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Working Paper
Do nonfinancial firms use interest rate derivatives to hedge?
We compile and analyze detailed information on the debt structure and interest rate derivative positions of nonfinancial firms in 2000 and 2002. We find that differences in debt structure across firms and time tend to be counterbalanced by difference in derivative positions. In particular, among derivative users, smaller firms tend to have relatively more interest rate exposure from liabilities than larger firms and tend to use derivatives that offset these exposures. Larger firms also tend to limit their interest rate exposures, but they do so through their choice of debt structure rather ...
Journal Article
Are Banks Exposed to Interest Rate Risk?
While banks seem to face inherent risk from short-term interest rate changes, in practice they structure their balance sheets to avoid exposure to such risk. Nonetheless, recent research finds that banks cannot offload all of the interest rate risk they are naturally exposed to. Historically, banks’ profit margins reflect their compensation for taking on interest rate risk and their stock prices are highly sensitive to changes in interest rates. These findings can help practitioners assess banks’ risk exposures and may have implications for unconventional monetary policy.
Journal Article
Assessing supervisory scenarios for interest rate risk
A new proposal by the Basel Committee on Banking Supervision for setting the amount of capital banks must hold against potential losses from interest rate risk uses only a few, very stylized scenarios. Analysis shows the proposed scenarios are extremely unlikely to occur. While they may be appropriate for setting bank capital guidelines, they are much less relevant for everyday risk management. Instead, using a modeling framework with a plausible range of interest rate scenarios would be more relevant to help banks manage their interest rate risk.
Working Paper
Interest Rate Risk at US Credit Unions
Rising interest rates have prompted concerns about losses on bank assets, especially following the failure of Silicon Valley Bank (SVB) in March 2023. In this working paper, we examine whether US credit unions could be subject to similar losses as banks and analyze how their regulatory capital would be affected. We estimate that after realizing losses from assets that have decreased in value and not yet been sold the overall net worth of the credit union industry would have fallen by 40 percent in 2023:Q1. Unrealized losses were most severe at the largest credit unions. Nonetheless, the bulk ...
Working Paper
Financial Characteristics of Cost of Funds Indexed Loans
Two recent articles by Hancock and Passmore (2016) and Passmore and von Hafften (2017) make several suggestions for improving the home mortgage contract to make homeownership more achievable for creditworthy borrowers. Though the proposals in the two papers differ in some aspects, one common feature is an adjustable rate indexed to a cost of funds (COF) measure. Such indices are based on the interest expense as a fraction of liability balance for one or a group of depository institutions. One of these, the 11th District Cost of Funds (COF) Index, was in wide use in the 1980s and '90s, but use ...
Journal Article
Bank Franchise as a Stabilizing Force
The banking shock of 2023 stemmed from banks’ exposure to interest rate risk by gathering short-term funds to invest in long-term assets. When interest rates rose rapidly during the monetary tightening cycle, banks incurred significant capital losses on their long-term assets, some of which were unrealized on their financial statements. However, bank franchise value—the present value of all future excess profits—which is also unrecognized, could hedge against the losses and provide some stability. Moreover, the potential loss of franchise value could discourage risk-taking, further ...
Working Paper
How inflationary is an extended period of low interest rates?
Recent monetary policy experience suggests a simple test of models of monetary non-neutrality. Suppose the central bank pegs the nominal interest rate below steady state for a reasonably short period of time. Familiar intuition suggests that this should be inflationary. But a monetary model should be rejected if a reasonably short nominal rate peg results in an unreasonably large inflation response. We pursue this simple test in three variants of the familiar dynamic new Keynesian (DNK) model. All of these models fail this test. Further some variants of the model produce inflation reversals ...
Working Paper
What's Wrong with Annuity Markets?
We show that the supply of life annuities in the U.S. is constrained by interest rate risk. We identify this effect using annuity prices offered by U.S. life insurers from 1989 to 2019 and exogenous variations in contract-level regulatory capital requirements. The cost of interest rate risk management accounts for at least half of the average life annuity markups or eight percentage points. The contribution of interest rate risk to annuity markups sharply increased after the great financial crisis, suggesting new retirees' opportunities to transfer their longevity risk are unlikely to improve ...
Working Paper
Can Spanned Term Structure Factors Drive Stochastic Yield Volatility?
The ability of the usual factors from empirical arbitrage-free representations of the term structure?that is, spanned factors?to account for interest rate volatility dynamics has been much debated. We examine this issue with a comprehensive set of new arbitrage-free term structure specifications that allow for spanned stochastic volatility to be linked to one or more of the yield curve factors. Using U.S. Treasury yields, we find that much realized stochastic volatility cannot be associated with spanned term structure factors. However, a simulation study reveals that the usual realized ...