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A new approach to the valuation of banks

Michael Adams

and Markus Rudolf

First Version: November 2006


This version: August 2010
Abstract
We argue that the business model of the bank exhibits such pe-
culiarities that it deserves a special treatment in the approach to its
valuation as well. In particular, the exposure to interest rate risk is a
major characteristic of its business, not only in the process of maturity
transformation but also as a major determinant of price margin and
business volume. There exists no common framework to value a bank
which adequately accounts for these features. We propose a valuation
model for banks based on Mertons (1974) structural model of the
rm, which we adapt to the banking rm by the help of term struc-
ture models of the interest rates. In this setting, we interpret banks
as a particular portfolio of long and short positions in interest-rate
sensitive assets. In doing so, we are able to show another peculiarity
of bank valuation, i.e. that the exercise price of a call option on the
rm value, representing the banks equity, is not the face value of bank
liabilities but their economic value.
JEL classication: C22, G12, G13, G21.
Key Words: matched maturity marginal value of funds, MMMVF,
bank valuation, term structure, model

We are grateful to Stewart C. Myers, Matthias Muck, and participants of the 2005
Burgenland doctoral seminar for helpful comments and the WHU USA foundation for its
nancial support. Any remaining errors are our own.

Groe Gallusstrae 10-14, 60272 Frankfurt, Germany E-mail: michael.adams@db.com.

WHU - Otto Beisheim Graduate School of Management, Endowed Chair of Fi-


nance, Burgplatz 2, 56179 Vallendar, Germany, Tel.: +49-(0)261-6509-421, e-mail:
markus.rudolf@whu.edu.
1
1 Introduction
In corporate nance, it is not unusual to specify valuation models for partic-
ular types of rms. For example, to mention just one of them, Brennan and
Schwartz (1985) propose a real-options based valuation approach to natu-
ral resource companies, explicitly modeling the options to temporarily close,
reopen and shut-down the mine. For similar reasons, one can argue for a
special valuation approach for banks. Indeed, Copeland, Weston and Shastri
(2005) (p. 872) address bank valuation as one of the unresolved issues in
nancial research.
The characteristics of the banking business motivating a distinct valuation
approach can be subsumed in four categories. First, banking is a heavily
regulated industry.
1
Second, banks operate on both sides of their balance
sheets, actively seeking prots not only in lending but also in raising capital
2
.
This is the aspect this paper concentrates on. Third, banks are exposed to
credit default risk, but they also actively seek credit risk as part of their
business model. Last but not least, the prot and the value of the bank is
much more dependent on interest rate risk than other industries.
The impact of the interest rate risk on bank value is mainly driven by the
banks assets and liabilities mismatch. Though, there exist further eects.
Bank rates adjust asymmetrically to changes in market rates. This results in
a time-varying spread which is typically larger in a high interest-rate envi-
ronment; see e.g. by Hannan and Berger (1991), Ausubel (1991), or Neumark
and Sharpe (1992), and data in the monthly report of the Bundesbank (2006).
Moreover, the demand for deposits and loans does not only depend on the
market rate but also on the rate a bank charges or pays. Also, loan demand
1
See e.g. Carey and Stulz (2006).
2
see MacLeod (1875), p. I:275.
2
and deposit demand typically have a negative correlation. Consequently,
interest rate eects on bank value are signicant and nontrivial.
In contrast to existing discounted cash ow based frameworks like Samuel-
son (1945), Flannery and James (1984a), and (1984a, 1984b), we propose a
valuation model for banks based on Mertons (1974) structural model of the
rm, which we adapt to the banking rm by the help of interest rate term
structure models. In this setting, we interpret banks as a particular portfolio
of long and short positions in interest-rate sensitive assets and thus aim at
integrating the interest rate-sensitivity into the valuation approach.
The paper is structured as follows. The next section outlines the busi-
ness model of a bank. Section 3 derives a structural rm valuation model
and applies it to banks. Section 4 provides a valuation approach for the
deposit business, section 5 for the loan business, section for the ALM busi-
ness. Finally, the valuation model of the entire bank is presented in section
7. Section 8 concludes the paper.
2 The business model of a bank
To describe the bank in terms of our portfolio view, we make several sim-
plifying assumptions. First, we abstract from taxes, reserve requirements,
minimum capital requirements and other regulatory factors that could im-
pact the banks prot and portfolio value. Second, we assume that there is
no depreciation, amortization, or other non-cash item, which provides the
useful equality of free cash ow to equity (FCFE) and bank prots. Finally,
concerning the denition of our banks prots, we assume that there are only
variable cost for the beginning
3
. When accounting for all of this, our banks
3
Neglecting issues of xed cost is not as absurd as it may seem at rst sight and will
greatly simplify our analysis. We show how to introduce xed cost later without changing
3
prot,
bank
, can be stated in its simplest form as dierence between the
return on assets and the costs of liabilities,

bank
= r
c
L
L r
c
D
D, (1)
where L denotes the loan volume and D the deposit volume. r
c
L
and
r
c
D
, indicate the rates the bank actually earns after variable cost of service
and net of servicing fees charged to customers, while individuals receive the
deposit rate r
D
and pay r
L
on their loans.
In order to separately identify the sources of cash ows on both sides of
the balance sheet, we apply an instrument from internal bank controlling, the
transfer pricing based matched maturity marginal value of funds (MMMVF),
in the valuation process
4
. This requires to break up the prots of entire bank
into the parts of its constituent business units, i.e. a loan business (LB), a
deposit business (DB), and a treasury department which is in charge of the
asset-liability management of the bank (ALM). The LB is in charge of issuing
loans and measuring and managing credit risk. The DB issues transactions
and savings deposits, providing its customers with an access to the payment
system and the bank with an internal funding of the LB. The ALMs main
task in our simple model of the bank is to manage the interest rate risk or,
more precisely, term structure risk stemming from the diering maturities
of the assets and liabilities or the positive duration gap between loans and
deposits. Applying the MMMVF transfer pricing framework, the prot of
our major results here.
4
The MMMVF framework allows to achieve a separation of the banks prot into
two parts: One depending on general capital market conditions as captured in the term
structure of interest rates and the other one depending on the banks market power in
loan and deposit markets.
4
the bank can be restated as

bank
= (r
c
L
r
=2
) L + (r
=1
r
c
D
) D + (r
=2
L r
=1
D)
=
LB
+
DB
+
ALM
,
(2)
where r
=2
signies the default-risk-free capital market rate for a longer
maturity and r
=1
represents a comparable rate for a shorter maturity.
5
In
this representation, the banks prot is the sum of prots of LB, DB and
ALM,
LB
,
DB
, and
ALM
, respectively. An additional task of the ALM
would be the equalization of any imbalances arising temporarily between the
volume of assets and liabilities by use of external nancing, taking long or
short positions in the interbank market. Again for reasons of simplication,
we start developing our model with the additional assumption of L = D,
which simplies equation (2) to
6

bank
= (r
c
L
r
=2
) D + (r
=1
r
c
D
) D + (r
=2
r
=1
) D. (3)
From this restatement of prots, the economic value of the banks equity,
V
E
, can be obtained as the sum of discounted future cash ows (DCF),
originating from its three business units, which is
V
E
= NPV (
bank
) = NPV
LB
+ NPV
ALM
+ NPV
DB
, (4)
5
These can be thought of as average eective maturities of loans and deposits, where
deposits typically have a shorter maturity than loans.
6
We assume this for expository reasons and not to restrict the generality of our model.
For L = D, one might e.g. implicitly assume that the equity of the bank equals its non-loan
assets such as cash and property. Additional asset balances would have to be included in
the valuation of the entire bank, of course.
5
where
NPV
LB
=
T

t=1

LB,t
(1 + r
LB
)
t
=
T

t=1
(r
c
L,t
r
=2,t
) D
t
(1 + r
LB
)
t
, (5a)
NPV
ALM
=
T

t=1

ALM,t
(1 + r
ALM
)
t
=
T

t=1
(r
=2,t
r
=1,t
) D
t
(1 + r
ALM
)
t
, (5b)
NPV
DB
=
T

t=1

DB,t
(1 + r
DB
)
t
=
T

t=1
(r
=1,t
r
c
D,t
) D
t
(1 + r
DB
)
t
, (5c)
and where r
LB
, r
ALM
, and r
DB
signify the required rates of return of the
three respective business units. T is the valuation time horizon; typically,
T = .
In equations (5), the value attributable to the deposit business is a func-
tion of the outstanding balances and the relative cost savings originating from
the issuance of deposits, that is, the deposit spread. In the same fashion, the
value of the loan business depends on loan volume, which we set equal to
the deposit volume, and the average realized loan spread. The contribution
of the ALM also is a function of average business volume and additionally
of the spread between two market rates of diering maturities, depending on
the slope of yield curve. The net present value for each business unit can
then be calculated by discounting the annual cash ow prots at a discount
rate that provides an appropriate return on equity.
Consequently, the denition of the banks prot in the MMMVF frame-
work and the resulting net present value of the bank in equations (4) and (5)
allow us to identify ve types of parameters that aect it and which we will
have to account for in a valuation model:
1. The deposit volume, D, representing the business volume of the bank,
2. the loan rate, r
L
, respectively the loan rate net of cost, r
c
L
,
3. the deposit rate, r
D
, respectively the deposit rate net of cost, r
c
D
6
4. the required return on equity of all three business units, r
LB
, r
DB
, and
r
ALM
5. the market rate r
=1
for a short maturity and a long maturity (r
=2
).
Among these, the last applies to all banks in general and represents their
duration-dependent interest rate risk exposure. Opposed to this, the former
four are bank-specic, thereby determining the idiosyncratic component of
each banks rm value.
To assume a constant interest rate like in equation (5), would disregard
the factor that is at the heart of a banks business. Not only the discounting
factor but also all three sources of a banks cash ow (LB, ALM and DB)
are highly interest rate sensitive. Therefore, we propose a bank valuation
model which accounts for interest rate sensitivity in that it views the bank
as a portfolio of interest-rate contingent claims. In the following, we lay out
the ground for such a model, which is based on Mertons (1974) structural
model of the rm.
3 Structural, risk-neutral rm valuation ap-
proach to the bank
The book value of deposits equals the face value of this liability, i.e. 1
deposited is recorded at 1 in the banks books. As long as the deposit
rate deviates from its MMMVF or opportunity rate, though, the economic
value of this deposit will also deviate from its book value. The ability of the
bank to raise liabilities at rates below comparable market rates creates an
intangible asset (market power). The value NPV
DB
of this intangible asset
is positive and equals the net present value of prots derived from the ability
7
BANK
V
L
V
D
assets liabilities
NPV
LB
NPV
DB
E
BANK
L
D
assets liabilities
E
NPV
LB
NPV
DB
(a) book value of the bank
(b) economic value of the bank
V
E
Figure 1: Book value and economic value of bank assets and liabilities
Remarks: E stands for book equity and V
E
for its economic value.
to issue at below market rates as dened in equation (5). This provides the
link between the book value, D, and the economic value, V
D
, of deposits:
V
D
= D NPV
DB
. (6)
The relation between economic and the book value is depicted in Figure
1. The same argumentation applies vice versa for bank assets as well. In
the absence of credit risk (or after accounting for the expected loss), the
economic value of the loan portfolio, V
L
, results as the sum of its book value,
L, and the net present value of the prots NPV
LB
:
V
L
= L + NPV
LB
. (7)
Finally, the economic value of the ALM, V
ALM
, equals its net present
value
V
ALM
= NPV
ALM
, (8)
because it does not have a net book value. By assumption, the book or
face value of the ALMs long position is oset exactly by its short position.
8
Changes in the slope of the term structure aect only the ALMs economic
value, which is reected in NPV
ALM
.
7
According to Black and Scholes (1973) and given a planning horizon T,
the value of debt, V
B,T
, and equity, V
E,T
, at the end of the planning horizon
can be described by option-like payout prole,
V
B,T
= B

max[D V
A,T
; 0], (9a)
V
E,T
= max[V
A,T
D; 0], (9b)
where V
A,T
is the economic value of the banks assets at the planning horizon
T and B

represents a risk-free bond with a face value that equals the face
value of the banks liabilities, which in our case consist exclusively of deposits
D. The economic asset value of the bank, V
A
, can be dened as
V
A
= A+ NPV (
bank
), (10)
where NPV (
bank
) is the present value of the banks future prots as
dened in equation (4) and A is the asset book value. For the non-banking
rm, the economic asset value or market value of assets equals the rm value.
In the case of the bank, however, the rm value exceeds the market value of
the banks assets because the bank also generates value on the liability side.
Indicating the banks rm value as its asset value, V
A
, allows to simplify a
comparison between the structural model of the rm and the structural model
of the banking rm. Moreover, with this notation we want to highlight the
consequences of this important dierence between the bank and the non-
bank, which will become apparent shortly. From equations (10) and (4)
7
This value is positively correlated with the slope of the yield curve implying that banks
are usually more protable in an upward sloping yield curve environment.
9
follows
V
A
= A + NPV
LB
+ NPV
DB
+ NPV
ALM
, (11)
which we can state alternatively in terms of the units economic values
as previously dened in equations (6), (7), (8),
V
A
= V
L
+ NPV
DB
+ V
ALM
= L + NPV
LB
+ NPV
DB
+ V
ALM
, (12)
where, by assumption, A = L = D. This result can be seen as an
expression for the banks economic asset value in the MMMVF framework.
In order to obtain the boundary conditions for the banking rm, we combine
this term in (12) with the payout proles for the non-banking rm in (9).
This lets us obtain the equivalent expressions for the banking rm, when
equation (6) is substituted in,
V
bank
B,T
= B

max[V
D,T
V
L,T
V
ALM,T
; 0], (13a)
V
bank
E,T
= max[V
L,T
+ V
ALM,T
V
D,t
; 0]. (13b)
In this equation, we can see an interesting particularity of the banking
rm: For non-banking rms, the exercise price of the options is the face or
book value of debt. However, when applying the structural model to the
banking rm, the exercise price of the options in the structural model is
not the book value of liabilities, D, but their economic value, V
D
. This is a
consequence of the duality of the banks business model, which also seeks to
extract a prot from issuing its own liabilities. An alternative representation
highlights the dierence, which we obtain by substituting back equation (6)
into (13),
V
bank
B,T
= B

max[D
T
NPV
DB
V
L,T
V
ALM,T
; 0], (14a)
V
bank
E,T
= max[V
L,T
+ V
ALM,T
+ NPV
DB,T
D
T
; 0]. (14b)
10
In other words, should the banks asset value, V
A
, fall below the book
value of its debt, D, shareholders will not choose to default but will rather
be willing to uphold the banks business operations as long as the net present
value extracted from the deposit base, NPV
DB
, is large enough to cover a
potential decrease of the rest of the banks assets, V
L
and V
ALM
, below the
book value of debt (deposits), D. For creditors of the bank, the decrease
of the put options exercise price from D to V
D
also increases the value of
their debt for they hold a short position in that option. The additional value
gained in the liability business increases the distance to default of the bank,
thereby decreasing its probability of default and increasing the value of its
debt, V
bank
B,T
. The next step is to model the underlying economic value of a
banks assets and liabilities.
4 Valuation approach to the deposit business
The analysis of deposits as interest rate sensitive claims includes Hutchison
and Pennacchi (1996), Selvaggio (1996), Jarrow and van Deventer (1998),
OBrien (2000), Kalkbrener and Willing (2004), and Dewachter, Lyrio and
Maes (2006). Although we will draw on elements and insights from all of
those, the model of Jarrow and van Deventer (1998) seems to be the most
useful for our problems.
8
Hutchison and Pennacchi (1996)s equilibrium ap-
proach would require the design of an analogous equilibrium in the loan
market before we could extend the model to the entire bank; besides, equi-
librium models often exhibit a poorer t in empirical implementations when
compared with arbitrage-free models because the former impose more struc-
8
A valuation based on this model yields at the same time an estimate for the deposit
balances eective duration, which is needed for selecting the appropriate MMMVF trans-
fer rate.
11
ture on the data.
9
The model of OBrien (2000) is similar to that of Jarrow
and van Deventer (1998) but additionally incorporates the asymmetric ad-
justment feature of the deposit rate, this comes at the price of sacricing
a closed-form solution to the valuation problem, though. In the trade-o
between allowing for an additional trait of empirical data and obtaining a
closed-form solution, we chose the latter.
4.1 The steps to take in the model
Following these approaches, we dene a pattern of deposit cash ows and
then apply a valuation model to them. As can be seen from table 1, the
NPV of the banks deposit business actually has two sources; one is the
spread earned in each period, D
t
(r
c
D,t
r
t
), and the other is the growth of
the deposit base from period to period D
(t+1)
D
t
. We will account for this
growth eect later in the derivation of our valuation formula.
t = 0 t = 1 . . . t = T 1 t = T
New deposits +D
0
+D
1
. . . +D
(T1)
Deposits withdrawn D
0
. . . D
(T2)
D
(T1)
Interest paid D
0
r
c
D,0
. . . D
(T2)
r
c
D,(T2)
D
T1
r
c
D,(T1)
Interest earned +D
0
r
0
. . . +D
(T2)
r
T2
+D
(T1)
r
(T1)
Table 1: Cash ow streams of the deposit business
Hence based on this, the valuation process of the deposit business is:
9
Duee (2002) for example nds that martingales possess a higher predictive power
than ane models and Dai and Singleton (2002) have similar concerns related to the
matching of the observed term structure. In other words, the dierence between the
yields predicted by an ane model at the estimated parameter values and the actual yield
data can be substantial.(Piazzesi (2003), p. 48).
12
1. Choose a term structure model to account for the dynamics of the short
rate, r
t
. Typical choices include single-factor strictly ane models,
such as Cox, Ingersoll and Ross (1985), multi-factor essentially ane
models, as proposed by Dai and Singleton (2000), and no arbitrage
models, e.g. Heath, Jarrow and Morton (1992) or Miltersen, Sandmann
and Sondermann (1997).
2. Specify a process for the deposit rate, r
D,t
, and the deposit base, D
t
.
3. In the deposit valuation equation, which we will derive within this
section in equations (16) and (17), substitute D
t
, r
D,t
, and r
t
with the
solutions to the (stochastic) processes of the deposit rate, the deposit
base, and the short rate. If possible, solve for an analytical solution.
4. Calibrate the process specications under the empirical probability
measure on a suitable data sample.
5. Should a closed-form solution be available, plugging in the estimates of
the parameters yields the deposit value; otherwise, use the estimates
for a Monte Carlo simulation to obtain a distribution of the deposit
value.
4.2 A multi-factor model for deposit valuation
Jarrow and van Deventer (1998) introduce a market segmentation hypothesis
to set up their deposit valuation model: There are two types of agents in
the market, banks and individuals. Both have specic trading limitations.
On one side, banks can issue a limited and exogenously given volume of
deposits, i.e. they are free to issue less but cannot issue deposits beyond this
limit. On the other side, individuals can hold deposits but cannot issue them.
13
Finally, both banks and individuals can buy and sell risk-free bonds without
limitation and do behave rationally in line with the usual assumptions.
10
Subsequently, these assumptions allow Jarrow and van Deventer (1998) to
value bank deposits using an arbitrage argument while at the same time
preserving a positive spread for the bank. In the case that deposits pay
less than the market rate, i.e. r
D
< r, individuals cannot arbitrage this
discrepancy away since they cannot issue bank deposits. As long as r
c
D
< r,
banks can issue deposits and invest the proceeds in the risk-free security,
thereby earning a positive spread, r r
c
D
> 0. As stated in the assumptions,
however, this does not represent an unlimited arbitrage opportunity since
banks are restricted in this type of transaction by the exogenously given
maximum amount of deposit volume in the market.
As a result, the absence of exploitable arbitrage opportunities in this
segmented deposit market implies that
r
D,t
r
t
for all t, (15a)
r
c
D,t
r
t
for all t, and (15b)
r
c
D,t
< r
t
for some t. (15c)
Based on the market segmentation, the deposit valuation formula can
be derived as a hedging portfolio which osets the cash ow pattern of the
deposit business as shown in table 1 in a risk-neutral valuation procedure,
i.e. as expectation, E
P

0
, under the risk-neutral probability measure, P

. This
yields
V
D
= D
0
+ E
P

T2

t=0

D
(t+1)
D
t
g(t + 1)

T1

t=0

D
t
r
c
D,t
g(t + 1)

D
(T1)
g(T)

, (16)
10
For a denition of rational behavior in nancial theory, see e.g. Ingersoll (1987). The
issue of credit risk when shorting the risk-free bond is discussed later.
14
where g(t) represents the money market account with g(0) = 1. Besides
the market rate, the cash ows of the deposit business depend on the deposit
base and the deposit rate, for both of which we suggested the specication
of a vector autoregressive (VAR) process. Hence, any exogenous explanatory
variable we include in these processes may add an additional state variable
to our deposit derivative.
11
Jarrow and van Deventer (1998) oer an intuitive interpretation for the
value of the deposit business V
D
in equation (16): The value of the deposit
liability is the sum of the book value of the initial deposit base, D
0
, plus
the present value of any changes in the deposit base over time, minus the
present value of total costs, and minus the present value of deposit volume
at maturity or the valuation horizon. In other words, the DBs economic
value is that of a series of T 1 single-period, risk-free bonds paying below
risk-free interest rates. Consequently, all of these bonds will have a price
below par and shorting them can derive positive value, since the proceeds
can be invested in the risk-free asset.
In analogy to the prot of the deposit business in equation (5c), an equiv-
alent but simpler valuation formula is given by
V
D
= E
P

T1

t=0
D
t

r
=1,t
r
c
D,t

g(t + 1)

, (17)
which in continuous time can be represented by (r
t
: Shortrate)
V
D
= E
P

T
0
D
t
(r
t
r
c
D,t
)
g(t)
dt

. (18)
The economic value of the deposit liability in equation (17) or equa-
tion (18) can be linked to the value of an interest rate swap, lasting for T
11
We rely on single-factor (ane) term structure models in their specication of deposit
dynamics. A three-factor model based on the term structure model of Heath, Jarrow and
Morton (1992) has been suggested by Kalkbrener and Willing (2004).
15
periods, receiving oating at r
t
and paying xed at r
c
D
, and with an alter-
nating principal of D
t
.
When specifying a multi-factor model of the term structure of interest
rates, we have the basic choice between exogenous and endogenous models.
Which one to choose is driven by the research focus, that is, economic in-
tuition vs. close t on the observed term structure. For example, we know
of only two existing papers proposing multi-factor frameworks for the valu-
ation of deposits, where one Dewachter, Lyrio and Maes (2006) relies on an
endogenous multi-factor ane term structure model (ATSM), and the other
(Kalkbrener and Willing 2004) implements its deposit valuation model based
on an exogenous HJM type of model and motivates this with better cali-
bration results with the non-parametric models. For our problem at hand,
though, we feel that endogenous models represent a more suitable choice.
Our primary concern is not to exactly price an interest rate derivative based
on the presently given shape of the term structure, but rather the valuation
of an deposit-type of interest rate derivative which depends on the long-run
dynamics of the term structure. With this rationale, we follow Dewachter,
Lyrio and Maes (2006).
Choosing a term structure model Among endogenous models, a com-
mon choice of multi-factor models is the class of essentially ane models,
which can include up to N state factors in their general specication. Set-
ting N = 3 is the usual choice in the literature to closely track the empirically
observed yield curve dynamics.
12
Now, we add a fourth risk factor to the spec-
ication of the ATSM which is supposed to capture the time-varying deposit
12
Recall the study of Litterman and Scheinkman (1991) and also see Knez, Litterman
and Scheinkmann (1994).
16
spread, r
t
r
D,t
.
13
This implies that the state factor process X
D
t
R
N+1
under the empirical probability measure can be stated as
dX
D
t
= K
D
(

X
D
X
D
t
)dt +
D

S
D
(X
D
t
) dW
D
t
, (19)
where

X
D
R
N+1
,
D
, K
D
R
(N+1)(N+1)
, dW
D
t
is a (N+1)-dimensional
independent standard Brownian motion under P, and S
D
(X
D
t
) R
(N+1)(N+1)
is a diagonal matrix of the form
S
D
(X
D
t
) =

S
D
1
0
0
.
.
. 0
0 0 S
D
N+1

, (20)
where diagonal elements are again given by
S
D
i
=
D
i
+
D
i

X
D
t
for i = 1, . . . , N + 1, (21)
with
D
i
R and
D
i
R
N+1
.
14
We modify the matrix of mean reversion
speed, K
D
, to have o-diagonal elements dierent from zero in row N + 1,
K
D
=

D
(1,1)
0 . . . 0
0
.
.
. 0 0
0 0
D
(N,N)
0

(N+1,1)
. . .
(N+1,N)

D
(N+1,N+1)

. (22)
If equation (22) had only diagonal elements,
(i,i)
, this would mean that the
mean-reversion speeds of state variables were independent. In the present
13
The idea to include the deposit spread as an additional state variable in the term
structure model was rst proposed by Dewachter, Lyrio and Maes (2006).
14
For the following derivations, we remark that in contrast to our heteroskedastic spec-
ication, Dewachter, Lyrio and Maes (2006) assume constant volatility; thus, some of our
results will deviate from theirs, such as e.g. the Riccati equations of the bond pricing
formula (36). For a specication similar to ours, see e.g. Duee (2002) or Duarte (2003).
17
case, however, where
(N+1,i)
= 0, this intuitively means that we relax the
assumption of independence between the state variable N +1 of the deposit
spread and the rest of the factors driving the term structure of the interest
rate, i.e. the deposit rate may be a function of the market rate.
Adding a state variable in such a fashion is an elegant way to install a
functional dependence of the deposit rate on the market rate. An unpleasant
and serious side eect of this procedure is the loss of a unique martingale
probability measure.
15
The addition of a state variable to an otherwise com-
plete market leads to market incompleteness. According to the Fundamental
Theorem of Finance, if a market is incomplete, the pricing kernel will be inde-
terminate, and according to the Martingale Representation Theorem, an in-
determinate pricing kernel is equivalent to an indeterminate martingale prob-
ability measure, or innitely many martingale probability measures.
16
This
also implies that arbitrage cannot be precluded. To overcome this problem,
Kalkbrener and Willing (2004) apply a variance-minimizing martingale
probability measure, as presented e.g. in Schweizer (1995) or Delbaen and
Schachermayer (1996).
17
According to the latter, the variance-minimizing
martingale measure is dened as the measure

P

which comes closest to the


given martingale measure P

, where the t is determined by the time-varying


market price of risk, (X
t
) R
N+1
. For this, recall from the denition of
the Radon-Nikodym derivative,
t
, that the density of P

with respect to
P is given by
= exp

t
0

D
(X
D
s
)dW
D
s

1
2

t
0

D
(X
D
s
)

2
ds

, (23)
15
This loss is not a weakness of this approach only. Kalkbrener and Willing (2004) face
the same problem.
16
Ross (2004) (chapter 1) provides an intuitive derivation of these relationships.
17
An alternative valuation approach would be good deal bounds. See Cochrane and
Saa-Requejo (2001) for this.
18
where
D
(X
t
) is the time-varying market price of risk and has the form

D
(X
D
t
) =

D
1
(x
D
1,t
) . . .
D
N
(x
D
N,t
) 0

, (24)
which according to Duee (2002) can be dened as

D
(X
D
t
) = S
D
t
+S
D
t
(1)
X
t
, (25)
where

1
. . .
N
0

, (26)
and R
(N+1)(N+1)
is a matrix in which the elements specify the depen-
dence of the market price of risk,
D
, on the vector of state variables with
the exception of row and column N + 1, which contain zeros. In the den-
sity of the Girsanov transformation in (23), P can be seen as the empirical
equivalent of an indeterminate martingale measure. More meaningful is the
variance-minimizing martingale measure,

P

, that can be obtained from its


density with respect to the observable empirical measure,

P,
= exp

t
0

D
(X
D
s
)dW
D
s

1
2

t
0

D
(X
D
s
)

2
ds

. (27)
Finally, obtaining dW
D
t
is straightforwardly possible by
d

W
D
t
= d

W
D
t

D
(X
t
)dt. (28)
For the calibration of the model, this basic relationship allows us to mod-
ify the drift and the stochastic term in (19) such that we obtain an empir-
ical state factor process from its risk-neutral equivalent under the variance-
minimizing martingale measure,

P

,
dX
D
t
=

K
D
(

X
D
X
D
t
)dt +
D

S
D
(X
D
t
) d

W
D
t
, with (29)

K
D
=K
D
+, (30a)

X
D
=(K
D
+)
1
(K
D

X
D
S

). (30b)
19
Specifying processes of the deposit rate and deposit base After
we have spent much eort on deriving the term structure model with the
additional state factor deposit spread, we can now conveniently formulate
the dynamics of the deposit rate as linear function of the state variables
vector X
t
,
r
D,t
=
D
0
+
D
1

X
D
t
+ u
D
t
, (31)
where
D
0
is a constant,
D
1

R
N+1
is a vector of coecients with

D
1

1 . . . 1
1,(N+1)

, (32)
and u
D
t
is the error term.
18
Concerning the deposit base, Dewachter, Lyrio and Maes (2006) do not
account for volume growth and concentrate on the decay rate only. They
justify this by limitations of data availability. Their simple assumption is
that deposits increase at the deposit rate, i.e. depositors do not collect the
interest earned, and decrease at the estimated decay rate, r
w
,
dD(t) = (r
D
(t) r
w
)D(t)dt. (33)
This specication is too simplistic for our purposes. In contrast to this,
while Kalkbrener and Willing (2004) did not spend much time on specifying
an innovative deposit rate process, they propose a more sophisticated evo-
lution of the deposit base, which seems suitable for our problem. In their
model, the deposit base D(t) is the sum of two terms, a deterministic trend
growth function, G(t), and a mean-reverting Ornstein-Uhlenbeck process of
the detrended deposit base,

D(t),
D(t) = G(t) +

D(t) with (34)
18
See Dewachter, Lyrio and Maes (2006) for a slightly dierent approach to obtain a
deposit rate process. Kalkbrener and Willing (2004) dene the deposit rate simply as a
linear function of the short rate r.
20
G(t) =
D
0
+
D
1
t, (35a)
d

D(t) =
D

D(t)dt +
D
d w
t
, (35b)
with constant
D
and the Wiener process d w
t
under the empirical probability
measure

P in an incomplete state space.
19
For simplicity, we assume that the
Wiener process of the deposit base is uncorrelated with those of the state
variable processes.
20
Deriving a deposit pricing formula For the derivation of a value of the
deposit business, V
D
, recall from (36) that in N-factor ATSMs, the value of
a risk-free zero bond at time t with time to maturity can be obtained by
B

(t, ) = exp

A
D
() B
D
()

X
D
t

. (36)
where A
D
() and B
D
() are ODEs given by the following Riccati equations
21
:
A()

=

X

B()+

i=
[

B()]

(37a)
B()

= K

B()

i=
[

B()]

i

x
. (37b)
These ordinary dierential equations (ODEs) can be solved by integration
under the initial boundary conditions A(0) = 0 and B(0) =0
N1
, which result
19
Kalkbrener and Willing (2004) note that, theoretically, the deposit base in this model
can become negative. To their defense, they propose to oor D(t) at 0 and mention that
this theoretical possibility did not play any role in their empirical study.
20
Kalkbrener and Willing (2004) allow for correlation but, in turn, limit the number of
state factor to N = 2.
21
A derivation of this solution to the Riccati problem for the multivariate case can be
found in Cochrane (2001), pp. 374377.
21
from (36) since we know that the initial zerobond price in time 0 is B

(t, 0) =
1 for a standardized unit of a risk-free zero coupon-bond. Solutions to these
ODEs are nite given some technical regularity conditions on K

and .
The Riccati equations can be solved by integration under the initial
boundary conditions A
D
(0) = 0 and B
D
(0) = 0
N1
. Analytical solutions
for these are not available in our setting. Instead, the numerical proce-
dure will be more cumbersome in the present case, as we allowed here for
a correlation among the state variables in the ODEs. For the calibration
of this model on historical deposit data, a discretization of the time steps
0 = t
0
, t
1
, . . . , t
s1
, t
s
= T with step size
t
= t
i
t
i1
is necessary.
Implementing a model describing the deposit behavior of a bank requires
to calibrate the following three processes:
dX
D
t
=K
D
(

X
D
X
D
t
)dt +
D

S
D
(X
D
t
) dW
D
t
, (38a)
r
D,t
=
D
0
+
D
1

X
D
t
+ u
D
t
, (38b)
D(t) =
D
0
+
D
1
t +
D

D(t)dt +
D
d w
t
. (38c)
5 Valuation of the loan business
For ease of modeling and exposition, we assume that the only credit product
a bank oers is a non-maturing overdraft facility, although, in principle, our
approach can be applied to all kinds of credit products when allowing for their
respective special characteristics and features. Regarding a formal valuation
setup for the loan business, a comparable market segmentation argument can
be made for the loan market.
22
When abstracting from credit default risk,
obtaining a valuation formula for the loan business is based on table 2 and
22
Jarrow and van Deventer (1998) propose this in their paper already; see p. 255.
22
equation (39) which are mirror images of the ones for the DB.
23
t = 0 t = 1 . . . t = T 1 t = T
New loans L
0
L
1
. . . L
(T1)
Loans paid o +L
0
. . . +L
(T2)
+L
(T1)
Interest received +L
0
r
c
L,0
. . . +L
(T2)
r
c
L,(T2)
+L
T1
r
c
L,(T1)
Interest paid L
0
r
=2,0
. . . L
(T2)
r
=2,(T2)
L
(T1)
r
=2,(T1)
Table 2: Cash ow streams of the loan business
For simplicity of modeling, we have chosen the same time intervals as for
deposits. This is a sensible and unproblematic assumption for it only aects
the frequency of estimation points in the models estimating the loan base
and the loan rate. The resulting decay rate and eective maturity of assets
should remain unaected of this assumption. Thus, the relevant rate would
still typically be one of longer eective maturity, = 2. Bank customers
pay r
L
on their loans and banks receive this rate less cost, r
c
L
. Assuming a
loan business with only such loans, a planning horizon T, and a exogenously
given loan volume of the bank, L
t
, the economic value of the banks assets is
analogously given by
V
L
= E
P

T
0
L
t
(r
c
L,t
r
=2,t
)
g(t)
dt

. (39)
5.1 Valuation procedure
The valuation procedure of the LB follows the same ve steps list in the
beginning of section 4, where one should resort to the same choice of term
structure model for reasons of consistency. Moreover, the term structure
23
When abstracting from credit risk we assume that credit risk can eciently be hedged
in the market so that its value impact can be neglected.
23
model should have multiple factors in order to avoid perfect correlations of
yields across maturities. Ideally, the dynamics of the loan rate are integrated
in the estimation of the essentially ane term structure dynamics as done
with the deposit rate already in the multi-factor model specication of the de-
posit business. We propose to add another state variable for the loan spread,
r
c
L,t
r
=2,t
, to the multi-factor framework presented above in section 4.2.
The implementation of our model with both spreads, the deposit spread and
the loan spread, increases the dimension of our original state vector X
t
by
2, from N = 3 to N + 2 = 5, which we can denote in the following with the
superscript LD, X
LD
t
R
N+2
. The process of the state variables under the
empirical probability measure becomes then
dX
LD
t
= K
LD
(

X
LD
X
LD
t
)dt +
LD

S
LD
(X
LD
t
) dW
LD
t
, (40)
where

X
LD
R
N+2
,
LD
, K
LD
R
(N+2)(N+2)
, dW
LD
t
is a (N + 2)-
dimensional independent standard Brownian motion under P, i.e. we do not
assume a correlation of the processes other than given by the joint dependence
on the short rate. S
LD
(X
LD
t
) R
(N+2)(N+2)
is again a diagonal matrix
of a form which follows in analogy from equation (20) and equation (21).
We stop here with further derivations to avoid a repetition of trivial results.
By help of the variance-minimizing martingale measure, we can once again
obtain a pricing equations although the market is incomplete. The price of
a risk-free zero coupon bond is given by the similar but extended formula
B

(t, ) = exp

A
LD
() B
LD
()

X
LD
t

, (41)
for which a closed-form solution cannot be derived. Hence, we suggest Monte
Carlo simulations of the stochastic processes describing the evolution of the
loan volume and the loan rate with parameters calibrated on historical loan
data. In this context, the far inferior amount of empirical studies on loans
24
as when compared to deposits is suspectingdata availability is certainly an
issue. Ausubel (1991) resorts to credit card loan data of interbank transac-
tions of loan portfolios and also discusses the issue of credit risk. Another
but related point is the higher opacity of the loan business. The appropriate
MMMVF transfer rate can be easily obtained as soon as an estimate of the
eective maturity of loans is available. Then, the empirically given can be
used as argument in the following denition of the yield y(t, ) at time t of
a riskless zero coupon bond maturing in ATSMs.
y

(t, ) =
ln B

(t, )

=
A() +B()

X
t

. (42)
When leaving these questions aside, we have to estimate two equations.
Of course, the estimation of the SDE in (40), including N +2 state variables,
serves as basis for the estimation of both r
D,t
and r
L,t
and therefore replaces
the estimation of (38a). When comparing the studies on deposit valuation
with Ausubel (1991) and Chatterjea, Jarrow, Neal and Yildirim (2003) on
credit card loan valuation, one nds that the loan rate exhibit traits similar
to those of the deposit rate, respectively. Consequently, a natural choice for
this is a process specication in analogy to the deposit rate:
r
L,t
=
L
0
+
L
1

X
LD
t
+ u
L
t
(43)
Finally, the assumption L = D alleviates us from estimating a third process.
6 Asset/Liability Management Valuation
The prot of the ALM is dened as

ALM
= D
t
(r
=2
r
=1
) . (44)
25
As such, this unit isolates and internalizes the interest rate risk stemming
from changes in the slope and the curvature of the term structure, represent-
ing a particular type of yield curve swap with time-varying notional principal.
This makes it similar to the DB and the LB but, in contrast to them, the
spread of the ALM is based on market rates and not bank rates. In turn,
that dierence slightly facilitates the valuation of the ALM, for which it can
be shown that its value in continuous time is given by the expectation under
the risk-neutral probability measure, E
P

0
,
V
ALM
= E
P

T
0
(r
=2,t
r
=1,t
) D
t
g(t)
dt

. (45)
Such structures are traded in the market as spreads of constant maturity
swaps, or yield curve steepeners: As opposed to a plain vanilla interest rate
swap, here both legs are oating but of diering maturities. Both market
rates can be obtained from the short rate process according to the result in
equation (42) as yields y(t, ) at time t of a riskless zero coupon bond matur-
ing from now. The stochastic process of D
t
is proposed in equation (38).
Once again, the distribution of V
ALM
has to be determined by simulation.
7 Valuation of the entire bank
Substituting (6) and (7) into equation (11) and adding precise time subscripts
and taking into consideration that A = L yields the equivalent expression
V
A,t
= V
L,t
+ D
t
V
D,t
+ V
ALM,t
. (46)
Unfortunately, there is no closed-form solution available for any of the
economic values in (46). Simulating the three components
24
of the bank
24
Loan, Deposit, ALM business.
26
value is a tedious task, whereas valuing options on the portfolio of all three
is even more complicated, even before taking into account that the strike
prices of both options are time-varying as can be observed in equations (47).
In the specication of V
L
, V
D
, and V
ALM
, we assumed independence of the
generating processes. Hence, these three values are correlated insofar only
as each of them is also a function of the short rate. From the boundary
conditions for bank debt, V
bank
B,T
, and bank equity, V
bank
E,T
, as derived in (13),
the value of our banks debt and equity can formally be dened as
V
bank
B,0
= E
P

0
[(B

max[V
D,T
V
L,T
V
ALM,T
; 0])] B

(0, T), (47a)


V
bank
E,0
= E
P

0
[max[V
L,T
+ V
ALM,T
V
D,T
; 0]] B

(0, T), (47b)


where an evaluation of the expectation involves the valuation of interest rate
options with time-varying strike prices, which can be achieved numerically.
25
The value components in equations (46) and (47) have to be calculated ac-
cording to the preceding paragraphs:
The multi-factor economic value of the deposit business value V
D,t
is
based on equation (36).
The economic value of the loan business value V
L,t
is implied by the
numerical solution to equation (41).
The economic value of the asset and liability management business
value V
ALM,t
is implied by the numerical solution to equation (45).
After having characterized the valuation model in a very stylized way in
section 3, the sections 4 to 6 have provided the formulas needed to ll into
(47).
25
While Rebonato (1998) gives a general overview of interest rate contingent claims val-
uation under dierent term structure models, the valuation of option with time-dependent
strike prices is put forward e.g. in Xia and Zhou (1997).
27
8 Conclusions
We argue that the problem of valuing a bank as a rm which is particularly
exposed to interest rate risk has not been adequately solved in the literature
so far. We propose a bank equity valuation model based on the contingent
claims theory and derive the banking rm value as constituting of the value
of three stylized business units, the asset business, liability business, and the
asset-liability management. The value of each of these units can be derived
in a risk-neutral valuation framework as equivalent to the costs of a hedging
strategy that osets the risk exposure but still allows for arbitrage prots.
There exist several models for the valuation of banking products and we have
exemplied our model drawing on the deposit valuation model of Jarrow and
van Deventer (1998) and extending it to the entire bank.
28
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