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@@SuccessMindset2180 diversification is key 🔑

Incorporating credit risk and contingency liquidity risk into the Funds Transfer Pricing (FTP) framework is essential for banks to accurately allocate costs and revenues across different business units. Let's explore how banks can develop benchmark models to effectively calculate these risks and determine the appropriate rates to include in the term rate for each risk category. Credit Risk in FTP: To incorporate credit risk into FTP, banks typically use risk-adjusted pricing models. These models assign a cost to credit risk, reflecting the probability of default and the potential loss given default. A common approach is to use credit spreads derived from market data or internal credit risk models. These spreads represent the additional yield investors demand for bearing credit risk. The credit spread is added to the risk-free rate to calculate the risk-adjusted term rate. The size of the credit spread depends on factors such as the credit rating of the counterparty, the maturity of the transaction, and prevailing market conditions. Banks may also consider the impact of collateral and credit enhancements when determining the appropriate credit spread. Contingency Liquidity Risk in FTP: Contingency liquidity risk refers to the cost associated with maintaining liquidity reserves to meet unexpected funding needs during periods of stress. Banks typically incorporate contingency liquidity risk into FTP by adding a liquidity premium to the term rate. The liquidity premium represents the additional cost incurred by the bank to hold liquid assets or maintain access to funding sources during times of market stress. The size of the liquidity premium depends on factors such as the bank's liquidity profile, the availability of alternative funding sources, and regulatory requirements. Banks may use metrics such as the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) to assess their liquidity risk profile and determine the appropriate liquidity premium to include in FTP. Developing benchmark models for credit risk and contingency liquidity risk involves analysing historical data, market conditions, and regulatory requirements to estimate appropriate risk premiums. These models should be regularly reviewed and updated to reflect changes in market dynamics and risk profiles. By incorporating credit risk and contingency liquidity risk into FTP, banks can ensure that pricing decisions accurately reflect the underlying risks associated with their funding and lending activities, ultimately supporting effective risk management and decision-making. If you require further elucidation on any aspect of this topic, please feel free to ask!

I'm glad you found the video content helpful! Understanding the intricacies of behavioral optionality in Interest Rate Risk in the Banking Book (IRRBB) can indeed be complex, especially when it comes to relating concepts like Constant Prepayment Rate (CPR) and Single Monthly Mortality (SMM) to Delta EVE calculations. Let's delve into this with a numerical example to illustrate how these factors interplay. Let's consider a hypothetical scenario where a bank holds a portfolio of fixed-rate mortgages. The Delta EVE (Economic Value of Equity) measures the change in the economic value of the bank's equity due to changes in interest rates. To calculate Delta EVE, we need to consider how changes in interest rates impact the present value of future cash flows from the portfolio, taking into account prepayment behavior. Here's how we can break it down: Initial Portfolio: Assume the bank holds a portfolio of fixed-rate mortgages with a total outstanding balance of £100 million. The average remaining term of the mortgages is 20 years. Interest Rate Change: Let's assume there's a parallel shift in the yield curve, leading to a 1% decrease in interest rates. CPR and SMM: Constant Prepayment Rate (CPR) represents the percentage of the outstanding mortgage principal that is prepaid each year. Let's assume a CPR of 6%. Single Monthly Mortality (SMM) is the monthly prepayment rate. It's calculated by dividing the CPR by 12. So, SMM = 6% / 12 = 0.5%. Calculating Prepayments: We calculate the prepayments for each period based on the outstanding balance and the SMM. For simplicity, let's assume prepayments are evenly distributed throughout the year. Calculating Delta EVE: We calculate the present value of future cash flows from the mortgage portfolio under the new interest rate scenario and compare it to the present value under the initial interest rate scenario. The difference represents the change in economic value, i.e., Delta EVE. Let's crunch the numbers. Given the complexity, I'll provide a concise example of the calculation in the next response.

Continuing with our example: 6. **Calculating Prepayments**: - Let's assume the bank's monthly mortgage payment is £1,000,000. - With a 0.5% SMM, each month 0.5% of the outstanding balance is prepaid. So, for our £100 million portfolio, £500,000 will be prepaid each month. 7. **Calculating Present Value of Future Cash Flows**: - Under the new interest rate scenario (1% decrease), we discount the future cash flows from the portfolio at the new lower rates. - Let's say the new interest rate for the remaining term of the mortgages is 4%. We calculate the present value of the remaining cash flows using this rate. 8. **Delta EVE Calculation**: - We compare the present value of future cash flows under the new interest rate scenario to the present value under the initial interest rate scenario. - The difference represents the change in economic value, i.e., Delta EVE. Let's put these calculations into action: Initial Present Value (PV) of Cash Flows: - Using the initial interest rate, let's say 5%, we calculate the PV of the remaining cash flows from the mortgage portfolio. New Present Value (PV) of Cash Flows: - Using the new interest rate of 4%, we calculate the PV of the remaining cash flows from the mortgage portfolio. Delta EVE: - Delta EVE = New PV - Initial PV By comparing the two present values, we can quantify the impact of the interest rate change on the economic value of the bank's equity, considering prepayment behavior. This example illustrates how CPR and SMM influence the calculation of Delta EVE in the context of IRRBB. Understanding these dynamics is crucial for banks to effectively manage interest rate risk and optimize their balance sheet strategies. If you need further clarification or additional examples, feel free to ask!

​@@ClaireTrythall Thank you for the answer!

@@ClaireTrythall Thank you for the answer!

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