Modelling Non-Maturing Deposits with Stochastic Interest Rates and Credit Spreads

Andreas Bohn

This chapter introduces an approach to hedging non-maturing deposits under stochastic deposit volumes, interest rates and credit spreads. The method described allows outflows to be captured from the unexpected weakening of the creditworthiness of a financial institution. Furthermore, it allows modelling of the negative convexity from margin compression risks, which are the risks of market rates falling close to or below a floor for interest rates paid to clients.

The second section of this chapter provides a brief overview of the scope of the deposits product. Subsequently, in the third section a static approach to constructing replicating portfolios is given. The fourth section describes the simultaneous modelling of deposit volumes, interest rates and credit spreads followed by a depiction of simulation results. The specific topic of hedge ratios for the margin compression risk follows. A summary concludes the chapter.

The approach described in this chapter is similar to the approach to hedging the present value of demand deposits presented by Jarrow and van Deventer (1998) and the method by Elkenbracht and Nauta (2006) for hedging the present value of the interest margin from