SENSITIVITY TO MARKET RISK Flashcards

Question

7.1 SMR | What are the disadvantages of the gap model?

Answer 1

* Only captures re-pricing risk * May not identify intra-period re-pricing risk * Does not measure of EVE * Can not analyze complex instruments

Answer 2

• Provides a framework for the evaluation of the impact of embedded options in financial instruments and where constraints are usually imposed so that the model is representative of current market conditions.

Answer 3

* Randomly generates thousands or millions of different scenarios by randomly changing a component for each run or iteration. * Can take into account the following: returns, volatility, correlations, and other factors. * In a stochastic valuation model, the average value generated by all the interest rate paths must equal the current observed price of the security.

Answer 4

* Single Monthly Mortality (SMM) * Constant Prepayment Rate (CPR) * Public Securities Associations (PSA)

Answer 5

* It is a measure of the amount of unexpected principal received in a given month. * The higher the SMM, the faster the repayment.

Answer 6

* Stochastic No Arbitrage Model | * Monte Carlo Simulation

Answer 7

• Constraints are imposed so that the average present value derived from all the paths must equal the observed market price of the Treasury security.

Answer 8

Constant prepayment rate unexpected principal received in a given year and simply annualizes the SMM

Answer 9

* It introduces a metric for projecting prepayments over the life of a pool of mtgs. * SMM and CPR ignore the tendency for prepayments to be modest in the early years of a pool of mortgages (the first 30 months of any pool). * A pool is considered to have 100% PSA if its CPR starts at 0% and increases 0.2% each month until it reaches 6% in month 30 months. * After month 30 months, it remains a constant 6%, so PSAs will increase by 100% with each 6% increase in CPRs. * A 1% SMM would be a 12% CPR, which would be a 200% PSA.

Answer 10

• Measures the percentage change in the economic value of a position given a small change in interest rates. • Three common types of duration • Macaulay Duration • Modified Duration • Effective Duration - It reflects the timing and size of cash flows that occur before an institutions contractual maturity. • Declines as time elapses • Equals less than maturity for instruments with payments prior to maturity • Equals maturity for zero-coupon instruments • Is lower for instruments with higher coupons • Is lower for amortizing instruments

Answer 11

Banks with significant option risk should not rely upon modified duration to measure IRR.

Answer 12

• The formula is MINUS Price x modified duration (if rates changed by only 50 bps, modified duration would be 1.245) -900.00 x .0249 = -22.41. * If rates fell, the estimated value would be $922.41 and if rates rose, it would be $877.59. * The MINUS sign represents the inverse relationship between price and rates. * Additionally, the less the change is basis points, the more precise the value will become.

Answer 13

• Yields a single interest rate risk number • Considers all expected cash flows • Generates a more comprehensive and more accurate IRR measurement

Answer 14

• Demands sophisticated accounting and information systems • Only works well for small interest rate changes

Answer 15

* months | * years

Answer 16

• Lower coupon or higher coupon • Less frequent or more frequent coupon resets Higher coupon and more frequent coupon resets

Answer 17

Remaining maturity

Answer 18

• Simplest form of duration; calculates the weighted average term of a maturity of a securities cash flow. • Duration is stated in month or years and always, • Always declines as time elapses, • Is less than maturity for instruments that have payments prior to maturity, • Equals maturity for zero-coupon instruments, • Is lower for instruments with higher coupons, • Is lower for amortizing instruments.

Answer 19

* Calculated from Macaulay duration and estimates price sensitivity for small interest rate changes * The formula is: Macauley Duration / (1+yield) * Modified Duration assumes that interest rate shifts will not change an instruments cash flows * Does not estimate price sensitivity for instruments w/ embedded options

Answer 20

• Is more effective for estimating price sensitivity for instruments with embedded options • Is only accurate for small (100 bps or less) rate changes; • For larger changes, the calculation must be adjusted for convexity

Answer 21

* Earnings Approach (gap analysis, simulation analysis) | * Economic Value Approach

Answer 22

• Focuses on risks to earnings, usually NII • Usually focuses on short term (generally up to 2 years) • Examples of this approach include maturity gap analysis and simulation models

Answer 23

• EVE is the net present value of all asset, liability, and off-balance sheet cash flows • Provides a broader scope approach than the earnings approach • Typically best suited for banks that mark most instruments to market

Answer 24

* System capabilities, * Adequacy of system inputs, * Reasonableness of assumptions, * Usefulness of output/reports, * Adequacy of periodic variance analysis

Answer 25

* Process of grouping together, either at the customer or sub-ledger level, accounts of similar types and cash flow characteristics, * Crucial component of the data input process, * Account aggregation improves the measurement system's efficiencies.

Answer 26

• Most critical review item - unreasonable assumptions render even the most complex IRR measurement system ineffective, • All assumptions should be formally reviewed, approved, assessed, revised as needed, and full documented. • Sensitivity of model results to assumptions should be analyzed

Answer 27

• Typically derived using a combination of internal | analysis and external sources

Answer 28

Assumptions are used to capture the following key parameters or characteristics: • Potential or projected interest rate movements, • Driver rate relationships, • Non-maturity deposit (NMD) rate sensitivity, and • Customer behaviors.

Answer 29

* Projected interest rate assumptions are an important component of measuring interest rate risk and may be generated by internal analysis or external sources, * Internal interest rate forecasts may be derived from implied forward yield curves, economic analysis, or historical regressions.

Answer 30

* Driver rates are used extensively in most income simulation and EVE models, * They capture the relationship between the primary market interest rates, or driver rates, and the pricing of bank products within the measurement system.

Answer 31

• Interest rate movements • How much of the variance is attributable to rate assumptions vs. other factors? • Driver rates • Is the variance due to lack of correlation or an inappropriate beta factor? • NMD rate assumptions commonly cause variances • Prepayment speeds • Are differences due to proxy prepayment speeds differing from forecast or bank prepayment speeds differing from proxy? • Account aggregation rules

Answer 32

* The measurement of optionality exposure typically has significant impacts on both sides of the balance sheet, * It is critical that customer behavior assumptions be reasonable and reflect each interest rate scenario measured.

Answer 33

• Rate Movements – Variance analysis (backtesting) should be done to isolate the differences attributable to rate assumptions • Driver rates – Used extensively in most income simulation and EVE models. - They capture the relationship between the primary market interest rates, or driver rates, and the pricing of the banks products within the measurement system. - Variances occur when actual bank rate changes do not mirror the driver rate changes. - A bank’s product rate is set to move at some fraction of the driver rate, called a beta adjustment or spread adjustment. - One driver rate assumption that commonly causes significant variances is associated with NMD assumptions because these must take into account numerous factors, including local and national competition, the bank’s potential funding needs, and the relative costs of alternative funding sources. • Prepayment speeds – affected by geographic location, loan size, and fixed vs. variable rates • Account aggregation – grouping together, either at the customer or sub-ledger level, accounts of similar types or cash flow characteristics.

Answer 34

Purpose is to assess the accuracy of the model

Answer 35

Variance analysis should be done periodically, and no less frequently than annually

Answer 36

* Flawed mathematics, * Flawed data or data entry, * Flawed assumptions.

Answer 37

Mathematical flaws, while relatively rare in widely available purchased systems, can occur and are generally within the purview of the independent review process, not the ongoing variance analysis.

Answer 38

Data errors should be minimized by a robust internal control process. This will assure that the starting point for the measurement system accurately reflects all material holdings, terms, and conditions.

Answer 39

All IRR measurement systems rely heavily on a series of assumptions and assessing the reasonableness of these assumptions is critical to ensuring the integrity of the measurement system results.

Answer 40

* Nature and size of the institution, * Complexity of its activities, * Risk management process, and management's ability to measure, monitor, and control market risk, * Adequate systems and controls, * Potential for market risk to adversely affect earnings and capital, * Trend and overall accuracy recent risk measurements, * Presence of items with particularly volatile or uncertain interest rate sensitivity.

Answer 41

• Market risk sensitivity is well controlled and there is minimal potential that earnings performance or capital position will be adversely affected; • Risk management practices are strong for the size, sophistication, and market risk accepted by the institution; • Level of earnings and capital provide substantial support for the degree of market risk taken by the institution.

Answer 42

• Market risk sensitivity is adequately controlled and there is only moderate potential that earnings performance or capital position will be adversely affected; • risk management practices are satisfactory for the size, sophistication, and market risk accepted by the institution; • Level of earnings and capital provide adequate support for the degree of market risk taken by the institution.

Answer 43

• Need to improve market risk control, • Significant potential that the earnings performance or capital position will be adversely affected, • Risk management practices need improvement given the size, sophistication, and level of market risk accepted by the institution, • Level of earnings and capital may not adequately support the degree of market risk taken by the institution.

Answer 44

• Control of market risk sensitivity needs improvement or there is significant potential that earnings performance or capital position will be adversely affected; • Risk management practices are deficient for the size, sophistication, and level of market risk accepted by the institution; • Level of earnings and capital provide inadequate support for the degree of market risk taken by the institution.

Answer 45

• Control of market risk sensitivity is unacceptable and the level of market risk taken by the institution is an imminent threat to its viability; • Risk management practices are wholly inadequate for the size, sophistication, and level of market risk accepted by the institution.

Answer 46

* Foreign Exchange * Commodity Activities * Equity Trading & Investing

Answer 47

• When yields decline, the price increases at an decreasing rate • When yields rise, the price decreases at an increasing rate • Example: Mortgage Backed Security

Answer 48

* Rate movements are gradual and applied over the time period measured * For example, when measuring a 300 bps rate increase during a 12-month period, the rate increase could be a 25 bps interest rate increases administered each month

Answer 49

* Rate shocks are administered at a more infrequent time intervals over the measured period but each increment is sustained and of equal amounts * For example, in a 300 bps increasing rate environment measured over a one-year time period, rates may be incrementally increased 75 bps over every quarter as opposed to monthly rate ramps.

Answer 50

• Non-parallel yield curve shifts are set by bank management at different reflection points on the yield curve during the period measured, these may be performed as a rate shocks, rate ramp, or stair step scenarios.

Answer 51

* Static Spread | * Option Adjusted Spread

Answer 52

• Spread, that when added to the implied forward rates, discounts the cash flows back to its observed market value.

Answer 53

• Spread, that when added to all interest rate paths generated in a Monte Carlo simulation, discounts the cash flows of an instrument back to its observed market value.

Answer 54

• When yields decline, the price increases at an increasing rate • When yields rise, the price decreases at an decreasing rate • Option-free instruments display positive convexity • Example: Treasury Security

Answer 55

* Rate shock is immediate and sustained * For example, in a 300 bps scenario the full effect of the rate increase would be administered immediately and remain for all time periods measured * 2010 IRR Policy Statement encouraged 300 to 400 bps shocks.

Answer 56

• Duration assumes that the relationship between price and yield is linear, it is actually curvilinear, or convex • Instruments that do not contain embedded options have positive convexity • Instruments with embedded options display negative convexity

Answer 57

* Independence * Skills and knowledge * Transparency * Communication of Results

Answer 58

• It determines effect of rate change on NII, Net Income, and sometimes the EVE, for a range of possible scenarios

Answer 59

* Can be more accurate than Gap Analysis | * Assess earnings and capital effects

Answer 60

• Highly dependent on accurate assumptions • Not typically "user friendly" • Requires advance info systems and technical expertise

SENSITIVITY TO MARKET RISK Flashcards

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