On the risk management of demand deposits: quadratic hedging of interest rate margins

• Published in: Annals of operations research Vol. 313; no. 2; pp. 1319 - 1355
• Main Authors: Adam, Alexandre, Cherrat, Hamza, Houkari, Mohamed, Laurent, Jean-Paul, Prigent, Jean-Luc
• Format: Journal Article
• Language: English
• Published: New York Springer US 01.06.2022; Springer; Springer Nature B.V; Springer Verlag
• Subjects: Accounting; Analysis; Balance sheets; Bank deposits; Banking industry; Banks; Business and Management; Combinatorics; Computational Finance; Deposits; Expected values; Fair value; Hedging; Hedging (Finance); Interest rates; Liability; Methods; Operations research; Operations Research/Decision Theory; Quantitative Finance; Risk Management; S.I.: Risk Management Decisions and Value under Uncertainty; Securities markets; Stochastic processes; Theory of Computation; Volatility; France; Quadratic hedging; Demand deposits; Interest rate margins; Risk management
• ISSN: 0254-5330; 1572-9338
• DOI: 10.1007/s10479-020-03726-1

This paper examines the problem of hedging banks interest rate margins. We assume that the demand’s deposits follow an exponential Lévy process with potential jumps. The forward market rates are assumed to follow the standard market model introduced by Brace et al. (Math Finance 7(2):127–155, 1997). As Adam et al. (Hedging interest rate margins on demand deposits, Université Paris 1 Panthéon-Sorbonne working paper, 2012), we consider that deposit rates depend linearly on market rates. Face to incompleteness, the liability manager must hedge both interest rate and demand deposit risks. For this purpose, we introduce various quadratic hedging criteria, allowing us to provide explicit hedging strategies that we further analyze. We illustrate in particular the impact of both the trends and the volatilities of interest rates and demand deposits.