KRM-ni

Net Income Simulation in Option - Adjusted Risk/Return Management

Introduction

KRM-ni is integrated with the full KRM product suite, allowing you to focus on the managing the firm’s earnings, and ultimately the value of the firm using the following measures:

• Net income simulation on a full credit-adjusted basis with stochastic default, incorporating the credit models of Robert Jarrow
• Net income simulation of both the full balance sheet and the transfer pricing portfolio, allowing management to see the relative future movements of hedged and unhedged net interest income
• Simulation of additions to and roll-offs from the balance sheet to a distant value at risk date, allowing VAR analysis on the balance sheet that you will have then, rather than assuming the future balance sheet will be identical to today’s. This allows default and loan prepayments to impact measured value at risk
• Net Income and Balance Sheet simulation for financial planning and variance analysis for monitoring new and existing business activity
• Earnings at Risk (EaR) measurements show probabilities for net income in the future
• Sensitivity and Component Analysis measures changes in earnings given parallel and non-parallel interest rate changes and with and without embedded options
• GAP analysis shows repricing and maturity structure of the firms’ financial instruments
• Ratio analysis, and more

Credit-Adjusted Net Income Simulation

Bankers’ experience in the 1997-1998 Asia crisis has confirmed what bankers have always known: credit risk and interest rate risk are interlinked and must be modeled together. New breakthroughs in credit risk modeling have been incorporated in a seamless way with KRM-ni. Kamakura’s most important articles in the public domain on credit risk are the following (to download a copy please go to our research page):

• Robert Jarrow, “Default Parameter Estimation Using Market Prices,” Financial Analysts Journal, (Sept./Oct. 2001). 

This paper provides an introduction to the Jarrow reduced form credit model which has been popular with clients of the Kamakura credit module KRM-cr.)

• Robert Jarrow and Yildiray Yildirim, “A Simple Model for Valuing Default Swaps When Both Market and Credit Risk Are Correlated,” forthcoming, The Journal of Fixed Income (with Yildiray Yildirim).

Jarrow and Yildirim shows the power of reduced form models to model market risk and credit risk on a fully integrated basis using the example of default swaps)

• Robert Jarrow and Don van Deventer, “Integrating Interest Rate Risk and Credit Risk in Asset and Liability Management,” Asset and Liability Management: The Synthesis of New Methodologies, Risk Publications, (1998)

Jarrow and van Deventer show that the hedging performance of reduced form models produces significantly less hedging error than hedging with the Merton model of risky debt.

• Robert Jarrow and Don van Deventer, “Practical Usage of Credit Risk Models in Loan Portfolio and Counterparty Exposure Management,” Credit Risk Models and Management, Risk Publications, (1999)

This Jarrow and van Deventer paper gives the default probability formulas for the Merton model of risky debt and shows that the original Merton credit model must be combined with a general equilibrium model of asset pricing to derive the default probabilities Jarrow and van Deventer show that two unobservable parameters are necessary to make this derivation and that they are the critical determinants of the default probabilities derived from the Merton model.

• David Shimko, Naohiko Tejima and Don van Deventer, "The Pricing of Risky Debt when Interest Rates are Stochastic," Journal of Fixed Income, September, 1993, pp. 58-66.

Shimko, Tejima and van Deventer show that it is unnecessary to assume constant interest rates, the most common assumption in the commercial applications of the Merton model of risky debt. The authors derive a random interest rates version of the model, allowing integrated market risk and credit risk management.

For more information, please see KRM-cr.

KRM-ni, in conjunction with KRM-cr, allows the following calculations to be incorporated in net income simulation:

• Simulated default using a default probability unique for each counterparty and consistent with observable market prices for that counterparty
• Simulated default using a user-supplied transition matrix that is consistent with the bank’s historical experience and internal ratings system
• Credit-adjusted valuation, allowing explicitly for default, at the end of each accounting period
• Credit-adjusted value at risk, with explicit modeling of default, for determination of capital adequacy and reserve adequacy.

Using KRM-ni for Liquidity Risk Analysis

Kamakura Risk Manager’s KRM-ni module is extremely helpful in analyzing liquidity risk because of the very high speed and precision of the KRM system:

• Ability to process millions, not just thousands, of transactions for maximum accuracy
• Ability to use up to 999 accounting periods
• Ability to have accounting periods that start and end on any calendar date
• Exact data count and holiday conventions for cash flow forecasting
• High quality term structure models overseen by Professor Robert Jarrow for maximum realism in modeling the impact of interest rates and credit risk on liquidity risk

High Volume Processing Capability

A recent survey of most of the 15 largest banks in the United States showed that Kamakura users were processing 30-50 times more data than banks using other vendors’ software. This is due to the speed of KRM analytics and the efficiency of KRM’s data base design.

Option-Adjusted Valuation

KRM-ni is particularly powerful because it properly accounts for the treatment of options, embedded options and derivatives, which were once considered a minor part of banking. Today, however, that view has dramatically changed. Today, bankers recognize that options and derivatives are key; that managing them is a vital strategic issue.

The sweeping impact of option-based risk is now undeniable. On the other hand, the return on options can be substantial, as when they are used to create a competitive advantage. KRM-ni can be used within the KRM product suite to measure and manage all aspects of options risk and return. For example, consider the options inherent in the following:

• Loans and mortgages can be refinanced or prepaid at anytime;
• Deposits can be added to – or withdrawn;
• Customers can default on loans – or add new loans;
• Customers can draw down or pay off their credit card balances.

KRM-ni accounts for these options for making decisions based on risk and return measures such as EaR. Similarly, KRM-mv and KRM-var allow you to expand your risk analytics to include mark-to-market for pricing, trading, and portfolio management; sensitivity analysis; built-in hedging analytics; VaR, and other decision support measures.

The combined use of the KRM integrated product suite allows you to maximize the opportunities and manage the risk for all types of instruments.

KRM-ni combines the most advanced thinking about options risk and generation of future interest rates with standard functionality for bread-and-butter financial planning and net income management and monitoring. This allows you to measure risk and return using more complex methods such as Earnings at Risk, along with traditional measures of earnings sensitivity analysis, GAP analysis, pro-forma financial statements, variance analysis, and ratio analysis. The intuitive design of KRM-ni guides the user comfortably from step to step. KRM-ni simplifies option-based risk management’s inherent complexity, while always considering an integrated risk management approach.

KRM-ni Features

KRM-ni is grounded in solid financial theory and allows you to implement leading-edge best practices solutions with a straightforward, user-friendly tool. It provides a practical and effective means of modeling, measuring, and managing earnings risk using both integrated and stand-alone features:

• Account Setup
  Account setup in KMR-ni allows for completion of several model requirements in one screen for logical input of basic account characteristics and new business defaults, reporting hierarchies, and aggregation parameters.
• Process Oriented Assumptions Input
  With open database access and flexible reading, writing, import and export functionality, KRM-ni offers easy maintenance and automated data entry. Current interest rates, yield curves, new business assumptions, and account data can be loaded automatically.
• Flexibility in defining Yield curves and interest rates
  Users can use automatically generated forward rates, or user defined interest rates, with automatic calculation of shocks and rotations for sensitivity analysis
• Audit Reports
  Printed reports showing account characteristics and modeling assumptions can minimize model risk
• Mix and Match Assumptions
  Assumptions in KRM-ni are defined such that the user can create result sets based on different prepayment, new business, and other assumptions for easy comparison and variance analysis.
• Analysis and Reporting
  KRM-ni analysis is facilitated by automatic calculation of basic interest rate risk measurements including interest rate shocks and yield curve rotation, overrides for embedded option assumptions, and EaR measurement. Reporting allows the user to easily compare these results.
• Traditional Earnings Risk Measurements
  Analysis using traditional measures such as single scenario, shocks, rotations, and variance analysis
• Earnings at Risk
  EaR using term structure model gives intuitive measures of probability of exceeding earnings risk limits
• Component Risk Sensitivity Analysis
  User can override assumptions such as prepayments and transaction costs, as well as embedded options such as caps and floors to isolate the impact of each risk component

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