Chapter 2

Market risk factors

This chapter deals with the description and modelling of the two stochastic risk factor underlying
the behaviour of deposits, namely market interest rates and Credit default swaps. We explain which
assumptions are made and what is their task in the valuation or risk management process.

2.1 Net interest Margins

One of the key factors involved in deposit management is the market rate. Such indicator influences
both client rates and deposit volumes, making it a fundamental risk factor to model.
The task of modelling market rates is fairly involved as it requires to pay particular attention to the
current phenomenon of negative rates, especially for very short tenors. The beginning of this
phenomenon might date back to ECB policy adjustment of late 2012, when it started lowering
refinancing rates (for expansionary monetary purposes) and generated expectation in the market that
zero or even negative interests could have become a reality shortly after. When the ECB in fact
eventually cut the rates below zero, this event had been already predicted and in turn reflected in the
market quotes where highly safe instruments were trading at negative rates. Such feature plays an
important role in inferring statistical relations for the deposit dynamics and requires care when
defining a model to describe its stochastic behaviour. Also, we need to appropriately modify the
valuation formula of eq. (1) in order to accommodate negative rates in the interest rate margin
without incurring in heavy negative cash flows generation.
In the Jarrow and van Deventer framework, we assume that banks reinvest deposits at a risk-free
rate, which is modelled assuming a very short term tenor, in order to be able to face liquidity needs.
Since we currently observe negative values for such short term instruments, we can assume that the
bank has an option to keep its money cash instead of reinvesting: then, we can simply floor the
market rate at zero and rewrite the interest margin as follows :

max { r t , 0 }d t

(2)

This can be still seen as a risk free margin and can be used to determine the economic value of
deposits. In the experiments section we will see that due to these very narrow margins, the
economic value of deposits is negative using a standard margin and in case we adopt the floor at
zero for market rates, we get a positive value but still approximately close to zero considering the
D0
initial value of deposit
.
While to recover the risk-free economic value we correctly assume that a bank invests its liabilities
from deposits into a risk-free rate with a very short term for liquidity needs so to face clients
withdrawals and interest payments, it is clear that such negative interest rates will lead the bank to

take over more risky behaviours in creating its replicating investment strategy. In the real world in
fact, a financial institution usually invests part of its funds into products bearing longer term rates.
Now, in order to model more realistic (but not risk-free) margins, we can build diverse stochastic

OIS 1M
1.5
1
%Rate

0.5
0
-0.5

Overnight indexed swap time series. The interest rate started falling below zero from 2014.

processes

(r i ( t ) , d ( t ) )

which represent in fact the net interest rate margin and depend on one or

more market rate and on the deposit rate. Bear in mind that the solutions proposed in the following
paragraph are not risk-free and hence not deemed to represent the economic value of deposits but
rather represent a more realistic projection of future cash flows.
2.1.2 Investment strategies against negative margins
As it has been already said, the bank normally looks for investment opportunities on a longer time
horizon which bears a higher interest rate, along with the short rate investment for liquidity
management. Hence, for each time step, our (simplified) asset portfolio will consist in a mix
r
between the short rate t and the longer term instrument yielding R(t , ) :

(3)

=a r t +(1a) Rt d t
Where a

represents the portion invested in the short term that will be rolled over in each period

and the remaining portion

(1a)

will be kept frozen up to maturity. Therefore the amount

invested in the shortest maturity during the interval

(t , )

represents the liquidity at immediate

disposal; in case of shortage of liquidity we will have to close some of the positions in the longer
maturity investment, selling the instruments before maturity at a discount.

In order to avoid negative reinvestments (i.e. periods where

< 0 ) but keeping funds in a short

term rate, we can instead ask to a third party for a tailored product which allows us to have at worst
a zero return. In particular, we want to be insured against periods where the short term rate is
smaller than our deposit rate, which consists in flooring our NIM at zero. This way, the hedged
margin will be:

=max {{r t d t ; 0 }

(4)

Again, as we postulated at the beginning, in case the bank can keep its money cash instead of
r
investing in a negative t , the final margin will be:

(5)

max { r t , 0 }d t + max {d t r t ; 0 }

Notice that this approach ensures to have a non negative return also for positive interest rate
scenarios, as long as the interest margin is negative.
A theoretical insurer would pay the bank the spread only in case the deposit rate is higher than the
short term market interest. In order to have an exact hedge against negative income, the notional of
Dt
such product should be the deposit volume for that period
, so that the bank can exactly
replicate the floored margin. Then, the fair value or price for this theoretical insurance product with
maturity T, should be:

Pd (0, t +1) Dt max {d t r t ; 0 }

t <T

This can be seen as the value of and exotic swap contract receiving

dt

and paying

rt

only if

the deposit rate is higher than the market rate. Notice also that the margin paid by the insurer is in
fact the difference between the insured and non insured margins (which is, (5) minus (2)) and in
turn the value of the insurance product, assuming we can perfectly hedge with a stochastic notional
Dt
, can be seen as the difference between the insured value and the economic value of deposits.
If we are not able to request a stochastic swap notional it will be necessary to derive concrete
estimates of future values of deposits: this establishes another reason to build a thorough model for
deposit dynamics (which will be discussed later in chapter 3).
Another approach for hedging against adverse interest rate scenarios consists in changing the
deposit rate policy so to obtain non-negative spreads. This way we would not need to buy any
insurance product; however, lowering deposit rates will have a negative impact on our deposit
dynamics, as investors will have less incentives to keep their money in the deposit account.

Assuming we have full flexibility in changing the deposit rate and assuming that our target solely
consists in generating no negative margin (which is, we do not care if the deposit volume is
negatively affected by our new policies), we can think of exactly replicating the operator in (4)
without any need of buying an insurance product. The importance of discretionary deposit rate
policy function is further discussed in 3.1 and in the empirical section. As a final remark, we remind
that all of the alternatives proposed for the modelling of the interest rate spread can accommodate
limitation on deposit rates: in fact, in case the legal framework does not allow to set negative
interests for retail deposits (this is the case for example of Italy), we would simply use a max
dt
operator on
so to floor it at zero. However, in such a situation, it would be more appropriate to
model the floor at zero directly inside the deposit rate policy function (see paragraph 3.1) so that
negative values are not generated at all, neither in the margin nor inside the relationship built for
deposit volume dynamics.
In this scenario of very tight margins, it is clear that it is not possible anymore for banks to profit
from market segmentation (invoked by [Jarrow]) and set deposit rates below the market interest so
to make risk-free profits. Instead, it is more likely that these financial institution will exploit the
maturity transformation (in the spirit of Diamond and Dybvig model (1983)) as modelled for
example in equation (3), such that very short term liabilities (i.e. demand deposits) will be invested
into longer term assets which bear a positive rate of return. Now, if we take a look at the OIS (riskfree) term structure, we can see that the interest on overnight indexed swap is negative up to 7
years, meaning that a bank will have to invest in very long term maturities to get a positive return,
increasing however its liquidity exposure and in turn potentially enhancing the fears of a bank run.
The alternative would be to look for higher return assets (possibly short term, matching liquidity
needs) which instead bear a higher credit risk. Clearly, the overall result is that the bank has more
incentives to take more risky behaviours both in terms of credit and liquidity risk which translate in
disincentives for clients to keep their money invested in deposits as they would not perceive them as
safe as before. We will see in the next chapter that this argument leads us to take into account the
default risk (by means of credit default swaps quotes) of the depositary institution inside the model
for the behaviour of customers.

EUR OIS term structure

0.4
0.3
0.2
0.1

OIS term structure

0
-0.1
-0.2
-0.3
-0.4
-0.5

2.2 The stochastic model for interest rates

The stochastic model we suggest to use in order to describe the behaviour of interest rates is the
Hull-White or Extended Vasicek. Such model do not restrict interest rates to be positive and its
dynamics are defined as follows:

d r t=k (t) [ ( t )r t ] dt + ( t ) dW ( t )

When , ,

are constant, the model reduces to Vasicek. When only is function of time we

talk about Hull-white; in case also

and

are functions of

we usually refer to

Extended Vasicek. This class allows for negative rates and usually grants a good fit of observed
term structure. In case of a margin including more than one interest rate (like eq. (3)), we need a
curve for each of them: this can be done by building explicitly different correlated stochastic
processes or by modelling the basis between the two rates we are considering. Multiple curves and
OIS-Libor modelling examples can be found in ([Castagna Cova],[mercurio], [Moreni Pallavicini]).
In paragraph 3.3, we will see that choosing the right model for interest rate behaviour is not trivial
and more complex methodologies can be implemented especially to overcome the issue of historical
and risk-neutral calibration.