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A Multi-Factor Model for the Valuation and Risk Managment of Demand Deposits
Abstract
This paper analyzes the relationship between banks’ divergent strategies toward specialization and diversification of financial activities and their ability to withstand a banking sector crash. We first generate market-based measures of banks’ systemic risk exposures using extreme value analysis. Systemic banking risk is measured as the tail beta, which equals the probability of a sharp decline in a bank’s stock price conditional on a crash in a banking index. Subsequently, the impact of (the correlation between) interest income and the components of non-interest income on this risk measure is assessed. The heterogeneity in extreme bank risk is attributed to differences in the scope of non-traditional banking activities: non-interest generating activities increase banks’ tail beta. In addition, smaller banks and better-capitalized banks are better able to withstand extremely adverse conditions. These relationships are stronger during turbulent times compared to normal economic conditions. Overall, diversifying financial activities under one umbrella institution does not improve banking system stability, which may explain why financial conglomerates trade at a discount.
... • Non financial corporations and producer households (NFC&PH), -up to 10 more than 250.000 Euros. ...
... We show the results in the following order: First, Tables 7,8,9,10,11 present, for each cluster of depositors, presents the economic value, the value of the liability, the zero rate floor value, the Duration and the Weighted Average Life; second, in Table 12 we show, again for each cluster of depositors, the term structure of liquidity at one, five and 10 years, which is also the cut-off time we chose. ...
... The approach is not very different, in spirit, from the one adopted in some other studies; for a very short and incomplete list, we mention the works by Jarrow and Van Deventer[12], Kalkbrener and Willing[13], Dewachter, Lyrio and Maes[10], Nystrom[14] and Blochlinger[3]. For a more general overview, see also Castagna and Fede, chapter 9,[6].8 ...
... The pass-through models were chosen to represent typical model classes linking product rates and market interest rates often used in the literature: an asymmetric partial adjustment model, which explicitly accounts for dierent adjustment speeds during up-and downward markets; a model that is motivated by best practice replicating portfolio approaches in use by many banks; an error-correction model, which allows short-term distortions to adjust to a long-term equilibrium; and nally a step-wise pass-through model with predened product rate jumps. Although most empirical papers suggest a volume process in their theoretical part, they rather assume deterministic, mostly constant volumes in their main empirical analysis due to the high uncertainty of future volume growth rates (Dewachter et al., 2006). O'Brien (2000) nds highly erratic volumes which can cause unrealistic growth rates and estimates. ...
... he concrete model choice has eects on the results. Jarrow and van Deventer (1998) propose in their framework a 1-factor Heath et al. (1992) and an asymmetric partial adjustment model for the product rate. Kalkbrener and Willing (2004) base their analysis on a 2-factor HJM model and link product rates to market rates via a piecewise linear function. Dewachter et al. (2006) use a joint yield curve-deposit rate model which incorporates an essentially ane 3-factor term structure model and an additional fourth factor for the product rate spread dynamics. The model by Hutchison and Pennacchi (1996) that supposes short rates follow a Vasicek (1977) process in the empirical estimation can also be embedded in the ...
... Janosi et al. (1999) implement the specication of Jarrow and van Deventer (1998) and analyze one US commercial bank's deposit data and aggregate NOW 3 account data from the Federal Reserve. Hutchison and Pennacchi (1996), O'Brien (2000) and Dewachter et al. (2006) estimate their models for around 200 US banks, approximately 100 US banks and 8 major Belgian banks, respectively. The data consists of MMDA 4 and NOW accounts in the case of the US surveys and of savings deposits in the case of the Belgian banks. ...
Non-maturing banking products are important asset and liability positions of banks. Their complexity inter alia arises from a non-trivial pass-through from market to product rates which makes the valuation and risk analysis challenging for both banks and banking supervisors. Based on a large data set, this paper provides a comprehensive analysis of the valuation and interest rate risk measurement of these products in the risk-neutral valuation framework of Jarrow and van Deventer (1998). We apply 6 term structure models and 4 interest rate pass-through models and estimate for each of these 24 model combinations the value and interest rate risk of 13 non-maturing product categories for up to 400 German banks on an individual bank level. We find that the choice of the term structure and the pass-through model is of limited importance for the valuation of non-maturing banking products. For ranking banks according to the interest rate risk of their products the pass-through process is of specific relevance. When the level of the interest rate risk is to be estimated, additionally an advanced term structure model should be chosen.
... Although they are de jure short-term liabilities they can have a rather high interest rate sensitivity (e.g. Hutchison and Pennacchi, 1996; Jarrow and van Deventer, 1998; O'Brien, 2000; Dewachter et al., 2006), because the development of the deposit rates and remaining time to maturity and initial maturity, respectively. As an extensive description of the TAM is beyond the scope of this paper, we refer the reader to Entrop et al. (2007) for details. ...
This paper analyses the robustness of the standardised framework proposed by the Basel Committee on Banking Supervision (2004b) to quantify the interest rate risk of banks. We generalise this framework and study the change in the estimated level of interest rate risk if the strict assumptions of the standardised framework are violated. Using data on the German universal banking system, we find that estimates of the interest rate risk are very sensitive to the framework's assumptions. We conclude that the results obtained using the standardised framework in its current specification should be treated with caution when used for supervisory and risk management purposes.
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?
Fundamentally, the objectives of funds transfer pricing (FTP) has remained the same as it was when it was first developed. However, in the environment of very low interest rates that preceded the recent financial crisis FTP frameworks in many banks have been left underfunded and underdeveloped. The financial crisis brought FTP into the regulatory spotlight. Regulators expect banks to be able to demonstrate how their FTP frameworks are aligned to the best practice principles for liquidity management. The paper reflects on the fundamental aspects of a FTP framework and its role in a bank.
Fundamentally, the objectives of funds transfer pricing (FTP) has remained the same as it was when it was first developed. However, in the environment of very low interest rates that preceded the recent financial crisis FTP frameworks in many banks have been left underfunded and underdeveloped. The financial crisis brought FTP into the regulatory spotlight. Regulators expect banks to be able to demonstrate how their FTP frameworks are aligned to the best practice principles for liquidity management. The paper reflects on the fundamental aspects of a FTP framework and its role in a bank.
We argue that the business model of the bank exhibits such pe-culiarities that it deserves a special treatment in the approach to its valuation as well. In particular, the exposure to interest rate risk is a major characteristic of its business, not only in the process of maturity transformation but also as a major determinant of price margin and business volume. There exists no common framework to value a bank which adequately accounts for these features. We propose a valuation model for banks based on Merton's (1974) structural model of the firm, which we adapt to the banking firm by the help of term struc-ture models of the interest rates. In this setting, we interpret banks as a particular portfolio of long and short positions in interest-rate sensitive assets. In doing so, we are able to show another peculiarity of bank valuation, i.e. that the exercise price of a call option on the firm value, representing the bank's equity, is not the face value of bank liabilities but their economic value. JEL classification: C22, G12, G13, G21.
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.
This paper tests for the existence of market power in banking, using data on demand deposit rates of households and corresponding market rates in five euro area countries. An implicit measure for market power is based on a partial adjustment model that also allows for an asymmetric response of deposit rates to changes in market rates. The period covers the ten years since introduction of the euro. The analysis indicates that banks are exercising major market power within the euro area. In addition to general sluggishness, bank deposit rates’ reactions are clearly asymmetric: flexible when market rates are decreasing and rigid when rates are increasing. The degree of asymmetric behaviour can be interpreted as a further indication of the market power banks exercise. Despite country differences, a general pattern of interest rate adjustment in demand deposit pricing is observable.
Variable rate savings accounts have two main features: the client rate is variable and deposits can be invested and withdrawn at any time. The client rate is not always equal to the short rate. However, customer behaviour is sluggish and actions are often performed with a delay. The savings account may therefore have some net value to the bank, and this value typically depends on the interest rate. This paper focuses on measuring the interest rate risk of such savings accounts on a value b&s. In order to model customer behaviour we implement a partial adjustment specification for the balance. The interest rate policy of the bank is described in an error-correction model. Based on these models we calculate the duration of the savings accounts and analyze the problem how to hedge these accounts.
This paper examines the distribution of Belgian consumer prices and its interaction with aggregate inflation over the period June 1976-September 2000. Given the fat-tailed nature of this distribution, both classical and robust measures of location, scale and skewness are presented. We found a positive short-run impact of the skewness of relative prices on aggregate inflation, irrespective of the average inflation rate. The dispersion of relative prices has also a positive impact on aggregate inflation in the short run and this impact is significantly lower in the sub-sample starting in 1988 than in the pre-1988 sub-sample, suggesting that the prevailing monetary policy regime has a substantial effect on this coefficient. The chronic right skewness of the distribution, revealed by the robust measures, is positively cointegrated with aggregate inflation, suggesting that it is largely dependent on the inflationary process itself and would disappear at zero inflation. These results have three important implications for monetary policy. First, as to the transmission of monetary policy, our results are in line with the predictions of menu cost models and therefore suggest that this type of friction can be an important factor behind the short run non-neutrality of monetary policy. Second, as to the design of robust estimators of core inflation, economic arguments based on menu cost models tend to highlight the importance of the absence of bias. We have proposed an unbiased estimator by taking the time-varying degree of chronic right skewness explicitly into account. Third, as to the optimal rate of inflation, the chronic right skewness found in the data provides no argument against price stability, as it appears as an endogenous response of optimising price setters and would disappear when targeting a zero inflation rate. This conclusion contrasts sharply with the implications of the exogenously assumed downward rigidity of Tobin (1972), which would justify targeting a sufficiently positive inflation rate in order to facilitate the adjustment of relative prices. Our empirical findings contradict the latter type of downward rigidity which implies a negative correlation between skewness and inflation. Therefore, the cross-sectional properties of Belgian inflation data do not provide strong arguments against a price stability-oriented monetary policy, such as the one pursued by the Eurosystem.
Using a market segmentation argument, this paper uses the interest rate derivative's arbitrage-free methodology to value both demand deposit liabilities and credit card loan balances in markets where deposits/loan rates may be determined under imperfect competition. In this context, these financial instruments are shown to be equivalent to a particular interest rate swap, where the principal depends on the past history of market rates. Solutions are obtained which are independent of any particular model for the evolution of the term structure of interest rates.
This study investigates the pricing behaviour of firms in the euro area on the basis of surveys conducted by nine Eurosystem national central banks. Overall, more than 11,000 firms participated in the survey. The results are very robust across countries. Firms operate in monopolistically competitive markets, where prices are mostly set following mark-up rules and where price discrimination is a common practice. Our evidence suggests that both time- and state-dependent pricing strategies are applied by firms in the euro area: around one-third of the companies follow mainly time-dependent pricing rules while two-thirds use pricing rules with some element of state-dependence. Although the majority of firms take into account a wide range of information, including past and expected economic developments, about one-third adopts a purely backward-looking behaviour. The pattern of results lends support to the recent wave of estimations of hybrid versions of the New Keynesian Phillips Curve. Price stickiness arises both at the stage when firms review their prices and again when they actually change prices. The most relevant factors underlying price rigidity are customer relationships - as expressed in the theories about explicit and implicit contracts - and thus, are mainly found at the price changing (second) stage of the price adjustment process. Finally, we provide evidence that firms adjust prices asymmetrically in response to shocks, depending on the direction of the adjustment and the source of the shock: while cost shocks have a greater impact when prices have to be raised than when they have to be reduced, reductions in demand are more likely to induce a price change than increases in demand.
This study investigates the relationship between the evolution of real options values and associated financing policies for Belgian companies in the sector of bio-industries. Each firm's situation regarding the relevant types of real options is stylistically represented through a scenario tree. The consumption of a time-to-build or a growth option is respectively considered as a success or a failure in company development. Empirically, several variables enable us to locate each company along the tree at any time. The study of transitions leads us to discover that failures tend to trigger higher leverage, unlike in the trade-off theory. Yet, the increases in debt maturity, in lease and in convertible financing confirm our predictions. Overall, we emphasize evidence of undercapitalization and of proper, yet insufficient, use of hybrid financing by biotech companies.
This paper uses an intertemporal general equilibrium asset pricing model to study the term structure of interest rates. In this model, anticipations, risk aversion, investment alternatives, and preferences about the timing of consumption all play a role in determining bond prices. Many of the factors traditionally mentioned as influencing the term structure are thus included in a way which is fully consistent with maximizing behavior and rational expectations. The model leads to specific formulas for bond prices which are well suited for empirical testing. See also the authors’ paper [ibid. 53, 363–384 (1985; Zbl 0576.90006)].
Variable rate savings accounts have two main features. The client rate is variable and deposits can be invested and withdrawn at any time. However, customer behaviour is not fully rational and actions are often performed with a delay. This paper focusses on measuring the interest rate risk of variable rate savings accounts on a value basis (duration) and on the problem how to hedge these accounts. In order to model the embedded options and the customer behaviour we implement a partial adjustment specification. The interest rate policy of the bank is described in an error-correction model.
This paper presents a unifying theory for valuing contingent claims under a stochastic term strllcture of interest rates. The methodology, based on the equivalent martingale measure technique, takes as given an initial forward rate curve and a family of potential stochastic processe for its subsequent movements. A no arbitrage condition restricts this family of processes yielding valuation formulae for interest rate sensitive contingent claims which do not explicitly depend on the market prices of risk. Examples are provided to illustrate the key results. © 2008 by World Scientific Publishing Co. Pte. Ltd. All rights reserved.
We solve the problem of approximating in ℒ² a given random variable H by stochastic integrals GT(ϑ) of a given discrete-time process X. We interpret H as a contingent claim to be paid out at time T, X as the price evolution of some risky asset in a financial market, and G(ϑ) as the cumulative gains from trade using the hedging strategy ϑ. As an application, we determine the variance-optimal strategy which minimizes the variance of the net loss H − GT(ϑ) over all strategies ϑ.
Risk management of non-maturing liabilities is a relatively unstudied issue of significant practical importance. Non-maturing liabilities include most of the traditional deposit accounts like demand deposits, savings accounts and short time deposits and form the basis of the funding of depository institutions. Therefore, the asset and liability management of depository institutions depends crucially on an accurate understanding of the liquidity risk and interest rate risk profile of these deposits.In this paper we propose a stochastic three-factor model as general quantitative framework for liquidity risk and interest rate risk management for non-maturing liabilities. It consists of three building blocks: market rates, deposit rates and deposit volumes. We give a detailed model specification and present algorithms for simulation and calibration. Our approach to liquidity risk management is based on the term structure of liquidity, a concept which forecasts for a specified period and probability what amount of cash is available for investment. For interest rate risk management we compute the value, the risk profile and the replicating bond portfolio of non-maturing liabilities using arbitrage-free pricing under a variance-minimizing measure. The proposed methodology is demonstrated by means of a case study: the risk management of savings accounts.
Traditional measures of interest rate risk assume that prices of financial assets and liabilities are set in perfectly competitive markets. However, evidence suggests that many retail financial markets do not follow the competitive paradigm. In this paper we employ a general contingent claims framework to value rents earned by banks in demandable retail deposit markets. Our analysis provides a natural and economically meaningful measure of interest rate risk for these imperfectly competitive markets. Using monthly survey data on NOW accounts and MMDAs, we estimate the value of retail deposit rents and deposit durations for over 200 commercial banks.
For the risk management and transfer pricing of non-maturity liabilities, banks in Europe often use a so-called replicating
portfolio technique. A commonly used implementation is replication of a fixed investment rule every time period. This paper
deals with the development of the portfolio in the long run, when using this methodology. Applying this replicating portfolio
technique yields, after a while, a steady state. Besides the straightforward result when volume is constant, we solve the
steady states for the case where the funds (volume) grow with a fixed rate (e.g. due to credited interest or growth in GDP).
We therefore define a system growth process, alternative to the Markov process (when volume is constant). From a transfer
pricing and risk-management point of view, the resulting portfolio should satisfy certain requirements concerning return and
flexibility. Once the steady state can be calculated for given growth rates, the investment policy can be specified. The importance
of taking account of a growth rate is illustrated. Growth in volume implies that a different rule will converge to the desired
steady state. This is illustrated analytically and with numerical examples. The purpose of the paper is not to find the ideal
hedge strategy for non-maturity liabilities, but to improve the existing risk management without any implementation costs
for the banks. Given the currently used methodology, accounting for a growth rate can significantly improve the risk management
of non-maturity liabilities.
As demonstrated by Klemperer (1987), if households face a cost of switching among brands of a differentiated good, pricing is likely to be more competitive, the greater is the fraction of customers that move into or around the market. I generalize this theory to a world with arbitrary market structure and test it empirically using panel data on bank retail deposit interest rates. I find that the amount of household migration in a market has a significant competitive influence on price markups, that is, a positive effect on the level of deposit interest rates. Consistent with the model, the magnitude of this effect depends in some cases upon the degree of market concentration.
Linear projections of returns on the slope of the yield curve have contradicted the implications of the traditional “expectations theory”. This paper shows that these findings are not puzzling relative to a large class of richer dynamic term structure models. Specifically, we match all the key empirical findings reported by Fama and Bliss ((1987) American Economic Review 77 (4), 680–692) and Campbell and Shiller ((1991) Review of Economic Studies 58, 495–514), among others, within large subclasses of affine and quadratic-Gaussian term structure models. Additionally, we show that certain “risk-premium adjusted” projections of changes in yields on the slope of the yield curve recover the coefficients of unity predicted by the models. Key to this matching are parameterizations of the market prices of risk that let the risk factors affect the market prices of risk directly, and not only through factor volatilities. The risk premiums have a simple form consistent with Fama's findings on the predictability of forward rates, and are also shown to be consistent with interest-rate feedback rules used by a monetary authority in setting monetary policy.
We describe the joint dynamics of bond yields and macroeconomic variables in a Vector Autoregression, where identifying restrictions are based on the absence of arbitrage. Using a term structure model with inflation and economic growth factors, together with latent variables, we investigate how macro variables affect bond prices and the dynamics of the yield curve. We find that the forecasting performance of a VAR improves when no-arbitrage restrictions are imposed and that models with macro factors forecast better than models with only unobservable factors. Variance decompositions show that macro factors explain up to 85% of the variation in bond yields. Macro factors primarily explain movements at the short end and middle of the yield curve while unobservable factors still account for most of the movement at the long end of the yield curve.
Exchange rates depreciate by the difference between domestic and foreign marginal utility growth or discount factors. Exchange rates vary a lot, as much as 15% per year. However, equity premia imply that marginal utility growth varies much more, by at least 50% per year. Therefore, marginal utility growth must be highly correlated across countries: international risk sharing is better than you think. Conversely, if risks really are not shared internationally, exchange rates should vary more than they do: exchange rates are too smooth. We calculate an index of international risk sharing that formalizes this intuition. We treat carefully the realistic case of incomplete capital markets. We contrast our estimates with the poor risk sharing suggested by consumption data and home-bias portfolio calculations.
The paper derives a general form of the term structure of interest rates. The following assumptions are made: (A.1) The instantaneous (spot) interest rate follows a diffusion process; (A.2) the price of a discount bond depends only on the spot rate over its term; and (A.3) the market is efficient. Under these assumptions, it is shown by means of an arbitrage argument that the expected rate of return on any bond in excess of the spot rate is proportional to its standard deviation. This property is then used to derive a partial differential equation for bond prices. The solution to that equation is given in the form of a stochastic integral representation. An interpretation of the bond pricing formula is provided. The model is illustrated on a specific case.
We construct and estimate a tractable model of macroeconomic and yield curve dynamics. Bond yields are affine in the state variables of a forward-looking macromodel, and are derived assuming absence of arbitrage opportunities. Our approach allows us to interpret the dynamics of yields and risk premia in terms of macroeconomic fundamentals. In an application to German data, the forecasting performance of the model is often found to be superior to that of the best available alternatives in the affine class. Our approach has considerable success in accounting for features of the data that represent a puzzle for the expectations hypothesis.
This paper analyzes the relationship between banks’ divergent strategies toward specialization and diversification of financial activities and their ability to withstand a banking sector crash. We first generate market-based measures of banks’ systemic risk exposures using extreme value analysis. Systemic banking risk is measured as the tail beta, which equals the probability of a sharp decline in a bank’s stock price conditional on a crash in a banking index. Subsequently, the impact of (the correlation between) interest income and the components of non-interest income on this risk measure is assessed. The heterogeneity in extreme bank risk is attributed to differences in the scope of non-traditional banking activities: non-interest generating activities increase banks’ tail beta. In addition, smaller banks and better-capitalized banks are better able to withstand extremely adverse conditions. These relationships are stronger during turbulent times compared to normal economic conditions. Overall, diversifying financial activities under one umbrella institution does not improve banking system stability, which may explain why financial conglomerates trade at a discount.
From a macroeconomic perspective, the short-term interest rate is a policy instrument under the direct control of the central bank. From a finance perspective, long rates are risk-adjusted averages of expected future short rates. Thus, as illustrated by much recent research, a joint macro-finance modeling strategy will provide the most comprehensive understanding of the term structure of interest rates. We discuss various questions that arise in this research, and we also present a new examination of the relationship between two prominent dynamic, latent factor models in this literature: the Nelson-Siegel and affine no-arbitrage term structure models.
I. The elements of term structure theory, 489. — II. The role of debt liquidity differences in the rate structure, 491. —
III. The role of speculative activity in the term structure, 496. — IV. Changes in the maturity structure of demand for funds,
502. — V. Yields on short-term and long-term U. S. government securities 1920–1957, 504. — VI. Some implications for credit
policy, 516.
Panel data on consumer bank deposit interest rates reveal asymmetric impacts of market concentration on the dynamic adjustment of prices to shocks. Banks in concentrated markets are slower to raise interest rates on deposits in response to rising market interest rates but are faster to reduce them in response to declining market interest rates. Thus, banks with market power skim off surplus on movements in both directions. Since deposit interest rates are inversely related to the price charged by banks for deposits, the results suggest that downward price rigidity and upward price flexibility are a consequence of market concentration. Copyright 1992, the President and Fellows of Harvard College and the Massachusetts Institute of Technology.
Dai and Singleton (2002) and Duffee (2002) show that there is a tension in affine term structure models between matching the mean and the volatility of interest rates.
This article examines whether this tension can be solved by an alternative parametrization of the price of risk. The empirical
evidence suggests that, first, the examined parametrization is not sufficient to solve the mean-volatility tension. Second,
the usual result in the estimation of affine models, indicating that some of the state variables are extremely persistent,
may have been caused by the lack of flexibility in the parametrization of the price of risk.
This paper documents patterns of price setting at the retail level in the euro area, summarized in six stylized facts. First, the average euro area monthly frequency of price adjustment is 15 p.c., compared to about 25 p.c. in the US. Second, the frequency of price changes is characterized by substantial cross product heterogeneity - prices of oil and unprocessed food products change very often, while price adjustments are less frequent for processed food, non energy industrial goods and services. Third, cross country heterogeneity exists but is less pronounced. Fourth, price decreases are not uncommon. Fifth, price increases and decreases are sizeable compared to aggregate and sectoral inflation rates. Sixth, price changes are not highly synchronized across retailers. Moreover, the frequency of price changes in the euro area is related to several factors, such as seasonality, outlet type, indirect taxation, pricing practices as well as aggregate or product specific inflation.
With hedgefunds, managers develop risk management models that mainly aim to play on the effect of de correlation.In order to achieve this goal,companies use the correlation coefficient as an indicator for measuring dependencies existing between(i)the various hedge funds strategies and share index returns and(ii)hedge funds strategies against each other.Otherwise, copulas are a statistic tool to model the dependence in a realistic and less restrictive way,taking better account of the stylized facts in finance.This paper is a practical implementation of the copulas theory to model dependence between differen the hedgefund strategies and share index returns and between these strategies in relation to each other on a "normal" period and a period during which the market trend is downward. Our approach based on copulas allows us to determine the bivariate VaR level curves and to study extremal dependence between hedgefunds strategies and share index returns through the use of some tail dependence measures which can be made into useful portfolio management tools.
ABSTRACT : This paper looks at how well Finland performs in high growth entrepreneurship and uses data from the Global Entrepreneurship monitor to benchmark Finland against other European countries. It is found that Finland’s prevalence rate of high growth entrepreneurial activity lags significantly behind most of its European and all of its Scandinavian peers. That this weak performance in high-growth entrepreneurship goes hand in hand with Finland being a world leader in per capita investment in R&D may be described as a paradox. The reasons underlying the underperformance of Finland remain however unclear. At this point, explanations should be sought in culture, industrial traditions and systemic experience in high growth entrepreneurship.
This paper investigates the effects of uncertainty on the investment behaviour using firm-level data for a sample of Belgian manufacturing firms. In general, the results confirm former analysis at the aggregate level, stating that uncertainty does matter but that the sign of the effect and its magnitude largely depend on which proxies are used and how they are defined. It is shown that uncertainty has mainly an impact on the decision to invest and to a much lesser extent on the amount invested. Furthermore, the difference between reversible and irreversible investment is crucial. The impact of volatility on irreversible investment is far more larger than on reversible investment. In some cases, the amount of reversible investment will increase with higher volatility.
Fundamentally, spreads between market and deposit interest rates increase when interest rates rise and decline when rates fall. Recent empirical studies have found this phenomenon to be related to market concentration. Static equilibrium models are poorly equipped to explain this behavior. In this paper, the author applies an intertemporal asset pricing model incorporating bank deposits as a form of money in order to analyze the pricing behavior of a banking sector exercising market power. His results extend the theoretical literature on deposit pricing and provide some insights into the behavior of interest rate spreads through time. Copyright 1995 by Ohio State University Press.
This paper uses reprojection to develop a benchmark to assess ECB monetary policy since January 1999, the start of EMU. We first estimate an essentially affine term structure model for the German SWAP yield curve between 1987:04-1998:12. The German monetary policy is then reprojected onto the EMU period (1999:01-2001:08). We find that the German real interest rate in place during the EMU period is significantly lower than it would have been in case the Bundesbank were still in charge. We also show the effect of EMU on the German SWAP yield curve. Short- and medium-term bonds seem to have been more affected than long-term bonds.
This paper analyzes the relationship between banks’ divergent strategies toward specialization and diversification of financial activities and their ability to withstand a banking sector crash. We first generate market-based measures of banks’ systemic risk exposures using extreme value analysis. Systemic banking risk is measured as the tail beta, which equals the probability of a sharp decline in a bank’s stock price conditional on a crash in a banking index. Subsequently, the impact of (the correlation between) interest income and the components of non-interest income on this risk measure is assessed. The heterogeneity in extreme bank risk is attributed to differences in the scope of non-traditional banking activities: non-interest generating activities increase banks’ tail beta. In addition, smaller banks and better-capitalized banks are better able to withstand extremely adverse conditions. These relationships are stronger during turbulent times compared to normal economic conditions. Overall, diversifying financial activities under one umbrella institution does not improve banking system stability, which may explain why financial conglomerates trade at a discount.
This paper analyzes the relationship between banks’ divergent strategies toward specialization and diversification of financial activities and their ability to withstand a banking sector crash. We first generate market-based measures of banks’ systemic risk exposures using extreme value analysis. Systemic banking risk is measured as the tail beta, which equals the probability of a sharp decline in a bank’s stock price conditional on a crash in a banking index. Subsequently, the impact of (the correlation between) interest income and the components of non-interest income on this risk measure is assessed. The heterogeneity in extreme bank risk is attributed to differences in the scope of non-traditional banking activities: non-interest generating activities increase banks’ tail beta. In addition, smaller banks and better-capitalized banks are better able to withstand extremely adverse conditions. These relationships are stronger during turbulent times compared to normal economic conditions. Overall, diversifying financial activities under one umbrella institution does not improve banking system stability, which may explain why financial conglomerates trade at a discount.
The bank credit card market, containing 4,000 firms and lacking regulatory barriers, casually appears to be a hospitable environment for the model of perfect competition. Nevertheless, this article reports that credit card interest rates have been exceptionally sticky relative to the cost of funds. Moreover, major credit card issuers have persistently earned from three to five times the ordinary rate of return in banking during the periods 1983-88. The failure of the competitive model appears to be partly attributable to consumers making credit card choices without taking account of the very high probability that they will pay interest on their outstanding balances. Copyright 1991 by American Economic Association.
This paper presents a unifying theory for valuing contingent claims under a stochastic term structure of interest rates. The methodology, based on the equivalent martingale measure technique, takes as given an initial forward rate curve and a family of potential stochastic processes for its subsequent movements. A no-arbitrage condition restricts this family of processes, yielding valuation formula for interest rate sensitive contingent claims that do not explicitly depend on the market prices of risk. Examples are provided to illustrate the key results. Copyright 1992 by The Econometric Society.
This paper presents an error-correction model of the interest rate pass-through process based on a marginal cost pricing framework including switching and asymmetric information costs. Estimation results for the euro area suggest that the proportion of the pass-through of changes in market interest rates to bank deposit and lending rates within one month is at its highest around 50%. The interest rate pass-through is higher in the long term and notably for bank lending rates close to 100%. Moreover, a cointegration relation exists between retail bank and comparable market interest rates. Robustness checks, consisting of impulse responses based on VAR models and results for a sub-sample starting in January 1999, show qualitatively similar findings. However, the sub-sample results are supportive of a quicker pass-through process since the introduction of the euro. JEL Classification: E43; G21.
This paper analyzes the relationship between banks’ divergent strategies toward specialization and diversification of financial activities and their ability to withstand a banking sector crash. We first generate market-based measures of banks’ systemic risk exposures using extreme value analysis. Systemic banking risk is measured as the tail beta, which equals the probability of a sharp decline in a bank’s stock price conditional on a crash in a banking index. Subsequently, the impact of (the correlation between) interest income and the components of non-interest income on this risk measure is assessed. The heterogeneity in extreme bank risk is attributed to differences in the scope of non-traditional banking activities: non-interest generating activities increase banks’ tail beta. In addition, smaller banks and better-capitalized banks are better able to withstand extremely adverse conditions. These relationships are stronger during turbulent times compared to normal economic conditions. Overall, diversifying financial activities under one umbrella institution does not improve banking system stability, which may explain why financial conglomerates trade at a discount.
Like security prices, retail deposit interest rates cluster around integers and "even" fractions. However, explanations for security price clustering are incompatible with deposit rate clustering. A theory based on the limited recall of retail depositors is proposed. It predicts that banks tend to set rates at integers and that rates are "sticky" at these levels. The propensity for integer rates increases with the level of wholesale interest rates and deposit market concentration. When banks set noninteger rates, rates are more likely to be just above, rather than just below, integers. The paper finds substantial empirical support for the theory's implications. Copyright The American Finance Association 1999.
This paper presents an essentially affine model of the term structure of interest rates making use of macroeconomic factors and their long-run expectations. The model extends the approach pioneered by Kozicki and Tinsley (2001) by modeling consistently long-run inflation expectations simultaneously with the term structure. This model thus avoids the standard pre-filtering of long-run expectations, as proposed by Kozicki and Tinsley (2001). Application to the U.S. economy shows the importance of long-run inflation expectations in the modelling of long-term bonds. The paper also provides a macroeconomic interpretation for the factors found in a latent factor model of the term structure. More specifically, we find that the standard "level" factor is highly correlated to long-run inflation expectations, the "slope" factor captures temporary business cycle conditions, while the "curvature" factor represents a clear independent monetary policy factor.
In this article I provide an empirical analysis of the term structure of interest rates using the affine class of term-structure models introduced by Duffie and Kan. I estimate these models by combining time series and cross-section information in a theoretically consistent way. In the estimation I use a Kalman filter based on a discretization of the continuous-time factor process and allow for a general measurement-error structure. I provide evidence that a three-factor affine model with correlated factors is able to provide an adequate fit of the cross-section and the dynamics of the term structure. The three factors can be given the usual interpretation of level, steepness, and curvature.
In this paper, we characterize, interpret, and test the over-identifying restrictions imposed in affine models of the term-structure. "We begin by showing, using the classification scheme proposed by Dai, Liu, and Singleton [10] for general affine diffusions, that the family of N-factor models can be classified into N + 1 non-nested sub-families of models. For each subfamily, we derive a canonical model with the property that every admissible member of this family is equivalent to or a nested special case of our canonical model. Second, using our classification scheme and canonical models, we show that many of the three-factor models in the literature impose potentially strong over-identifying restrictions, and we completely characterize these restrictions. Finally, we compute simulated-method-of-moments estimates for several members of the sub-family of three-factor models that nest the "benchmark" model of Chen [8], and test the over-identifying restrictions on the joint distribution...
We show that financial liberalizations positively impact the growth prospects of a large sample of economies. Our results show that, on average, liberalizations lead to a one percent increase in annual real economic growth over a five-year period. Our research also explores the channels whereby liberalizations impact economic prospects, in particular, the cost of equity capital, the e#ciency of equity markets, and the capital investment process. Finally, we explore the country-specific characteristics that lead to liberalizations being more or less e#ective than the average. # We appreciate the helpful comments of Peter Henry. The views expressed are those of the authors, and do not necessarily reflect the views of the Federal Reserve System. Send correspondence to: Campbell R. Harvey, Fuqua School of Business, Duke University, Durham, NC 27708. Phone: +1 919.660.7768, E-mail: cam.harvey@duke.edu . 1 Introduction One of the most fundamental national policy decisions of the pas...
. We prove that for continuous stochastic processes S based on(Omega ; F ; P) for which there is an equivalent martingale measure Q 0 with square-integrable density dQ 0 =dPwe have that the so-called "variance optimal" martingale measure Q opt for which the density dQ opt =dPhas minimal L 2 (P)-norm is automatically equivalent to P. The result is then applied to an approximation problem arising in Mathematical Finance. 1. Introduction Let S = (S t ) t2IR+ be an IR d -valued semi-martingale based on(Omega ; F ; (F t ) t2IR+ ; P) which in most of this paper will be assumed to be continuous. The process S may be interpreted to model the discounted price of d stocks. A very important tool in Mathematical Finance is to replace the original measure Pby an equivalent local martingale measure Q, sometimes also called a risk-neutral measure. More formally we denote as in [DS 94a] by M(P) = fQø P: Q is a probability measure and S is a Q-local martingaleg the set of all probabi...
Financial Risk Management in Banking: The Theory and Application of Asset and Liability Management
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