Securitized banking and interest rate sensitivity

Review of Quantitative Finance and Accounting - Gorton and Metrick (J Financ Econ 104:425–451, 2012) coin the term “securitized banking” to refer to the combination of asset...     

Banks' option to lend,interest rate sensitivity,and credit availability

Interest rate risk is a major concern for banks because of the nominal nature of their assets and the asset-liability maturity mismatch. This paper proposes a new way to derive a bank's interest rate sensitivity, by examining separately the effects of interest rate changes on existing loans(loans-in-place) and potential loans (loans-in-process). A potential loan is shown to be equivalent to an American option to lend, and is valued using option theory. An increase in interest rates generally has a negative effect on existing loans. However, if both deposit and lending rates rise by the same amount, the value of a potential loan generally increases. Hence a bank's lending slack (or ratio of loans-in-process to loans-in-place) will determine its overall interest rate risk. Empirical evidence indicates that low-slack banks indeed have significantly more interest rate risk than high-slack banks. The model also makes predictions regarding the effect of deposit and lending rate parameters on bank credit availability. Empirical tests with quarterly data are generally supportive of these predictions. This revised version was published online in June 2006 with corrections to the Cover Date.     

Risk-based pricing of interest rates for consumer loans

By focusing on observable default risk's role in loan terms and the subsequent consequences for household behavior, this paper shows that lenders increasingly used risk-based pricing of interest rates in consumer loan markets during the mid-1990s. It tests three resulting predictions: First, the premium paid per unit of risk should have increased over this period. Second, debt levels should have reacted accordingly. Third, fewer high-risk households should have been denied credit, further contributing to the interest rate spread between the highest- and lowest-risk borrowers.For people obtaining loans, the premium paid per unit of risk did indeed become significantly larger after the mid-1990s. For example, for a 0.01 increase in the probability of bankruptcy, the corresponding interest-rate increase tripled for first mortgages, doubled for automobile loans and rose nearly six-fold for second mortgages. Additionally, changes in borrowing levels and debt access reflected these new pricing practices, particularly for secured debt. Borrowing increased most for the low-risk households who saw their relative borrowing costs fall. Furthermore, while very high-risk households gained expanded access to credit, the increases in their risk premiums implied that their borrowing as a whole either rose less or, sometimes, fell.     

Re-examination of interest rate sensitivity of commercial bank stock returns using a random coefficient model

This article develops and tests a random coefficient two-index model for commercial bank stock returns which controls for the time-varying interest rate sensitivity caused by a bank's changing maturity profile. Using a sample of 51 actively traded commercial banks, the seemingly unrelated regression results provide evidence that commercial bank stock returns are significantly interest rate sensitive. The effect of interest rate changes on bank stock returns is found to be positively related to the maturity mismatch between the bank's assets and liabilities, when the proxy for interest rate changes and the proxy for maturity mismatch are compatible to each other.This article was written while I was a doctoral student at the University of North Carolina at Chapel Hill. It was presented at the 1989 FMA Annual Meeting in Boston.     

On alternative interest rate processes

In this paper alternative interest rate processes are estimated for Denmark, Germany, Sweden, and the UK, using the generalized method of moments (GMM). In line with the study by Chan, Karolyi, Longstaff, and Sanders (1992) on US data, there seems to be a positive relation between interest rate level and volatility for some countries. In contrast to their study, it is found that mean-reversion plays an important role for the specification of the interest rate dynamics. The results seem to be robust to the use of different moment conditions, and simulations of the estimated models reveal that they are fairly able to capture non-fitted moments as well. In addition, there is evidence of a structural change in the Danish interest rate process in August 1985, which may be due to a change in monetary policy. The small sample properties of the GMM estimators are also studied through simulations.     

Determinants of interest rate swap spreads

This study argues that an interest rate swap, as a non-redundant security, creates surplus which will be shared by swap counterparties to compensate their risks in swaps. This action in turns affects swap spreads. Analyzing the time series impacts of the changes of risks of swap counterparties on swap spreads, we conclude that both lower and higher rating bond spreads have positive impacts on swap spreads. We also derive a risk–spread relation to test if swap counterparties are firms with differential credit ratings. Since the risk allocation between swap counterparties varies over business cycles, hence this factor needs to be controlled. We conclude that (1) similar results hold if the business cycle factor is controlled and (2) swap spreads contain procyclical element and are less cyclical than lower credit rating bond spreads.     

The pricing of interest rate swaps

Interest rate swaps have become an important tool for financial institutions because they provide a convenient way to reduce interest rate risk. Swaps allow financial institutions to obtain short-term deposits in the local deposit market and then transform these into longer-term liabilities. The growth of swaps has been explosive, with the swap market growing from nothing in 1981 to an estimated $889 billion in 1987. In addition to their role in managing interest rate risk, swaps have become important to financial managers for other reasons, and as a result the swap market is monitored by financial managers as are money and capital markets. Because of its growing importance, an empirical perspective on how swaps are priced is needed. This article develops a simple market model and then estimates the model using data provided by three major swap market participants.     

Equilibrium implications of interest rate smoothing

We introduce a macro-finance model in which monetary authorities adjust the money supply by targeting not only output and inflation but also the slope of the yield curve. We study the impact of McCallum-type rules on capital growth, the volatility of interest rates, the spread between long- and short-term rates, and the persistence of monetary shocks. Our model supports the Federal Reserve's choice to incorporate financial data in their policy decisions and expand the monetary base to decrease the nominal interest rate spread at the cost of lower expected long-term growth.     

Exchange rate dynamics under alternative optimal interest rate rules

We explore the role of interest rate policy in the exchange rate determination process. Specifically, we derive exchange rate equations from interest rate rules that are theoretically optimal under a few alternative settings. The exchange rate equation depends on its underlying interest rule and its performance could vary across evaluation criteria and sample periods. The exchange rate equation implied by the interest rate rule that allows for interest rate and inflation inertia under commitment offers some encouraging results — exchange rate changes “calibrated” from the equation have a positive and significant correlation with actual data, and offer good direction of change prediction. Our exercise also demonstrates the role of the foreign exchange risk premium in determining exchange rates and the difficulty of explaining exchange rate variability using only policy based fundamentals.     

Measuring consumer switching costs in the television industry

In this article, I develop and estimate a model of dynamic consumer behavior with switching costs in the market for paid‐television services. I estimate the parameters of the structural model using data on cable and satellite systems across local US television markets over the period 1992–2006. The results suggest switching costs range from $159 to $242 for cable and from $212 to $276 for satellite providers in 1997 dollars. Using a simple dynamic model of cable providers, I demonstrate that switching costs of these magnitudes can significantly affect the firms' optimal strategies.     

Exchange rate dynamics under alternative optimal interest rate rules

We explore the role of interest rate policy in the exchange rate determination process. Specifically, we derive exchange rate equations from interest rate rules that are theoretically optimal under a few alternative settings. The exchange rate equation depends on its underlying interest rule and its performance could vary across evaluation criteria and sample periods. The exchange rate equation implied by the interest rate rule that allows for interest rate and inflation inertia under commitment offers some encouraging results — exchange rate changes “calibrated” from the equation have a positive and significant correlation with actual data, and offer good direction of change prediction. Our exercise also demonstrates the role of the foreign exchange risk premium in determining exchange rates and the difficulty of explaining exchange rate variability using only policy based fundamentals.     

Interest rate expectations and interest parity

This paper examines an hypothesis for explaining divergences from interest parity that is based on interest rate expectations. If interest rates are expected to rise significantly within the arbitrage oppurtunity implies riskless profit. Waiting in ths way has been noted in the historical literature, seems to make sense theoritically (if portfolio adjusment cost in the capital market outweigh any costs of being out of long term equilibrium), and explains a significant portion of US-UK interest parity divergences using onshore assets in a recent floating preiod.     

中国利率衍生品市场前瞻

近年来,全球金融衍生市场发展很快,衍生产品交易量已经远远超过基础证券市场.因其在对冲风险、发现价格、降低融资成本、提高市场效率和增强流动性等方面所发挥的重要作用,正在受到越来越多的关注.中国的金融衍生品市场还刚刚起步,目前推出的品种中,利率衍生品包括债券远期和利率掉期,汇率衍生品有外汇远期和货币掉期.国内衍生品运行一年多来,各品种的成交量逐步增加,市场成员的关注程度日益增强,其作用也在迅速扩大.     

Regime shifts in interest rate volatility

I find evidence of regime shifts in interest rate volatility using short-rate data from the U.S., the U.K., Japan, and Canada. The regime shifts, if unaccounted for, could lead to spurious volatility persistence when the volatility processes are estimated with the stochastic volatility (SVOL) model. In contrast, the apparent persistence in volatility drops sharply in three out of the four countries when I estimate the volatility processes with the regime-switching stochastic volatility (RSSV) model. I also contribute to the literature by showing how to account for correlation in the regime-switching stochastic volatility model, which is important for modeling asymmetric volatility.     

Tacit collusion under interest rate fluctuations

Previous literature has shown that demand fluctuations affect the scope for tacit collusion. I study whether discount factor fluctuations can have similar effects. I find that collusion depends not only on the level of the discount factor but also, and more surprisingly, on its volatility. Collusive prices and profits increase with a higher discount factor level, but decrease with its volatility. These results have important implications for empirical studies of collusive pricing, the role that collusive pricing may play in economic cycles and the study of cooperation in repeated games.