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THC Blog : Low-Interest Rate Regime

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    Low-Interest Rate Regime: Challenges and Solutions
    Posted on 2020-01-09 | Author: Olga
    The low rate regime has vast ramifications on balance sheet and portfolio performance.
    Recently, European global banks such as Deutsche Bank, HSBC, and others have refocused
    their business models in response to the low-interest rates.
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THE PROBLEM
Option, option everywhere - Option Risk everywhere. The current low-interest rates have significant repercussions on capital markets. For example, many banks experienced a torrent of residential mortgage prepayments and called bonds during the third quarter of 2019, lowering financial income significantly. Regulators call such prepayment spikes "option risk". The Asset-Liability Committee (ALCO) has to manage option risk, especially when there are many options embedded on the balance sheet.
 
The specifications and explanations should include the following:
1. Local Volatility Model
The model specification is relatively simple and robust. There are only five parameters to specify the model. (i) Parameter [a] specifies the short term volatility. (ii) Parameter [b] specifies the short-term increase or decrease of volatility. (iii) Parameter [c] specifies the decay of the volatilities over time; (iv) [d] in the long term volatilities. (v) Parameter [p] is the skewness of the binomial distribution.
2. Historical Trends
To underscore the transparency of the Local Vol model, a historical trend of the term structure of volatilities is provided. The graph depicts the projected one-month interest rate volatilities of the Local Volatilities Model.
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3. Rate Distribution
The Rate Distribution presents the capital market relative pricing of rates rising vs falling.
4. Out-of-the-Money (OTM) Impact on Rate Distribution
Many interest rate models are calibrated with only At-the-Money Options. But when interest rates are low, the Out-of-the-Money options can have a significant impact on the Rate Distribution, and hence the pricing of caps and floors.
 
In Summary
  • The term structure of volatilities identifies the market perceived uncertainties of short term and long term events
  • Rate Distributions identify the two side tail distributions of rates
  • Calibration should use both OTM and ATM options to correctly price the cap/floor structures embedded in loans.
If you are interested in learning more we invite you to:
Call us at 269-558-5004 or email us at support@thomasho.com.
Download the THC white paper, Arbitrage-Free Interest Rate Model in Negative Rate Regimes
Subscribe to our YouTube channel at http://www.youtube.com/c/ThomasHoCompanyLtd
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