Systemic risk and firm size: is notional amount a good metric?

Purpose Many recently enacted financial regulations exempt smaller entities. While the literature on systemic risk provides efficiency justifications for certain exemptions, the efficiency rationale depends on measuring size appropriately. This paper aims to argue that notional amount, the metric used in derivatives regulations, is a flawed measure of an entity’s contribution to systemic risk. This study discusses an alternative size measure – entity-netted notionals or ENNs – which better reflects risk exposure as discussed in that literature and provides empirical evidence on these two metrics. Design/methodology/approach This study first discusses the relationship between the systemic risk literature and size-based exemptions. This study then describes the current metric and our risk-based alternative. Finally, this paper presents regulatory data on US interest rate swaps (IRS) and uses this to characterize some features of risk exposure. Findings The unique data set provides empirical insight into how well the size metric used in current regulations corresponds to a more theoretically oriented measure. This study finds the relationship between the metrics is fairly weak for entities for whom the size-based exemption will soon be ending, and provide an empirical basis for understanding why they differ. This study also provides evidence on the correlation of risk within this group of entities. Practical implications The paper has important implications for regulation of derivatives and financial markets more generally. To the extent exemptions for small entities make good policy, having the appropriate metric is critical. As such, the metric could be a valuable tool for regulators. Originality/value This paper examines the likely objectives of size-based exemptions from financial regulations and relates them to the systemic risk literature. It provides a unique empirical description of IRS positions, which allows us to examine the relationship between the metric used by regulators and our alternative.

Between Scylla and Charybdis: The Bermudan Swaptions Pricing Odyssey

Bermudan swaptions are options on interest rate swaps which can be exercised on one or more dates before the final maturity of the swap. Because the exercise boundary between the continuation area and stopping area is inherently complex and multi-dimensional for interest rate products, there is an inherent “tug of war” between the pursuit of calibration and pricing precision, tractability, and implementation efficiency. After reviewing the main ideas and implementation techniques underlying both single- and multi-factor models, we offer our own approach based on dimension reduction via Markovian projection. Specifically, on the theoretical side, we provide a reinterpretation and extension of the classic result due to Gyöngy which covers non-probabilistic, discounted, distributions relevant in option pricing. Thus, we show that for purposes of swaption pricing, a potentially complex and multidimensional process for the underlying swap rate can be collapsed to a one-dimensional one. The empirical contribution of the paper consists in demonstrating that even though we only match the marginal distributions of the two processes, Bermudan swaptions prices calculated using such an approach appear well-behaved and closely aligned to counterparts from more sophisticated models.

Financial engineering to optimize risk management in banks based on Interest Rate Swaps to better hedge the exposure to interest rate fluctuations the case of banks in Syria

The banking system is affected by uncertainties related to the evolution of pandemic. One of the identified risks is that of a fluctuation of rates. Volatility of Interest rates is one of the major risks for the banking system. Therefore, financial engineering can be used as a very important hedging practice for banks against such a risk. The aim of this study is to develop a risk hedging mechanism to better overcome market volatility by hedging position against the exposure to interest rate risk based on credit derivatives. Therefore, this study uses Interest Rate Swaps (IRS)s to better hedge the exposure of banks to interest rate fluctuations in stress conditions giving consideration to the case study of banks in Syria in optimizing hedging practices based on Interest Rate Swaps. The aim is to use financial engineering to provide banks with a hedging technique to better absorb shocks in times of stress conditions. This has been discussed and illustrated with visual model diagrams. The case study of banks in Syria is not just the story of individual banks but a window into how to hedge the exposure of banks in stress conditions. In the end, most banking crises are quite similar. The recommendations set out in this study provide banks with an optimized hedging practice which is not part of current financial engineering at banks in Syria.

The changing of the guard (LIBOR to SOFR) and how both insurers and regulators are responding

The London Inter-bank Offered Rate (LIBOR), the rate for which banks can borrow short-term from each other, and perhaps the most common floating interest rate benchmark, is going away, and may become obsolete by end of year (EOY) 2021. LIBOR is being replaced by the Secured Overnight Financing Rate (SOFR) in the U.S. and by other country-specific alternative risk-free rates abroad. However, SOFR differs in several key respects from LIBOR; for example, LIBOR includes credit risk, is unsecured, is based on expert judgment, and has a full-term structure, whereas SOFR is a risk-free rate, is collateralized, is based on market transactions, and has no term structure. We examine the credit risk and maturity risk adjustments needed to ease the transition, along with fallback provisions for legacy contracts tied to LIBOR. We discuss the ramifications of rate transition to insurance companies, as it relates to their assets, liabilities, and internal processes. We then consider the perspective of both U.S. and global insurance regulators while highlighting specific areas of inquiry. We conclude with an overview of general recommendations for insurers to manage these risks, along with a detailed discussion about whether interest rate swaps tied to LIBOR will continue to be deemed as an effective hedge for accounting and valuation purposes.