Local Volatility Interest Rate Model

Thomas S. Y. Ho () and Sang Bin Lee
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Thomas S. Y. Ho: Thomas Ho Company, Ltd.
Sang Bin Lee: Hanyang University

Chapter 81 in Encyclopedia of Finance, 2022, pp 1901-1918 from Springer

Abstract: Abstract The board of directors must now prepare risk management policies for regimes of low-interest rates and increased loss rates to fulfill its fiduciary responsibility to ensure the safety and soundness of the financial institution. Negative rates and higher unexpected loss rate regimes can no longer be ignored, and bankers should seek answers to the following crucial questions: How should the balance sheet be managed if negative rates and higher losses prevail? Are the current risk management models are appropriate for managing the balance sheet? This chapter explains how the local volatility model can provide what-if financial simulations, essential to balance sheet risk management, to address these questions. In particular, the chapter proposes financial simulation assumptions for the base case and stress scenarios. It also formulates balance sheet strategies for community banks to manage capital, liquidity, credit, and interest rate risks consistent with the bank’s risk culture while maintaining profitability. Furthermore, it demonstrates the validity of the local volatility model to navigate the impacts of COVID 19, allowing bankers to model balance sheet elements affected by the capital market’s negative rate regimes. Finally, it highlights the limitation of interest rate models widely used today in dealing with the applications described above.

Keywords: Rate distribution; Forward rates; Distribution skewness; Arbitrage-free models; Interest rate models; Normal modes; Lognormal models; Interest rate forecast; Calibration; Expectation hypothesis; Fisher equation; Local volatility model; Term structure of volatilities (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1007/978-3-030-91231-4_25

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