Dealers' hedging of interest rate options in the U.S. dollar fixed-income market

Despite investors' willingness to hold a variety of financial assets and risks, a significant share of interest rate options exposures remains in the hands of dealers. This concentration of risk makes the interest rate options market an ideal place to explore the effects of dealers' dynamic hedging on underlying markets. Using data from a global survey of derivatives dealers and other sources, this article estimates the potential impact of dynamic hedging by interest rate options dealers on the fixed-income market. The author finds that for short-term maturities, turnover volume in the most liquid hedging instruments is more than large enough to absorb dealers' dynamic hedges. For medium-term maturities, however, an unusually large interest rate shock could lead to hedging difficulties.Hedging (Finance) ; Options (Finance)

Incorporating New Fixed Income Approaches into Commercial Loan Valuation

Growing competition, convergence of the loan and capital markets, and the greater complexity of commercial loan structure have heightened the need for banks to manage their loan portfolios in a more sophisticated way. This is true for the management of individual transactions and for the loan portfolio as a whole. In order to do so, each and every loan must be valued more accurately to account for the credit risk imbedded in the loan, loan migration, its structure and subsequent periodic fees and repricing agreements. In short, loans must be priced in a much more dynamic and complete way than is the case today. To do so, however, requires that banks acquire a deeper understanding of loan valuation and apply the newer techniques of the bond market to the loan market. Specifically, the new standards to credit analysis require the following steps to be taken: Loans must be accurately rated, monitored, and tracked through time. This history will prove important, not only for the existing loan, but also for all subsequent loans that can benefit from the migration pattern that is unique to the specific institution. A. The credit officer must more accurately value the underlying pricing conventions built into the loan market. These are often neglected when loans are priced as bonds. The existence of a repricing grid, a periodic fee structure and various repricing techniques are often neglected in favor of the assertion that loans are merely small bonds. B. Structure must be more accurately priced. Towards this end, it is necessary for the individual institution to recognize that structure has value. It should be quite apparent that the options imbedded in the loan portfolio have value; we have known the value of options imbedded in bonds for some time. As the derivative market has expanded, we trade these options that are part of the collective loan agreement in isolation. It is incumbent upon the banking community to more accurately price these options and to incorporate them into the pricing of loans that have imbedded options. To do all this would result in an improvement in the ability of banking institutions to value their loans, define their required spreads, and to both aggressively and accurately compete. It is often the case that structure and repricing are powerful tools to be employed in the competitive financial community. At the moment, however, structure is often given away and options are often neglected in competitive bidding. Banks can compete more effectively for their customers and have higher yielding loan portfolio to the extent that they have the ability to price the value of these options, to use the repricing of the credit spread and to know the migration of credit quality that is specific to the credit portfolio of their particular bank. There is no question that the market for credits is under severe competitive pressure. In such an environment, knowledge of the underlying portfolio and its value is the only true weapon for successful competition. Those that lag behind will be gamed by competitors and gamed by their customers. They will find they are subject to what academics call "the winner's curse." They will lose the good deals and win the bad ones. In today's world, information about the underlying lending relationship is the only adequate defense for a successful banking firm.

Analysis of portfolio insurance strategies based upon empirical densities

Mestrado em FinançasEste estudo avalia a performance das mais comuns estratégias de Portfolio Insurance, baseando essa análise em simulações de blocos móveis de Bootstrap. Nesta análise consideramos não apenas as tradicionais medidas associadas à Teoria Média-variância, mas também outras medidas associadas ao Downside Risk, bem como classificações de dominância estocástica. Foram identificadas evidências que suportam que a estratégia CPPI 1 deve ser preferida em termos da sua dominância face às restantes. Contrariamente, a estratégia SLPI deverá ser preterida face a outras estratégias de Portfolio Insurance. Encontrámos igualmente evidências de que deverão ser escolhidas barreiras mínimas mais elevadas, com o objectivo de maximizar a utilidade da generalidade dos investidores. Consistentemente, e meramente em termos de performance, a estratégia CPPI 3 é aquela que apresenta resultados mais satisfatórios. Ao longo desta análise, tentamos proporcionar uma nova visão sobre as controversas estratégias de Portfolio Insurance, tentando tornar mais eficiente a decisão de futuros investidores.This study evaluates the performance of the most common Portfolio Insurance Strategies based on a block-moving bootstrap simulation. We consider not only the traditional mean-variance approach, but also some measures of downside risk and stochastic dominance. We find that CPPI 1 should be preferred in terms of stochastic dominance. We also find that SLPI is constantly dominated by all the other strategies and a floor of 100% should be preferred to lower ones. Consistently, and purely in terms of performance analysis, CPPI 3 tends to outperform other strategies. During this analysis, we try to provide another insight into the controversy over Portfolio Insurance strategies, turning the decision-making process for future investors more efficient

The use of derivatives to hedge embedded options : the case of pension institutions in Denmark

The main purpose of this paper is to examine the growing use of derivatives by Danish pension institutions as a risk management tool to hedge embedded options on their balance sheets. Throughout the 1980s and 1990s it was a widespread practice for Danish pension institutions to guarantee a minimum interest rate on new pension policies. With the new millennium global interest rates declined steeply and equity markets came crashing down. Suddenly the guarantees on pension contracts were in the money. The policies already written could not be changed, leaving liabilities and assets mismatched, profits in the red, and capital reserves drained. Out of necessity, and in some cases virtue, Danish pension institutions turned in scale to derivatives, allowing for a more active approach to hedging, asset and liability management, and even profit generation. Through the use of derivatives, pension institutions have avoided the need to renegotiate their guaranteed contracts with policy holders. They have succeeded as an industry in transforming their pay-off curves and haveemerged with better matched asset/liability positions and lower exposure to interest rate risk. But the expanded use of derivatives also raises some risk management and regulatory issues, such as operational and counterparty risks as well as effective internal control systems and regulatory oversight.Investment and Investment Climate,Economic Theory&Research,Insurance&Risk Mitigation,Non Bank Financial Institutions,Settlement of Investment Disputes

Traffic Light Options

This paper introduces, prices, and analyzes traffic light options. The traffic light option is an innovative structured OTC derivative developed independently by several London-based investment banks to suit the needs of Danish life and pension (L&P) companies, which must comply with the traffic light solvency stress test system introduced by the Danish Financial Supervisory Authority (DFSA) in June 2001. This monitoring system requires L&P companies to submit regular reports documenting the sensitivity of the companies’ base capital to certain pre-defined market shocks – the red and yellow light scenarios. These stress scenarios entail drops in interest rates as well as in stock prices, and traffic light options are thus designed to pay off and preserve sufficient capital when interest rates and stock prices fall simultaneously. Sweden’s FSA implemented a traffic light system in January 2006, and supervisory authorities in many other European countries have implemented similar regulation. Traffic light options are therefore likely to attract the attention of a wider audience of pension fund managers in the future. Focusing on the valuation of the traffic light option we set up a Black-Scholes/Hull-White model to describe stock market and interest rate dynamics, and analyze the traffic light option in this framework.Traffic light solvency tests; regulatory solvency requirements; asset-liability management in pension funds; hedging interest rate and stock price risk; derivatives pricing; Black-Scholes/Hull-White model

Economic Valuation Models for Insurers

Recently much attention has been given to the approaches insurers undertake in valuing their liabilities and assets. For example, in 1994 the American Academy of Actuaries created a Fair Valuation of Liabilities Task Force to address the issue. In 1997, the Academy established a Valuation Law Task Force and a Valuation Tools Working Group to investigate the various valuation approaches extant and to make recommendations on which models are best suited to the task. Much of the published work has focused on attributes of the various models, their strengths and shortcomings. Some of the work has addressed the larger questions, but in our view, it is useful and necessary to provide a taxonomy of approaches and evaluate them in a systematic way in accordance with how well they achieve their aims. In this paper we focus primarily on the economic valuation of insurance liabilities, although we do address some valuation issues for assets. We begin in Section I by defining insurance liabilities. Next, in Section II, we discuss the criteria for a good economic valuation model. This is followed by a taxonomy of valuation models in Section III. In Section IV, we examine insurance liabilities in the context of this taxonomy and identify the minimum requirements of an economic valuation approach that purports to value them adequately. An illustration of the application of a modern valuation model is given in Section V. We conclude in Section VI by discussing some limitations of our analysis, and offer some recommendations for implementation.