For some time now, negative interest rate policies (NIRPs) and negative yields have been dominating global headlines, but it seems to me that the discussion has become even more amplified in recent weeks. With headlines ranging from speculation about NIRPs in the US: The Fed May be Preparing for the Unthinkable — Negative Interest Rates in America,[i] to the new normal existence in Europe of negative yielding bonds: Negative yielding Euro Corporate Bonds,[ii]it is no doubt important to address the risk modeling requirements in this environment.
With the above headlines in mind, how can risk managers conduct stress tests on the impact of potential future drops in rates? And how can managers effectively construct portfolios that hold negative yielding bonds?
To help answer these questions, I turned to two risk experts from the Cognity team, Teodosi Geninski and Elena Stoyanova, for a bit of history and an overview of Cognity’s unique “real world” modeling capabilities for negative interest rates. Following is a snapshot of our discussion.
TG: Before rates began to drop, the widespread modeling techniques were easy to understand and something that most risk platforms offered.
ES: Then negative interest rates crashed those models.
TG: Yes. The financial models needed to value in and adequately capture the probability of falling rates - such as Shifted SABR or Bachelier models - rely on techniques that standard modeling frameworks a la Black-Scholes could not handle. We saw some ad hoc solutions emerge, such as systems that could model by security one at a time for negative strikes on options, but it was clear that the market needed a scalable, forward-thinking solution that could handle negative interest rates in general.
ES: And so the Cognity team built that very framework!
TG: Exactly. Cognity is an open and flexible multi-model platform that does not impose any one model or paradigm, and enables easy model customization.
ES: That is why the market turned to us. Cognity can handle the more complex models that erase the constraints of negative models.
TG: The Cognity platform deploys a comprehensive shifted SABR model framework across the full range of supported interest rate instruments and includes an embedded volatility conversion algorithm allows for log-normal and normal market volatility data inputs.
ES: It is fair to say that asset managers and hedge funds get the most accurate pricing of interest rate options from Cognity, including support for negative interest rates and negative payments in floating rate dependent instruments.
TG: That is correct, and our team will be happy to discuss with any of our current Cognity customers who would like some guidance, or prospective Cognity users interested in a demo.
BISAM Cognity’s accurate and reliable risk models work across all asset classes and adapt to all market regimes. Visit www.bisam.com/cognity to download the risk modeling brochure or request a demo.