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Market Risk Engine for Negative Basis Investment Portfolio
A German mid-sized cooperative bank has asked financial risk fitness in cooperation with the IVA - Institut für Vermögensaufbau to develop a risk engine capable of modeling the investment portfolio within the bank´s banking book.
The portfolio, also termed “negative basis investment portfolio” consists of paired positions of asset swaps (bonds swapped to floating rates) and single name credit default swaps (CDS). The project involved a historical simulation engine that required both bonds and CDS valuations on an end of day basis.
The team developed CDS spread valuation models both on a hazard rate basis (the O´Kane & Turnbull method) and on the structural model (“Merton”) approach.
The risk engine develops daily portfolio risk metrics: 99% VaR, 97.5% ES and 99% accounting Loss values – which stand as the basis for capital allocation in conformity with the Basel III regulatory stipulations – IRRBB (Interest Rate Risk in Banking Books). The team has further developed the model to include back testing capabilities and daily position valuations on a mark to market or mark to model basis.
