Calculating the effective duration of all of a bank’s assets and liabilities is not a trivial exercise. As we have seen many of these assets and liabilities contain embedded options.
Bond markets can be reasonably certain that an issuer able to refinance its debt will exercise its call option if it is deep in-the-money. This is not the case for many bank assets and liabilities that contain embedded options, such as fixed rate mortgages and time deposits, where it is more a matter of probabilities and many of these options will not in fact be exercised even though they are in-the-money. Estimating effective economic duration requires the use of sophisticated modeling techniques.
Archive for November, 2009
Credit spreads
November 9th, 2009The use of duration as a measure of interest rate risk implicitly assumes that there is no relationship between credit spreads and the level of risk-free rates. In fact it ignores credit spreads completely. In a stable interest rate environment, but where credit spreads are widening, the use of duration as a measure of changing economic value will tend to overstate the value of a bank’s assets and hence its economic value.