Embedded Options And Interest Rate Risk For Commercial Bank

The market-oriented interest rate is an important link in the chain of the market-oriented finance of our country, and its implementation step is speeding up. The market-oriented interest rate is the necessary requirement of its financial reformation and entrance to WTO in China. The market-oriented interest rate results in both the right of fund-pricing independently of the commercial bank and the main market risk. The interest rate refers to the possible lost of the market value of the financial institution and the rights and interests of its proprietor. It is the result, in the condition of the market-oriented interest rate, of the market value of the asset of the financial institution, its debt and its cash changed by the undulation of the interest. It is due to the mismatching of the financial assets and the debt caused by the changing interest rate. The interest rate is the capital price, which fundamentally decides the value change of all the other financial assets, so it is also one of the kernel risks. The interest rate can cause financial fragility. It is even considered to be the only reason in some countries. To meet the requirements of the Basel Accord, the bank should set up the risk-control system according to the complexity of their own business. In this background on the micro lay, this paper analyses the present situation of the interest rate risk faced by the commercial banks of our country and their reason of setting up risk-control system in the process of the market-oriented interest rate in China. Then it offers an argument from the technical perspective of the potential various interest rate risks of the commercial banks since the interest rate is market-oriented, as well as some commonly used methods and techniques to control and manage them. Among all the risk-control techniques, this paper put the emphasize on the analysis of a main one: based on the duration-convexity gap technique of the bank asset balance sheet, especially when the embedded options are contained in the bank asset and debt, how to measure the interest rate risk resulted by the of the embedded options'influence, that is, the influence of the two main indices, duration and convexity. Afterward, it discusses how to adjust the duration and convexity gap management in the presence of the embedded options accordingly in order to manage the interest rate precisely and effectively in the situation of various embedded options present in the bank asset and debt. The term structure of interest rates of Hull and White and the trinomial model are adopted in this paper to work out the value of the embedded options, and then the price of the financial product. When the interest rate is changed, the duration and the convexity of the financial product are worked out by the price change. Finally, the interest rate risk can be controlled or avoided by the gapping management. With a calculating example, this paper preliminarily demonstrates and probes into how the duration gap and the convexity are influenced by the embedded options, and then how the precision of the traditional duration gap are influenced. On this basis, the programming and managing modal of the duration-convexity with embedded options risk-controlling are proposed. Finally, on the macro lay, concrete measures and suggestions are offered on how to set up an effective interest rate risk-controlling system for the Chinese commercial banks.