Extrapolating Long-Maturity Bond Yields for Financial Risk Measurement

Insurance companies and pension funds have liabilities far into the future and typically well beyond the longest maturity bonds trading in fixed-income markets. Such long-lived liabilities still need to be discounted, and yield curve extrapolations based on the information in observed yields can be used. We use dynamic Nelson-Siegel (DNS) yield curve models to extrapolate risk-free yield curves for Switzerland and several countries. We find slight biases in extrapolated long bond yields of just a few basis points. In addition, the DNS model allows the generation of useful financial risk metrics, such as ranges of possible yield outcomes over projection horizons commonly used for stress-testing purposes. Therefore, we recommend using DNS models as a simple tool for generating extrapolated yields for long-term interest rate risk management. This paper was accepted by Kay Giesecke, finance.

What's Wrong with Annuity Markets?

We show that the supply of life annuities in the U.S. is constrained by interest rate risk. We identify this effect using annuity prices offered by U.S. life insurers from 1989 to 2019 and exogenous variations in contract-level regulatory capital requirements. The cost of interest rate risk management accounts for at least half of the average life annuity markups or eight per- centage points. The contribution of interest rate risk to annuity markups sharply increased after the great financial crisis, suggesting new retirees' opportunities to transfer their longevity risk are unlikely to improve in a persistently low interest rate environment.

Risk Management for Bonds with Embedded Options

This paper examines the behavior of the interest rate risk management measures for bonds with embedded options and studies factors it depends on. The contingent option exercise implies that both the pricing and the risk management of bonds requires modelling future interest rates. We use the Ho and Lee (HL) and Black, Derman, and Toy (BDT) consistent interest rate models. In addition, specific interest rate measures that consider the contingent cash-flow structure of these coupon-bearing bonds must be computed. In our empirical analysis, we obtained evidence that effective duration and effective convexity depend primarily on the level of the forward interest rate and volatility. In addition, the higher the interest rate change and the lower the volatility, the greater the differences in pricing of these bonds when using the HL or BDT models.

Interest Rate Risk, Measurement, and Management

Interest rates are part of the fabric of finance, used for assessing rates of return on investments, determining costs of capital to firms, compounding and discounting cash flows, and as underlying variables in many derivative instruments. As interest rates change, so do values of associated securities, resulting in substantial risk to investors in these financial products. Interest rate risk measurement is often defined in terms of the sensitivity of prices to changes in interest rates. Duration is a measure used for small changes in rates, and convexity provides a correction to duration when the rate changes are larger. Forecasting how short- and long-term rates move based on macroeconomic factors becomes important for businesses in any country, as these rate changes affect borrowing costs and investment opportunities. Financial institutions carry out interest rate risk management using instruments such as interest rate swaps, or through more advanced approaches such as asset-liability management and gap analysis.

Economic Consequences of the AOCI Filter Removal for Advanced Approaches Banks

ABSTRACT We examine economic consequences of U.S. bank regulators' phased removal of the prudential filter for accumulated other comprehensive income for advanced approaches banks beginning on January 1, 2014. The primary effect of the AOCI filter is to exclude unrealized gains and losses on available-for-sale securities from banks' regulatory capital. We predict and find that, to mitigate regulatory capital volatility resulting from the filter removal, advanced approaches banks increased the proportion of investment securities classified as held-to-maturity, thereby limiting their financing and interest rate risk management options, and they decreased securities risk, thereby reducing their interest rate spread. We further predict and find that these banks borrow more under securities repurchase agreements potentially collateralized by held-to-maturity securities and reduce loan supply owing to their reduced financing options, and that they increase loan risk to mitigate the decrease in their interest rate spread. JEL Classifications: G21; G28; M41; M48. Data Availability: Data are available from the public sources cited in the text.

PASS-THROUGH RATE STUDY FOR HONG KONG BANKING INDUSTRY AND ITS APPLICATION TO NONMATURITY DEPOSITS INTEREST RATE RISK MANAGEMENT

Basel Committee on Banking Supervision published Standards on Interest Rate Risk in Banking Book in April 2016. Apart from others, it proposed a standardized framework under which banks should identify core and noncore deposits within their stable nonmaturity deposits (NMD) and determine appropriate cash flow slotting for the NMD. This paper proposed a unique solution to slot Core NMD into repricing time buckets to address Basel requirements on NMD. The proposed solution was based on pass-through rate model under ECM (error correction model) framework. The solution itself showed interesting mathematical property to form a generalized Fibonacci sequence with converged partial sum. What is more, this paper proposed a model-neutral back testing scheme to make objective comparison of performance across different NMD repricing behavior models. The contents of this paper are expected to be useful for practitioners due to lack of quantitative modeling and model validation methodologies on this topic in the industry while, at the same time, to motivate academic discussion on the best practice and further enhancement of the modeling approach for the industry.