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An Introduction to Derivative Securities, Financial Markets, and Risk ManagementAdvanced Financial Risk Management, 2nd ed.

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The Federal Reserve will announce the results of the “DFAST” stress tests on March 5. On March 13, 2014, we pointed out the many reasons why the Federal Reserve-mandated stress testing process will be a less accurate measure of financial institutions’ risk than the market’s price on those institutions’ promise to pay a dollar in the future. The market place considers all scenarios, not just three as in the Fed’s CCAR stress tests. The market place invests cold hard cash to price various financial institutions’ promises to pay.

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The author wishes to thank his colleague, Managing Director for Research Prof. Robert A. Jarrow, for twenty years of guidance and helpful conversations on this critical topic.

As zero interest rate policies and negative interest rates ripple through world financial markets, many legacy interest rate risk systems and asset and liability management systems have been unable to keep pace. In this note, we use 100,000 scenarios from a modern 9 factor Heath, Jarrow and Morton interest rate simulation from Kamakura Corporation to illustrate the model validation issues that arise when one admits that negative interest rates have a probability that is not zero.

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The author wishes to thank his colleague, Managing Director for Research Prof. Robert A. Jarrow, for twenty years of guidance and helpful conversations on this critical topic.

The Federal Reserve’s 2015 Comprehensive Capital Analysis and Review stress testing regime has included 3 points on the U.S. Treasury yield curve since 2014. The Bank for International Settlements has required that at least six interest rate risk factors be used to model market risk since 2010. At the same time, negative interest rates are visible across Europe, in Japan and in Hong Kong. Given the complexity of the interest rate risk environment, it is critical that the users of both internal and third-party asset and liability management and enterprise risk management systems perform an essential step in model validation.

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The bankruptcy of Detroit brings new pressure on municipal bond investors and related exchange-traded funds like (HYD) (NUV) (PML) (PZA) (IIM) (NIO) (VMO) specializing in municipal bonds to heighten risk management and to hedge where appropriate. One potential tool in that regard is the single name credit default swap market, which is featured almost constantly in discussions of municipal entity credit risk. A recent example is “ Traders Find Short Bets on Puerto Rico a Challenge,” a Wall Street Journal blog. The author notes.

“Default insurance on Puerto Rico, sold in the form of derivatives called credit-default swaps, is available from few dealer banks. The contracts also have barely traded because the protection is not available to buy in meaningful amounts and disclosures from the Commonwealth have been limited, some market participants said.”

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A number of authors have suggested that credit default swap pricing be used as a basis for setting deposit insurance premiums for banking firms. We re-examine this proposal in this note, the fifth of a semiannual series of reports on credit default swap trading in U.S. bank and bank holding company reference names. This note updates the prior Kamakura Corporation report on credit default swap trading on U.S. banks for the 207 weeks ended December 26, 2014. We find that MBIA Insurance Corporation and Bank of America Corporation were the institutions traded most heavily in the credit default swap market over the 2010 to 2014 period. This updated report also confirms the conclusions of the five prior reports: that there is trading only in the largest or most troubled bank holding companies in United States and that the credit default swap market does not provide a credible basis for pricing deposit insurance of U.S. banks.

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