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Identifying, valuing and hedging of embedded options in non-maturity deposits

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  • Blöchlinger, Andreas

Abstract

Non-maturity deposits like savings accounts or demand deposits contain significant option risks caused by the bank’s discretionary pricing and the customers’ withdrawal right. Option risks follow from inherent non-linear factor exposures. I propose an ordinal response model for deposit rate jumps to identify non-linear factor exposures and a discrete-time term structure model to value the resulting option risks and to derive hedge measures “outside the model”. My delta profile resembles a constant maturity swap, but vega and gamma are more pronounced, which demonstrates that the widespread practice of static hedging with zero bonds is inadequate.

Suggested Citation

  • Blöchlinger, Andreas, 2015. "Identifying, valuing and hedging of embedded options in non-maturity deposits," Journal of Banking & Finance, Elsevier, vol. 50(C), pages 34-51.
    • Handle: RePEc:eee:jbfina:v:50:y:2015:i:c:p:34-51
    DOI: 10.1016/j.jbankfin.2014.09.013
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    References listed on IDEAS

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    1. Charles Kahn & George Pennacchi & Ben Sopranzetti, 1999. "Bank Deposit Rate Clustering: Theory and Empirical Evidence," Journal of Finance, American Finance Association, vol. 54(6), pages 2185-2214, December.
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    More about this item

    Keywords

    Discrete-time dynamic term structure model; Discretionary pricing; Mark-to-model valuation; Ordinal response model; Volatility risk;
    All these keywords.

    JEL classification:

    • C25 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Discrete Regression and Qualitative Choice Models; Discrete Regressors; Proportions; Probabilities
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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