EAR and EVEAR numbers help regulators, financial analysts and investors to explain the subsequent variability of commercial banks' net interest income and net income over time.

A modelling process of short-term interest rate risk management for the South African commercial banking sector

This study focuses on banking book interest rate risk (IRR) management, more specifically short-term IRR management (SIRR). This type of risk is partly induced by the inflation targeting policy of the South African Reserve Bank (SARB). As a result, inflation leads to an uncertain interest rate cycle and a period of uncertain interest rate levels as it relates to lending and borrowing activities in the South African commercial banking sector. This study highlights what causes short-term interest rate risk and how the banks may forecast and manage the SIRR with reference to the inflation targeting policy. The banking industry manages a high volume of fund transactions and portfolios of investments. The banks are intricately involved in the financial markets and are therefore exposed to a large number of risk factors. A sound banking system is an important prerequisite for a country’s future economic development. One key empirical finding of this research is that 50 per cent of the South African banks agree that loans that cannot undergo immediate rate adjustments are exposed to the repo-rate adjustment after the Monetary Policy Committee (MPC) meeting. Banks surveyed see the need for the development of a short-term interest rate risk (SIRR) management process to better control such repo-rate risk. The next key empirical finding is that interest rate risk is still managed via traditional repricing gap and sensitivity analysis which is not ideal for risk management due to inherent weaknesses (such as not quantifying capital risk exposure). This agrees with the Pricewaterhousecoopers Balance Sheet Management benchmark survey

Interest Rate Risk Management and Dynamic Portfolio Selections

The dynamic portfolio selections in the sense of Markowitz’s mean-variance are addressed in an incomplete market and the effect of interest rate risk on them is discussed. According to Markowitz’s measure risk approach, the interest rate risk is divided into the controllable risk and the uncontrollable risk. The former can be hedged, but the latter cannot. The zero-coupon bond is an efficient tool to avoid the interest rate risk. The optimal payoff resulting from self-financed strategies and the mean-variance efficient frontier are expressed explicitly. The results show that the optimal payoff and the efficient frontier are not affected by the controllable risk of interest rate, but by the uncontrollable risk. The efficient frontier is a part of a hyperbola if there exists the uncontrollable risk. The expected optimal payoff grows with the increase of risk; however, the margin expected optimal payoff lowers. The efficient frontier is a straight line if and only if there is no uncontrollable risk.

Interest Rate Volatility and Risk Management: Evidence from CBOE Treasury Options

This paper investigates US Treasury market volatility and develops new ways of dealing with the underlying interest rate volatility risk. We adopt an innovative approach which is based on a class of model-free interest rate volatility (VXI) indices we derive from options traded on the CBOE. The empirical analysis indicates substantial interest rate volatility risk for medium-term instruments which declines to the levels of the equity market only as the tenor increases to 30 years. We show that this risk appears to be priced in the market and has a significant time-varying relationship with equity volatility risk. US Treasury market volatility is found to be appealing from an investment diversification perspective since the VXI indices are negatively correlated with the levels of interest rates and of equity market implied volatility indices, respectively. Although VXI indices are affected by macroeconomic and monetary news, they are only partially spanned by information contained in the yield curve.

Securitization and Bank Intermediation Function

The move from the originate-to-hold to originate-to-distribute model of lending profoundly transformed the functioning of credit markets and weakened the natural asset transformation function performed by financial intermediaries for centuries. This shift also compromised the role of banks in channeling monetary policy initiatives, and undermined the importance of traditional asset-liability practices of interest rate risk management. The question is, therefore, whether securitisation is conducive to the optimal hedging of bank interest rate risk. The empirical results reported in this work suggest that banks resorting to securitisation do not, on average, achieve an unambiguous reduction in their exposure to the term structure fluctuations. Against this background, banks with very high involvement in the originate-to-distribute market enjoy lower interest rate risk. This however by no means implies superior risk management practices in these institutions but is merely a result of disintermediation.

Securitization and Bank Intermediation Function

The move from the originate-to-hold to originate-to-distribute model of lending profoundly transformed the functioning of credit markets and weakened the natural asset transformation function performed by financial intermediaries for centuries. This shift also compromised the role of banks in channeling monetary policy initiatives, and undermined the importance of traditional asset-liability practices of interest rate risk management. The question is, therefore, whether securitization is conducive to the optimal hedging of bank interest rate risk, with this being of particular relevance in the current economic and monetary conditions. The empirical results reported in this work suggest that banks resorting to securitization do not, on average, achieve an unambiguous reduction in their exposure to the term structure fluctuations. Against this background, banks with very high involvement in the originate-to-distribute market enjoy lower interest rate risk. This however by no means implies superior risk management practices in these institutions but is merely a result of disintermediation.

Household Interest Rate Risk Management

I investigate household interest rate risk management by solving a life-cycle asset allocation model that includes mortgage and bond portfolio choice. I find that most investors prefer an adjustable-rate mortgage and thereby save on the bond risk premium that is contained in fixed-rate mortgage payments. Only older, risk-averse investors hold some fixed-rate mortgage debt. Together with a position in short-term bonds this enables them to hedge against changes in the real interest rate, while the inflation exposure of the debt and bond positions cancel out. Hedging house price changes with bonds only occurs at the end of the life cycle. Early in the life cycle short-sale constraints prevent an effective hedge.

The interest rate sensitivity of real estate

This study yields a contribution to a better understanding of the interest rate sensitivity of real estate and should enable a more sophisticated interest rate risk management, especially for insurance companies and pension funds. This is achieved by modelling the whole life of a typical office investment property, based on a representative and exclusive data set for the Swiss investment real estate market. The interdependencies between interest rates, inflation, office market rents, current rent paid and expenses are modelled empirically. We perform Monte Carlo simulations that explicitly incorporate the uncertainty of the underlying stochastic processes, of their interdependencies and of modelling uncertainties, thus providing an indication of the final estimate’s uncertainty. Our results show that the interest rate sensitivity of a typical office property is 13.1%, with a standard deviation of 7.8%. The risk premium, the state of the macroeconomic environment, the degree of rotation of the interest curve and the remaining lifetime of the property are found to be the prime determinants of interest rate sensitivity.

Can an Accounting-Based Duration Model Effectively Measure Interest Rate Sensitivity?

I examine whether a duration transformation of financial accounting information adequately captures interest rate sensitivity in financial institutions. First, I calculate an ex-ante measure of interest rate sensitivity in complex banking institutions based upon a model developed by bank supervisors at the Federal Reserve Board of Governors; the duration measure is a combination of financial accounting information and duration proxies. Second, I test for an association between this ex-ante measure of interest rate sensitivity and both accounting and capital market ex-post measures of interest rate sensitivity. The results show a predictable relationship between ex-ante modeled interest rate sensitivity and banks’ ex-post accounting performance and stock returns given observed changes in market interest rates. I conclude that an interest rate sensitivity model based upon a combination of financial accounting information and duration proxies can be used to predict interest rate sensitivity in complex banks, including publicly-traded bank holding companies. The issue is important because interest rate risk management is integral to financial institutions, and its reliable measurement using publicly-available accounting data is relevant to bank managers, researchers, market participants, and regulators.

On the Independence of Assets and Liabilities: Evidence from U.S. Commercial Banks, 1990-2005

Traditional asset-liability management techniques limit banks' abilities to structure their balance sheets-but more recently, financial innovations have allowed banks the chance to manage interest rate risk without constraining their asset-liability choices. Using canonical correlation analysis, we examine how the relationships between asset and liability accounts at U.S. commercial banks changed between 1990 and 2005. Importantly, we show that asset-liability linkages are weaker for banks that are intensive users of risk-mitigation strategies such as interest rate swaps and adjustable loans. Perhaps surprisingly, we find that asset-liability linkages are stronger at large banks than at small banks, although these size-based differences have diminished over time, both because of increased asset-liability linkages at small banks and decreased linkages at large banks.

Managing Interest Rate Risk: The Next Challenge?

Are the managers of financial institutions ready for the small but increasingly significant risk of inflation in the near future, due to the unprecedented fiscal and monetary responses of the U.S. government to prevent an economic collapse? This paper addresses this important issue by reviewing important findings in the area of interest rate risk management. We discuss five classes of models in the fixed income literature that deal with hedging the risk of large, non-parallel yield curve shifts. These models are given as M-Absolute/M-Square models, duration vector models, key rate duration models, principal component duration models, and extensions of these models for fixed income derivatives, for valuing and hedging bonds, loans, demand deposits, and other fixed income instruments. These models can be used for designing various hedging strategies such as portfolio immunization, bond index replication, duration gap management, and contingent immunization, to protect against changes in the height, slope, and curvature of the yield curve. We argue that the current regulatory models proposed by the U.S. Federal Reserve, the Office of Thrift Supervision, and the Bank of International Settlements, may understate the true interest rate risk exposure of financial institutions, if sharp increases in interest rates lead to higher default risk and quickening of the pace of deposit withdrawals.

Interest Rate Cycles and Corporate Risk Management

We study the ability of US firms to manage interest rate risk during changes in monetary policy. From annual reports we extract interest rate derivative positions and analyze how they change with the cyclical movements in interest rates. Our hand-collected data follows firms' year-end positions in interest rate derivatives from 1990 through 2000, allowing us to evaluate their performance over time as well as in the cross-section. The 1990s constitute a unique period with pronounced interest rate cycles and with derivatives reporting requirements conducive to our analysis. We also investigate whether users of interest rate derivatives differ from non-users and whether those that appear to be speculating using interest rate derivatives differ from hedgers. In our sample, which is drawn from the Standard and Poor's 500 index, about 50% of the firms can be characterized using interest rate derivatives to hedge, about 33% of firms appear to use them to speculate and the remaining 17% do not use interest rate derivatives. Firms that use derivatives are larger, and appear to be more financially levered, have lower return on assets as well as lower market-to-book ratios than non-users. Despite attempting to separate firms that follow consistent hedging policies from those that opportunistically change net derivative exposures over time, we find no significant differences between those more likely to be hedgers and those that appear to be speculators based on standard proxies for financial distress costs and agency costs. However, the operating cash flows of hedgers are more sensitive to interest rate changes, suggesting differences between the underlying businesses of the two categories. We find no systematic evidence that firms categorized as speculators are able to correctly anticipate changes in interest rates.

Corporate debt issues and interest rate risk management: Hedging or market timing?

Apart from the obvious reasons for raising capital, a firm can hedge its interest rate exposure by issuing debt, the value of which moves in an opposite direction from the value of its assets as interest rate varies. We examine whether firms in the UK market make full use of debt issuances for hedging purposes or if they have other considerations. Our evidence shows that firms’ choices of debt issues are primarily driven by debt market conditions in an effort to lower their costs of capital rather than managing their firm-specific interest rate exposures. This suggests that market timing, as opposed to hedging, is the primary motivation behind corporate debt issuances.

Networth exposure to interest rate risk: An empirical analysis of Indian commercial banks

In the Basel II era, management of interest rate risk in the banking book has become significant. In the first study of its kind, we develop a simulation based driver-driven approach to estimate the impact of interest rate volatility on the networth of Indian banks during the period 2002–2004. We derive the interest rates that drive changes in deposit and prime lending rates (PLR). Then we perform Monte Carlo simulation and multiple regressions, on these driver rates, to obtain simulated shocks to deposit rates and PLR. We use these simulated shocks to get the 99% worst EVE loss for the sample banks. These losses are much larger than what the existing literature suggests. This is because, apart from repricing risk, we are the first to find evidence of significant basis risk. Our results have important policy implications both for banks and regulators.

Household Interest Rate Risk Management

I investigate household interest rate risk management by solving a life-cycle asset allocation model that includes mortgage and bond portfolio choice. I find that most investors prefer an adjustable-rate mortgage, and thereby save on the bond risk premium that is contained in fixed-rate mortgage payments. Only older, risk-averse investors hold some fixed-rate mortgage debt. Together with a position in short-term bonds this enables them to hedge against changes in the real interest rate, while the inflation exposure of the debt and bond positions cancel out. Hedging house price changes with bonds only occurs at the end of the life cycle. Early in the life cycle short-sale constraints prevent an effective hedge.

Implied deterministic volatility functions: An empirical test for Euribor options

AbstractThis study proposes the implied deterministic volatility function (IDVF) for the volatility as the function of moneyness and time in the Heath, Jarrow, and Morton (1992) model to price and hedge Euribor options across moneyness and maturities from 1 January 2003 to 31 December 2005. The IDVF models are extended to two‐ and three‐factor models, indicating that they are potential candidates for interest rate risk management. Based on the criteria of in‐sample fitting, prediction, and hedging, it is found that two‐factor IDVF models provide the best in‐sample and prediction performance, whereas three‐factor IDVF models yield the best results for hedging. Correctly specified multifactor models with the volatility as the function of moneyness and time can replace inappropriate onefactor models. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 29:319–347, 2009