Scenario-based measurement of interest rate risks

Purpose - This paper aims to propose a scenario-based approach for measuring interest rate risks. Many regulatory capital standards in banking and insurance make use of similar approaches. The authors provide a theoretical justification and extensive backtesting of our approach. Design/methodology/approach - The authors theoretically derive a scenario-based value-at-risk for interest rate risks based on a principal component analysis. The authors calibrate their approach based on the Nelson–Siegel model, which is modified to account for lower bounds for interest rates. The authors backtest the model outcomes against historical yield curve changes for a large number of generated asset–liability portfolios. In addition, the authors backtest the scenario-based value-at-risk against the stochastic model. Findings - The backtesting results of the adjusted Nelson–Siegel model (accounting for a lower bound) are similar to those of the traditional Nelson–Siegel model. The suitability of the scenario-based value-at-risk can be substantially improved by allowing for correlation parameters in the aggregation of the scenario outcomes. Implementing those parameters is straightforward with the replacement of Pearson correlations by value-at-risk-implied tail correlations in situations where risk factors are not elliptically distributed. Research limitations/implications - The paper assumes deterministic cash flow patterns. The authors discuss the applicability of their approach, e.g. for insurance companies. Practical implications - The authors’ approach can be used to better communicate interest rate risks using scenarios. Discussing risk measurement results with decision makers can help to backtest stochastic-term structure models. Originality/value - The authors’ adjustment of the Nelson–Siegel model to account for lower bounds makes the model more useful in the current low-yield environment when unjustifiably high negative interest rates need to be avoided. The proposed scenario-based value-at-risk allows for a pragmatic measurement of interest rate risks, which nevertheless closely approximates the value-at-risk according to the stochastic model.