A practical example

These days i discussed with a friend, who works as a risk manager a really interesting topic. I would like to share our findings with you. The solution is related to the following previous article:

http://chillinrecommendations.blogspot.com/2009/03/bullish-or-bearish.html

The problem

The bank, where he works face a common problem. The low interest rates lead many people to strike a bargain, a long term fixed rate mortgage. Actually a nice thing for these clients and in this very moment as well a nice thing for the bank. However, the bank may find itself in a challenging situation because the sensitivity of the equity towards rising interest rates is quite high. Actually management relies on analyst expectations that interest rates won't rise within the next years, so they tend more to higher some alert levels than to really solve the problem.

Analysts track record may not be the best. Even if they were, it is a misdecision to not hedge this risk. Let's look at two scenarios:

Analysis

- As Analysts expect, there will be no inflationary pressure on interest rates. In this scenario, the question is how deep interest rates can fall. Actually i suppose a maximal decrease of 1%, because they fluctuate already on distressed level. The possibility for this scenario lies at 30%.

=> Therefore the payoff for scenario 1 is -0.3.

- Against Analysts forecasts, the massive monetary intervention will lead to inflationary pressure. The markets realize this really fast and interest rates soar to elevated levels. Even with an increase of 2% we stay beyond 5%, which doesnt really represent an environment of inflationary pressure. So i suppose interest rates to rise 3% in this scenario, with a 20% possibility.

=> This leads to a payoff for scenario 2 of +0.6

- The third scenario is the most possible one. Interest rates tend to remain stable over a year or two. The last 50% possiblity are dedicated to this scenario.

=> The payoff equals zero.

Conclusion

If you count all three scenarios together, and you believe analysts expectation. You find yourself in an payoff of +0.3. If you don't care about analysts expectation, which should be my preffered position, the payoff would be +0.66.

Therefore i can hardly recommend everyone who face a similar decision to hedge their risk within a portfolio or to reduce equity sensitivity of a bank.