Dynamics of Interest Cash Flows From a Banks Loan Portfolio with Continuously

Distributed Maturities
(A case of sudden stepwise change in yield curve)

Ihor Voloshyn

August 2014

Version 2

Working paper

Ihor Voloshyn
PhD., senior scientist at Academy of Financial Management
of Ministry of Finance of Ukraine
38-44, Degtyarivska str.,
04119, Kyiv, Ukraine
Tel. +38 044 486 5214
vologor@i.ua

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Electronic copy available at: http://ssrn.com/abstract=2461150

Abstract
A continuous-time deterministic model for analytical simulation of impact of the
change in yield curve on banks interest income from a fixed rate loans portfolio is
presented. It is considered both differential and integral presentations of equations
for dynamics of principal and interest cash flows. The model allows taking into
account the arbitrary movements in interest rates. Examples of calculation of total
(from portfolio) and partial (across maturities) interest cash flows and
corresponding interest rates on those cash flows are given. The sensitivity of total
interest cash flows is evaluated for some changes in yield curve on loans that obeys
the Nelson-Siegel model.

Key words: bullet loan, fixed rate loan, loan portfolio, principal cash flow, interest
cash flow, interest accrual, sensitivity of interest cash flows, yield curve, NelsonSiegel model, sudden stepwise change, interest rate risk, continuous-time model,
differential advective equation, Volterra integral equation

JEL Classifications: G17, G21, G32, C61, C63

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Electronic copy available at: http://ssrn.com/abstract=2461150

1. INTRODUCTION

Interest rate risk is one of the main types of risk that significantly affects the
change in banks earnings and capital. Variation in earnings is an important focal
point for interest rate risk analysis because reduced earnings or outright losses can
threaten the financial stability of an institution by undermining its capital adequacy
and by reducing market confidence. (BIS, 2004).
It is well-known that the sources of interest rate risk are repricing risk, yield
curve risk, basis risk and optionality (BIS, 2004).
In practice banks face two issues. The first of these is to define interest rate
risk exposure. Banks operate under constant reproduction of their asset and
liability contracts. New interest-bearing assets and liabilities continuously replace
old matured assets and liabilities. Due to this fact the banks interest rate risk
exposure is unceasingly changed.
And the second of these is to forecast the potential course of future interest
rates. Yield curves may in the future vary their slope, curvature and shape.
To solve these two issues it is suitable a dynamic simulation approach which
allows taking into account more detailed assumptions about the future course of
interest rates and expected changes in a bank's business activity (BIS, 2004).
The paper is focused on theoretical analysis of the impact of changes in
interest rates on a banks accrual earnings. The continuous-time model is going to
use for this research. Such a model allows integrating the balance sheet, income
statement and ALM (asset liability management) forecasting processes into a
single process giving a forward-looking and integrating view on the issue.
Note that transfer to a continuous-time model allows using a rich store
of methods of functional analysis, giving a qualitative picture of a banks
business activity, discovering general regularities of banks dynamics
(Linder, 1998).

2. MODEL

Let an interest-bearing portfolio of a bank consist of the fixed interest rate bullet
loans in which only interest is paid continuously for the lifetime of loan; the
principal is paid in one lump sum at the end of the term to maturity (Business
Dictionary). The portfolio is changed due to repayment of the existing loans and
issuance of the new ones from different borrowers. The loans of the existing
borrowers are not rolled over. Each new loan is issued to a new borrower.
Moreover, influence of default and prepayment on cash flows is neglected.
Let the new principal cash flows CFp(t,w) from the new loans with the
primary term to maturity w at the time t be originated with interest rate r(t,w). The
existing principal cash flow with the remaining term w to maturity at the time t has
other yield of rr(t,w). Assume that interests are accrued according to the simple
interest approach.
Note that to take the term structure of interest rate into account it is followed
to use a dynamic model for banks cash flows. Voloshyn (2004), Freedman (2004),
Selyutin and Rudenko (2013) are developed the continuous-time models which are
based on the partial differential equations of advective type. Voloshyn (2007)
proposed to distinguish the cash flows of principals and interests. He showed that
dynamics of principal and interest cash flows is described by the similar equations:
CFp (t , w)
t

CFp (t , w)
w

S p (t , w) , (1a)

CFi (t , w) CFi (t , w)

S i (t , w) , (2a)
t
w

where CFp(t,w) and CFi(t,w) are the cash flows of principals and interests,
respectively, with the remaining term w to maturity at time t;
Sp(t,w) and Si(t,w) are the intensities of appearance of the new cash flows of
principals and interests, respectively, with the primary maturity w at the time t. In
other words, there are demands for principal and interest;
t is the time;
w is the (primary or remaining) term to maturity;
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and
are the partial derivatives respect to time t and term w to maturity,
w
t

respectively.
It should be noted that the cash flows CFp(t,w) and CFi(t,w) are partial
(across terms to maturity) cash flows.
A loan demand function may depend on interest rate on loans, rollover ratio,
macroeconomic parameters, etc. But for simplification such dependences will be
abandoned. Besides, the loan demand is supposed to be a deterministic function.
Note that the above mentioned assumptions may be released.
The equations (1a and 2a) have the following integral representations
(Voloshyn, 2004; Selyutin and Rudenko, 2013):
t

CFp (t , w) p (t w) S p ( s, t w s) ds (1b)
0
t

CFi (t , w) i (t w) Si ( s, t w s) ds (2b)
0

where s is the time parameter, p(t+w) and i(t+w) are the initial conditions for
CFp(t,w) and CFi(t,w), respectively. If it is needed to find an unknown demand
function that the equations (1b and 2b) will become linear Volterra equations of the
second kind.
Note that the principal Sp(t,w) and interest Si(t,w) intensities are linked
through interest rate r(t,w):
Si(t,w)=Sp(t,w)r(t,w), (3)
and the cash flows of principals CFp(t,w) and interests CFi(t,w) are linked through
interest rate rr(t,w):
CFi(t,w)= CFp(t,w)rr(t,w), (4)
where r(t,w) and rr(t,w) are the interest rates on the new and existing principal cash
flows, respectively, or the yield curves for the primary and remaining terms to
maturity. Note that r(t,w) and rr(t,w) are the interest rates on cash flows.
Consider the portfolio parameters. So, the dynamics of the portfolio volume
B(t) is described by the following equation (Volosyn, 2005):

dB(t )
CFp (t ,0) S p (t , w) dw , (5a)
dt
o

where B(t) is the portfolio volume.

The first term in right side of the equation (5a) is debit turnover and the
second term is the credit turnover of the portfolio.
Instead the equation (5a) knowing CFp(t,w) it is easy to find the volume of
the loan portfolio at the time t or the total (from the portfolio) principal cash flow:

B(t ) CFp (t , w) dw . (5b)

o

This expression (5b) shows that the total principal cash flows generated by
the loan portfolio consist of all existing non-matured principal cash flows.
Further consider the interest cash flow from the portfolio or the velocity of
portfolio interest accrual (Volosyn, 2007):
CF (t ) B(t ) R(t )

dII (t )
, (6)
dt

where CF(t) is the interest cash flow from the portfolio at the time t, R(t) is the
interest rate on the portfolio, II(t) is the interest income from the portfolio. Note
that R(t) is an interest rate on the loan balance.
Then, dynamics of CF(t) can be describe by the next equation (Volosyn,
2007):

dCF (t )
CFi (t ,0) S i (t , w) dw . (7a)
dt
o

The first term in right side of the equation (7a) is the total outflows of
interest cash flows caused by the repayment of matured principal cash flows and
the second term is the total inflows of interest cash flows caused origination of new
loans.
Instead the equation (7a) knowing CFi(t,w) it is easy to find the interest cash
flow from the portfolio at the time t:

CF (t ) CFi (t , w) dw . (7b)
o

This expression (7b) shows that the total interest cash flows generated by the
loan portfolio consist of all existing non-matured interest cash flows.

3. EXAMPLE

Consider how a sudden stepwise change (at time t>0) in yield curve for loans
affects a banks interest income.
Let the yield curve follows the Nelson-Siegel model (James and Webber,
2005):
w

1 exp
1
w

, (8)
r ( w, ) 0 1 2 1
2 exp
w
1

where w is the term to maturity, {0, 1, 2, 1} is the vector of the models

parameters, exp(x) is the exponential function. The long rate is equal to 0 and the
short rate is equal to 0+1. 2 and 1 control location and height of the hump.
Note that the Nelson-Siegel model allows describing changes in slope,
curvature and shape of the yield curve. In particular, it defines normal, inverted, ,
U- and S-shaped yield curves.
The stationary solution
To get the stationary solution for interest cash flows it is conveniently to use the
differential equations (2a and 7a) with the following conditions:
CFi (t , w)
dCF (t )
0.
0 and
dt
t

Then, dropping time t the equation (2a) is reduced to the form:

dCFi ( w)
Si ( w) (9)
dw

with the initial condition (7a):

CFi (0) S i ( w) dw . (10)

o

Then, integrating the equation (9) with the initial condition (10) leads to the
following stationary distribution of interest cash flows:
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CFi ( w) S i ( w) dw . (11)
w

Arguing similarly, using the equations (1a and 5a) and dropping time t the
following stationary distribution of principal cash flows is obtained:

CFp ( w) S p ( w) dw . (12)
w

The non- stationary solution

For simplicity, but without loss of generality, assume that the intensity of the
appearance of new principal cash flows from new loans is stationary and obeys the
exponential law of distribution respect to maturity w:
S p ( w)

w
, (13)
exp
2
2
S

where 2 is the characteristic maturity of loan portfolio; S S p w dw is the total

0

intensity of appearance of new cash flows. Then, the distribution of principal cash
flows has the following stationary form:
w
CFp ( w) p ( w) S exp . (14)
2

Let the initial condition i(w) for the equation (2b) be stationary and equal
to:

m
r (m, 1 ) dm .
exp

2
w 2

i (w)

Let the yield curve with the parameters vector 1 be suddenly (at time t>0)
step-wisely changed on the one with the parameters vector 2.
Then, the intensity (3) of appearance of interest cash flow is equal to:
Si ( w) S p ( w) r ( w, 2 )

w
r ( w, 2 ) .
exp
2
2
S

Herewith, the interest rates R(t) on the portfolio (from the equation (6)) and
the one rr(t,w) on the principal cash flows with the remaining term w to maturity
(from the equation (4)) are equal to, respectively:

R(t )

CF (t , w)
CF (t )
and rr(t , w) i
.
CFp (t , w)
B(t )

The sensitivity of the portfolio interest cash flows may be estimated by the
following formula:
S 1 (t 0) 2 (t 0)

CF (1)
1 , (15)
CF (0)

where CF(1) and CF(0) are the portfolio interest cash flows at t=0 and t=1 year,
respectively. This measure is a simple indicator of interest rate risk.
The sensitivity (15) shows how will be relatively changed the interest cash
flows from portfolio during 1 year caused by the sudden stepwise change in the
yield curve at time t>0. Input data for calculation is given in Table 1.
Table 1. Input data for calculation
Parameters
The total intensity of appearance of
new cash flows
The portfolio volume
The characteristic maturity of loan
portfolio

Designation
S

Value at time t=0

1

Value at time t>0

1

B
2

1
1.5 year

1
1.5 year

Results of calculation are presented on Fig. 1-5.

Fig. 1. Isolines of interest cash flows CFi(t,w) under 0 =5%, 1=-1%, 2=-6%, 1=1
at the time t=0 and 2=6% at the time t>0
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Fig. 2. Dynamics of interest rate R(t) on the loan portfolio under 0 =5%, 1=-1%,
2=-6%, 1=1 at the time t=0 and 2=6% at the time t>0

Fig. 3. Interest rate rr(t,w) on principal cash flows and the one r(w,2) on new cash
flows under 0 =5%, 1=-1%, 2=-6%, 1=1 at the time t=0 and 2=6% at the time
t>0

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Fig. 4. The sensitivity of portfolio interest income CF(1)/ CF(0)-1 to change in 2

under 0 =5%, 1=-1%, 2=0%, 1=1 at the time t=0

Fig. 5. The sensitivity of portfolio interest income CF(1)/ CF(0)-1 to change in 1

under 0 =5%, 1=-1%, 2=0%, 1=1 at the time t=0

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4. SUMMARY
Dynamics of a banks loan portfolio may be described by only the four equations
for total and partial cash flows of principals and interests. This model is an
internal (relatively market) model of banks activity.
Besides, it needs to use a model for loan demand (intensity of appearance of
new principal cash flows) and an interest rate model. Note that the loan demand
function is an interim model of interaction between market and the bank. And the
interest rate model is an external model that describes market behavior.
Theoretical result is useful to give general regularities of banks dynamics
and, for example, to debug computer programs. To employ the developed model in
practice it needs to pass to a discrete presentation of the obtained equations.
The questions related to:
the more realistic assumptions on a loan demand function, including the
inherent uncertainty of demand and renewal effect,
the uncertainty caused by default and prepayment,
a non-stationary dynamics of interest rate, etc.
are remained for further research.

LITERATURE
1. Basel Committee on Banking Supervision (2004). Principles for the
Management and Supervision of Interest Rate Risk.
http://www.bis.org/publ/bcbs108.pdf.
2. Business Dictionary. Bullet loan.
http://www.businessdictionary.com/definition/bullet-loan.html.
3. James, J. and Webber, N. (2005). Interest Rate Modelling. J. Wiley & Sons,
654p.
4. Freedman, B. (2004) An Alternative Approach to Asset-Liability
Management. 14-th Annual International AFIR Colloquium (Boston).
http://www.actuaries.org/AFIR/Colloquia/Boston/Freedman.pdf.
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5. Linder, N. (1998). A Continuous-Time Model for Banks Cash Management

// Finansovye Riski (Ukraine). #3, p.107111.
6. Selyutin, V. and Rudenko, M. (2013). Mathematical Model of Banking Firm
as Tool for Analysis, Management and Learning. http://ceur-ws.org/Vol1000/ICTERI-2013-p-401-408-ITER.pdf.
7. Voloshyn, I.V. (2004). Evaluation of bank risk: new approaches. Kyiv:
Elga, Nika-Center, 216 p. http://www.slideshare.net/igorvoloshyn3/ss15546686.
8. Voloshyn, I.V. (2005) A transitional dynamics of banks liquidity gaps //
Visnyk NBU (Ukraine). #9, p.2628.
http://www.bank.gov.ua/doccatalog/document?id=40077.
9. Voloshyn, I.V. (2007). A Dynamic Model of the Cash Flows of an Ideal
Interest Bank / Upravlenie riskom (Russia). #4(44), p.4650.
http://www.ankil.info/lib/3.

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