Dear Clients and Partners,
On March 19, 2020, Treasury discount bill rates fell to 20 basis points. As rates continue to fall, a possible negative rate regime can no longer be ignored. Bankers should seek answers to the following crucial questions:
- How should the balance sheet be managed if negative rates prevail?
- Is the current risk management model appropriate for managing the balance sheet?
- How should Adjustable Rate Mortgages (ARMs) with caps and floors be priced? Are the embedded options (prepayment behavior) of a 30-year fixed mortgage loan affected?
We are providing this paper to explain the Local Volatilities Model and show empirical evidence of the validity and applications of the model.
The main contributions of the paper are:
- Demonstrate the applicability of the Local Volatilities model when interest rates are low or even negative
- Present the historical trends of interest rate term structure of volatilities and their applications
- Introduce the risk measure of rate distribution, in particular, the mean, variance and skewness of a rate distribution, which have many applications for balance sheet and risk management
- Highlight the limitation of interest rate models widely used today.