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1.Best Practices for Implementing Funding Sensitivity Adjustments[Original Blog]
1. Understand the Context:
- Before diving into specific adjustments, grasp the context. What is the purpose of your funding sensitivity analysis? Are you assessing the impact of interest rate changes, liquidity constraints, or credit risk? Each context requires tailored adjustments.
- Example: Imagine you're managing a bank's liquidity risk. Your funding sensitivity adjustments will differ from those made by an investment fund manager analyzing interest rate risk.
- Avoid oversimplification. Funding sources vary in terms of maturity, cost, and availability. Instead of treating all liabilities as homogeneous, segment them based on characteristics.
- Example: Suppose you're analyzing a corporate's debt portfolio. Instead of lumping all bonds together, differentiate between short-term commercial paper, medium-term notes, and long-term bonds. Adjust sensitivity parameters accordingly.
3. Duration and Convexity:
- Leverage duration and convexity metrics. Duration measures the sensitivity of a security's price to interest rate changes. Convexity accounts for curvature effects.
- Example: If you're managing a bond portfolio, consider adjusting sensitivity based on the duration and convexity of individual bonds. Longer-duration bonds are more sensitive to rate changes.
4. Scenario-Based Adjustments:
- Funding sensitivity isn't static. Run scenario analyses to assess extreme market conditions. Adjust parameters based on stress tests.
- Example: In a rising interest rate scenario, adjust funding sensitivity upward. Conversely, during a liquidity crisis, consider more conservative adjustments.
5. Behavioral Assumptions:
- Understand how stakeholders behave under stress. Do depositors withdraw funds rapidly during crises? Do lenders tighten credit lines? Incorporate behavioral assumptions.
- Example: If you're modeling a bank's deposit base, assume a higher withdrawal rate during economic downturns. Adjust sensitivity parameters accordingly.
6. Collateral and Haircuts:
- Collateralized funding involves haircuts—discounts applied to collateral values. Adjust sensitivity based on collateral quality and market volatility.
- Example: When analyzing repo transactions, consider the haircut applied to the collateral. A volatile market may necessitate a larger adjustment.
- Funding structures evolve. Regularly review and update sensitivity parameters. monitor market trends and regulatory changes.
- Example: If your organization issues floating-rate debt, adjust sensitivity based on the current yield curve. Don't rely on outdated assumptions.
8. stress Testing and reverse Stress Testing:
- Stress tests reveal vulnerabilities. Reverse stress tests identify critical thresholds. Use both to refine adjustments.
- Example: In a reverse stress test, determine the maximum rate increase that would lead to funding distress. Adjust parameters to stay below this threshold.
9. Quantify Impact:
- Always quantify the impact of adjustments. Use metrics like Value-at-Risk (VaR) or Expected Shortfall (ES).
- Example: If you adjust funding sensitivity due to credit risk, calculate the change in VaR. Is it within acceptable limits?
10. Documentation and Transparency:
- Document your assumptions, methodologies, and adjustments. Transparency ensures consistency and facilitates communication.
- Example: When presenting your analysis to stakeholders, explain why you adjusted certain parameters. Transparency builds trust.
Remember, funding sensitivity adjustments are both an art and a science. Balance theoretical rigor with practical insights. By following these best practices, you'll navigate the intricate world of funding risk more effectively.
Best Practices for Implementing Funding Sensitivity Adjustments - Funding Sensitivity Adjustment Analysis: How to Adjust and Adapt Your Funding Sensitivity and Parameters