Duration as a strategic interest rate risk management tool in financial institutions / Gary Wayne van Vuuren
Banks and financial institutions record core banking activities (taking deposits and makingloans) on the balance sheet of the banking book, but trading book (trading and investment) pursuitsare recorded off-balance-sheet. Both books are subject to considerable risk from numeroussources, but regulatory capital reserves - to shield from unexpected market moves - are not requiredfor the banking book as they are for the trading book. Both of these substantial shortcomingswill be addressed in the near future. The 2005 initiation of new global accounting standardswill ensure that trading book derivative fair values are recorded and reported on the balancesheet while the new Basel accord, due for full implementation in 2007, will regulate the calculationand reservation of capital required for the banking book. These changes are expected to betterregulate and manage the transparency of financial institutions' activities and so prevent largescale economic disasters or deliberate corporate fraud. Institutions not compliant with the newrules will face severe financial losses, regulatory fines and possible debilitating legal action.One of the most commonly-used tools for measuring and managing interest rate risk, theMacaulay duration, has enjoyed almost unchallenged success, but it employs severely restrictiveand unrealistic assumptions which constrain its usefulness and reliability in the rapidly-changingworld of defaultable securities, those with embedded derivatives and instruments with perpetualmaturities. Robust measures which more accurately approximate interest rate risk by relaxingunrealistic assumptions are required.Applications which significantly improve the accuracy of the Macaulay duration are consideredas well as a new look at the duration problem in general. The influence of a more accurate durationmeasure on duration gap provides a significantly improved economic Market Value of Equity.The role of this enhanced measure is crucial for risk management as well as regulatory andaccounting compliance.
Year of publication: |
2005
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Authors: | Van Vuuren, Gary Wayne |
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