Joint Interest Rate Risk Management of Balance Sheet and Hedge Portfolio
Zurich Cantonal Bank; University of Basel
Core Dynamics GmbH
August 21, 2006
We present a multi-period mean-variance optimization program which allows for a joint optimization of the balance and off-balance sheet. We first prove a conjecture of Li and Ng (2000), Leippold et al. (2004, 2003) about the equivalence of the original non-separable mean-variance problem and its embedding into a higher dimensional separable problem. We then show that given a time independent term structure, the one-period and the multi-period problem are equivalent. If the best forecast of the interest rates is the forward rate, we prove that it is then optimal to mimic the benchmark strategy. We apply the model to UBS data and show that the myopic models are not acceptable for key rate delta profile management. We further calculate present values of a portfolio for different strategies. It follows that the optimal dynamic portfolio strategy leads to a return of 3.12% compared to 2.6% for the myopic model.
Number of Pages in PDF File: 38
Keywords: Balance and Off Balance Sheet Analysis, Interest Rate Risk, Dynamic Mean Variance Optimization
JEL Classification: G18, C19, G21, C69working papers series
Date posted: May 17, 2006
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