Asset-Liability and Liquidity Management

CHAPTER 5Interest Rate Models

Interest rate is the main risk factor examined in ALM analysis. The fundamental business model of a bank as a financial intermediary is based on the difference between interest earned on its assets and interest paid on its liabilities. The existence of this spread exposes the bank to interest rate risk on its earnings. Interest rate scenario analysis and planning for possible adverse cases are integral parts of banks' balance sheet management and to perform these, ALM teams rely on interest rate models. An interest rate model is a mathematical construct that characterizes the movement of interest rate over a period of time. It considers the stochastic nature of rate movement while taking into account the current interest rate environment, as well as historical rate movements.

A change in interest rate also impacts the value of assets and liabilities of banks. We introduced the discounted cash flow method in an earlier chapter as the fundamental tool for valuation of financial instruments. However, for some complicated instruments, such as callable bonds and mortgage-backed securities, we cannot perform valuation based only on the discounted cash flow method. For such instruments, alternative valuation methods are developed that are founded on interest rate models.

In this chapter we introduce a few interest rate models and we will use these models in later chapters for valuation purposes and also in simulation analysis of net interest income. Our ...