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ALMA MATER STUDIORUM – UNIVERSITÀ DI BOLOGNA

SCHOOL OF ECONOMICS MANAGEMENT AND STATISTICS

MSc Quantitative Finance

Risk management and Valuation of


Sight Deposits

Candidate: Matteo Gerardo Palumbo

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Basic Definitions

Sight (Demand) deposit: Non-maturity, interest bearing deposit account, where


money can be withdrawn at any time without prior notice

Behavioral modeling: Deposit volume dynamics are linked to market interest and
deposit rate movements. Clients respond to different financial and economic
environments. The goal is to have a better understanding and forecasting of deposit
volume evolution, for hedging and liquidity management.

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Fundamentals

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Fundamentals: The three building blocks

 Market Interest Rate

 Deposit Rate

 Deposit Volume

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Fundamentals: Examples of Deposit Models

 Deposit rate Function

 Deposit Volume Dynamics

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Fundamentals: The JvD Valuation Formula (1998)

The (arbitrage-free) Fair Value of demand deposits assuming market


segmentation, i.e. Banks can set the deposit rate below the market rate:

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Current issues and Consequences

Current issues: 1) Low and negative market rates


2) Explosion of CDS premia (i.e. default risk) in 2011 and
increasing concern on banks stability

Consequences: 1) Market rate above the deposit rate (JvD does not hold)
2) Risk remuneration (especially for non-guaranteed amounts)
3) Narrow margins imply riskier investment strategies

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Adjusting the model

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Adjusting the model: Deposit Rates

We extend the linear model to non-Guaranteed amounts, including a risk


premium, which is proxied by the CDS:

The possibility of non-linear as well as lagged effects should not be excluded

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Adjusting the model: Deposit Volumes

Behavioral model including the CDS:

Where we define the CDS spread as the difference between the individual
CDS and a benchmark:

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Adjusting the model: bank runs

We can also include bank runs by assuming that for a high enough level of CDS,
people are going to panic and run to withdraw in mass. We can model through an
indicator function:

Using a cumulative distribution (in the fashion of Nystrom (2008) ) instead of the
indicator function we get:

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The JvD Valuation Formula: Extensions and Alternatives

Assuming we can keep money cash insteaed of investing in the overnight:

Considering interest payments only: avoids assumptions on investment strategies

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Statistical analysis

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Data Description

 Aggregate Data on demand deposits: Bank of Italy “Bollettino statistico”

 Four Classes of deposits, divided by amount held in each account

 Market rate proxy: 1M EUR OIS

 CDS premia: 5Y Senior quotes

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Statistical analysis: Deposit Rates

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Statistical analysis: Deposit Rates (cont’d)

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Statistical Analysis: Deposit Volumes

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Experiments and Simulations

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Experiments: Sources of Stochasticity

 Short rate process

 CDS process

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Experiments: Valuation

 Economic value:

Interest expenses value:

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Experiments: Future Volumes term structure

 Average expected volume:

 Maximum exp. volume:

 Minimum exp. volume:

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Experiments Results

Simulated volumes paths on a 10 year period

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Experiments Results: Bank runs

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Experiments Results

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Experiments: Hedging by Deposit Rate policy

L(0) = 2 438 478 L(0) = 2 805 850

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What else and What’s next?

 Optimize trade-off between interest expenses and volume stabilization

 Replicating portfolios

 Stochastic Calibration problems: Historical vs Risk neutral

 Bail-in directive enhances the effect of CDS

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References

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