The Rise and Fall of US dollar Interest Rate Volatility: Evidence from Swaptions
Fabio Fornani, BIS Quarterly Review, September 2005
This paper looks at recent volatility in US dollar interest rates, as measured by the price of swaptions. It finds that US dollar interest rates increased in volatility between 2001 and early 2004, particularly for US rates with short maturities, but then fell off in the period up to March 2005. In the period up to early 2004, dollar volatilities included a significant amount of compensation for risk.

A Review of BackTesting and BackTesting Procedures
Sean Campbell, Finance and Economics Discussion Series, Federal Reserve Board, April 2005
Regulators compel banks with large trading books to set aside capital against market risk, measured in terms of the Value at Risk methodology. This technical paper looks at the backtesting that helps give confidence to regulators and others who use Value-at-Risk measures for risk management purposes. It classifies backtesting methodologies and looks favorably on the performance of backtests that assess the accuracy of a VaR model at several quantiles, rather than a single quartile.

Government of Canada Yield Curve Dynamics
Grahame Johnson, Bank of Canada, Bank of Canada Review, February 2005
Zero-coupon rates are a fundamental building block for analysts trying to model prices and risk in the interest rate markets. This paper offers a statistical analysis of the evolution of Government of Canada zero-coupon interest (spot) rates from 1986-2003. It identifies the small number of factors that seem to drive the evolution of the yield curve. The researchers find that, contrary to assumptions implicit in a number of pricing and risk management models, none of the yield-curve measures exhibit daily changes that fit a normal distribution. Compared to a normal distribution, there are a larger number of observations close to the mean, and also a larger number of extreme outliers.

Cross Border Diversification in Bank Asset Portfolios
Claudia Buch et al., European Central Bank, working paper, January 2005
Portfolio managers often rely on the diversification effects of investing in different countries, but it is not entirely clear whether such “country diversification” is more or less important than “industry diversification”. This paper examines the problem, noting that there are some logical reasons to think that “country diversification” might become less potent as markets become more integrated, e.g., in Europe. The paper both reviews the literature surrounding the issue and offers some tentative answers.

Survey of OTC Derivatives Market
BIS survey, 6 December 2004
This triennial survey showed that the global over the counter derivatives market grew strongly between June 2001 and June 2004, with the notional principal outstanding rising by 120% to some $220 trillion. Credit derivatives, increasingly used to manage credit risk in bank loan portfolios, grew especially fast, with volumes up sixfold or more.

Principles for the Management and Supervision of Interest Rate Risk
Basel Committee, July 2004
Even though interest rate risk is not part of the Basel II minimum capital calculations (Pillar I), banks are expected to hold capital in line with their interest rate exposures. This paper looks at the key sources of bank interest rate risk and sets out some rather broad principles for how it can be managed (updated from earlier recommendations in the 1990s). As well as offering comment on the role of the Board, management oversight, risk measurement and so on, the paper describes the Basel Committee’s standardized interest rate shock to test bank portfolios.

Management’s Understanding of Interest Rate Risk Models
Avi Peled, Federal Reserve Bank of Philadelphia, SRC Insights, Second Quarter, 2004
This paper offers a regulator’s perspective on the interest rate risk models and asset/liability models that smaller banks employ to control their interest rate exposures. The paper looks at the model risks that can arise, and comments on how to improve the standard of interest rate risk modeling results. In particular, banks should consider how correlations between model components might break down.

Short Put Options in Retail CDs
Cheryl Sulima, Federal Reserve Bank of Chicago, Capital Markets News Insight, May 2004
Many community banks in the US use retail CDs as a significant source of funding. These funds are relatively stable because depositors have to pay a fee if they take their money out of the bank before a given term is up. But if interest rates rise fast enough, it can make sense for depositors to pay this penalty and move their money. The tendency of depositors to do this represents a risk to bank funding and the cost of bank funding – it is, in effect, an indirect form of interest rate risk. This paper reviews the problem, noting that the size of the risk depends on the bank’s degree of dependence on CDs for funding, the maturity profile of the portfolio, and the size of the penalties set for early withdrawal.  The wild card in any analysis, however, is the degree to which depositors can be expected to behave rationally in taking their decision to withdraw money once interest rates go up.

Principles for the Management and Supervision of Interest Rate Risk
Basel Committee on Banking Supervision, January 2001
This paper offers a list of general principles for managing interest rate risk in the banking industry. Principles 1 to 13 refer to the general process of interest rate risk management including the development of a business strategy, the assumption of assets and liabilities in banking and trading activities, as well as a system of internal controls. In particular, they address the need for effective interest rate risk measurement, monitoring and control functions. Principles 14 and 15 address the supervisory treatment of interest rate risk in the banking book.

Spillovers Across US Financial Markets
Roberto Rigobon and Brian Sack, Sloan School of Management and Board of Governors of the Federal Reserve System, working paper, April 2003
This technical paper looks at how shifts in the price of assets in the long-term interest rate, short-term interest rate and stock markets influence each other. The paper offers a clear non-mathematical introduction to the key issues, before describing a ‘structural form GARCH’ model that attempts to take account of the interrelationships between assets (in contrast to existing reduced-form models). The authors demonstrate the importance of the ‘strong contemporaneous interactions’ of the interest rate markets and stock market by means of a simple portfolio risk management example.

Interest Rate Caps ‘Smile’ Too! But Can the Libor Market Models Capture It?
Robert Jarrow, Haitao Li & Feng Zhao, Kamakura working paper, January 2003
Research on interest rate caps and swaptions has focused on the behaviour of at-the-money instruments, largely because the data for prices of instruments with different strikes is difficult to obtain. Using more than two years of daily interest rate cap price data, this paper sets out to provide a systematic documentation of a volatility smile in cap prices. The authors find that Black (1976) implied volatilities exhibit an asymmetric smile (sometimes called a sneer) with a stronger skew for in-the-money caps than out-of-the-money caps. The volatility smile is time varying and is more pronounced after September 11, 2001. The authors conclude that the existing class of LIBOR market models cannot fully capture the volatility smile.

Counterparty Credit Risk in Interest Rate Swaps during Times of Market Stress
Antulio Bomfim, Federal Reserve Board, December 2002
This article uses data from the time of the Russian default crisis of 1998 to examine the role that counterparty risk plays at times of market stress in the interest rate swaps market. The paper offers discusses the institutional background to the interest rate swaps market and introduces the theoretical models that inform interest rate swap pricing and risk management. It concludes that counterparty concerns did not play a major part in the swap market during the Russian default crisis, probably because the market had faith in existing risk management mechanisms such as collateralisation.

When Portfolio Loans Are Sold, An Institution Effectively Trades A Future Stream of Interest Income For Current Fee Income and Cash
FHLB Insider newsletter, February 2003
This short article from the Federal Home Loan Bank of Indianopolis looks at the effect of selling mortgage loans and the related interest rate risk. The article discusses the effect of rate changes – and changes in rate environments - on the prepayment of loans of different terms. It compares the relative prepayment risks of portfolios and discusses the degree to which banks should hedge against the risk of a rise in interest rates (from an FHLBI perspective).  This second Insider article, from September 2001, looks at how to use Libor-indexed instruments to hedge against rising interest rates.

How Informative are Value-At-Risk Disclosures?
Philippe Jorion, University of California at Irvine, working paper, forthcoming Accounting Review October 2002
How much do the VAR numbers published by banks actually tell us about the level of risk that institutions are running? This paper by noted VaR researcher Philippe Jorion looks at the problem by analysing VaR numbers disclosed by eight major banks in relation to their subsequent trading revenue volatility. The results suggest that VaR numbers do indeed indicate the volatility of a bank's trading revenues, both over time and (especially) between different institutions. It's a potentially important result, given the regulatory pressure on companies of all kinds to disclose market risk VaR numbers, and given the growing pressure on banks to disclose additional risk statistics on credit and operational risks. But Jorion suggests the key benefit of VaR calculations is that they make the bank itself think more clearly about risk/return trade-offs.

Fair Values, Performance Reporting and Bank Analysts' Risk and Valuation Judgments
D. Eric Hirst, Patrick Hopkins, James Wahlen, University of Texas, Indiana University, working paper, February 2002
How much is the perception of risk and risk-adjusted value affected by the format in which bank risk information is presented? In particular, what happens when bank equity analysts are presented with information in different formats such as full fair-value information versus risk disclosures in the notes to bank statements? This study - the first to jointly consider risk and valuation judgments in the context of alternative fair-value reporting regimes - finds that the format in which information is presented has a significant effect. Bank analysts correctly assess significantly higher risk and lower share value for the exposed bank than for the hedged bank when fair value gains and losses on all financial assets and liabilities are recognized in a statement of performance. But under a piecemeal recognition of fair value gains and losses, bank analysts' valuation judgments do not seem to distinguish between exposed and hedged banks.

The Value of Using Interest Rate Derivatives to Manage Risk at US Banking Organizations
Elijah Brewer III, William E. Jackson III, and James T. Moser, University of North Carolina, Federal Reserve Bank, Fed Reserve Bank of Chicago Economic Perspectives, fourth quarter 2001
This article looks at the financial characteristics of banks that use derivatives to manage their interest rate risk, compared to the characteristics of banks that manage their interest rate risk in other ways. It finds that derivative users tend to grow their loan portfolio more quickly and have lower insolvency risk, while being able to hold relatively lower levels of risk capital. It also finds that larger organizations are much more likely to use large volumes of derivatives to manage interest rate risk, presumably because of the economies of scale that are necessary to fund investment in risk management skills and systems. The return on book equity is about the same for users and non-users of derivatives. The authors conclude that interest rate derivatives seem to be beneficial to bank risk management, on the whole, and that over-regulation of their use might be counterproductive.

What Factors Determine International Real Estate Security Returns?
Foort Hamelink and Martin Hoesli, Lombard Odier & Cie, University of Genva, working paper, July 2002
The risk and return of portfolios of real estate securities should, in theory, be enhanced by improved diversification of the investment portfolio. But which key risk factors are most important in assembling an international portfolio? This paper first identifies some key 'pure' risk factors affecting all securities, a size effect, a value/growth factor, and the country of origin of the security. Then it analyses data between 1990 and 2002 to show that the "pure" country factor appears to be the most important, but that its importance has diminished slightly during the period. The importance of the growth/value factor is also quite substantial. The importance of size has diminished slightly over the period, and remains rather marginal.

Optimum Bank Equity Capital and Value at Risk
Udo Broll and Jack E. Wahl, Saarland University and Dortmund University, 2002
This working paper asks what is the optimum amount of equity capital in a banking firm under the value-at-risk concept? It explores certain simple effects of applying the VAR methodology to this problem, finding for example that the confidence level set by management with reference to the bank's risk horizon has a significant effect on capital decisions. It suggests that bank asset/liability management and other managerial decisions cannot be separated from decisions about how much equity capital should, optimally, be invested by the bank's owners.

Dealing with Dangerous Digitals
Uwe Schmock, Steven Shreve, Uwe Wystup, RiskLab, Carnegie Mellon, Commerzbank, working paper, October 25, 2001
Options with discontinuous payoffs are generally traded above their theoretical Black-Scholes prices because of the hedging difficulties created by their large delta and gamma values. A theoretical method for pricing these options is to constrain the hedging portfolio and incorporate this constraint into the pricing by computing the smallest initial capital that permits super-replication of the option. This paper develops this idea for exotic options, and shows how the theory of leverage-constrained pricing can be successfully applied to compute close-to-market option values. It also serves as a practitioner's guide to derive explicit formulae and compute prices by finite difference methods.

The Internet Makes Life Insurance Markets More Competitive
Jeffrey Brown and Austan Goolsbee, Harvard University, University of Chicago, autumn 2001
The past five years have witnessed an explosion in the growth of Internet marketplaces as alternatives or supplements to traditional retail markets in insurance. The Internet should reduce search costs for consumers and make markets more competitive, but much empirical work on the Internet has not been supportive of the theory. Previous research has generally found large dispersion of prices online, and prices either modestly lower or actually higher than their offline counterparts. This Lumina award-winning paper documents how important the Internet can be for offline market competition, in relation specifically to the US market for term life insurance for several reasons.

On the Coherence of Expected Shortfall
Carlo Acerbi and Dirk Tasche, AbaxBank and RiskLab, working paper, September 2001
‘Expected shortfall’, in several variants, has been proposed as remedy for the deficiencies of value-at-risk (VaR), which in general is not a coherent risk measure. In fact, most definitions of expected shortfall lead to the same results when applied to continuous loss distributions. Differences may appear when the underlying loss distributions have discontinuities. This paper compares some of the definitions of expected shortfall, pointing out there is one that is robust in the sense of yielding a coherent risk measure regardless of the underlying distributions. Moreover, this expected shortfall can be estimated effectively even in cases where the usual estimators for VaR fail.

Liquidity Shocks, Systemic Risk and Market Collapse: Theory and Application to the Market for Perps
Chitru S. Fernando and Richard J. Herring, University of Michigan, Wharton School, August 2001
Traditional explanations of market crashes rely on the collapse of an asset price bubble, or the exacerbation of an information asymmetry sufficient to cause less-informed participants to withdraw from the market. The authors of this paper show that markets can crash even without these conditions, and present a model in which markets crash when investors shift their beliefs about the liquidity of the secondary market. They say the collapse of the market for perpetual floating-rate notes (perps) provides an especially clear illustration of the theory because a shift in liquidity beliefs appears to have been the sole determinant of the market crash. They point out that, since market liquidity arises endogenously from the diversity of liquidity needs across the investor base, the broader the investor base, the lower the probability of a systemic liquidity shock.

Diversification Benefits of Emerging Markets Subject to Portfolio Constraints
Kai Li, Asani Sarkar, Zhenyu Wang, University of British Columbia, Federal Reserve Bank of New York, updated July 2001
This paper examines the international diversification benefits subject to portfolio constraints, in particular, constraints on short selling. It shows that the international diversification benefits remain substantial for US equity investors when they are prohibited from short selling in emerging markets. It seems that the integration of world equity markets reduces, but does not eliminate, the diversification benefits of investing in emerging markets subject to short-sale constraints.

Market Discipline Prior to Failure
Julapa Jagtiani and Catherine Lemieux, Federal Reserve Bank of Chicago, November 2000
This paper examines market-pricing behaviour for bonds issued by bank holding companies in the period prior to failure of their bank subsidiaries. The results indicate that bond prices are related to the financial condition of the issuing bank holding companies, and that bond spreads start rising as early as six quarters prior to failure as the issuing firm's financial condition and credit rating deteriorate. Strong market discipline exists during this critical period – bond spreads for troubled banking organisations are many times those of healthy ones. The results suggest that bond spreads could potentially be useful to bank supervisors as a warning signal from the financial markets. In addition, the finding implies that the proposals to require bank holding companies to issue publicly traded debt in a greater volume and frequency will likely enhance market discipline in the banking system when it is most needed.

The Asset Allocation of Emerging Market Mutual Funds
Piti Disyatat and R Gaston Gelos, IMF, August 2001
In an uncertain world, practitioners and economists are more interested than ever in the mechanisms that might cause a shock in one market to spread to other markets around the world. This International Monetary Fund working paper looks at the problem of whether emerging market equity funds, in their efforts to rebalance portfolios and stay in line with benchmark indices, might form an unwitting channel for risk contagion. The paper’s conclusion suggests that there is evidence for the importance of benchmark following, or herding, by funds but that other factors are important as well.

Pure Contagion and Investors’ Shifting Risk Appetite: Analytical Issues and Empirical Evidence
Manmohan S Kumar and Avinash Persaud, IMF and State Street Bank, September 2001
This IMF working paper looks at the evidence for, and impact of, shifts in investor appetite for risk across different markets. It reviews the reasons why market crises seem to be contagious across economic regions, and concludes that shifts in investor attitudes to risk help to explain why market crises tend to cluster together. It offers a framework for identifying changes in risk appetite, and discusses how to differentiate between weak domestic fundamentals and financial contagion as the immediate source of any financial markets crisis.

Sending the Herd off the Cliff
Avinash Persaud, December 2000
Might the kind of market-sensitive risk management systems favoured by today’s regulators actually make markets more prone to crisis? Avinash Persaud makes a case against the herding of quants in this, the First Prize Essay on Global Finance for the year 2000 in the Institute of International Finance competition in honour of Jacques de Larosière.
(PDF download)

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