ABSTRACT

First Derivatives National Bank is a case problem that illustrates the use of Heath-Jarrow-Morton type arbitrage-free stochastic term structure models in the measurement and management of interest rate risks of a hypothetical commercial bank. Unlike the more traditional duration-based approach to interest rate risk management, the stochastic term structure approach is able to capture the option-like features associated with securities and derivative products held and issued by the bank. With this framework of analysis, the case illustrates how a commercial bank that holds and issues complex interest-sensitive assets and liabilities can set the interest rate risk exposure of its equity position to a predetermined target.