| Cash flow Metric modelling | Description | Risks Limitations of metric captured • The metric approximates the gap risk |
| Earnings-based: • Gap | Gap analysis allocates all relevant interest rate sensitive instruments maturity behavioural into predefined dates, assumptions. which time buckets are either It calculates according contractually the to net their fixed positions repricing or based (‘gaps’) or on in | only linearly. Gap (only risk parallel • It positions is based within on the a assumption particular time that all |
| analysis: Repricing gap | each time bucket. It approximates the change in net interest rate income ensuing from a yield curve shift by multiplying each net position with the corresponding interest rate change. The modified duration approximates the relative change in the net | risk) bucket mature or reprice simultaneously. • It fails to measure basis and option risk. |
| Unconditional cash flows (it is assumed that the timing of cash flows is Economic independent of the value: specific interest • Duration rate scenario) analysis: Modified duration/P V01 of equity | present value of a financial instrument due to a marginal parallel shift of the yield curve by one percentage point. The modified duration of equity measures the exposure of an institution to gap risk in its non-trading book. PV01 of equity is derived from the modified duration of equity and measures the absolute change of the equity value resulting from a 1 basis point (0.01%) parallel shift of the yield curve. The starting point is the allocation of all cash flows of interest rate sensitive instruments into time buckets. For each instrument type, an appropriate yield curve is selected. The modified duration of each instrument is calculated from the change of its net present value due to a 1 percentage point parallel shift of the yield curve. The modified duration of equity is determined as the modified duration of assets times assets divided by equity minus the modified duration of liabilities times liabilities divided by equity. | • The metric only applies to marginal shifts of the yield curve. In the presences of convexities, it may Gap risk underestimate the effect of larger (only parallel interest rate movements risk) • It only applies to parallel shifts of the yield curve • It fails to measure option risk and captures basis risk at best partially. |
| Cash flow Metric modelling | Description PV01 of equity is obtained by multiplying the modified duration of equity by the value of equity (i.e. assets minus liabilities) and dividing by 10 000 to arrive at the value change per basis point. The partial modified duration of an instrument for a specific time bucket is calculated as the modified duration above, except that not | Risks Limitations of metric captured • The metric only applies to marginal |
| • Partial | the segment entire corresponding yield curve is shifted to the time in parallel, bucket. but These only partial the yield measures curve | Gap risk interest presence rate of convexity, changes. In the the metric |
| modified duration/p artial PV01 | show the sensitivity of the market value of the banking book to a marginal shift of the yield curve in particular maturity segments. To each time bucket’s partial measure a different magnitude of a shift can be applied, such that the effect of a change of the yield curve’s shape can be computed for the entire portfolio. | (parallel and may underestimate the effect of non-parallel larger interest rate movements. risk) • It fails to measure the basis and option risk. |
| Cash flows partially or fully conditional on interest rate scenario (it is assumed that the timing of cash flows of options, of Earnings-instruments with based: embedded, explicit Focus on options and – in net interest more sophisticated income (NII) approaches – of component: instruments of • Change of which the maturity NII depends on clients’ behaviour, is modelled conditional on the interest rate scenario) | The change of NII is an earnings-based metric and measures the change of the net interest income over a particular time horizon (usually 1-5 years) resulting from a sudden or gradual interest rate movement. The starting point is the mapping of all cash flows of interest rate sensitive instruments to (granular) time buckets (or using the exact repricing dates of individual positions in more sophisticated systems). The base scenario for the calculations reflects the institution’s current corporate plan to project the volume, pricing and repricing dates of future business transactions. The interest rates used to calculate future cash flows in the base scenario are derived from forward rates, appropriate spreads or market expected rates for different instruments. In assessing the possible extent of NII changes, banks use assumptions and models to predict the path of interest rates, the run-off of existing assets, liabilities and off-balance-sheet items, and their potential replacement. | Gap risk (parallel and non-parallel), basis risk and, • Sensitivity of the outcome to the provided all modelling and behavioural cash flows assumptions are modelled • Complexity scenario dependent, also option risk |
| Cash flow Metric modelling | Description Earnings-based metrics can be differentiated according to the sophistication of projecting future cash flows: simple run-off models assume that existing assets and liabilities mature without replacement; constant balance sheet models assume that maturing assets and liabilities are replaced by identical instruments; while the most complex dynamic cash flow models reflect business responses to differing interest rate environments in the size and composition of the banking book. All earnings-based metrics can be used in a scenario or stochastic analysis. Earnings at risk (EaR) is an example of the latter, which measures the maximum NII change at a given confidence level. The change in EVE is the change in the net present value of all cash | Risks Limitations of metric captured Gap risk (parallel and • Sensitivity of the outcome to the |
| Economic value: Focus on | flows balance-sheet assuming originating that items all from banking resulting banking book from book positions a assets, change run liabilities in off. interest and rates, off- | non- parallel), basis risk • modelling assumptions Stochastic and metrics, behavioural which apply |
| economic value equity of (EVE) | The interest interest rate rate scenarios risk can or be by assessed the distribution by the ∆EVE of ∆EVE for using specific Monte | and, if all distributional assumption, may fail to cash are modelled flows • capture Full revaluation tail risks Monte and non-linearities Carlo |
| • Change EVE in | example change Carlo or for historical of a the given latter, simulations. confidence which measures level. Economic the value maximum at risk equity (EVaR) value is an | dependent, also scenario option approaches demanding interpret (‘black-box’) and are computationally may be difficult to risk • Complexity |