A multi-factor model for the valuation and risk management of ...

Abstract
How should we value and manage deposit accounts where deposits have a zero contractual
maturity, but which, in practice, remain stable through time and are remunerated below market
rates Does the economic value of the deposit account differ from the face value and can we
reliably measure it To what extent is the economic value sensitive to yield curve changes In this
paper, we try to answer the above questions. The valuation is performed on yield curve, deposit
rate and deposit balance data between December 1994 and June 2005 for a sample of Belgian
bank retail savings deposits accounts.
We find that the deposits premium component of Belgian savings deposits is economically and
statistically significant, though sensitive to assumptions about servicing costs and outstanding
balances average decay rates. We also find that deposit liability values depreciate significantly
when market rates increase, thereby offsetting some of the value losses on the asset side. The
hedging characteristics of deposit accounts depend primarily on the nature of the underlying interest
rate shock (yield curve level versus slope shock) and on the average decay rate. We assess the
reliability of the reported point estimates and also report corresponding duration estimates that
results from a dynamic replicating portfolio model approach more commonly used by large
international banks.
JEL-code : G12, G21.
Keywords: Demand deposits, ALM, risk management, arbitrage free pricing, flexible-affine term
structure model, interest rate risk, IFRS 39, fair value accounting.
NBB WORKING PAPER No. 83 - MAY 2006