Detailed Brief - Interest Rate Risk

Robert Serena

May 2023

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About the author – Robert Serena

Mr. Serena is a Risk Management and Actuarial executive with a unique blend of
financial services functional experience across insurance, reinsurance, commodity
trading, and commercial banking - numerous technical and leadership roles in the First
Line-of-Defense (Actuarial, Investment Management, and Capital Markets & Trading)
and Second Line-of-Defense (Risk Management and Compliance).
He holds a BS in Electrical Engineering from Rice University, an MS in Operations
Research from the University of New Haven, and several professional certifications –
Fellow in the Society of Actuaries (FSA), Chartered Financial Analyst (CFA), Financial
Risk Manager (FRM), Chartered Property Casualty Underwriter (CPCU), Certified in
Risk and Information System Control (CRISC), and the Sustainability and Climate Risk
(SCR) certificate.
He currently lives in Charlotte, North Carolina with his wife and two children.

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Contents
Section 1.0 - Executive Summary ...................................................................................................................................................................................... 5
Section 2.0 – Practical Implementation Considerations ..................................................................................................................................................... 6
Section 3.0 – Time value of money/interest compounding/bond pricing ............................................................................................................................. 7
3.1 – Time value and compounding .............................................................................................................................................................................. 7
3.2 - Basic Bond Pricing ............................................................................................................................................................................................... 8
Section 4.0 – Fundamentals of Yield Curve Construction .................................................................................................................................................. 9
4.1 – Background and overview .................................................................................................................................................................................... 9
4.2 – Day count conventions ....................................................................................................................................................................................... 10
4.3 – Different types of yield curves ............................................................................................................................................................................ 11
4.4 – Yield Curve Fitting Methods ............................................................................................................................................................................... 14
4.4.1 - Non-parametric methods............................................................................................................................................................................. 15
4.4.2 - Parametric methods .................................................................................................................................................................................... 18
4.5 – Deriving Market Yields and yield curve shape drivers ........................................................................................................................................ 18
Section 5.0 – Risk Management and Sensitivity Measures .............................................................................................................................................. 21
5.1 – Full valuation ..................................................................................................................................................................................................... 21
5.2 – Taylor series approximation ............................................................................................................................................................................... 22
5.3 - Duration.............................................................................................................................................................................................................. 22
5.4 - Convexity ........................................................................................................................................................................................................... 27
5.5 – Other risks with fixed income securities ............................................................................................................................................................. 27
Section 6.0 – Interest Rate Simulation Methods .............................................................................................................................................................. 28
6.1 Background and overview ..................................................................................................................................................................................... 28
6.2 – Statistical Distributions ....................................................................................................................................................................................... 29
6.3 - Considerations for Interest Rate simulation models ............................................................................................................................................ 32
6.4 - Sample simulation runs ...................................................................................................................................................................................... 33
6.4.1 Impact of # trials on simulation statistics........................................................................................................................................................ 33
6.4.2 Lognormal (Mean, Variance) ......................................................................................................................................................................... 35
6.4.3 PERT (Minimum, Mode, Maximum)............................................................................................................................................................... 36
6.4.4 Gamma (𝜶, 𝜷) ............................................................................................................................................................................................... 38
Section 7.0 – Portfolio Management considerations ........................................................................................................................................................ 39
7.1 – Background and Overview ................................................................................................................................................................................. 39
7.2 – Financial performance for US L&H sector (2021) ............................................................................................................................................... 41
7.3 – How do L&H insurers invest? ............................................................................................................................................................................. 43
7.4 – Investment income allocation ............................................................................................................................................................................. 44
Section 8.0 – Interest Rate Derivatives (IRDs) ................................................................................................................................................................. 46
8.1 – Background and Overview ................................................................................................................................................................................. 46
8.2 – Market characteristics ........................................................................................................................................................................................ 49
8.3 – Interest rate swaps ............................................................................................................................................................................................ 54
8.4 – Black model ....................................................................................................................................................................................................... 56
8.5 – Caps and floors.................................................................................................................................................................................................. 57
8.5.1 – IRCs........................................................................................................................................................................................................... 57
8.5.2 – IRFs ........................................................................................................................................................................................................... 58
8.6 - Swaptions ........................................................................................................................................................................................................... 59
Section 9.0 – Secured Overnight Financing Rate (SOFR) ............................................................................................................................................... 62
9.1 – Background and Overview ................................................................................................................................................................................ 62
9.2 – IOSCO Best Practices ....................................................................................................................................................................................... 64

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 9.3 – Reference Rates ................................................................................................................................................................................................ 65
9.4 – What is LIBOR and how it calculated? ............................................................................................................................................................... 67
9.5 – What is SOFR? .................................................................................................................................................................................................. 69
9.5.1 – Daily SOFR ................................................................................................................................................................................................ 69
9.5.2 – CME SOFR Futures ................................................................................................................................................................................... 70
9.5.3 – SOFR Index and averages ......................................................................................................................................................................... 76
9.5.4 – Term SOFR rates ....................................................................................................................................................................................... 78
9.5.5 – SOFR usage considerations....................................................................................................................................................................... 83
Section 10.0 – Risk-Neutral Dynamics............................................................................................................................................................................. 84
10.1 – Background and Overview ............................................................................................................................................................................... 84
10.2 – One-period model ............................................................................................................................................................................................ 86
Section 11.0 – Financial Statement Impacts (Banks and Insurers) .................................................................................................................................. 89
11.1 – Background and overview ................................................................................................................................................................................ 89
11.2 Bank Financial Statements ................................................................................................................................................................................. 89
11.2.1 - Bank balance sheet .................................................................................................................................................................................. 90
11.2.2 - Bank Income Statements .......................................................................................................................................................................... 91
11.3 Insurer Financial Statements .............................................................................................................................................................................. 92
Section 12.0 – Nationally Recognized Statistical Rating Agencies (NRSROs) ................................................................................................................. 93
12.1 – Background and overview ................................................................................................................................................................................ 93
12.2 Standard and Poor’s ........................................................................................................................................................................................... 93
12.2.1 – General purpose ...................................................................................................................................................................................... 94
12.2.2 – Special Purpose ....................................................................................................................................................................................... 94
Appendix A – Terms of Reference ................................................................................................................................................................................... 96
Appendix B – IOSCO Best Practice Principles ............................................................................................................................................................... 100

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Section 1.0 - Executive Summary
The purpose of this detailed brief is to provide the reader with a comprehensive “nuts and bolts”
treatment of Interest Rate Risk Management (IRRM) and the related topical areas that impact IRRM/are
impacted by IRRM – including but not limited to (1) Bond pricing, (2) Yield curve construction, (3) Risk
Management metrics, (4) Simulation methods, (5) Portfolio construction and management
considerations, (6) Interest rate derivatives, (7) Alternative reference rates (SOFR), (8) Risk neutral
frameworks, and (9) Bank and Insurer financial statements.

When considering the range of Enterprise Risks that can impact any organization (Financial and Non-
Financial), IRRM can impact any type of organization in any industry. But IRRM specifically has a
material impact on the profitability and balance sheet strength of financial services organizations,
particularly depository institutions (commercial and retail banks, thrifts, savings and loans, and credit
unions), and insurance firms (Life, Annuity and Health (LAH), Property & Casualty (P&C)).

Interest Rate Risk is defined in several alternative ways, as follows:

• INVESTOPEDIA – The risk that an investment's value will change due to a change in the absolute
level of interest rates, in the spread between two rates, in the shape of the yield curve, or in any
other interest rate relationship.
• WIKIPEDIA - The risk that arises for bond owners from fluctuating interest rates. How much interest
rate risk a bond has depends on how sensitive its price is to interest rate changes in the market.
The sensitivity depends on two things, the bond's time to maturity, and the coupon rate of the bond.
• OFFICE OF THE COMPTROLLER - Interest rate risk is the risk to earnings or capital arising from
the movement of interest rates. It arises from differences between the timing of rate changes and
the timing of cash flows (repricing risk); from changing rate relationships among yield curves that
affect bank activities (basis risk); from changing rate relationships across the spectrum of maturities
(yield curve risk); and from interest-rate-related options embedded in bank or insurer products
(option risk).

From these definitions, it is clear that varying interest rates can impact a bank or insurer’s operational
performance in in the form of increases/decreases in Net Investment Income (NII) or Net Interest Margin
(NIM), and also their balance sheet strength, and correspondingly capital ratios, in the form of realized
and unrealized increases/decreases to the market value of bonds held on the balance sheet to support
the organization’s underlying liabilities.

Several types of readers should find at least some portion of the content in this brief useful – actuaries,
corporate finance professionals, investment professionals, treasury professionals, etc. The content is
moderately technical, and I assume the reader has a solid background in algebra, undergraduate level
calculus, stochastic processes, and statistics. I encourage the reader to take a run through the Terms
of Reference (Appendix A – Terms of Reference) before proceeding to the main document in order to
gain familiarity with the key terms.

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Section 2.0 – Practical Implementation Considerations
When a financial services firm is building out a new IRRM framework from scratch, or enhancing an
existing framework, of equal or greater importance to the many technical nuances of the framework
(the items discussed in this brief) are the practical operational constraints to implementing the
framework. These constraints will be unique to each firm, and therefore require a bespoke approach.
As described in Section 11.0 – Financial Statement Impacts (Banks and Insurers), insurers and
depository institutions are materially impacted by interest rate risk, and as regulated institutions, must
have well established IRRM frameworks in order to meet regulatory requirements. But the requirements
for each are quite different. By design, depository institutions “invest long” and “borrow short”, and thus
have an inherent ALM mismatch. Banks quantify the extent of the mismatch by grouping assets and
liabilities by time or maturity buckets to get a sense of what is termed the “repricing risk”.
In contrast, insurers “borrow long” and “invest long” and have a closer ALM balance. This section
focuses specifically on LAH insurers. The implementation discussion is framed around the “people,
processes, and systems” that are critical success factors when implementing an IRRM framework.
• People
• The functional groups most directly involved in IRRM will be treasury, accounting, financial
reporting, corporate actuarial, enterprise risk management, and the Chief Investment Office
(CIO).
• Given the complexity of IRRM, each of these groups play different roles and will need to be
staffed with individuals with the appropriate skills. Following is a comprehensive list of the range
of skills required for an implementation to be successful:
• Knowledge of the economics and risk profile(s) of the products that the insurers sells; and
• Knowledge of the capital markets (risk factors, traded securities, derivatives, liquidity, etc)
and the firm’s investment strategy; and
• Knowledge of the administrative and modeling systems used in managing IRRM; and
• Knowledge of the accounting requirements (statutory, GAAP, embedded value) that impact
the reported value of primary securities and derivatives.
• Processes
• Reports and monitoring tools that track the underlying asset (market values, book values) and
liability exposures (statutory reserves, account values), as well as relevant risk metrics (duration,
convexity, duration gap, DV01, etc) at different levels of granularity (portfolio level, entire firm).
• Well-defined governance venues – Asset Liability Management Committee, Transaction Review
Committee, Model Governance Committee, Finance Committee, etc.
• Well-defined and clear policies – Asset Liability, Capital Management, Product Development,
Investment, etc.
• Systems
• Modeling systems - Third-party applications that can take inforce ALM data from the firm’s
administrative systems (appropriately cleaned and aggregated) and run different types of cash
flow projections; and
• Administration systems – Different systems used to house individual assets and liabilities; and
• Market Data systems – third party systems like Bloomberg; and

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 • Valuation systems – Inhouse-developed or third-party applications that are used to value
complex securities or derivatives.

Section 3.0 – Time value of money/interest compounding/bond pricing

3.1 – Time value and compounding
Interest rates are the “prices” associated with borrowing/lending money for different periods of time.
Interest may be compounded in different ways, ranging from annually to continuously.

• Simple interest
• An approach seldom used in the real world but described here for the sake of completeness.
• If an investor deposited $D into a bank account that credited interest on a simple interest basis
at a rate of R% per year, the formula for the investor’s accumulated account balance after T
years is given in the formula below.
• Balance(T) = D ∗ (1 + R ∗ T)
• An examination of the formula shows that the simple interest approach does not provide the
investor with the “interest on interest” benefit that compound interest provides. Every incremental
crediting of interest is always done based on (1) The initial deposit and (2) The credited rate R.
• Compound Interest
• The same use case described above modified for compound interest would have the following
balance formula:
• Balance(T) = D ∗ (1 + R)T
• More generally, the formula for calculating the present value (PV) of a cash flow (CF1 ) paid out
1 year into the future (i.e., M compounding periods), where the interest rate (I) is compounded
M times per year, is given by the formula below:
CF1
• Present Value = I M
(1+ )
M
• The above relationship can be generalized to fit a range of compounding frequencies form (1)
Annual compounding (M=1) to (2) Continuous compounding where the frequency of
compounding is every second of every day (M = ∞). The generalization of the above formula
that captures the continuum of possibilities is given by:
CF1
• Present Value = lim M
M→∞ (1+ I )
M
• And the specific formula for continuous compounding is given below (e represents the value
−𝐼
2.718281828 ...): Present Value = CF X e(100)

An example will serve to illustrate the differences in a given present value calculation from discounting
at the same Annual Percentage Rate (9.00%) compounded at different frequencies – Annually, Semi-
Annually, Quarterly, Monthly, and Continuously. The results from these five calculations are illustrated
in Exhibit 1 below. It is clear from the relative size of the results that a higher compounding frequency
equates to a lower PV of the sample cash flow ($1,000 paid at the end of year 1). This makes sense in
that the “compounding effect” is greater with a higher frequency, which effectively translates to an
investor having to invest less $s upfront at time zero in order to get the same result ($1,000) at time 1.

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 Frequency Discount Factor Present Value
Annually 1 $917.43
( ) = .91743
1.09
2
Semi-annually $915.73
1
( ) = .91573
. 09
1+
2
4
Quarterly $914.84
1
( ) = .91484
. 09
1+
4
12
Monthly $914.24
1
( ) = .91424
. 09
1+
12

Continuously EXP(−.09) = .91393 $913.93

EXHIBIT 1 – Illustration of different compounding frequencies

3.2 - Basic Bond Pricing

A coupon bond is an investment security that pays a fixed rate of interest (e.g., the coupon rate) for a
specified period (e.g., the bond term) on a specified principal amount (e.g., the face amount). The
general valuation formula for a bond with Yield-to-Maturity I compounded annually, a coupon rate of C,
a term of N years, and a face amount of FN is given by the equation below:

F ∗C FN
• Bond Price = ∑N N
t=1 (1+I)t + (1+I)N

The sample bond and related parameters in Exhibit 2 are used to illustrate the non-linear relationship
between the bond price and the yield:

Parameter Value of parameter

Bond YTM (Compounded Annually) 10%
Bond Coupon Rate (Annual payment) 10%
Face Amount $1,000
Term of bond 20 years
Exhibit 2 – Parameter values for a bond

The graph and the supporting data table below (Exhibit 3 and Exhibit 4) clearly illustrate the non-
linear relationship between the price of a bond and underlying yields. The absolute price change is
larger given an X basis point decrease in the bond yield versus an X basis point increase in the bond
yield. This can be seen on the graph by noting that the price curve is steeper as yields decrease below
the par yield (10.00%) than it is as yields increase above the par yield. This can also be seen on the
data table below the graph. The last row in the table gives the market value changes in the bond when
moving from the par yield (10.00%) to the reference yield of 7.00%. For example, the absolute change
in Market Value is greater when yields decrease 300 bps from 10.00% to 7.00% ($317.82 increase in
price) than when yields increase by 300 bps from 10.00% to 13.00% ($210.74 decrease in price). The
price curve flattens out as yields increase above the par yield.

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 Relationship of MV to yields
$1,400.0 0 40.00%
$1,200.0 0 30.00%
Market Value

$1,000.0 0 20.00%
$800.00 10.00%
$600.00 0.00%
$400.00 -10.00%
$200.00 -20.00%
$0.00 -30.00%
7.00%
7.50%
8.00%
8.50%
9.00%
9.50%
10.00%
10.50%
11.00%
11.50%
12.00%
12.50%
13.00%
Interes t Rate

Market Yields Change in value Bond Market Values

EXHIBIT 3 – Bond price and change in value

EXHIBIT 4 – Table illustrating bond prices for a range of yields (YTM +/-300 basis points)

Section 4.0 – Fundamentals of Yield Curve Construction

4.1 – Background and overview
At a basic level, the yield curve is a graph that illustrates the relationship between the yields and the
corresponding maturity for a given class of bonds. Exhibit 5 below illustrates two real-world US
Treasury yield curves – (1) As of Monday 01/03/2022 (upward sloping) and (2) As of Friday 12/30/2022
(slightly inverted or downward sloping). Just as one can build a yield curve for US Treasury securities,
one can also build a yield curve for any class of bond – Municipal, Investment-grade Corporates, Sub-
Investment grade, etc.

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Exhibit 5 – Two actual yield curves from 2022

An important attribute of a yield curve that will influence the return that a fixed income investor realizes
over some investment horizon is the shape of that curve. There are 4 basic yield curve shapes. Exhibit
6 below captures these 4 shapes and provides the economic drivers that result in that specific shape
occurring.

Yield Curve Description

Shape
Normal • Curve is upward sloping (long-term yields > short-term yields).
• Investors anticipate an expanding economy.
• Long-term securities offer a risk premium (inflation, credit) over short-term.

Flat • Yields for all maturities are equal.

• Signals uncertainty about the state of the economy.
• Views on risk premiums are unclear.

Inverted • Long-term rates < short-term rates.

• Signals lower inflation expectations and correspondingly lower risk premiums → economy expected to
weaken.
• Viewed as a leading indicator for recession.

Humped • Can represent a transition state between normal and inverted.

• May represent an atypical surge in demand for medium-term bonds.

Exhibit 6 – Different yield curve shapes

4.2 – Day count conventions

The day count convention is an industry-standard methodology to calculate the number of days
between two dates. There are several notable use cases for day count conventions related to fixed
income securities and fixed income derivatives:
• Calculating accrued interest over time for a variety of fixed income investments; and
• Calculating the present value on a coupon-bearing bond when the valuation date is in between two
coupon payment dates.
There are 5 specific day count conventions that are used for fixed income securities:

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 30
• ➔ Calculates the daily interest using a 360-day year and then multiplies that amount by 30 (to
360
derive the monthly interest); and
30
• ➔ Calculates the daily interest using a 365-day year and then multiplies that amount by 30 (to
365
derive the monthly interest); and
Actual
• ➔ Calculates the daily interest using a 360-day year and then multiplies that amount by the
360
actual number of days in each period (to derive the monthly interest); and
Actual
• ➔ Calculates the daily interest using a 365-day year and then multiplies that amount by the
365
actual number of days in each period (to derive the monthly interest); and
Actual
• ➔ Calculates the daily interest using the actual number of days in the year and then multiplies
Actual
that amount by the actual number of days in each period (to derive the monthly interest).

4.3 – Different types of yield curves

There are also 4 different variants of the yield curve:
• The Yield-to-Maturity curve; and
• The Par Yield curve; and
• The Spot Rate curve, and
• The Forward Rate curve.

An important first step is to describe the attributes of the US Treasury Curve. The Treasury Curve is
made up of 3 distinct security types – Treasury Bills, Treasury Notes, and Treasury Bonds. The table
in Exhibit 7 below illustrates the specific maturities that each security type covers, and whether each
security type is coupon-bearing or zero-coupon.

Security Which Maturities? Coupon-bearing or zero-coupon Coupon Frequency

Bill All <= 1 year Zero-coupon N/A
Note 2 years, 3 years, 5 years, and 10 years Coupon-bearing Semi-annual
Bond >10 years to 30 years Coupon-bearing Semi-annual
Exhibit 7 – Attributes of the Treasury Curve

Yield to Maturity (YTM)

The YTM is described as the return that an investor in a coupon-bond could expect to earn if she held
the bond to maturity. While the YTM is a useful mathematical construct to utilize in bond valuation
formulas, it is highly unlikely that every interim coupon payment will earn exactly the YTM when that
cash flow is reinvested. This risk is termed reinvestment risk and is the risk that prevailing market rates
at the time of cash flow reinvestment will have changed (either up or down) from the prevailing YTM
level at issue.

The Par Yield

This variant of the yield curve is typically only used with newly issued bonds, not secondary market
offerings (bonds traded post issue). This curve depicts the yield value required at each maturity point
that results in the bond at that maturity point being priced at par (e.g., the price equal to the face
amount). From an examination of the basic bond pricing formula above in Section 3.2 – Basic Bond

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Pricing, one can see that if the YTM is equal to the coupon rate, then the price of the bond will be equal
to the face amount.

Spot Rates
A spot rate for a particular maturity represents the yield on a bond at the maturity that does not pay any
interim coupons – the only cash flow after issue is the return of the face amount at maturity. Unlike the
YTM, which represents the actual return on a coupon-bearing bond only under idealized market
conditions, the spot yield does represent the actual return for the zero-coupon investor on account of
there not being any reinvestment risk.

There is an established relationship between the YTM on a coupon-bearing bond of a given maturity
and the “package” of zero-coupon bonds into which any coupon-bond can be decomposed. An example
will serve to illustrate this relationship. Assume a 2-year annual coupon bond with a YTM of R, a coupon
rate of C (=R), and a face amount of $1,000. The timeline in Exhibit 8 below illustrates the cash flows
on this bond.

EXHIBIT 8 – Temporal illustration of the cash flow components for a 2-year coupon bond

The pricing formula below illustrates the relationship between par yields, spot rates, and forward rates.

F∗ C F F∗ C F F∗ C F
• Price = ∑2t=1 (1+C)t + (1+C)2
= ∑2t=1 (1+S 1
+ (1+S 2
= ∑2t=1 (1+S 1
+ (1+S
1) 2) 1) 1 )(1+F1,1 )

• F = bond face amount and

• I = C = Par Yield.
• St = the Spot Rate for maturity t; and
• F1,1 = the forward rate for 1 period at time 1.

The above formula is an example of bootstrapping and is possible because of the “no-arbitrage” or
“break-even” principle. For this specific example, the principle states that an investor looking to lock in
a yield for two years should be indifferent between (1) investing in a 1-year zero-coupon bond and then
rolling over the proceeds from that bond at t=1 into another 1-year zero-coupon bond, or (2) investing
directly in the 2-year zero-coupon bond at time 0. The above relationship between par yields, spot
rates, and forward rates applies for any maturity T.

The next step is to generalize the relationship between YTMs and spot rates for a bond of any maturity.
Start with a 6-month bond, and then extend the analysis in 6-month increments for several additional
maturities, and then generalize the formula:
• 6-month coupon bond:
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 • Since a 6-month coupon bond is mechanically the same as a 6-month zero-coupon bond (e.g.,
no interim coupons are paid), the 6-month YTM and the 6-month spot rates are the same.
• For this reason, the bootstrapping methodology does not apply to the 6-month maturity.
• 12-month coupon bond:
• Characterized by one interim coupon payment at the 6-month point, and a final payment at the
1-year point in the amount of (1) The 2nd coupon payment and (2) the face amount.
C C F C C 1 C 1+C
• EQUATION 1 − PV = (1+C)1
+ (1+C)2 + (1+C)2 = (1+C)1
+ (1+C)2 + (1+C)2 = (1+C)1
+ (1+C)2. The
numerator in the 3rd-term simplifies to 1 on the assumption that the bond is priced at par, and
similarly the entire expression is equal to 1 since the bond is priced at par.
C C 1 C 1+C
• EQUATION 2 − PV = (1+S1 )1
+ (1+S )2
+ (1+S )2
= (1+S1 )1
+ (1+S 2
since the 2nd and 3rd terms in
2 2 2)
the expression have a common denominator.
• Then derive an expression for S2 by setting the two equations equal (and both are =1) and solving
1+c
for S2 → S2 = 2√ c − 1.
1−
1+S1

• 18-month coupon bond:

• Characterized by two interim coupon payments at the 6-month and 12-month points, and a final
payment at the 18-month point in the amount of (1) The 3rd coupon payment and (2) The face
amount.
C C C F C C C 1 C
• EQUATION 1 − PV = (1+C)1
+ (1+C)2 + (1+C)3 + (1+C)3 = (1+C)1 + (1+C)2 + (1+C)3 + (1+C)3 = (1+C)1 +
C 1+C
(1+C)2
+ (1+C)3. The numerator in the 4th-term simplifies to 1 on the assumption that the bond is
priced at par, and similarly the entire expression is equal to 1 since the bond is priced at par.
C C C 1 C C 1+C
• EQUATION 2 − PV = (1+S1 )1
+ (1+S 2
+ (1+S 3
+ (1+S 3
= (1+S1 )1
+ (1+S 2
+ (1+S 3
since the 3rd
2) 3) 3) 2) 3)
and 4th terms in the expression have a common denominator.
• Then derive an expression for S3 by setting the two equations equal to one another and solving
1+c
for S3 → S3 = 3√ c c
−1
1−( + )
1+S1 (1+S2 )2

• 24-month coupon bond:

• Characterized by three interim coupon payments at the 6-month, 12-month points, and 18-month
points, and a final payment at the 24-month point in the amount of (1) The 4th coupon payment
and (2) The face amount.
C C C C F C C C C
• EQUATION 1 − PV = (1+C)1
+ (1+C)2 + (1+C)3 + (1+C)4 + (1+C)4 = (1+C)1 + (1+C)2 + (1+C)3 + (1+C)4 +
1 C C C 1+C
(1+C)4
= (1+C)1
+ (1+C)2 + (1+C)3 + (1+C)4. The numerator in the 5th-term simplifies to 1 on the
assumption that the bond is priced at par, and similarly the entire expression is equal to 1 since
the bond is priced at par.
C C C C 1 C C C
• EQUATION 2 − PV = (1+S1 )1
+ (1+S 2
+ (1+S 3
+ (1+S 4
+ (1+S 4
= (1+S1 )1
+ (1+S 2
+ (1+S 3
+
2) 3) 4) 4) 2) 3)
1+C
(1+S4 )4
since the 4th and 5th terms in the expression have a common denominator.

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 • Then derive an expression for 𝑆4 by setting the two equations equal to one another and solving
1+𝑐
for 𝑆4 → 𝑆4 = 4√ 𝑐 𝑐 𝑐
−1
1−( + + )
1+S1 (1+S2 )2 (1+S3 )3

The process can be repeated for any maturity t, and the equation to solve for the spot rate for maturity
1+c
t will reduce to the following general equation → Sn = n − 1.
√1−(∑i=n−1 c
)
i=1 i
(1+Si )

Forward Rates
The concept of a forward rate is simple. There are two key parameters that fully describe a forward rate
– (1) The temporal difference between the current time and the beginning of the future period to which
the forward rate applies and (2) The term or maturity of that forward rate. Exhibit 9 below illustrates
the concept:

Exhibit 9 – Characterization of sequential spot rates

As described above, each spot rate can be recovered from the full YTM curve. Similarly, the full forward
rate curve can be recovered from the full spot rate curve. The general equation to solve for the T-period
spot rate is given by the formula below as a function of the geometric mean of the 1-period forward
rates between t=0 and t=T.

• (1 + ST )T = (1 + F0,1 ) (1 + F1,1 ) (1 + F2,1 ). . . (1 + FT−1,1 )

• ST = T√(1 + F0,1 ) (1 + F1,1 ) (1 + F2,1 ). . . (1 + FT−1,1 ) − 1

4.4 – Yield Curve Fitting Methods

If a risk management practitioner has a par yield curve available (e.g., coupon rates = yield-to-maturity
rates), then the spot rate curve can be fully specified. Then the spot rate curve can be used to fully
recover the forward rate curve.

However, bootstrapping only recovers spot rates (and forward rates) at the maturity points for which
there is a par yield available. It is quite possible that a specific fixed income security has cash flow
maturities that do not neatly match up with the specified maturity points. This practical challenge is
tackled using one of two approaches:
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• Fitting a parametric (closed form) solution to the observed points; or
• Using a spline or other non-parametric methods to interpolate maturity points on the spot or forward
curve at maturities other than the market-observed points.

There are many different interpolation methodologies used – the next section touches on 2 non-
parametric methods in this brief – Linear Interpolation and Cubic Spline Interpolation – and 1 parametric
method, the Nelson-Siegel method.

4.4.1 - Non-parametric methods

The starting point in applying a non-parametric method is the sequence of {tenor, yield value} tuples
that can be built up from market instruments such as cash deposits, coupon bonds, or interest rate
derivative instruments (swaps, futures).

The next step is to fit a piecewise functional form to each curve segment between the adjacent points
specified above. Each of these points (e.g., those that are derived from observed yields on fixed income
instruments traded in the market) are referred to as “knot points.” To begin the discussion, define two
key variables – (1) EY represents the Estimated Yield at any point on the curve ex the knot points
defined above and (2) MY represents the Market Yield at any of the knot points.

4.4.1.2 - Linear Interpolation

The simplest functional form that can fit is that of a straight line and is given by the equation below:

• yi = ai xi + bi
• ai and bi are the coefficients that apply to the ith curve segment.
• The ith curve segment is between the points {t i−1 , MYi−1 } and {t i , MYi }

Using a line to fit the piecewise segments between each knot point is problematic on account of having
to satisfy the condition that adjacent line segments must be equal at their shared knot point. This
condition can be solved, but the resulting fitted curve will not be smooth since each line segment has
its own, constant slope. This property of the line segments makes it impossible to derive a smooth
curve that goes through each of the knot points.

Exhibit 10 below captures the basic structure of a linear interpolation exercise.

EXHIBIT 10 – Structure of linear interpolation

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Assume that knot points and market yields are available at T = 𝒕𝟎 (MY𝒕𝟎 ) and T = 𝒕𝟑 (MY𝒕𝟑 ). Then the
estimated yields for the intermediate points on the number line above (T = t1 and T = t 2 ) can be
defined as follows:

𝐭 −𝐭 𝐭 −𝐭
• 𝐄𝐘𝐭 𝟏 = ( 𝐭𝟏 −𝐭 𝟎 ) 𝐌𝐘𝟎 + (𝐭 𝟑 −𝐭 𝟏 ) 𝐌𝐘𝟏
𝟑 𝟎 𝟑 𝟎
𝐭𝟐− 𝐭𝟎 𝐭 𝟑 −𝐭 𝟐
• 𝐄𝐘𝐭 𝟐 = ( 𝐭 ) 𝐌𝐘𝟎 + (𝐭 ) 𝐌𝐘𝟏
𝟑 −𝐭 𝟎 𝟑 −𝐭 𝟎

4.4.2.1 – Polynomial Spline Interpolation

Because of the shortcomings of the linear interpolation approach described above, a more robust
methodology than linear interpolation that allows for a more realistic curve fit is polynomial spline
interpolation.

As a first step, define some basic terminology:

• A spline is a piecewise polynomial function that is made up of polynomial segments that are joined
together at user-selected “knot points.” The knot points are the observed market yield (t i , MY(t i ))
tuples for the specific yield curve being modeled. There are (n+1) knot points of the form
{((t o , MY(t 0 ))) , ((t1 , MY(t1 ))) , ((t 2 , MY(t 2 ))) , … , ((t n , MY(t n )))} that serve as inputs to the
process.
• The cubic spline functional form is commonly used for term structure modeling. This means that
each piecewise curve segment is a cubic polynomial with the general functional form EYi (t) =
ai (t − t i )3 + bi (t − t i )2 + ci (t − t i ) + di for i ϵ {0 , 1 , 2, … , n − 1}. There are n discrete curve
segments.
• ai , bi , ci , and di – the coefficients that apply to the ith curve segment.
• The ith curve segment is between the points (t i−1 , MYi−1 ) and (t i , MYi )
• To go back to our example from section 4.1 - Background and Overview, the US Treasury yield
curve structure as of Friday 12/30/2022 had 13 knot points at the following maturities (measured in
months): t = {1 , 2 , 3 , 4 , 6 , 12 , 24 , 36 , 60 , 84 , 120 , 240 , and 360}. The interpolation exercise is to
fit a mathematical function to some or all these points.

Exhibit 11 below illustrates the concept of a potentially infinite number of different solutions to the
problem.

EXHIBIT 11 – Range of different potential cubic splines (with different a, b, c & d coefficients)1

1SOURCE → Fitting the term structure of interest rates: the practical implementation of cubic spline methodology, City University Business School, 25
pages, (no publication date given)
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The key attribute of fitting cubic polynomials to the piecewise segments is that it allows for “smoothing”
criterion to be applied, as follows:

• Criterion 1 – The value of adjacent polynomials are equal at their common knot points.
• Criterion 2 – The respective 1st derivatives of adjacent polynomials are equal at their common knot
points.
• Criterion 3 – The respective 2nd derivatives of adjacent polynomials are equal at their common knot
points.
• Criterion 4 – The 2nd derivative of the ith polynomial is continuous between knot points.

The above functional form and the 4 criterion points above can be expressed in a compact form, as
follows:
• The general functional form EYi (x) for each of the n curve segments is given by the following sets
of equations:
EY0 (t) = d0 (t − t 0 )3 + c0 (t − t 0 )2 + b0 (t − t 0 ) + a0 , t 0 ≤ t ≤ t1
EY1 (t) = d1 (t − t1 )3 + c1 (t − t1 )2 + b1 (t − t1 ) + a1 , t1 ≤ t ≤ t 2
EY2 (t) = d2 (t − t 2 )3 + c2 (t − t 2 )2 + b2 (t − t 2 ) + a2 , t 2 ≤ t ≤ t 3
• EYi (x) = EY3 (t) = d3 (t − t 3 )3 + c3 (t − t 3 )2 + b3 (t − t 3 ) + a3 , t 3 ≤ t ≤ t 4
EY4 (t) = d4 (t − t 4 )3 + c4 (t − t 4 )2 + b4 (t − t 4 ) + a4 , t 4 ≤ t ≤ t 5
:
{EYn−1 (t) = dn−1 (t − t n−1 )3 + cn−1 (t − t n−1 )2 + bn−1 (t − t n−1 ) + an−1 , t n−1 ≤ t ≤ t n
• For each shared knot point t i , i ϵ {1,2,3, … , n − 1}, the first three crtierion points are given by the
EYi (t i+1 ) = EYi+1 (t i+1 )
following equations { EYi′ (t i+1 ) = EYi+1
′
(t i+1 )
′′ ′′
EYi (t i+1 ) = EYi+1 (t i+1 )

The (n+1) ordered-pairs {t i , MYi } for i = 0, 1, 2, . . . , n, bound n discrete curve segments, and (n-1)
shared knot points that are common to each pair of the adjacent curves. The above equations apply
only at the common knot points, and so there are (n-1) equations to solve for each of the 3 criterion
points above, or (3n-3) equations to solve. Additionally, require the fitted curve to equal the Market
Yields at each of the knot points, and so there are (n+1) equations of the form EYi−1 (xi ) = MYi−1 that
must be solved, giving a total of (4n-2) equations. However, there are 4n unknowns in the form of the
coefficients for each curve segment{ai , bi , c, di }n−1
i=1 . So that requires the addition of two additional
constraints – there are variations to the basic cubic spline methodology that provide additional
constraints.

• Approach # 1 → This is referred to as a natural spline. This requires that EY ′′ (t 0 ) = EY ′′ (t N ) = 0.

• Approach # 2 → This is referred to as a clamped spline. Rather than the 2 nd derivatives at the
interval endpoints being equal to 0, the first derivatives at the interval endpoints are equal to a known
constant, or EY ′ (t 0 ) = b0 and EY ′ (t N ) = bN

Combining all these equations and solving for the 4n unknowns requires the use of Gaussian
elimination and linear algebra techniques. While not complex, these techniques involves a lot of interim
algebraic steps to solve for all 4n variables, and the details of these techniques are not discussed in
this brief. But programming languages that are specifically designed for performing quantitative
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analytics on large datasets (e.g., R, Matlab, Python) will have pre-built code modules to accomplish
this task.

4.4.2 - Parametric methods

There are multiple closed form models that can be used to fit a yield curve, but only one of those models
is discussed in this article – the Nelson & Siegel (N&S) model. This model specifies a functional form
for the instantaneous forward rate and is given by the equation below:

−t t −t
• f(t) = β0 + β1 exp( τ ) + β2 τ exp( τ )
• β0 is the long − term asymptotic value of f(t) and is ≥ 0
• β1 is the spread between the long and short − term rates
• β0 + β1 is then equal to the short − term rate
• β2 determines the magnitude and direction of the hump in the curve

The notion behind the N&S model is to be able to capture the range of naturally occurring shapes in
market observed yield curves while using only three parameters.

4.5 – Deriving Market Yields and yield curve shape drivers

In this section, the discussion focuses on how to derive the “all-in” market yield as the sum of (1) The
risk-free rate, (2) The liquidity premium, and (3) the credit risk premium.

A yield curve can be constructed for any class of fixed income investment – US government bonds,
municipal bonds, corporate bonds, structured mortgage security, etc. US government securities
(Treasury bills, notes, and bonds as described above) represent the “baseline” risk-free yield curve
from which all other yield curves are developed. Risk-free in the context of Treasury securities means
“credit risk free” and “liquidity risk free,” but not “interest rate risk free.” Any fixed income security,
regardless of its credit risk or liquidity risk profile, is subject to interest rate risk. And the higher the
duration of the security, the higher the sensitivity of that security to interest rate risk.

Liquidity risk is the risk that arises when there is a lack of a deep market for a given fixed income
instrument – this typically means that there are a lack of sufficient buyers, sellers, or both for that given
instrument. Liquidity risk manifests itself as a wider spread between the price at which the security can
be bought (the bid), and the price at which the security can be sold (the ask or the offer). This means
that buyers may pay a higher price and sellers may receive a lower price in an illiquid market vs. the
prices that one observes in a very liquid/deep market. When purchasing either a newly issued or on-
the-run fixed income security, buyers will require a higher yield for less liquid securities. Although not
true in all cases, liquidity typically decreases with increasing term to maturity, and the liquidity risk
premium correspondingly increases with increasing term to maturity.

Credit risk is the risk borne by the buyer of a fixed income security that the original issuer of the fixed
income security will either (1) Be unable to pay a portion of the contractual cash flows due to financial
or operational distress or (2) Completely default on the obligation.

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With these 3 components, an “all-in” market yield can be built-up for a fixed income security that is
characterized by credit rating and term to maturity, and the formula is given below:

• Y(t, Rating) = RF(t) + LP(t) + CS(t, Rating) with the following definitions:
• Y = market yield
• RF (t)= Risk free rate from the Treasury yield curve for maturity t.
• LP (t) = Liquidity risk premium for maturity t.
• Rating = the credit rating of the issuer at the time of issue.
• CS (t, Rating) = Credit spread for maturity t and the original issuer credit rating.

There are several different variants of credit spread measures:

Nominal Spread
This value is the spread that is added onto the risk-free rate (specifically, the Bond-Equivalent Yield
(BEY) or the Yield to Maturity (YTM)) for a given maturity to account for all of the potential risks that
may be present in a corporate bond or other non-Treasury bond. These potential risks include (1)
Interest rate risk, (2) Credit risk (both spread and default), (3) Liquidity risk, and (4) Reinvestment risk.
It is important to note that the nominal spread is defined with regard to a single maturity. Assume an
investor is weighing the purchase of a 3-year coupon bond. Her two options are a treasury bond (only
interest rate risk, no credit risk) and a 3-year AA, non-callable corporate bond (both interest rate risk
and credit risk).
So, assuming that the two bonds are equally liquid, the single difference in risk profile between the two
bonds is that of credit risk – being an obligation of the US Federal Government, the T-Bond has no
credit risk, while the AA corporate will have some level of credit risk (expressed as a probability of
default (PoD)). The yield on the corporate bond will typically be higher than the yield on the T-Bond,
and the higher yield is driven by the addition of the nominal spread to the base risk-free rate.
However, the nominal spread has several weaknesses:
• Since it is added to the YTM of the same maturity Treasury bond, it implicitly assumes that all cash
flows from the risky bond (like the corresponding Treasury) are discounted at the same yield. Said
another way, the nominal spread assumes that all coupons are reinvested at the risky bond yield
until the bond’s maturity – this assumption implicitly assumes a flat yield curve, which is not realistic.
• Bonds may come with embedded options – the options can be granted to the issuer (e.g., a callable
bond that the issuer can “call back” and redeem the outstanding principal when interest rates drop)
or to the investor (e.g., a puttable bond in which the investor can “put” the bond back to the issuer
and demand early repayment of the principal when interest rate rise).
• These embedded options, if/when they come into the money, can materially alter the underlying
bond’s cash flow profile, and this risk is not reflected in the nominal spread.

Zero-Volatility Spread (Z-spread)

For any non-treasury coupon bond, the Z-spread is the spread that makes the present value of cash
flows discounted at the Treasury spot rate plus the spread equal to the bond’s observed price.

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• Z-Spread is a measure of the spread the investor realizes over the entire Treasury spot rate curve
if the bond is held to maturity. In other words, the investor that purchases the bond is not impacted
by interest rate volatility if he/she elects to hold the bond until maturity.
• It is not a spread off of a single point on the Treasury curve like the Nominal Spread. Additionally,
whereas the nominal spread is relative to a YTM rate of the same maturity, the Z-spread is relative
to the entire spot rat rate curve. This is a more accurate approach since it is the spot rate curve that
is actually used to value the cash flows from fixed income securities.
• This measure improves on the Nominal Spread in that the Z-spread recognizes the shape of the
entire spot rate yield curve.
• The weakness of the Z-spread is that it assumes that the yield curve does not change in the future
– it only accounts for the current term structure of interest rates. Because it assumes that the yield
curve does not change (e.g., does not have volatility), it does not account for the volatility in bond
cash flows that could occur due to the different types of embedded options mentioned above in the
description of nominal spread.

Option-Adjusted Spread
OAS is the constant spread that, when added to the spot rates on the binomial interest rate tree, will
cause the market price of a bond to equal the present value of its cash flows.

• The OAS is an improvement on the Z-spread because it accounts for the fact that the future
uncertainty that characterizes the cash flow profiles of bonds with embedded options. OAS takes
the Z-Spread one step further by realizing callable bonds have cash flows with uncertainty.
• In order to explicitly take account of the cash flow impact of any embedded options, the OAS must
be calculated using a binomial tree or Monte Carlo simulation methodology.
• By explicitly accounting for cash flow volatility, the OAS removes the cost of the option and allows
the investor to perform a relative value comparison between the bond in question and other fixed
income securities – both callable and non-callable.
• The OAS accounts for the residual risks that are remaining after the options has been explicitly
accounted for in the projected bond cash flows – specifically credit risk and liquidity risk.
• There are several key points of comparison between the OAS and Z-spread:
• For bonds without options, OAS = Z-spread
• For a bond with a call option, the OAS is less than the Z-spread
• For a bond with a put option, the OAS is greater than the Z-spread
• The difference between the Z-spread and the OAS is referred to as the “option cost.”
• The Black Derman Toy (BDT) stochastic process is often used to model a short-term interest rate,
σ′ (t)
and is given by the equation dln(r) = (θ(t) + ln(r)) dt + σ(t)dZt
σ(t)
• r = the instantaneous short rate at time t.
• θ(t) = the value of the underlying asset at expiry.
• σ(t) = the volatility of the short rate (r) at time t.
• Zt = standard Brownian motion under a risk neutral probability measure.
• dZt = the differential of Zt .

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 σ′ (t)
• The ratio governs the mean reversion speed of the simulated short rate.
σ(t)
Interpolated Spread
The Interpolated Spread or I-spread is the difference between the YTM of the defaultable bond and the
linearly interpolated yield for the same maturity on the Treasury bond curve.

T −T
• IST = YTM(riskybond)TD − [YTMT1 + (T2D− T1
1
) X(YTMT2 − YTMT1 )]
• YTMT1 = The YTM at maturity point T1 for the Treasury Bond.
• YTMT2 = The YTM at maturity point T2 for the Treasury Bond.
• TD = The specific maturity point for the defaultable bond.
• T1 , T2 - The two maturities that bracket the defaultable bond maturity.

Exhibit 12 below contains the 4 basic theories that have developed to explain the shape and slope of
the yield curve:

Theory Description
Pure • The slope of the yield curve only reflects investor’s expectations about the future evolution of
Expectations short-term rates.
• If investors are bullish about the prospects for the economy, they will typically expect short term
rates to rise. This would result in an upward sloping yield curve.

Segmented • The yield curve can be split up into maturity buckets or segments.
Markets • The yield dynamics for each maturity bucket are uniquely determined by the supply and demand
balance by investors for the bonds in that segment.
• Therefore, the bonds in each segment are unique asset classes and unrelated to the bonds in any
other segment.

Liquidity • The slope of the yield curve reflects not only investor’s expectations about future short-term rates,
Preference but also the premium that they require for holding longer-term, less liquid bonds.
• This is the liquidity premium cited in the equation above.

Preferred • Assumption is that all investors have a “maturity preference” and will willingly shift to another
Habitat maturity bucket if the yield pickup is sufficient to offset the risk of switching maturity buckets.

Exhibit 12 – Theories that explain the shape of the yield curve

Section 5.0 – Risk Management and Sensitivity Measures

5.1 – Full valuation
This method is more complex mathematically and procedurally than the modified duration/convexity
approach (described below in 5.2 – Taylor Series Approximation) in which the change in market value
of a bond for a given change in yields can be estimated analytically using the first two terms in the
Taylor Series. The full valuation method requires the (1) Use of a term structure model and (2) A
simulation model (either a binary tree or a full Monte Carlo simulation)
While more complex, this full valuation method is far more flexible than the modified approach in that it
can be used to value any type of fixed income security – (1) Bonds without options, (2) Bonds with
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options, and (3) Complex structured mortgage securities. This method allows for adjusting the cash
flows along each path to reflect the impact of the embedded option, whether the option is in the favor
of the bond issuer (callable bonds) or the bond investor (puttable bonds).

5.2 – Taylor series approximation

The Taylor series expansion can be used to estimate the value (or value change) of any fixed income
asset. The price change of a bond given a slight change in yields, from y0 to y1 = y0 + ∆R, can be
calculated using the following equation:

1 ′′ 1
• P1 = P0 + f ′ (y0 )∆R + f (y0 )(∆R)2 + (additional terms) = P0 − DD ∗ ∆R + ∗ DC ∗ (∆R)2
2 2
• DD = dollar duration and DC = dollar convexity. Both terms are defined in the following sections.
• P1= estimated value of the bond at the new yield, y1 .
• P0= original value of the bond at the initial yield, y0 .
• ∆R = change in yields = y1 − y0 .
• f(y) = the bond price as a function of the yield.
• f ′ (y0 ) = the first derivative of the price function evaluated at the initial yield y0 , and f ′′ (y0 ) = the
second derivative of the price function evaluated at the initial yield y0 .
• f (n) () are the various derivative moments of the price function f(y). The remaining terms in the
Taylor Series expansion are these higher order derivatives combined with ∆R raised to
increasing exponents.

5.3 - Duration
The term “duration” is defined with regard to fixed income assets and has two interpretations:

• Measures the weighted average of the times until the fixed cash flows of the specific fixed income
security are received by the investor; or
• Measures the price sensitivity to yield, the rate of change of price with respect to yield, or the
percentage change in price for a parallel shift in yields.

Before delving into the technical definitions of duration, following are some important attributes of
duration:

• A bullet or zero-coupon bond of any type – Treasury, Corporate, or Municipal – will not have any
interim cash flows. The only cash flow will be the return of principal with accumulated interest at the
bond maturity. The duration of any zero-coupon bond is equal to the bond’s maturity.
• EXAMPLE: The duration for a single cash flow is equal to the maturity of the cash flow. For
example, the duration of a $1,000 cash flow paid 6 months from today is .5 years.
• The use of duration alone in estimating price changes is accurate only for a small range around the
initial yield, where the price changes are linear (i.e., same absolute price change given an increase
in yields of X bps versus a decrease in yields of X bps). As the yield moves further away from the
initial yield, the price/yield curve becomes increasingly “non-linear”, necessitating the use of the

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 second order term (i.e., convexity) in the Taylor series approximation. This concept is illustrated
above in 3.2 - Basic Bond Pricing.
• EXAMPLE: A 5-year treasury bond with semi-annual coupons that trades at par ($100). There
is an annual coupon rate of 10% (this coupon rate translates to a $5 coupon payment every 6
months), and the Yield to Maturity (YTM) is 10%.
• The forward cash flow profile is captured in Exhibit 13 below. Even though the principal
repayment at time t=5 years is the largest cash flow by a 20X factor, the duration of the bond is
< 5 years on account of the weights applied to the interim cash flows for t =.5 years to t=4.5
years (e.g., the coupons paid at those projection time steps).

EXHIBIT 13 – Illustration of the cash flow pattern of a typical coupon bond

There are seven important variants of duration to define - McCauley, Modified, Effective, Portfolio,
Key Rate, Duration Gap, and Dollar Duration.

• MaCauley Duration (MacD)

1 t
∑t=N
t=1 t∗CFt ∗( ) 1 1 t
• MacD = 1+R
1 t = (P ) ∑t=N
t=1 t ∗ CFt ∗ (1+R)
∑t=N
t=1 CFt ∗(1+R)
o

• t = time until the cash flow is paid/received

• Po = the base price of the bond given the initial (e.g., unchanged) yield curve
• PV(CFt ) = the present value of the undiscounted cash flow (CFt ) paid/received at time t =
CFt
(1+R)t
• CFt = the undiscounted cash flow received at time t.
• R = the single discount rate used to discount all future cash flows.
• The above expression applies in the case of interest rates compounded annually. With some
minor changes, this general formulation can accommodate any interest rate compounding
frequency.
∑t=N
t=1 t∗CFt ∗EXP(−Rt)
• EXAMPLE #1: Duration = ∑t=N
is the formula when rates are continuously
t=1 CFt ∗EXP(−Rt)
compounded.

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 mt
t=N 1
∑t=1 t∗CFt ∗( R )
1+
• EXAMPLE #2: Duration = m
mt is the formula when rates are compounded m
1
∑t=N
t=1 CFt ∗( R )
1+
m
times per year.
• This variant of duration is known as the MaCaulay Duration (MacD) and is the only type of
duration measured in time-units (e.g., months, years), and for any fixed-income security with
interim payments (coupon payments for a bond), the duration will always be less than the term
to maturity.
• If all of the future cash flows CFt are positive, and all such cash flows are paid in the time
interval (t1 , t 2 , t 3 , … , t N ), then the MacD will strictly adhere to the inequality t1 ≤ MacD ≤ t N .

• Modified Duration (ModD)

1 dP d
• ModD = − (P ) ∗ (dR) = − dR ln (P)
0
• P0 = the initial price of the bond before any rate changes.
dP
• = the first derivative of the bond price function with respect to yields.
dR
• This variant of duration is known as the Modified Duration (ModD) and is expressed as the
percentage change in the bond price for a 100 basis-point change in the reference interest
rate. It is important to note that the ModD assumes that the bond cash flows do not change
with changing interest rates.
• The formula for Modified Duration is given by the following formula → Modified Duration =
Macauley Duration
YTM
1+
Number of coupons per year

• YTM = The bond′s underlying yield to maturity

• When interest rates are continuously compounded, the MacD and the ModD are numerically
equal. This equivalence is captured in the steps below:
• STEP 1: P(R) = ∑t=N t=1 CFt ∗ EXP(−Rt)
dP(R) dP(R)
• STEP 2: = [∑t=N t=N
t=1 CFt ∗ EXP(−Rt)] = ∑t=1 −t ∗ CFt ∗ EXP(−Rt)
dR dR
dP(R) ∑t=N
t=1 t∗CFt ∗EXP(−Rt)
• STEP 3: = ∑t=N
t=1 −t ∗ CFt ∗ EXP(−Rt) = (− ) ∗ P0 = −MacD ∗ P0
dR P0
1 dP 1
• STEP 4: ModD = − (P ) ∗ (dR) = − (P ) ∗ (−MacD ∗ P0 ) = MacD
0 0

• Effective Duration (ED)

• The ED is different than the ModD in that it takes account of the impact of interest rate changes
on the bond’s future cash flows. The ED is also referred to as the Option-Adjusted Duration
(OAD).
• This measure is useful when quantifying the interest rate sensitivity of callable bonds and other
fixed income securities with embedded optionality.
• There is no closed-form expression for the ED. It can only be calculated by utilizing a Monte
Carlo simulation model to value the security under alternative interest rate scenarios.
P− − P+
• Effective Duration = 2P
0 ∆Shift

• −
P = the security or portfolio value after a parallel shift down in rates.
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 • P + = the security or portfolio value after a parallel shift up in rates.
• P0 = the security or portfolio value for the base (e.g., unshifted) scenario.
• ∆Shift = the interest rate shift amount applied.

• Portfolio Duration (PD)

• The duration of a portfolio of fixed income securities can be calculated by combining one of the
duration measures above for an individual security with basic portfolio theory. An example will
serve to illustrate the approach.
• Assume an institutional investor such as a pension plan is 100% invested in a mix of different
bond classes – US treasuries, municipal bonds, and investment grade (IG) corporate bonds.
The pension plan is invested 40% in IG corporates (100 individual bonds), 30% in municipals
(50 individual bonds), and 30% in US treasuries (200 individual bonds). The formulas for the
various component durations are expressed below:
• Dport = (40% X Dcorp ) + (30% X DMuni ) + (30% X DUST )
• Dcorp = ∑100 50 200
i=1 (wi,corp X Di,corp ), DMuni = ∑i=1(wi,Muni X Di,Muni ), DUST = ∑i=1 (wi,UST X Di,UST )
Market Value (Bond i from Class X)
• wi,Class X = = the weighting factor for bond i in Class X.
Total Market Value (All bonds in Class X)
• Di,Class X = the duration for bond i in class X.

• Key Rate Duration (KRD)

• Unlike the other, standard measures of duration (MacD, ModD, and ED) that assume a parallel
shift, the sensitivity of the bond value to a change in the spot rate for just a single maturity is
known as the Key Rate Duration for that maturity. KRDs do not require an assumption of a
parallel shift in the yield curve.
• The KRD is the sensitivity of the reference bond’s value to a 1.00% change in the relevant yield
while keeping all other yields constant.
P− −P+
• 0 0
KRDm = the key rate duration for the maturity m = 2∗.01∗P
0
• P0− = the bond or portfolio value after a decrease of 1.00% in the key rate.
• P0+ = the bond or portfolio value after an increase of 1.00% in the key rate.
• P0 = the initial bond or portfolio value before any change in the key rate.
• Using a set of KRD’s to characterize a bond’s sensitivity is an improvement over using a single
ED number because a parallel shift in the yield curve is a very unrealistic event and seldom
occurs in the real world. Non-parallel shifts of distinct types – (1) Twists (short rates increase
while long rates decrease, or vice versa), (2) Flattening, (3) Inversions (short rates become larger
than long rates), etc are much more common.
• To generalize the math supporting KRDs:
• Let us use the notation R = [R1 , R 2 , R 3 , … R N ] to describe the vector of N spot rates
underpinning the valuation of a given bond.
• The value behind a KRD is that unlike the conventional duration measure, a parallel shift in
the entire yield curve is not required. Given this attribute of KRDs, a non-level shift pattern
can be accommodated, with the vector of shift amounts in each spot rate described by ∆R =
[∆R1 , ∆R 2 , ∆R 3 , … ∆R N ].

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 ∂P
• The overall change in the value of the bond is estimated by dP = (∂R ∗ ∆R1 ) +
1
∂P ∂P ∂P
(∂R ∗ ∆R 2 ) + (∂R ∗ ∆R 3 ) + ⋯ + (∂R ∗ ∆R N )
2 3 N
• Using the above result, along with rearranging terms, gives us the overall % change in the
dP 1 ∂P
bond price given a change in each of the N spot rates ➔ = − [(− P ∗ ∂R ) ∗ ∆R1 +
P 1
1 ∂P 1 ∂P 1 ∂P
(− P ∗ ∂R ) ∗ ∆R 2 + (− P ∗ ∂R ) ∗ ∆R 3 + ⋯ + (− P ∗ ∂R ) ∗ ∆R N ].
2 3 N
1 ∂P
• Each term in parentheses can be rewritten as KRDi = − P ∗ ∂R . Then the entire expression
i
dP
is given by = −[(KRD1 ) ∗ ∆R1 + (KRD2 ) ∗ ∆R 2 + (KRD3 ) ∗ ∆R 3 + ⋯ + (KRDN ) ∗ ∆R N ].
P
• If there is a parallel shift, then ∆R = [∆R1 , ∆R 2 , ∆R 3 , … ∆R N ] = ∆R = [∆R, ∆R, ∆R, … ∆R], and
the above equation reduces to the standard equation for the overall duration.

• Duration Gap Analysis

• This formula applies specifically to banks and quantifies the combined interest rate exposure of
a bank’s book of assets and liabilities. Banks are exposed to interest rate risk whenever the rate
sensitivity for the asset side differs from the rate sensitivity of the liability side.
• An important concept in the management of bank interest rate risk is immunization or positioning
the maturity profile of the organization’s assets and liabilities, and correspondingly the duration
profile, to give a duration gap of 0. Or using the equation above, set K = 0, and immunization
can be achieved when DA = w X DL .
• K = duration gap = (DA − w x DL )
• DA = average duration of assets
• DL = average duration of liabilities
• A = Market Value of assets
• L = Market Value of liabilities
• S = market value of surplus or capital = A − L
L
• w = ratio of liabilities to assets = A

• Dollar Duration (DD)/Dollar Value of Basis Point (DV01)

• In the prior sections, the duration measures were interpretable as (1) The weighted-average time
to repayment of the investor’s capital or (2) The % sensitivity of the bond’s value to rate changes.
• In this section, there are two duration measures – DD and DV01 – that quantify the actual $
change in a bond’s value given changes in interest rates.
∆ Bond value ∆P
• DD = − ∆ yields (in decimal form) = − ∆R = the negative of the slope of the price function ➔ This leads
to ∆ Bond value = −(DD) ∗ (∆ yields (in decimal form)).
• DV01 = ∆ Bond value for a 1 basis point change in rates = DD ∗ .0001 ➔ This leads to
∆ Bond value = −(DV01) ∗ (∆ yields (in basis points))
• For a portfolio with N individual bond positions, each of the N component bonds has a unique
dollar duration (DDt ) and dollar convexity (DCt ). The portfolio dollar duration and dollar convexity
are given by the following equations:
• DDport = ∑t=N t=N
t=1 DDt , DCport = ∑t=1 DCt

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5.4 - Convexity
Convexity (given by C) is analogous to gamma for an option => it is the second-order or quadratic
component of a bond’s price sensitivity and is defined by the following equations.

∂2 P ∂2 (CFT ×exp(−R×T))
• = = T 2 ∗ CFT ∗ EXP(−R ∗ T) = C ∗ P0
∂R ∂R2
1 ∂2 P
• C = (P ) ∗ (∂R2 )
0
• The dollar convexity (DC) is the sensitivity of the dollar duration of a bond with respect to changes
in the yields.
d2 P dDD
• DC = = −
dR2 dR
1 ∂2 P d2 P dDD
• Since C = (P ) ∗ (∂R2 ), and DC = = − , then DC = P ∗ C
0 dR2 dR

Convexity can be interpreted in a couple of ways:

• As the second derivative of the bond price function, or the “curvature” of the bond price/yield graph;
and
• The second term in the Taylor series approximation to the full price of a bond, the first term being
related to the duration.
• As the portfolio of a bond’s change in value due to a yield change that is not accounted for by the
duration.

Exhibit 14 below illustrates the asymmetry in bond value changes for interest rate moves below the
par yield vs. interest rate moves above the par yield.

EXHIBIT 14 – Illustration of bond price vs. market yield relationship

5.5 – Other risks with fixed income securities

Fixed income securities are vulnerable to multiple types of credit and market risk, in addition to interest
rate risk. These different risk factors are described in Exhibit 15 below:

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 Risk factor Description
Reinvestment • The total return of a fixed income security is composed of (1) Coupon payments, (2) Capital Gains, and (3)
Interest earned on interim cash flows (i.e., bond coupons and prepayments of principal).
• If interest rates have decreased between the time of original issue and the time of the interim cash flow
payment, the investor will have to reinvest the cash flows at lower rates, thereby decreasing the 3rd return
component above. So, interest rate movements have opposing effects on components (2) and (3) above.

Call Risk • Bond indentures may contain a provision that allows the issuer to retire, or “call,” all, or part of the issue before
the maturity date. Typically, the issuer seeks to retain this right in expectation of being able to refinance an
existing bond at a lower interest rate.
• The presence of a call provision presents 3 difficulties to the investor, as follows: (1) The cash flow pattern of
a callable bond is not predictable, (2) An issuer is apt to call a bond when interest rates are below initial levels,
giving rise to reinvestment risk for the investor, and (3) The capital appreciation potential of a callable bond is
potentially limited, if the call value (i.e. the return of principal to the investor) is less than the current market
value of the bond.

Credit risk • The risk that the issuer of a fixed income security either (1) Completely defaults on the obligation (unable to
make timely interest and principal payments on the security) or (2) Experiences a credit downgrade, resulting
in a decrease in the market value of the security.
• Investors more commonly face the second scenario above, or a decrease in the security’s market value due to
an increase in the credit spreads (i.e., the total yield, which is the sum of the risk-free rate and the credit spread,
increases when spreads increase).

Maturity risk • This is the “interest rates” version of the basis risk that one finds with commodities (e.g., locational basis
differential for natural gas, quality differential for crude oil), or the risk that yields at different maturities change
at different rates.

Inflation risk • The risk that a fixed income investor will lose purchasing power because the rate of inflation is higher than the
rate of interest paid on a bond’s coupons.

Liquidity risk • Liquidity is the ease with which an investor can liquidate a fixed income position at or near its true value. This
risk is quantified in the form of the bid-ask spread on a security.
• The size of the spread for a fixed income security is inversely proportional to the trading volume for that security,
and the higher the spread, the greater the liquidity risk.

Foreign • If the cash flows on a fixed income security are denominated in a currency other than the investor’s home
Exchange risk currency, the investor faces the risk that the foreign currency depreciates against his/her home currency
between the time of purchase and the time when the cash flows are repatriated to the home currency.

Volatility risk • This affects only those fixed income securities that have embedded optionality, such as callable and putable
bonds, mortgage-backed securities, etc.
• As the underlying (interest rates) exhibit greater volatility, the value of the embedded options become greater,
thereby changing the value of the underlying security.

Exhibit 15 – Other risk factors impacting the valuation of fixed income securities

Section 6.0 – Interest Rate Simulation Methods

6.1 Background and overview
The purpose of this section is to provide the reader with technical background on Monte Carlo
simulations (MCS).

MCS is a mathematical technique that is used to model real-world physical or financial systems in which
the goal is to observe one or more output variables from the given system. Exhibit 16 below illustrates
a generic “black box” system to which an MCS could be applied. This complex system encodes a closed
form mathematical relationship between the input variables {xi }i=6 i=3
i=1 and the output variables {yi }i=1 .

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EXHIBIT 16 – Illustration of a complex system

The simplest approach would be to set point estimates for each of the 6 input variables Xi, and then
use the functional relationship to compute point estimates for the 3 output variables Yi . The weakness
with this approach is that it gives the user no sense of the level of uncertainty, or range, in each of the
output variables.

A more robust approach is to (1) Perform the following steps in either Microsoft Excel with an MCS
add-in or (2) Code an MCS model using a programming language such as R, Python, or Matlab:

• Assume a statistical distribution for each of the 6 input variables, each with a mean and a standard
deviation.
• Assume or derive pairwise correlations amongst and between each of the 6 input variables.
• Code the functional form of the predicted variable and run a sufficiently large number of simulation
trials so that the mean and variance (and other critical statistics) of the output variables stabilize
within a specified tolerance level.

Developing a mathematical model in a spread sheet or a software development environment is typically

cheaper and easier to build than a scale real-world model. MCS models enable the user to perform
“What-If testing” on the simulated system to observe what impacts changes in the input variables have
on the distributions of the output variables.

6.2 – Statistical Distributions

There are two types of random variables (hereafter RVs) used in MCS models – discrete and
continuous.

• Discrete RVs take on a limited set of values, and each value is assigned a certain probability or
likelihood of occurring. The sum of the probabilities across all values must be 1.00 (100%).
• Continuous RVs take on any values between two specified endpoints.

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Before delving into the technical specifics of discrete and continuous distributions, it is important to
define the different types of parameters that can be used to characterize a probability distribution:

• Location
• A numerical measure that describes the relative east/west location of a probability distribution
on the X-axis.
• An example of a location parameter is the mean of a normal distribution. The mode and the
median are also location parameters.
• Regardless of which of the above measures is used, a location parameter describes where on
the X-axis a given distribution is centered.
• EXAMPLE – Any normal distribution, regardless of its mean and variance, is symmetrical about
its mean. N (0,1) is the standard normal distribution and is located to the left of a more generic
normal distribution, N (2,5).
• Scale
• A numerical measure that describes the relative spread of a probability distribution about its
mean or other central tendency on the X-axis.
• An example of a scale parameter is the variance or standard deviation of a normal distribution.
• EXAMPLE – The N (0,1) and the N (0,5) are both centered around a mean of 0 on the X-axis,
but the latter distribution has a wider spread around 0 given its higher standard deviation (5
vs.1).
• Shape
• A numerical measure that is neither a location nor a scale parameter. Rather than impacting (1)
The east/west location of a distribution or (2) The spread of distribution around its mean,
changing the shape parameters impacts the shape of the resulting distribution.
• EXAMPLE: Skewness is a measure of the relative symmetry of a distribution about its mean,
and kurtosis is a measure of the amount of “probability mass” that is in the tails for a given
distribution. Both are shape parameters.

Discrete Random Variable

A discrete RV is a listing of all of the values that the specified RV can take on paired with the
corresponding probability for each value. Because a discrete RV only takes on specific values, or mass
points, the PDF is often called the Probability Mass Function or PMF. For both discrete and continuous
RVs, another critical term is the Cumulate Distribution Function (CDF). The CDF represents the
cumulative form of the PDF, and in mathematical terms, is given by the expression F(k) = P(X ≤ k)
where k is a numeric value within the domain of the independent random variable X.

Two different examples of discrete RVs are captured below:

• EXAMPLE #1 → Count of boys in a grammar school class

• The table below in Exhibit 17 shows the 10 possible names and the number of boys associated
with each name.
• The count for each name is the underlying random variable (X), and the ratio of that count to the
total number of boys in the class (100) is the probability that a given boy has a specific name.

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 • The expected value is given by the expression E(x) = ∑i=10
i=1 X i ∗ P(X i ) and the variance is given
i=10 2
by the expression VAR(x) = ∑i=1 (Xi − E(x)) ∗ P(Xi ).

Name X = Number of boys with name P(x) - Probability x = K

Tim 15 15%
John 20 20%
Nick 10 10%
Bob 10 10%
Dan 5 5%
Phil 10 10%
Mike 15 15%
Gus 3 3%
Victor 2 2%
Jim 10 10%
TOTAL 100 100%
EXHIBIT 17 – Illustration of a discrete PDF

• EXAMPLE #2 → Discrete Exponential distribution

• Exhibit 18 below is another example of a discrete random variable. This exhibit shows the PDF
(in blue) and the CDF (in amber).
• In this instance, x takes on the discrete values in the range {0.00, 0.50,1.00, 1.50, 2.00…,15.00}.
There are 31 individual values, and the parameter value (mu) is scaled to produce a sum of 1.00.
• The PDF illustrated represents an exponential distribution. The functional form of the
−x
Exp ( )
μ
Exponential PDF is given by the equation f(x) = for x ≥ 0, where the only required
μ
parameter required for an exponential distribution is the mean of the distribution (μ).

EXHIBIT 18 – PDF for the exponential distribution

Continuous Random Variable

Typically, the domain of a continuous RV (e.g., the range of the input variable) will be of the form
{−∞, +∞} or {0, +∞}. For continuous RVs, unlike discrete RVs, a specific value on the PDF curve does
not represent a probability. Rather, the PDF is used to calculate the probability that the random variable
takes on values in a specific range.

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Exhibit 19 below is a hypothetical normal distribution. For ease of illustration, the range is constrained
to be x ϵ {−1,000, +1,000}. The PDF is used to calculate the area underneath the curve between those
two points. For instance, the area between X = 0 and X = 2 would and is calculated by the
x=2
expression P(0 ≤ x ≤ 2) = ∫x=0 f(x) dx.

EXHIBIT 19 – Illustration of a hypothetical normal distribution

6.3 - Considerations for Interest Rate simulation models

There are several important considerations when modeling interest rates, as follows:

• Volatility – The volatility of the short rate tends to be related to the absolute level of the underlying
interest rate.
• Mean Reversion - Interest rates tend to exhibit mean reversion, or the property that when the
simulated value of a specific interest rate exhibits a material departure from its own long-term
average (either above or below the average), then market forces will work to bring that interest rate
back towards its long-term average.
• Negative Rates – Prior to the period following the Great Financial Crisis (2008 to 2023), negative
interest rates had not been observed in the market. It is hard to know if rates will continue to exhibit
this behavior, and so a model developer has to make reasoned choices when designing their model
as to whether they wish to restrict simulated rates to be non-negative.

There is one specific model that implements all 3 of these attributes – known as the Cox Ingersoll Ross
(CIR) model. CIR is known as a 1-factor model (there is only one underlying stochastic process driving
market risk).

• dr = α(γ − rt )dt + σ√rt dWt , with each of the variables having the following definitions:
• α = the speed of mean reversion.
• γ = the long-term mean of the short rate rt .
• σ√rt = the standard deviation factor

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 • Wt = the stochastic random variable referred to as a Weiner process
• The 1st term in the expression above is the drift term and is the mechanism to enforce mean
reversion. When 𝑟𝑡 ≥ 𝛾, then the drift term is negative, and the simulated value is “pulled”
downwards towards the mean. When 𝑟𝑡 < 𝛾, then the drift term is positive, and the simulated
value is “pulled” upwards towards the mean.

Constraining the simulated rates to be non-negative is enforced through the operation of the 2 nd term.
The standard deviation is proportional to the square root of the level of the short rate. This means that
when the short rate is exceedingly small (close to zero), the standard deviation becomes small, and the
evolution of the short rate is dominated by the drift term.

6.4 - Sample simulation runs

The application Model Risk Complete from Vose Software was used to run sample simulations in the
following sections. Model Risk Complete is a Microsoft Excel add-in that comes standard with a rich
set of probability density functions, reporting, and modeling capabilities. There are 3 simulations and
generated histogram visualizations for each for the following PDFs – Lognormal, PERT, and Gamma.

6.4.1 Impact of # trials on simulation statistics

Before delving into the visualizations below, it is important to first describe the impact of increasing the
number of trials on the simulated distribution. There is both a qualitative/visual impact and a quantitative
impact.
The visual impact can be seen in the sequence of histograms in Exhibit 20 below. There are 6 discrete
simulations of the standard normal distribution (e.g., normal with mean = 0, SD = 1), starting with 10
trials, and then increasing the number of trials by 10X with each subsequent result (e.g.,
10➔100➔1,000➔10,000➔100,000➔1,000,000). The sequence clearly shows that with an increasing
# of trials, the simulated distribution becomes more concentrated, symmetric, and well-behaved about
the mean=0.

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EXHIBIT 20 – Histograms for varying # of trials – 10 to 1,000,000 (increasing by 10X)
This observed visual pattern is confirmed quantitatively as well. The key distribution statistics are
summarized in Exhibit 21 below – mean, minimum, maximum, standard deviation, skewness, and
kurtosis. The statistics are evolving as expected – the mean and standard deviation are evolving
towards their “steady state” values of 0 and 1 respectively, the min/max combination are evolving
towards being equal and opposite (one indicator of symmetry), and finally the skewness and kurtosis
are similarly evolving towards their respective steady state values of 0 and 3 (steady state for a standard
normal distribution).

Number of simulation trials

N=10 N=100 N=1,000 N=10,000 N=100,000 N=1,000,000
Mean 0.0864983
0.126872 0.044573 0.003906 0.003944 -0.001017

Minimum -1.888409 -2.661789 -2.890016 -3.609015 -4.459319 -4.715282

Maximum 1.212136 2.711408 3.472181 4.272238 4.393953 4.689616

Standard Deviation 1.084446 0.928732 0.975296 0.996484 1.002137 1.000408

Skewness -0.737255 -0.015384 0.049677 0.004808 0.009036 6.122380 E-5

Kurtosis 2.493017 3.550812 2.958489 2.941528 2.995886 2.999249

EXHIBIT 21 – Evolution of key distributional statistics for N (0,1) distribution

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6.4.2 Lognormal (Mean, Variance)
In this subsection and the two subsections that follow, the visualizations illustrate the impacts (location,
scale, shape) of using different parameterizations of three different PDFs – (1) Lognormal, (2) PERT,
and (3) Gamma.

The lognormal distribution is useful for modeling any variable that has a domain x ∈ {0, ∞} and is
positively skewed. If Y is a standard normal variable (e. g. Y~N(0,1)), and the pair (μ, σ) are both real
numbers and > 0, then the distribution of the random variable X = EXP(μ + σY) is lognormal with
parameters (μ, σ). So (μ, σ) are the mean and standard deviation respectively of Y, while the mean and
variance of X is given by the following equations:

1
• Mean = EXP (μ + 2 ∗ σ2 )
• Variance = (EXP(σ2 ) − 1)(EXP(2μ + σ2 ))

The basic equations for the PDF, CDF and underlying distribution parameters is captured in Exhibit 22
below:

Quantity Formula
Probability Density Function 1 (ln(x)−μ)2
• f(x) = ( ) ∗ EXP [− ]
x√2πσ2 2σ2

Cumulative Distribution Function No closed form solution

Parameter Restriction • σ>0

• μ ∈ (−∞, +∞)

Domain • x≥0

Mean 1
• EXP (μ + ∗ σ2 )
2

Mode • exp(μ − σ12 )

Variance • (EXP(σ2 ) − 1)(EXP(2μ + σ2 ))

Skewness • (EXP(σ2 ) + 2)√EXP(σ2 ) − 1

Kurtosis • EXP(4σ2 ) + 2EXP(3σ2 ) + 3EXP(2σ2 ) − 6

EXHIBIT 22 – Formulas for the lognormal distribution

The key modeling parameters for the lognormal are the mean and the variance. Below are three
different parameterizations that were run in Model Risk. In Model Risk, the user can assign a specific
output name to each unique parameterization.

• Lognormal_Output_1 is Lognormal (5, 2); and

• Lognormal_Output_2 is Lognormal (25, 10); and
• Lognormal_Output_3 is Lognormal (125, 50); and

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Exhibit 23 below is the visualization for the three distributions. The impact of the different parameters
are clear:

• Location - Output_1 is to the left of Output_2, and Output_2 is to the left of Output_3. This is
consistent with Output_3 having the largest mean.
• Scale – Output_1 is more concentrated and has a smaller spread than Output_2, and similarly
Output_2 is more concentrated and has a smaller spread than Output_3. Again, this is consistent
with the assigned standard deviations for each parameterization.

Exhibit 23 – Comparison of the sample distributions above

6.4.3 PERT (Minimum, Mode, Maximum)

The PERT distribution is a variation of the Beta distribution and is often used for modeling expert
estimates. It is characterized by 3 parameters – (1) The Minimum, (2) The Mode, and (3) The Maximum.
The basic equations for the PDF, CDF and underlying distribution parameters is captured in Exhibit 24
below:

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 Quantity Formula
Probability Density Function (x−min)α1 −1 (max−x)α2 −1
• f(x) =
β(α1 ,α2 )(max−min)α1 +α2 −1
μ−min max−μ
• where α1 = 6 ⟦ ⟧ , α2 = 6⟦ ⟧
max−min max−min
min+4mode+max
• with μ =
6
• and β(α1 , α2 ) is the Beta function

Cumulative Distribution Function βz (α1 ,α2 )

• F(x) = = Iz (α1 , α2 )
β(α1 ,α2 )
x−min
• Where z =
max−min
• and βz (α1 , α2 ) is an incomplete beta function

Parameter Restriction • Min<mode<max

Domain • min ≤ x ≤ max

Mean min+4mode+max
• μ=
6

Mode
Variance (μ−min)(max−μ)
•
7

Skewness min+max−2μ 7
• √(μ−min)(max−μ)
4

Kurtosis (α1 +α2 +1)(2(α1 +α2 )2 +α1 α2 (α1 +α2 −6))

• 3
α1 α2 (α1 +α2 +2)(α1 +α2 +3)

Exhibit 24 - Formulas for the PERT distribution

The PERT distribution is interesting because 2 of the parameters – (1) Minimum and (2) Maximum –
are both locational and scale parameters as defined above in 6.2 – Statistical Distributions.

Exhibit 25 below illustrates the simulation results (100,000 trials) for three different parameterizations
of the PERT distribution:

• PERT_Output_1 is PERT (0, 2, 4).

• PERT_Output_2 is PERT (0, 6, 12); and
• PERT_Output_3 is PERT (0, 18, 36).

The impacts of the three parameter sets are clear → The lower the spread
(Output_1<Output_2<Output<3), the more “peaked” and concentrated the distribution.

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Exhibit 25 – Output from Model Risk for the PERT distribution
6.4.4 Gamma (𝜶, 𝜷)
The gamma distribution is a two-parameter continuous distribution – (1) Shape (𝛼) and (2) Scale (𝛽) –
that is used to model the waiting times for different event types.

The basic equations for the PDF, CDF and the underlying distribution parameters is captured in Exhibit
26 below:

Quantity Formula
𝑥
Probability Density Function 𝛽 −𝛼 𝑥 𝛼−1 𝐸𝑋𝑃(− )
• f(x) = 𝛽
Γ(𝑘)
• Γ(𝑘) = gamma function = (𝑘 − 1)!

Cumulative Distribution Function • No closed form solution

Parameter Restriction • 𝛼 > 0, 𝛽 > 0

Domain • 𝑥 ∈ (0, ∞)

Mean • 𝛼𝛽

Mode • (𝛼 − 1)𝛽 if α > 1

• 0 if α > 1

Variance • 𝛼𝛽2

2
Skewness •
√𝛼

6
Kurtosis •
𝛼

Exhibit 26 - Formulas for the Gamma distribution

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Exhibit 27 below illustrates the simulation results (100,000 trials) for three different parameterizations
of the PERT distribution:
• Gamma_Output_1 is Gamma (5,5); and
• Gamma_Output_2 is Gamma (5,10); and
• Gamma_Output_3 is Gamma (5,20).

For the Gamma distribution, the mean = α ∗ β, and so is increasing with the move from
Gamma_Output_1(25) to Gamma_Output_2(50) to Gamma_Output_3(100). This trend can clearly be
seen in the visualization since the center of each histogram moves to the right. Similarly, the 𝜎 = 𝛼 ∗
𝛽 2 , and so Gamma_Output_3 is wider and less concentrated than 1 and 2.

Exhibit 27 – Output from Model Risk for the Gamma distribution

Section 7.0 – Portfolio Management considerations

7.1 – Background and Overview
The purpose of this section is to provide some background and context on the structure
of Life and Health (L&H) insurer investment portfolios and overall financial performance.
The bulk of the financial and performance information included in the following sections
was excerpted from the 2022 Annual Report on the Insurance Industry prepared by the
Federal Office of Insurance (FIO). The FIO was initiated with the advent of Title V of the
Dodd Frank Act in 2010. The L&H sub-sector of the US insurance industry covers
individual and group life insurance, individual and group annuities (deferred and
immediate), and accident & health products.

L&H Insurers are among the largest institutional investors in the US and globally, and
specifically are large investors in fixed income and credit market instruments. These
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insurers typically segregate their asset portfolio into two accounts (1) The General
Account (GA) and (2) Separate Accounts (SA). Each account has a specific operational
and legal purpose…descriptions follow:

• General Account
• Assets in the GA are legally owned by the insurer and are not individually divisible
amongst the firm’s policyholders.
• Any product specific guarantees (e.g., minimum crediting rate on a Deferred
Annuity, specified death benefit for a Variable Annuity, etc) are supported by
assets in the GA. This is a critical concept distinguishing the GA from SAs – if the
insurer provides a guarantee on an insurance product that is supported by the GA,
and the provision of the guarantee winds up costing the insurer more than the price
charged for the guarantee, then the insurer must absorb the loss.
• As a general matter, traditional life insurance products (Term and Whole Life) and
fixed-rate interest sensitive products (Universal Life and Deferred Annuities) are
supported by assets in the GA.
• Premiums paid related to these products are deposited in the GA, and the
corresponding benefit payments and operational and investment expenses are
paid from the GA.
• Oftentimes, insurers will segment their GA portfolios. Segmentation is an
operational mechanism to map assets with specific risk profiles (e.g., duration,
convexity, liquidity, credit, etc) to back specific liabilities or product groups with
similar risk profiles. In this way, the insurer can achieve a more optimized Asset
Liability Management (ALM) balance within each liability portfolio.
• Separate Account
• A portfolio of assets “separately” owned by a specific investor or policyholder.
Unlike assets in the GA, assets in an SA are individually owned.
• SAs can be opened at a bank, brokerage, or in this instance, by an insurer.
• Since SAs are by design bespoke and have a specific purpose, any given insurer
may operate one or more SAs.
• The most common usage of an SA for an L&H insurer is to house the invested
assets underpinning variable products – either life insurance or annuities. These
products are mutual funds with an insurance product “wrapper,” and since the
investment choices in such products include asset classes other than conventional
fixed income (e.g., public equity, private equity, hedge funds, real assets, other
alternative assets), the portfolio allocations within the typical SA will differ from the
GA.

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 • To continue with the theme above related to guarantees, and unlike the GA, SAs
are structured as pass-through legal entities. This means that the individual
policyholder or investor has discretion in selecting the investments in their
respective account, and thus accrues any gains/absorbs any losses realized by
these assets.

7.2 – Financial performance for US L&H sector (2021)2

As a starting point, Exhibit 28 below is the 10-year illustration of (1) Net Investment
Income (NII) and (2) Net Yield on Invested Assets (NYIA) for US L&H insurers. The left-
hand axis is dollars of aggregate NII, and the right-hand axis is the aggregate NYIA
expressed as a percentage. Its notable that while the NYIA was steadily decreasing from
2012 to 2020 from ~4.90% to ~4.10% (with a slight uptick in 2021 to ~4.20%), the NII
was moderately (but steadily) increasing from $167 billion in 2012 to $201 billion in 2021.

EXHIBIT 28 – Aggregate US L&H insurer NII and NYIA (2012 – 2021)

Exhibit 29 and Exhibit 30 below illustrate key aggregate performance metrics for US
L&H insurers over the 5-year period 01/01/2017 to 12/31/2021, including Total Revenue,
Net Gain from Operations before FIT, Net Income, and Operating Margin. The steep
drop in revenues and net income is very apparent in 2020 due to COVID, but the industry
recovered sharply in 2021 to reach revenue levels slightly above 2019 levels.

2
SOURCE → Annual Report on the Insurance Industry (2022), Federal Insurance Office, Published Sept 2022
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EXHIBIT 29 – Aggregate income statement for L&H insurers for 2017 to 2021

EXHIBIT 30 – Selected line items and operating margin for 2017 to 2021

EXHIBIT 31 below illustrates the aggregate level and growth of capital and surplus for
US L&H insurers over the 5-year period 01/01/2017 to 12/31/2021. Additionally, Exhibit
32 decomposes the drivers of the capital and surplus growth over the 10-year period
from 01/01/2012 to 12/31/2021. Not surprisingly, the main driver of the increase in capital
and surplus has been 10 straight of years of positive net income, while dividend
payments to shareholders have decreased capital and surplus.

EXHIBIT 31 – Aggregate US L&H capital and surplus for 2017 to 2021

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EXHIBIT 32 – Aggregate US L&H net income, capital gains/losses, dividends

7.3 – How do L&H insurers invest?3

Historically, L&H insurers have been amongst the largest institutional investors in fixed
income asset classes. This attribute of L&H investment portfolios is largely driven by the
fact that many of the products that L&H insurers “manufacture” are long-duration
products – Life Insurance, Annuities, Disability Income (DI), and Long-Term Care (LTC)
– in which the “temporal separation” between the manufacture and sale of the contract
and the ultimate payment of the relevant benefit stream (e.g., death benefit for life
insurance, monthly payments for annuities, DI or LTC) can extend into multiple decades.
In addition to this long-duration characteristic, the expected cash flow patterns of these
products (excluding the impacts of embedded options) can be similar to the cash flow
patterns of bonds.

With that background context, since the Great Financial Crisis of 2008/2009 (GFC),
interest rates have trended steadily downward. Since the profitability of an L&H insurer
is tightly linked to the ability to earn a positive margin on invested assets, this downward
trend in rates has put downward pressure on L&H insurer profit margins. For this reason,
while fixed income continues to be the predominant asset class, L&H insurers have been
steadily increasing their investment allocations to alternative assets over the past 10
years. This trend is illustrated in Exhibit 33 below. Additionally, the highlighted row in
Exhibit 34 clearly indicates the continued importance that fixed income asset classes
play in L&H investment portfolios.

3 SOURCE → Annual Report on the Insurance Industry (2022), Federal Insurance Office, Published Sept 2022
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EXHIBIT 33 – Growth in L&H insurers allocation to alternative investments

EXHIBIT 34 – Aggregate portfolio allocations of L&H insurers for the period

7.4 – Investment income allocation

At a high level, L&H insurers are known as financial intermediaries. They collect premiums from
policyholders, and invest those funds in a range of different asset classes in order to generate a
sufficiently high return, which when combined with the premium cash inflows, allows the insurer to
satisfy multiple competing objectives:

• Paying policyholder claims; and

• Paying all fixed and variable expenses; and
• Funding capital contributions; and
• Generating a sufficient return on capital for the firm’s investors (e.g., shareholders for a stock firm,
policyholders for a mutual firm).

This process is illustrated in Exhibit 35 below.

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EXHIBIT 35 – Investment cycle for an insurance firm

This process, and the required institutional capabilities to execute it successfully, are particularly critical
for L&H insurers as compared to other insurers. The reason for this distinction is that the
competitiveness of certain types of life insurance products (e.g., whole life, universal life), and all types
of fixed-rate annuity products are highly dependent upon earning a competitive return on invested
assets.

Many life and annuity insurers have portfolios of “participating products” – participating products are
those products that offer the possibility of dividends to their respective policyholders. The choice of
investment income allocation approach is critical in the dividend-setting process.

The starting point for the overall dividend-setting process is a determination by the firm’s management
of the level of “divisible surplus.” Divisible Surplus is the aggregate amount of capital to be distributed
to policyholders that own participating policies. This distribution is based on another important concept
referred to as the “Contribution Principle.” The Contribution Principle requires divisible surplus to be
distributed to the appropriate dividend factor classes in proportion to the contribution that those factor
classes made to that aggregate surplus.

“Dividend Factor Classes” are logically defined policy groupings whereby the policyholders in each
class share one or more attributes or characteristics:

• Structure of policy factors; or

• Similarity of the policy types; or
• Similarity of experience; or
• The period over which the policies were issued; or
• The underwriting and marketing practices of the policies.

The underlying experience factors that are typically used to determine the overall dividend allocated to
a particular factor class are (1) Mortality, (2) Morbidity, (3) Expenses, (4) Investment Income, (5) Policy
Termination, or (6) Tax.

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Section 8.0 – Interest Rate Derivatives (IRDs)
8.1 – Background and Overview
The purpose of this section is to provide the reader with technical background on the broader
derivatives market, selected types of IRDs and context on how they are used, and valuation
considerations for each of the selected instrument types. An important first step is to frame the overall
derivatives market in terms of the size and range of instrument types for both Over the Counter (OTC)
and Exchange Traded Derivatives (ETDs). While derivatives can be used to hedge the underlying risks
in any industry (financial services or otherwise), the vast majority of derivatives end-users are financial
firms.
There is a distinction to make between:
• Securities such as equities, bonds, Exchange Traded Funds (ETFs), Exchange Traded Notes
(ETNs), and various structured securities (Asset Backed Securities, Collateralized Loan Obligations,
Collateralized Debt Obligations); and
• Derivatives such as swaps, futures, forwards, options, caps, floors, swaptions, etc. Derivatives are
financial instruments that derive their value from an underlying security price, index, or benchmark.
In this section, the “derivative underlying” is referred to as a risk factor. Since a derivative instrument
derives its value from the changes in these underlying risk factors, the derivative would not exist in
the absence of these risk factors.
Definitions of key terms follows:
• Cleared
• A derivative contract that is initially negotiated bilaterally between two counterparties, and if the
contract meets the requirements for clearing, is then submitted to a Central Clearing
Counterparty (CCP) for clearing.
• This means that rather than each counterparty looking to the other for payment, they both
become counterparties of the CCP.
• Novation
• Refers to the process of substituting the original contract with a replacement contract, where the
original party agrees to forgo any rights afforded to them by the original contract.
• In most novation agreements, the parties agree to extinguish the original contract and replace it
with an entirely new contract.
• Specific to derivative markets, novation refers to the arrangement where security holders
transfer their securities to a clearinghouse, which then sells the transferred securities to buyers.
• The clearinghouse acts as the go-between in the transaction and assumes the counterparty risk
associated with one party defaulting on their obligations.4
• Settlement
• The delivery of securities or cash from one counterparty to another following a trade. Payments
are final and irrevocable once the settlement process is complete.
• Physically settled derivatives, such as some equity derivatives, require securities to be delivered
to central securities depositories.

4 SOURCE → Corporate Finance Institute, Online search

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 • Settlement of cash-settled interest rate swaps is in the form of periodic interest payments based
on an interest rate over the term to maturity.5
• Open Interest6
• The total number of futures or options contracts held by market participants at the end of the
trading day. It is used as an indicator to determine market sentiment and the strength behind
price trends.
• Open interest is calculated by adding all the contracts from opened trades and subtracting the
contracts when a trade is closed.
• Open interest and volume are related concepts. One key difference is that volume counts all
contracts that have been traded, while open interest is the total # of contracts that remain open
in the market.
• Notional Value
• Notional value is the nominal or face amount of a financial instrument that is used to calculate
payments made on that instrument.
• Notional values often are not indicators of true economic exposure, but they serve as a more
consistent indicator of market activity and scale than book/adjusted carrying value (BACV) or
fair value, both of which can be affected by factors such as market prices and accounting
treatment.7
• Gross Market Value (GMV)8
• Sum of the absolute values of all outstanding derivatives contracts with either positive or
negative replacement values evaluated at market prices prevailing on the reporting date.
• Thus, the gross positive market value of a dealer's outstanding contracts is the sum of the
replacement values of all contracts that have a positive Mark-to-Market (MtM) on the reporting
date (and therefore, if they were settled immediately, would represent claims on counterparties).
• The gross negative market value is the sum of the values of all contracts that have a negative
value on the reporting date (e.g., those contracts that have a negative MtM on the reporting date
and therefore, if they were settled immediately, would represent liabilities of the dealer to its
counterparties).
• The term "gross" indicates that contracts with positive and negative replacement values with the
same counterparty are not netted.
• Gross Credit Exposure (GCE)
• Equal to the GMV adjusted for legally enforceable bilateral netting agreements (but not adjusted
for collateral).
• GCE is a measure of counterparty credit risk before accounting for the value of any collateral
that the counterparty has posted for the transaction.
• Close-out Netting
• A process applied to OTC transactions in which the various obligations (with positive and
negative mark-to-market values) that exist between two counterparties are terminated and
reduced to a single net payable or receivable.
• Central Clearing Counterparty (CCP)

5 SOURCE → Risk Glossary, Risk.net, https://www.risk.net/definition/settlement

6 SOURCE → Introduction to Futures course, Chicago Mercantile Exchange, Publication Date - Unknown
7 SOURCE → Derivatives Primer, National Association of Insurance Commissioners (NAIC), Publication Date - Unknown
8 SOURCE → Statistical release: OTC derivatives statistics at end-December 2021, BIS, Published May 12, 2022

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 • A financial institution that takes on counterparty credit risk between parties to a transaction and
provides clearing and settlement services for trades in foreign exchange, securities, options, and
derivative contracts.
• CCPs are highly regulated institutions that specialize in managing counterparty credit risk. CCPs
"mutualize" (e.g., share amongst their members) counterparty credit risk in the markets in which
they operate.9
• Swap Execution Facility (SEF)
• Swap execution facilities were created under the 2010 Dodd-Frank Act to better regulate and
increase transparency for swaps deals, both before and after the trade.
• The Dodd-Frank Act defined a SEF as, "A facility, trading system or platform in which
multiple participants have the ability to execute or trade swaps by accepting bids and
offers made by other participants that are open to multiple participants in the facility or
system, through any means of interstate commerce”
Exhibit 36 provides descriptions of each type of derivative instrument.
Instrument Description
Type
Forwards • A forward is an agreement for the future delivery of a specific quantity of an asset at a specified price, at a designated
time.
• Although payment and delivery are made in the future, the price is determined on the initial trade date.
• Forwards can be customized to meet the specific needs of the parties and are bilateral contracts that trade OTC.
• Examples include foreign currency forwards and interest rate forwards.

Futures • A futures contract is an agreement to buy or sell, in the future, a specific quantity of an asset at a specific price at a
designated time.
• It is a standardized agreement (so terms cannot be customized) that can be closed or terminated prior to expiration.
Futures are like forwards, but they are standardized and trade on an exchange.
• They are, therefore, subject to margin (a deposit of cash or other collateral) and other requirements of the exchange,
but because they are standardized and exchange-traded, they possess greater liquidity and transparency than
forwards.
• Examples of typical assets underpinning futures contracts include commodities, foreign currencies, interest rates and
stock indices.

Swaps • A swap is an agreement in which counterparties agree to exchange future streams of cash flows over a set period. The
cash flows are calculated based on a notional amount.
• Typically, the only dollars that are exchanged between the parties are the cash flows, not the notional amount—except
for currency swaps, where the notional principal is also exchanged.
• Certain “plain-vanilla” swaps now are standardized and trade on exchanges, while others are over-the-counter contracts
negotiated between parties.
• Swaps are primarily used to mitigate or add exposure to certain risks such as interest rate risk—useful for insurers in
adjusting portfolio duration—or foreign exchange risk.
• Examples of swaps are interest rate swaps and currency swaps.

Credit Default Swaps • A credit default swap is a derivative instrument in which there is a transfer of credit risk from one party to another.
• The buyer purchases credit protection on a reference entity—typically an individual corporate issuer (a single-name
CDS)—in exchange for a stream of payments.
• If any specified credit event occurs, the buyer delivers the instrument it holds to the seller of protection in exchange for
the full notional value.
• Alternatively, the seller of protection pays an amount that constitutes the loss in case of default. When you buy CDS or
buy credit protection, you reduce, or hedge credit risk. When you sell CDS or write protection, you assume credit risk.

Index-Based Swaps • An index based CDS is a credit default swap whose underlying is an index that is accepted as a key benchmark of the
overall market’s credit risk.
• One such group, the CDX indices, tracks the performance of specific baskets of single-name CDS.
• For example, the IG CDX consists of a basket of CDS on 125 individual investment grade credits, and the HY CDX
consists of CDS on 100 high yield credits. The CDX indices have fixed composition and fixed maturities.

9 SOURCE → Central Clearing Counterparty, Wikipedia, https://en.wikipedia.org/wiki/Central_counterparty_clearing

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 • A new series of CDX indices is established every six months with a new underlying portfolio and maturity date to reflect
changes in the credit market and to help investors maintain a constant duration, if needed.
• Investors can use CDX indices to hedge a portfolio’s credit risk or to gain exposure to a diversified portfolio of IG or HY
corporate credits.
• Customized CDS can also be created to hedge specific risks. For instance, if an investor wants to hedge exposure to five
individual credits in its portfolio, it could enter a first to default swap where the reference basket consists of the five specific
credits.
• If any one of these five reference credits defaults during the term of the contract, the counterparty will be required to make
the investor whole, and the contract will be terminated.

Options • Options are contracts in which the writer (seller) of the option grants the buyer of the option the right but not the obligation
to buy from or sell to the writer a specified quantity of a designated instrument, at a specified price (the strike) within a
specified period.
• The writer of the option grants this right to the buyer in exchange for a certain sum of money (the premium).
• There are two types of options: a call option and a put option.

EXHIBIT 36 – Descriptions of common derivative instrument types10

In addition to describing the different types of derivative instruments above in Exhibit 36, Exhibit 37
below describes the different commercial and government use cases for derivatives.

EXHIBIT 37 – Use cases for derivatives11

8.2 – Market characteristics

Derivatives can be designed to hedge almost any “underlying” price or risk factor – limited only by the
creativity of the bank or dealer that is underwriting the instrument. But the most common underlying
risk factors are equity prices, interest rates, bond prices, market indices, credit spreads, commodity
prices, foreign exchange prices, etc. There are three distinct types of derivative contracts:
• Over the Counter (OTC – not cleared)
• A derivative that is NOT traded on a regulated exchange but is bespoke and bilaterally
negotiated between two counterparties.

10 SOURCE → Derivatives Primer, National Association of Insurance Commissioners (NAIC), Publication Date - Unknown
11 SOURCE → Evolution-of-OTC-Derivatives-Markets-Since-the-Financial-Crisis, ISDA, Publication Date = Jan 2020
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 • Two counterparties will typically enter into an OTC contract vs. seeking a comparable ETD
contract because they wish to set contract parameters that are not available with ETDs.
• Over the Counter (OTC - cleared)
• Derivative transactions that originate on a bilateral, OTC basis, but can be submitted for clearing
to a CCP on account of meeting specified contract parameters.
• Exchange-Traded (ETD)
• A derivative that is listed on a regulated exchange. The most well-known regulated exchange in
the US is the Chicago Mercantile Exchange (CME) in Chicago.
• With an ETD contract, the exchange is the counterparty for every transaction.
• This attribute requires ETD contracts to have standard contractual parameters (unlike OTC
contracts). These standardized parameters include contract size, maturity date, underlying
index/price, etc.
• The most common types of ETD contracts are futures and options.
The Bank for International Settlements (BIS) regularly publishes periodic reports on the global OTC
derivatives markets. This sub-section highlights selected key exhibits from several recent BIS reports.
Exhibit 38 below is an excerpt from the 11/30/2022 OTC report that illustrates both (1) The gross
market value and credit exposure of the total OTC market (left hand side) and (2) The notional amounts
outstanding broken down by derivative type (right hand side).

EXHIBIT 38 – Excerpt from 06/30/2022 BIS Derivative Statistics report

Exhibit 39 captures some key observations from the two above charts:
Contract type 06/30/2012 06/30/2015 06/30/2018 06/30/2021 06/30/2022
Overall $641.305 $551,298 $594,832 $609.996 $632.238
Interest rate $525.117 $446,946 $481,086 $488.099 $502.586
% of total 81.9% 81.1% 80.9% 80.0% 79.5%
EXHIBIT 39 – Selected notional values from the BIS 11/30/2022 report (all amounts in trillions)

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An examination of this data for the time period 2012 – 2022 highlights two critical points – (1) The size
of the IRD OTC market is large relative to the overall OTC derivatives market and (2) While the overall
market notional amount trended downward in the years following the GFC, the proportion that IRDs
form of the total notional was very consistent over this period…~80%.
Exhibit 40 below provides the GMV for the past 5 semi-annual BIS updates – the GMV is stated on
both a $ basis ($18.348 trillion as of 06/30/2022) and as a % of notional outstanding (2.90% as of
06/30/2022). It is interesting to note that the GMV attributable to IRDs ($11.816 trillion out of $18.348
trillion) sits at 64.4%, which is lower than the ~80% observed for notional amounts.

EXHIBIT 40 – Excerpt from the ISDA key trends report for the first half of 202212

Exhibit 41 below provides the GCE for the past 5 semi-annual BIS updates – the GCE is stated on
both a $ basis ($3.3 trillion as of 06/30/2022) and as a % of notional outstanding (.50% as of
06/30/2022).

12
SOURCE → Key-Trends-in-the-Size-and-Composition-of-OTC-Derivatives-Markets (1st half 2022), International Swaps Dealer Association (ISDA),
Published Dec 2022.
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EXHIBIT 41 – Excerpt from the ISDA key trends report for the first half of 202213

Exhibit 42 below provides a more detailed breakdown of the IRDs on 06/30/2022 by (1) Instrument
type and (2) Counterparty. The 3 highlighted values clearly illustrate the importance of IRS relative to
the overall OTC market:
• IRS’ account for ~82% ($414.223 trillion) out of $502.586 trillion of total notional for IRDs.
• The overall notion for both FRAs and IRS’ is $463.581 trillion ($414.223+$49.358) out of $502.586
trillion.
• Of the $463.581 trillion, ~$394.147 trillion is listed with a counterparty of “Central Counterparty” →
this category covers derivatives that are submitted for clearing to various CCPs.

EXHIBIT 42 – Source data supporting the 06/30/2022 BIS Derivative Statistics report

13SOURCE → Key-Trends-in-the-Size-and-Composition-of-OTC-Derivatives-Markets (1st half 2022), International Swaps Dealer Association (ISDA),
Published Dec 2022.
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This result is critically important to the smooth functioning of the global derivatives market and is a
direct result of the regulatory changes that were implemented as part of the Dodd Frank Act of 2010:
• Increased use of (1) ETDs where practicable and (2) Submittal of conforming OTC trades for
clearing through CCPs: and
• Higher capital and margin requirements for non-cleared OTC trades; and
• Increased use of exchange or electronic trading platforms for OTC transactions; and
• Reporting of OTC trades to data repositories.
Specific to the IRD markets, in addition to the material increases in market values and notional amounts
due to increases in the general level of interest rates, there is another critical development that is
impacting investor flows into IRDs. The transition from using LIBOR as a reference rate to using various
overnight Risk-Free Rates (RFRs) (SOFR in the US - Section 9.0 – Secured Overnight Financing Rate
(SOFR)).
The LIBOR → SOFR transition is directly impacting the relative size of Forward Rate Agreements
(FRAs) and Interest Rate Swaps (IRSs). As can be seen in Exhibit 43 below, the structure of FRAs
are not compatible with the new RFRs, and notional amounts attributable to FRAs are decreasing
uniformly across the major currencies. Similarly, 1-period IRSs are being used as proxies for FRAs and
are seeing an increase (particularly in the US) in notional amounts.

EXHIBIT 43 – Excerpt from 06/30/2022 BIS Derivative Statistics report

LIBOR was discontinued as a reference rate in cash instruments in the following major currencies as
of 12/31/2021 → British Pound, Swiss Franc, Euro, and the Japanese Yen. The US is scheduled to
discontinue LIBOR on 06/30/2023.
Exhibit 44 below clearly illustrates the sharp decrease in LIBOR-based bond issuance post
01/01/2022, and the corresponding share increase in RFR-based bond issuance post 01/01/2022.

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EXHIBIT 44 – Excerpt from the BIS report “The post-Libor world: a global view from the BIS
derivatives statistics”14

8.3 – Interest rate swaps

Interest Rate Swaps (IRS) are a type of interest rate derivative that has a symmetric or linear payoff
profile. An IRS contract is characterized by a fixed rate known as the “swap rate” and a floating rate
index (e.g., LIBOR, SOFR, prime rate, etc). A linear payoff profile means that the payoff is a “linear
function” of the underlying interest rate upon which the IRS is based.
The simplest form of an IRS is known as a “fixed for floating” swap. This type of swap is structured such
that one counterparty pays the fixed rate and receives the floating rate for a fixed period of time, with
the opposite being the case for the other counterparty. The counterparty receiving the floating rate is
said to be “long the IRS” since they benefit when the contract floating index increases, and the opposing
counterparty is “short the IRS”. Each IRS has a notional value or face amount that that is the basis for
calculating the periodic interest payments. The counterparties to an IRS do not exchange the notional
amount at any time during the swap term. The notional amount is only used to calculate the respective
fixed-rate and floating-rate interest payments.
The parameters of an IRS are structured such that the present value of the payments to be made is
equal to the present value of the payments to be received. This equality of present values at inception
means that an IRS is a “zero cost to enter” type of derivative. The swap rate is calculated using the
following formula:
PV of floating rate payments
• Swap Rate = Dayst
∑t=N
t=1 (Notional)∗( )∗(dft )
365
• Dayst = the number of days (using the day count convention) in payment period t.
• dft = the discount factor that applies for payment period t.
• N = the number of interest rate payments made under the swap.

14
SOURCE → The post-Libor world: a global view from the BIS derivatives statistics, BIS, Published Dec 2022
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Another important quantity related to the swap rate is known as the “swap spread”. The swap spread
is given by the following equation. It is important to note that the swap spread references the US
Treasury security with the same maturity (M in the equation) as the specific swap:
• Swap Spread M = Swap RateM − US TreasuryM
Exhibit 45 below illustrates the cash flows of a generic IRS.

EXHIBIT 45 – Illustration of swap cash flows

One common usage of an IRS is to hedge the risk of increasing rates on a floating rate loan. An example
will serve to illustrate the economic impact of a swap.
• Company A obtains a business loan from Commercial Bank X to fund an expansion in its business
operations. The loan principal/amount is $1,000,000. The loan is not amortizing but involves the
repayment of the entire loan principal in a single lump sum at the end of the 5-year term (e.g., a
balloon payment loan).
• The loan term is 5 years (01/01/2023 to 12/31/2027).
• The loan has an interest rate tied to LIBOR + a credit spread (200 basis points), and Company A
makes interest payments quarterly. LIBOR resets quarterly and is set in advance of each quarterly
period (20 total reset periods over the life of the loan). The loan uses the Actual/Actual day count
convention.
• The credit spread is tied to Company A’s creditworthiness at the time the loan was issued and
remains fixed for the 5-year term of the loan.
• The initial value of LIBOR on 01/01/2023 is 5.00% and the all-in rate is 7.00%. Company A makes
quarterly payments in arrears (e.g., the payment for the 1st quarterly period is made on 04/01/2023
based on the interest rate set on 01/01/2023).
Exhibit 46 below illustrates the first 8 quarterly payments (e.g., payments due on 04/01/2023 through
01/01/2025), and includes the general formula for calculating quarterly interest payments. The variable
pattern of the quarterly interest payments clearly indicates the interest rate risk profile of a floating-rate
loan → as the quarterly rate resets below the initial level of 5.00% (e.g., resets at 4.50% for Q2 2023),
the payment decreases below its initial level, and when the quarterly rate resets above the initial level
of 5.00% (e.g., resets at 5.50% for Q4 2023), the payment increases above its initial level. Given that
our hypothetical loan accumulates interest on an Actual/Actual day count convention, the number of
days in each quarter has a minor impact on the payment amount. But the key driver is the LIBOR rate.

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EXHIBIT 46 – Illustration of floating rate loan mechanics

The next decision confronting Company A is to determine whether they wish to hedge part or all of the
loan using an IRS. A perfect hedge would be if the swap notional was sized at $1,000,000 to match the
principal amount of the loan, and the floating rate index is LIBOR with a quarterly reset, and the term
of the IRS was 5-years to match the term of the loan. Exhibit 47 illustrates the combined structure of
the underlying business loan and the IRS.

EXHIBIT 47 – Combined loan + IRS hedged structure

8.4 – Black model

The Black model is a modification of the basic Black Scholes option pricing model and is primarily used
to value European options on equity futures. The key parameters for the Black model are defined below:
• T = the expiration time of the option
• t = current time index
• S = strike price on option
• r = risk-free rate
• Pt = spot price of the underlying at time t
• PT = projected spot price of the underlying at expiration time T
• σ = the volatility of the underlying price (P)
• Φ(∗) = the Gaussian distribution function
• PCall = MAX(PT − S, 0), PPut = MAX(S − PT , 0)
The Black model assumes that the underlying price at expiration - PT - is lognormally distributed. Using
this assumption, the valuation formulas for both calls and puts are given below:

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• PCall = e−rT [PT Φ(d1 ) − SΦ(d2 )], PPut = e−rT [SΦ(−d2 ) − PT Φ(−d1 )]
P 1 P 1
ln( T )+ σ2 T ln( T )− σ2 T
• d1 = S 2
, d2 = S 2
= d1 − σ√T
σ√T σ√T

8.5 – Caps and floors

Interest Rate Caps (IRCs) and Interest Rate Floors (IRFs) are both examples of interest rate options.
An interest rate option, unlike an IRS, is a non-linear instrument. This means that the payoff profile of
an option is not symmetric about any specific fixed price. An option can be combined with an underlying
cash instrument (e.g., business loan or bond) and customized to achieve a specific payoff profile.
However, there is a cost to this flexibility in the form of the premium that the buyer must pay to the
option seller.
An interest rate option will be characterized by the following parameters:
• Underlying index or price – typically a reference interest rate like LIBOR or SOFR.
• Time to expiration.
• Strike Price – This is the fixed level that will trigger (1) An IRC to pay if the reference rate rises
above it or (2) An IRF to pay if the reference rate falls below it.
• Volatility – The historical or implied volatility of the contract’s underlying risk factor.

8.5.1 – IRCs
IRCs will pay out when the reference index rises above the strike price. Since the objective of
purchasing an IRC is to hedge the risk of increasing rates, one potential use of an IRC is to combine it
with a business loan in which the borrower pays a floating rate on the loan.
The borrower (and IRC buyer) can set the strike price on the IRC to a level that below which they are
comfortable accepting the floating rate payments without any offset from the IRC, and above which the
IRC will offset the floating rate interest rate payments on the loan $ for $. An IRC is package of European
call options, with each individual call option being referred to as a “caplet”.
An example will serve to illustrate the concept – the specifics from the example above in the IRS section
will be used. Company A will need to enter an IRC that contains 20 caplets (5-year loan with quarterly
interest payments), with the notional value on each caplet equal to the principal amount of the loan.
The parameters for each “caplet” will be the same (except for the time to expiration):
• Notional = $1,000,000
• Strike = 5.00%
• Time to expiration = {.25, .50, .75, 1.00, …, 5.00} measured in years
Exhibit 48 illustrates the cash flow mechanics of the combined position.

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EXHIBIT 48 – Combined loan + IRC hedged structure

The payoff on any given caplet is given by the following formula:

• Payofft = (Notional) ∗ (τ) ∗ (MAX(Indext − Strike, 0))

• Notional = the notional amount of the IRC.
• τ = the fraction of a year passed based on the day count convention. EXAMPLE – If the reference
quarter was Q1 2023, and the day count convention was Actual/Actual (as defined in 4.2 – Day
count conventions), then the value of τ for the first payment date – 04/01/2023 – is 90/365.
• Indext = the value of the underlying risk factor (for this example, LIBOR) at time t.
• Strike = the strike level selected by the IRC purchaser.
The present value of an IRC is given by the following formula:

• PV(0) = N ∗ ∑t=n
t=1 τt Dt (Ft Φ(d1 ) − KΦ(d2 ))
• Price = PV(0) = present value at time 0.
• N = notional value
• n = the number of payments to be made under the IRC
• Dt = D(0, Tt ) = the discount factor from time Tt to 0
D
( t−1 −1)
•
Dt
Ft = F(t; Tt−1 , Tt ) = = the forward rate for period (Tt−1 , Tt )
τt
• Tt = the time of the t-th caplet cash flow.
• τt = Tt − Tt−1
• Φ(∗) = the cumulative distribution function for the standard normal
F +
ln( t) .5∗σ2t ∗Tt
• d1,2 = K −
σt ∗√Tt
• σt = the standard deviation

8.5.2 – IRFs
IRFs will pay out when the reference index decreases below the strike price. Since the objective of
purchasing an IRF is to hedge the risk of decreasing rates, one potential use of an IRF is to combine it
with a purchased bond in which the investor receives a floating rate coupon on the bond. The investor
(and IRF buyer) can set the strike price on the IRF to a level that above which they are comfortable

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with the level of the floating rate payments they are receiving without any offset from the IRF, and below
which the IRF will supplement the floating rate coupon payments received on the bond $ for $. An IRF
is package of European put options, with each individual put option being referred to as a “putlet”.
The payoff on any given caplet is given by the following formula:

• Payofft = (Notional) ∗ (τ) ∗ (MAX(Strike − Indext , 0))

• Notional = the notional amount of the IRF.
• τ = the fraction of a year passed based on the day count convention. EXAMPLE – If the reference
quarter was Q1 2023, and the day count convention was Actual/Actual (as defined in 4.2 – Day
count conventions), then the value of τ for the first payment date – 04/01/2023 – is 90/365.
• Indext = the value of the underlying risk factor (for this example, LIBOR) at time t.
• Strike = the strike level selected by the IRF purchaser.
The present value of an IRC is given by the following formula:

• PV(0) = N ∗ ∑t=n
t=1 τt Dt (KΦ(−d2 ) − Ft Φ(−d1 ))
• Price = PV(0) = present value at time 0.
• N = notional value
• n = the number of payments to be made under the IRC
• Dt = D(0, Tt ) = the discount factor from time Tt to 0
D
( t−1 −1)
•
Dt
Ft = F(t; Tt−1 , Tt ) = = the forward rate for period (Tt−1 , Tt )
τt
• τt = Tt − Tt−1
• Φ(∗) = the cumulative distribution function for the standard normal
F +
ln( t) .5∗σ2t ∗Tt
• d1,2 = K −
σt ∗√Tt
• σt = the standard deviation

8.6 - Swaptions
In this section, the basic mechanics and financial structure of a swaption, as well as the corresponding
valuation formulas, are developed.
As the name suggests, a swaption is a combination of (1) An IRS and (2) An option and provides the
buyer with the option to enter into an IRS with (1) A predetermined notional value, (2) A predetermined
term, (3) A predetermined interest rate, (4) A predetermined start date, and (5) A predetermined interest
payment frequency.
• Payer Swaption
• The buyer acquires the right (but not the obligation) to pay a fixed interest rate and receive a
floating interest rate on an IRS to be entered into at a predetermined future date.
• Similarly, the seller will receive a fixed interest rate and pay a floating interest rate on an IRS to
be entered into at a predetermined future date.
• The buyer may enter a swaption if they anticipate taking out a floating rate business loan and
wish to hedge against the risk of increasing interest rates.
• Receiver Swaption

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 • The buyer acquires the right (but not the obligation) to pay a floating interest rate and receive a
fixed interest rate on an IRS to be entered into at a predetermined future date.
• Similarly, the seller will receive a floating interest rate and pay a fixed interest rate on an IRS to
be entered into at a predetermined future date.
• The buyer may enter into a swaption if they anticipate investing in a floating rate bond and wish
to hedge against the risk of decreasing interest rates.
An example will serve to illustrate the swaption cash flow mechanics:
• The valuation date for this financial structure is 01/01/2023.
• Company A wants to undertake a $1,000,000 capital investment in a new business operation on
01/01/2024. The firm is looking to finance the investment with a floating rate loan for $1,000,000
and a term of 3 years.
• The floating rate index for the loan is LIBOR + 100 bps (reflecting the idiosyncratic credit risk for
Company A), and the firm will pay interest on the loan quarterly for 3 years (12 total interest
payments).
• 3-month LIBOR is currently at 3.50% and the fixed rate on a 3-month swap is 4.00%. While the firm
believes that rates will drop over the next year, they also recognize that their view may not be
realized and wishes to hedge against increasing interest rates since their financing costs on the
capital investment will increase.
• The firm has a breakeven cost of capital of 6.00%, and with an eye towards conservatism, enters a
swaption with a strike of 4.00%.
• The parameters of the swaption follow:
• Trigger condition → If the fixed rate on the IRS is >=4.00%, then Company A will trigger the
swaption and enter a 3-year IRS on 01/01/2024. If the fixed rate <4.00%, then the swaption will
not be triggered.
• Term = 3 years starting in 1 year.
• Company A will receive 3-month LIBOR and pay 4.00%.
• The option premium on swaptions is typically stated as a % of the notional amount. In this
example, the total premium is 2.40% of the notional, or $24,000. The firm will pay this amount
ratably over the term of the swap, or .15% ($1,500) per quarter for each of the 16 quarters in the
combined term of the transaction (1-year swaption + 3-year loan/swap if swaption is triggered).
Exhibit 49 illustrates the payoff profile for any given quarter of the combined business loan + swaption
position given different scenarios of (1) The IRS fixed rate being above or below 4.00% and (2) Different
levels of 3-month LIBOR.

EXHIBIT 49 – Illustrative payout profile for a combined loan + swaption position

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An examination of the results indicates that if 3-month LIBOR is at or below 4.00%, the unhedged
position performs better for Company A than the hedged position. Once 3-month LIBOR moves above
4.00%, the hedged position performs better than the unhedged position.
The Black option model can be adopted for use (discussed in 8.4 – Black model) with swaptions. The
modified Black model has the following parameters:
• T = expiration date of the swaption
• σF = volatility of the forward swap rate
• is = strike rate for the swaption
• iF = market swap rate at the expiration of the swaption (time T)
• N = swap notional amount
• t 0 = T = swaption expiration date and start of IRS. t1 , t 2 , t 3 , … , t N > t 0 = T
The timeline in Exhibit 50 will help to illustrate the operation of the swaption:

EXHIBIT 50 – Illustration of the time sequencing of a swaption

The financial settlement to the buyer of a payer swaption at time T (expiration of the swaption) is given
by the following formula:

• If iF ≥ is , ∑i=N
i=1 N ∗ e
−(ti −T) (i
∗ F − is ) ∗ (t i − t i−1 )
• If iF < is , 0
Using the above expression for the value at t=T, the value at t=0 is given by the formula:

• e−T ∗ ∑i=N
i=1 N ∗ e ∗ F − is ) ∗ (t i − t i−1 ) = N ∗ ∑i=N
−(ti −T) (i
i=1 N ∗ e
−ti (i
∗ F − is ) ∗ (t i − t i−1 )
The price of a swaption can be determined by an application of the Black model. The ith term in the
formula above is given by N ∗ (iF − is ) ∗ (t i − t i−1 ), and represents the undiscounted settlement

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payment paid to the swaption holder of a European call option (caplet) with time expiration t i . Using the
Black model, the price at t=0 of that settlement payment is given by the formula:
• N ∗ e−ti ∗ (t i − t i−1 ) ∗ [iF Φ(d1 ) − is Φ(d2 )]
i 1 i 1
ln( F )+ ∗σ2F ∗T ln( F )− ∗σ2F ∗T
• is 2 is 2
d1 = , d2 = = d1 − σF ∗ √T
σF ∗√T σF ∗√T

The total value of the payer swaption is given by summing all the individual call options:
• PPS = price for payer swaption = N ∗ A[iF Φ(d1 ) − is Φ(d2 )]
• A = ∑i=ni=1 e
−iti (t
∗ i − t i−1 )
Similarly, the total value of a receiver swaption is given by summing all the individual put options:
• PRS = price for receiver swaption = N ∗ A[is Φ(−d2 ) − iF Φ(−d1 )]

Section 9.0 – Secured Overnight Financing Rate (SOFR)

9.1 – Background and Overview 15
In 2014, the Federal Reserve Board and the New York Fed established the Alternative Reference Rates
Committee (ARRC), a group of private market participants tasked with identifying robust alternatives to
USD LIBOR and supporting a transition away from LIBOR. As of the date of this brief (May 2023), there
are over 300 member and nonmember institutions including banks, asset managers, insurers, and
industry trade organizations contributing to the ARRC’s work.
To identify robust alternatives to USD LIBOR anchored in observable transactions in deep and active
markets, the ARRC developed the following criteria to evaluate potential alternative rates:
• Benchmark Quality: Whether the market underlying the rate can be expected to remain sufficiently
deep and active to support a robust reference rate; and
• Methodological Quality: Whether the rate is produced in accordance with internationally accepted
best practices; and
• Accountability: Whether compliance with best practices can be ensured; and
• Governance: Whether the rate is produced subject to a governance structure that promotes the
integrity of the benchmark; and
• Ease of Implementation: How easily a transition to the rate could be done.
As part of its evaluation process, the ARRC considered a comprehensive list of potential alternatives,
including:
• Term unsecured rates; and
• Overnight unsecured rates like the Overnight Bank Funding Rate (OBFR); and
• Term secured rates; and
• Overnight secured rates like the Secured Overnight Financing Rate (SOFR); and
• Treasury bill and bond rates.

15 SOURCE → Alternative Reference Rates Committee: SOFR Starter Kit Part I, Federal Reserve Board
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In 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as the reference rate that
has the best combination of attributes as a replacement for LIBOR as a pricing mechanism for a wide
range of financial transactions (e.g., consumer and business loans, bond issues, derivative contracts).
The ultimate deadline for the phasing out of LIBOR is June 30, 2023. A reference rate is defined as a
benchmark interest rate that is used to set other, related interest rates. Some well-known examples of
reference rates are the Federal Funds Rate, the Prime Rate, LIBOR, and the rates on various US
Treasury securities.
Exhibit 51 illustrates the size of the actual transactions underpinning the SOFR daily rate vs. other
indices. Additionally, Exhibit 52 provides a side-by-side comparison of SOFR and LIBOR. The
differences between the two benchmark rates are significant – (1) Market depth, (2) Backward-looking
vs. forward looking, (3) Secured vs. unsecured, (4) Based on actual transactions vs. estimates, and
other differences.

EXHIBIT 51 – Comparison of daily volumes across money market benchmark rates

EXHIBIT 52 – Excerpt from FHLB publication – SOFR vs. LIBOR attribute comparison16

16 SOURCE → Transition from LIBOR to SOFR: A Primer for Members, FHLB Chicago, published June 2019
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9.2 – IOSCO Best Practices17
In April 2013, the International Organization of Securities Commissions (IOSCO) published a
Consultation Report: Principles for Financial Benchmarks (April Consultation Report), which requested
comments from the public on the proposed final Principles for Financial Benchmarks. The principles
were developed by IOSCO’s Board Level Task Force on Financial Market Benchmarks.
The IOSCO Board created the Task Force considering investigations and enforcement actions
regarding attempted manipulation of major interest rate benchmarks. Those investigations and
enforcement actions raised concerns over the fragility of certain benchmarks – in terms of both their
integrity and their continuity of provision - that has the potential to undermine market confidence,
potentially harming both investors and the real economy.
IOSCO’s objective was to create an overarching framework of Principles for Benchmarks used in
financial markets. Specifically, the IOSCO Board sought to articulate policy guidance and principles for
benchmark-related activities that will address conflicts of interest in the benchmark-setting process, as
well as transparency and openness when considering issues related to transition.
To inform this work, IOSCO’s Task Force initially reviewed a selection of benchmarks, representing a
number of asset classes in different jurisdictions. That review, as well as IOSCO’s consideration of
benchmark issues in the context of oil price reporting agencies helped identify certain broad, generic
risks to the credibility of benchmarks arising from vulnerabilities in the benchmarks’ methodology,
transparency, and governance arrangements.
These risks arise from incentives stemming from conflicts of interests, which may be amplified when
Expert Judgement is used in benchmark determinations. The following factors should be considered
when assessing the risk of a benchmark:
• Submissions of Benchmarks: There are a variety of methods by which different forms of data are
developed, collected, and transmitted to Administrators. The submission process may create
additional vulnerabilities to the determination process if not addressed by appropriate controls and
policies. For example, there may be conflicts of interests in and incentives to manipulate the
determination process where the Submitters are also Market Participants with stakes in the level of
the Benchmarks. Furthermore, there may be other conflicts of interests and opportunities for
manipulative conduct created by the possibility of voluntary and/or selective Submissions, the varied
composition of Submitters, and discretion in the selection of data to be submitted.
• Content and transparency of Methodologies: If the procedures and policies concerning the
Methodology do not contain adequate detail, the ability of Stakeholders to evaluate the credibility of
a Benchmark may be restricted. Furthermore, a lack of transparency may allow abusive conduct to
influence Benchmark determinations. Low transparency and the absence of strong internal controls
may also create opportunities for gaming Submissions to influence a Benchmark.
• Governance processes: The enforcement cases reviewed by the Task Force illustrate that
conflicts of interest at both the Submitter and Administrator levels can create incentives for abusive
conduct. These conflicts can arise within the variety of structures that may exist in the Benchmark
Submission and compilation processes. For example, Submitters, Administrators, Calculation
Agents or other third parties may attempt to manipulate a Benchmark by submitting false or

17
SOURCE – Principles for Financial Benchmarks – IOSCO – July 2013
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 misleading data or by attempting to influence personnel at the Administrator level who are
responsible for the exercise of Expert Judgment.
These Principles are intended to promote the reliability of benchmark determinations, and address
benchmark governance, quality, and accountability mechanisms. Although the Principles set out
uniform expectations, IOSCO does not expect a one-size-fits-all method of implementation to achieve
these objectives. The Principles provide a framework of standards that Administrators should
implement according to the specificities of each benchmark. In particular, the application and
implementation of the Principles should be proportional to the size and risks posed by each benchmark
and/or Administrator and the benchmark-setting process.
IOSCO’s benchmark principles are comprised of 4 “primary principles” (Governance, Quality of the
Benchmark, Quality of the Methodology, and Accountability) that are then mapped to a total of 19 sub
or implementing principles that provide greater granularity. Exhibit 53 summarizes this mapping.

Primary Principle # of sub-principles

Governance 5
Quality of the Benchmark 5
Quality of the Methodology 5
Accountability 4
EXHIBIT 53 – Summary of IOSCO primary principles

The table in Appendix B provides more details on each of the implementing principles.

9.3 – Reference Rates

As described above, a reference rate is defined as a benchmark interest rate that is used to set other,
related interest rates.
The requirements for a reference rate are as follows:
1. Provide a robust and accurate representation of interest rates in core money markets that is not
susceptible to manipulation. Benchmarks derived from actual transactions in active and liquid
markets, and subject to best-practice governance and oversight, represent the best candidates in
terms of this criterion; and
2. Offer a reference rate for financial contracts that extends beyond the money market. Such a
reference rate should be usable for discounting and for pricing cash instruments and interest rate
derivatives. For example, Overnight Index Swap (OIS) contracts of different maturities should
reference this rate without difficulty, providing an OIS curve for pricing contracts at longer tenors;
and
3. Serve as a benchmark for term lending and funding. Given that financial intermediaries are both
lenders and borrowers, they require a lending benchmark that behaves not too differently from the
rates at which they raise funding. For instance, banks may fund a long-term fixed rate loan to a
client by drawing on short-term (variable rate) funding instruments. To hedge the associated interest
rate risk, a bank may enter into an interest rate swap as a fixed rate payer in return for receiving a
stream of floating interest rate payments determined by a benchmark that reflects the bank’s funding

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 costs. If the two types of rate diverge, the bank runs a “basis risk” between its asset and liability
exposures.18
LIBOR meets requirements (2) and (3) above, but it fails to meet requirement (1) for 4 specific
reasons, as follows:
1. LIBOR was constructed from a survey of a small panel of banks reporting non-binding quotes rather
than actual transactions. This created ample scope for panel banks to manipulate LIBOR
submissions.
2. Second, sparse activity in interbank deposit markets stood, and still stands, in the way of a viable
transaction-based benchmark based on interbank rates. Even before the Great Financial Crisis
(GFC), very few actual transactions underpinned the submissions for the longer LIBOR tenors.
Since then, interbank trading has plummeted, especially in the unsecured segment.
3. The increased dispersion of individual bank credit risk since 2007 has undermined the adequacy of
benchmarks such as LIBOR that aim to capture common bank risk, even for users seeking a credit
risk exposure. Moreover, money market pricing has become more sensitive to liquidity and credit
risk, with banks reducing term lending to each other and increasingly turning to non-banks to source
unsecured term funding. This has also exacerbated the dispersion among key money market rates
as well as the divergence between risk-free rates and credit/liquidity-sensitive benchmarks such as
LIBOR.
4. Due to regulatory and market efforts to reduce counterparty credit risk in interbank exposures, banks
have also tilted their funding mix towards less risky sources of wholesale funding (in particular,
repos). Derivatives market reforms (such as the mandatory shift to central clearing of standardized
Over The Counter (OTC) derivatives, and a move towards more comprehensive collateralization of
OTC derivatives positions) have also increased the importance of funding with little or no credit risk.
As a result, markets for swaps and other derivatives have already been transitioning away from
LIBOR to OIS rates for discounting and valuation purposes for more than a decade. Against this
background, the current reform effort can be seen as, in part, broadening the existing sweep to
encompass cash markets and cementing the shift in a clear set of standards.
When considering these issues with LIBOR, the global effort to select one or more new reference rates
have emphasized the importance of constructing reference rates that are based on actual market
transactions (as opposed to a survey of a sample of large banks). With that context, following are some
of the key attributes of an optimized reference rate:
1. Shorter tenor, by moving to O/N markets, where volumes are larger than for longer-dated tenors
such as three months; and
2. Moving beyond interbank markets to add bank borrowing from a range of non-bank wholesale
counterparties (cash pools/money market funds, other investment funds, insurance companies etc);
and
3. In some jurisdictions, drawing on secured rather than unsecured transactions. The secured
transactions could also include banks’ repurchase agreements (repos) with non-bank wholesale
counterparties.19

18 SOURCE → Beyond LIBOR: a primer on the new reference rates, BIS, Published March 2019
19 SOURCE → Beyond LIBOR: a primer on the new reference rates, BIS, Published March 2019
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9.4 – What is LIBOR and how it calculated?20
LIBOR is a reference interest rate that was launched by the British Bankers Association (BBA) in 1986
and is the reference rate at which large banks indicate that they can borrow short-term wholesale funds
from one another on an unsecured basis in the interbank market. This usage covered conventional
business and consumer loans, but also extended to newly developed financial instruments known as
derivatives – including but not limited to interest rate swaps, floating rate agreements, interest rate caps
and floors, etc – that private sector firms (both financial and non-financial) used to hedge the underlying
interest exposures given rise to by their respective business activities.
At one point historically, LIBOR was calculated for multiple currencies (10) and maturities (15). That
means that there were 150 currency/maturity LIBOR pairs. Exhibit 54 below summarizes the different
currencies and maturities that were available.

EXHIBIT 54 – Summary of LIBOR currencies and maturity options21

Every weekday at about 11 a.m., 18 large banks reported the rate at which they believed they could
borrow a “reasonable” amount of dollars from each other in the so-called London interbank market →
the specific survey question being asked was “At what rate could you borrow funds, were you to
do so by asking for and then accepting interbank offers in a reasonable market size just prior
to 11 am?”.
They reported rates for each of the 15 borrowing terms that range from overnight to one year. The
financial news agency Thomson Reuters gathered the reported rates on behalf of the BBA, threw out
the four highest and four lowest, and averaged the rest. This process of discarding outlier data points
and taking the average of the remaining data points was referred to as “trimming the mean”, and the
ultimate calculated rate that was published was referred to as “the fixing”. There was a distinct
calculated rate for each of the 150 currency/maturity pairs.
The rationale for using LIBOR as a reference rate stemmed from the fact that since LIBOR represented
the borrowing terms amongst and between the world’s largest and most creditworthy financial
institutions, it should serve as a lower bound on the borrowing rates that smaller, less creditworthy
institutions and individuals should observe in the market. LIBOR was supposed to reflect reality—an
average of what banks believed they would have to pay to borrow a “reasonable” amount of currency

20
SOURCE – A variety of articles from the ARRC of the Federal Reserve Board

21 SOURCE – LIBOR: Origins, Economics, Crisis, Scandal, and Reform, Federal Reserve – published March 2014
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for a specified short period. That is, it represented the cost of funds—although a bank may not actually
have a need for the funds on any given day.
LIBOR can be decomposed into its component parts using the following equation:
• LIBOR = Overnight risk free rate over the term + Term premium + Bank term credit risk +
Term liquidity risk + Term risk premium
• 𝐎𝐯𝐞𝐫𝐧𝐢𝐠𝐡𝐭 𝐫𝐢𝐬𝐤 𝐟𝐫𝐞𝐞 𝐫𝐚𝐭𝐞 𝐨𝐯𝐞𝐫 𝐭𝐡𝐞 𝐭𝐞𝐫𝐦 = Hypothetical overnight interest rate at which a
riskless institution could expect to borrow over the LIBOR loan period.
• 𝐓𝐞𝐫𝐦 𝐩𝐫𝐞𝐦𝐢𝐮𝐦 = The intertemporal rate of substitution for the term of the loan.
• 𝐁𝐚𝐧𝐤 𝐭𝐞𝐫𝐦 𝐜𝐫𝐞𝐝𝐢𝐭 𝐫𝐢𝐬𝐤 = The borrower’s counterparty credit risk component, commensurate
with the loan maturity.
• 𝐓𝐞𝐫𝐦 𝐥𝐢𝐪𝐮𝐢𝐝𝐢𝐭𝐲 𝐫𝐢𝐬𝐤 = Compensates for maturity risk incurred by the lender by tying up funds
for a longer period of time. Could include market illiquidity for interbank funds that may increase
the lender’s rollover refinancing costs.
• 𝐓𝐞𝐫𝐦 𝐫𝐢𝐬𝐤 𝐩𝐫𝐞𝐦𝐢𝐮𝐦 = Builds in compensation for the risk that any of these components may
have realizations that differ from their expected amounts.22
One of the critical shortcomings of LIBOR is the fact that while $200 trillion of transactions (consumer
loans, securitizations, floating-rate notes, business loans, and derivatives) are priced against LIBOR,
the $ value of actual daily transactions is a small fraction of that value (~$500 million). Exhibit 55 clearly
illustrates this attribute.

EXHIBIT 55 – LIBOR transaction volume vs. notional $ volume of linked transactions23

22
SOURCE – LIBOR: Origins, Economics, Crisis, Scandal, and Reform, Federal Reserve – published March 2014
23 SOURCE → Alternative Reference Rates Committee: SOFR Starter Kit Part I, ARRB
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9.5 – What is SOFR?
9.5.1 – Daily SOFR
SOFR is a fully-transaction based, risk-free reference rate. It is a broad measure of the cost of
borrowing cash overnight collateralized by U.S. Treasury securities.
SOFR covers the most volume of transactions of any rate based on the U.S. Treasury repurchase
agreement (repo) market. As a good representation of conditions in the overnight Treasury repo market,
SOFR reflects the economic cost of lending and borrowing by the wide array of market participants
active in the market.24
SOFR has several attributes that are distinct from LIBOR and other similar, unsecured wholesale
funding rates:
• It is a rate produced by the Federal Reserve Bank of New York (FRBNY) for the public good; and
• It is derived from an active and well-defined market with sufficient depth to make it extraordinarily
difficult to ever manipulate or influence; and
• It is produced in a transparent, direct manner and is based on observable transactions, rather than
being dependent on estimates, like LIBOR, or derived through models; and
• It is derived from a market that was able to weather the global financial crisis and that the ARRC
credibly believes will remain active enough in order that it can reliably be produced in a wide range
of market conditions.25
There are a wide range of financial market participants directly involved in the Treasury repo market,
including asset managers, banks, broker dealers, corporate treasurers, insurance companies, money
market funds, pension funds, and securities lending agents. Beyond the diverse entities that regularly
transact directly in the repo market, there is a significant number of entities with indirect exposure to
the Treasury repo market.
For example, any investor in the $4.5 trillion money market fund industry has exposure to the repo
market. Similarly, pension funds like the California Public Employees’ Retirement System (CALPERS),
which serves over two million members in the retirement system typically lend cash in the repo market.
Exhibit 56 below captures the diversity of members of the Fixed Income Clearing Corporation (FICC)
eligible to transact in the Repo Market:

EXHIBIT 56 – Breakdown of FICC members in the repo market26

24
SOURCE → Frequently Asked Questions, Alternative Reference Rates Committee, published August 2021
25
SOURCE → Templates for Using SOFR, Federal Reserve, published April 2019
26
SOURCE → Alternative Reference Rates Committee: SOFR Starter Kit Part II, ARRC
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SOFR is based on a broad universe of US Treasury Repo trade activity from the following 3 sources:
• Tri-party Treasury General Collateral (GC) repo transactions cleared and settled by Bank of New
York Mellon (BNYM), excluding repo transactions made through the Fixed Income Clearing
Corporation (FICC) General Collateral Financing (GCF) repo market, and excluding transactions in
which the Federal Reserve is a counterparty; and
• Tri-party Treasury GC repo transactions made through the FICC GCF repo market, for which FICC
acts as central counterparty; and
• Bilateral Treasury repo transactions cleared through the FICC Delivery-versus-Payment (DVP)
service.
There are specified data quality rules that are applied to the transactions from each of these 3 sources,
as follows:
• BNYM Tri-party GC Repo
• Transactions with the Federal Reserve are removed.
• “Open” trades that are economically like overnight trades are included.
• Transactions between affiliated entities that are not conducted at arm’s length are removed.
• FICC GCF
• Any pair of duplicate trades with FICC as central counterparty is treated as a single trade.
• Transactions between affiliated entities are included because they are blind brokered.
• FICC DVP Bilateral Repo Data
• Transactions between affiliated entities are included, because counterparty names are not
identified in the data supplied to FRBNY.
• For any given day, FRBNY ranks all FICC DVP bilateral repo trades by their transaction rates,
from lowest to highest, and then removes 25 percent of trading volume corresponding to the
lowest transaction rates. The goal of this data filtering is to remove repo transactions in which
Treasury collateral is likeliest to be trading “special,” to achieve a residual set of bilateral repo
data that (if not purely) reflects GC transactions.
After editing each of the three sets of source data, FRBNY pools them, then ranks the aggregate of
repo trading volumes by their transaction rates, from lowest to highest, then computes the transaction-
weighted median repo rate (e.g., the repo rate for which half of the day’s trading volume is transacted
at rates that are equal to it or less than it and for which the other half of the day’s trading volume is
made at rates that are equal to it or greater than it). This transaction-weighted median repo rate then
becomes the day’s SOFR benchmark value.27
9.5.2 – CME SOFR Futures
Both SOFR futures contracts reference the same underlying SOFR daily rate, and the methodologies
for developing the settlement prices for each are described below.
One-month SOFR Futures
On any given business day, there are 14 actively quoted one-month contracts, including the current
month and the 13 subsequent months. EXAMPLE: On Monday January 30, 2023, the “front month”

27 SOURCE → What is SOFR, Chicago Mercantile Exchange, Published March 2018

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monthly contract was January 2023, and the 13 subsequent months are February 2023 through
February 2024.
This can be seen below in Exhibit 57 below, which is an excerpt from the quote screen on the CME
website. The highlighted column is the transaction volume on the current business day for the
respective contract in that row. Not surprisingly, the first eight contract months (January 2023 through
August 2023) exhibit higher volumes, and thus greater liquidity, than the trailing 6 months (September
2023 through February 2024).

EXHIBIT 57 – Excerpt from the CME quote page for the One-Month SOFR Futures contract

Each of the 14 contracts has a unique contract code. Exhibit 58 decomposes the code:

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EXHIBIT 58 – Decomposition of the CME SOFR Futures contract code

Exhibit 59 below provides the 1-letter code for each of the 12 calendar months.
Month Code
January F
February G
March H
April J
May K
June M
July N
August Q
September U
October V
November X
December Z
EXHIBIT 59 – CME month codes for derivative contracts

The final settlement price is calculated as 100 – R, where R is the arithmetic average of the daily SOFR
rates for the given calendar month. The methodology for developing the daily SOFR rate is described
above in Section 9.5.1. The following formula gives the calculation of R:
t=D
∑t=1 c SOFRt
• R= Dc
• SOFR t = the daily SOFR rate.
• Dc = the number of days in each calendar month.
The average R is then rounded to the nearest 1/10 th of a basis point, and as described above, the
settlement price → SOFR Future1 month = 1 − R. This process is described in more detail below:
• For all business days t, let the daily SOFR rate be given by rbt .
• For all non-business days t, let the daily SOFR rate be given by rnbt .
• If t is a Saturday, then rnbt = rnbt−1 . If t is a Sunday, then rnbt = rnbt−2.
• If t is a holiday that falls on Monday, then then rnbt = rnbt−3. If t is a holiday that falls on Tuesday
through Friday, then rnbt = rnbt−1 .

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• Finally, the final value of R is given by the following equation:
∑all business days rbt +∑all non−business days rnbt
• R= Dc

A sample calculation is illustrated in Exhibit 60 below. This calculation is for the July 2017 contract.

EXHIBIT 60 – Illustration of the calculation of the 1-month SOFR futures settlement price28

Three-month SOFR
On any given business day, there are 10 years of consecutive, quarterly contracts quoted on the CME,
as well as a limited number of “off-quarter” months listed in the first 6 months out from the valuation
date. EXAMPLE: For the Monday January 30, 2023, valuation date, the “front quarter” contract
is December 2022, and there are 40 remaining quarterly contracts on the CME quote board
spanning the period from March 2023 to December 2032. Additionally, there are quotes for the
off-quarter months in the time period from January 2023 to June 2023 – January 2023, February
2023, April 2023, and May 2023.
This can be seen below in Exhibit 61 below, which is an excerpt from the quote screen on the CME
website and covers the contracts out through Dec 2024.

28 SOURCE → SOFR Futures Settlement Calculation, Chicago Mercantile Exchange, published 2019
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EXHIBIT 61 – Excerpt from the CME quote page for the Three-Month SOFR Futures contract

There are 5 key date and temporal attributes for a given 3-month SOFR futures contract, as follows:
• The Contract Month is the specific quarterly month (e.g., March, June, September, and December)
in which the contract interest accumulation period starts.
• The Delivery Month is the specific quarterly month (e.g., March, June, September, and December)
in which the contract interest accumulation period ends, and the contract is financially settled.
• The Start Date is the 3rd Wednesday in the contract month. The time series of SOFR daily dates
that starts in the contract month includes the value from the start date.

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• The End Date is the 3rd Wednesday in the delivery month. The time series of daily SOFR rates that
underpin the corresponding future contract DOES NOT include the value from the end date. The
contract terminates trading on the day before the end date (Tuesday).
• An important concept related to the pricing and settlement of the 3-month futures contract is the
Contract Reference Quarter (CRQ). The CRQ for a given futures contract is characterized by the
period between the start date and the end date.
• An example will serve to illustrate the CRQ concept. Exhibit 61 above illustrates the quotes for the
3-month contract on January 30, 2023. The “front quarter” contract is December 2023. For the
December contract, the start date was December 21, 2022, and the end date for this contract is
March 15, 2023.
The final settlement price of an expiring SR3 contract is based on the daily SOFR rates for all calendar
days occurring within the CRQ. The final settlement price, like the one-month contract, is determined
by the formula 100-R where R represents the annualized rate of interest derived from the compounding
of all daily SOFR rates during the CRQ, rounded to the nearest 1/100th of a basis point. Simple interest
is accrued for all non-Business Days in the reference quarter (weekends and holidays) based on the
SOFR daily rate from the preceding good Business Day. Then all Business Days’ interest is
compounded. The resulting rate is represented as an annualized interest rate using the money market
day count convention (Actual/360).
The process for calculating R is described below:
• Weekends and holidays (non-business days) are not included in the time series of daily SOFR
values that form the futures settlement price, but there are prices included for non-business days,
and these prices are mapped to the preceding last business day. EXAMPLE – No SOFR daily
rates were published on Saturday January 28, 2023, and Sunday January 29, 2023, but the
rate from the previous good business day (Friday January 27th) will be counted three times
(e.g., Friday as the last business day, and Saturday and Sunday as the subsequent non-
business days).
• With that basic structure in place, the Daily Interest Accumulation Factor (DIAF) is calculated for
each business day in the CRQ. For those business days that are followed by a weekend or a holiday,
the DIAF will be computed using simple interest and reflect the number of days for which that day’s
rate applies.
1 SOFRt
• If day t is bracketed by 2 business days, then DIAFt = (1 + 360 ∗ ).
100
n SOFR
• t
If day t precedes a weekend or a holiday, then DIAFt = 1 + (360 ) ( 100 )
• Taken together, the overall DIAF for the CRQ is given by the equation
t=days in CRQ nt SOFRt 360
• DIAFoverall = [∏t=1 {1 + ( )( )} − 1] ∗ ( ) ∗ 100
360 100 D
• SOFR t = the SOFR daily rate.
• nt = the number of calendar days for which the SOFR daily rate rt applies.
• D = the number of calendar days in the relevant CRQ.
Exhibit 62 below is an example that illustrates the calculation of the future settlement price for the June
2017 contract. The impact of weekends in the time series is highlighted – the closing price on each of
the 13 Fridays in the CRQ are counted three times (not once) in the development of the settlement
price.

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EXHIBIT 62 – Illustration of the development of the 3-month SOFR futures settlement price29

9.5.3 – SOFR Index and averages

In addition to publishing the daily SOFR rate, FRBNY also publishes three compounded averages for
the tenors 30-day, 90-day, and 180-day and a SOFR Index Rate that allows for the calculation of a
compounded average over custom time periods. It is important to note that while the SOFR daily rate
is published on the next business day after the day that the underlying transactions supporting the rate
occurred (e.g., the value date), the 3 compounded averages and the SOFR Index Rate are published
on their value date, or the final date in the averaging period covered by the respective rate.
The general formula for the various compounded averages is given below:
D SOFRi ∗ ni 360
• b
SOFR Average = [∏i=1 (1 + 360
) − 1] ∗ Dc
• SOFR i = the SOFR daily rate on day i.
• Db = the number of business days in the calculation or averaging period.
• ni = the number of days for which the SOFR daily rate on day i applies.
• Dc = the number of calendar days in the calculation or averaging period.
Since the rate is not published on non-business days (e.g., holidays and weekends), the calculation
methodology accounts for these days as follows:
• For any Saturdays that fall within the averaging period, the averaging calculation maps the SOFR
daily rate from the Friday before; and
• For any Sundays that fall within the averaging period, the averaging calculation maps the SOFR
daily rate from the Friday before.

29 SOURCE → SOFR Futures Settlement Calculation, Chicago Mercantile Exchange, published 2019
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• For any holidays that fall within the averaging period, the averaging calculation maps the SOFR
daily rate from most recent business day preceding the holiday.
The SOFR Index Rate measures the cumulative return that an investor would have received if they had
invested in an instrument earning the daily SOFR Rate since its inception on April 2, 2018. The
calculation methodology for the SOFR Index Rate is described below:
• SOFR Indext = 1.000 if t = April 2, 2018,
SOFRt ∗ nt
• SOFR Indext = ∏tt=April 2,2018 (1 + ) if t > April 2, 2018
360
• t is the measurement date for the SOFR index value.
Finally, to build on the SOFR Index Rate formula above, compounded averages for customized time
periods can be calculated using the SOFR Index formula, as follows:
SOFR Indext+n 360
• 𝑆OFR Custom Average (start = t, end = t + n days) = ( − 1) X
SOFR Indext n

FRBNY publishes the daily SOFR Rate on their site (SOFR daily values). Exhibit 63 below is an excerpt
of the last daily rate (2nd column from the left) and the various percentile rates (1 st, 25th, 75th, 99th) of
the daily rates for the last 10 business days.

EXHIBIT 63 – Excerpt from the FRBNY site illustrating SOFR daily rate

Similarly, Exhibit 64 below is an excerpt from the FRBNY site that captures the various averages for
the last 10 business days (SOFR averages and index values).

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EXHIBIT 64 – Excerpt from the FRBNY site illustrating SOFR averages and index values

9.5.4 – Term SOFR rates

Before delving into the technical aspects of the SOFR term rate development, an important first step is
to enumerate the principles and best practice recommendations that the ARRC has put forth regarding
the market usage of term SOFR rates.
• Meet the ARRC’s criteria for alternative reference rates, like the criterion applied to the construction
of the SOFR daily rate; and
• Be rooted in a robust and sustainable base of derivatives transactions over time, to ensure that its
use as a reference rate is consistent with best practices and the ARRC’s own standards; and
• Have a limited scope of use, to avoid (i) use that is not in proportion to the depth and transactions
in the underlying derivatives market or (ii) use that materially detracts from volumes in the underlying
SOFR-linked derivatives transactions that are relied upon to construct a term rate, making the term
rate itself unstable over time; and
• The ARRC supports the use of the SOFR Term Rate in addition to other forms of SOFR for business
loan activity —particularly multi-lender facilities, middle market loans, and trade finance loans—
where transitioning from LIBOR to an overnight rate has been difficult and where use of a term rate
could be helpful in addressing such difficulties.
• The ARRC also recognizes that the SOFR Term Rate may also be appropriate for certain
securitizations that hold underlying business loans or other assets that reference the SOFR Term
Rate and where those assets cannot easily reference other forms of SOFR; and
• The ARRC does not support the use of the SOFR Term Rate for most of the derivatives markets,
because these markets already reference SOFR compounded in arrears and transitioning
derivatives markets to the more robust overnight risk-free rates (RFRs). 30

30 SOURCE → ARRC Best Practice Recommendations Related to Scope of Use of the Term Rate, ARRC, published 2021
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In addition to the Daily SOFR rate, the Chicago Mercantile Exchange (CME) publishes daily, forward
looking interest rate estimates or term rates for the following tenors – (1) 1-month, (2) 3-month, (3) 6-
month and (4) 12-months. These 4 term rates are developed using daily quotes from 2 different futures
CME SOFR contracts:
• One-month SOFR Futures (labeled SR1) – 13 consecutive month’s contracts; and
• Three-month SOFR Futures (labeled SR3) – 5 consecutive quarterly contracts (March, June,
September, and December.
Two economists from the Federal Reserve - Erik Heitfield and Yang-Ho Park – published a paper in
February 2019 that describes a modeling approach that utilizes daily SOFR futures prices to estimate
daily SOFR term rates. The technical specifics of this approach are described below.
As described above in 9.5.3 – SOFR Index and averages, FRBNY publishes 3 SOFR averages (30-
day, 60-day, and 180-day) on a daily basis that are calculated in arrears using a compound interest
formula. Each of these averages are entirely backward looking, whereas the SOFR term rates are at
least partially (or entirely) forward looking. The key difference between backward and forward-looking
interest rates is that backward-looking refers to realized daily SOFR rates, and forward-looking refers
to projected SOFR daily rates. The Heitfield/Park model assumes that projected SOFR daily rates are
dependent on policy actions taken by the Federal Open Market Committee (FOMC) of the Federal
Reserve Board. An FOMC policy action involves changing the Federal Funds Rate (FFR). As such, the
model assumes that the projected SOFR daily rate will change (up or down) when an FOMC meeting
occurs and remain constant in between FOMC meetings.
The first process step is to specify the basic functional form for the forward rate. Consistent with the
attribute described above (forward daily SOFR rates only move when the FOMC changes the Fed
Funds rate), this formulation takes a step-function approach.
• f(t, θ) = f(t 0 ) + ∑Mk[θk ∗ I(t ≥ Mk )]
• f(t, θ) = the projected SOFR daily rate on date t.
• f(t 0 ) = the starting rate for the projection. This rate is the “base rate” to which the step changes
in the projected SOFR daily rate coinciding with the change in the FFR are applied.
• t 0 = the starting date for the projection.
• t = the time index variable for the projected SOFR daily rates and represents a future calendar
day.
• θ = a vector of length k. The model assumes that there are k FOMC meetings between the
valuation date t 0 and the maturity of the term rate, and θk is the assumed change in the FFR
flowing from the kth FOMC meeting.
• I(t ≥ Mk ) = an indicator variable that returns a vector of length k with each entry either being (1)
0 if t < Mk or (2) 1 if t ≥ Mk .
• Mk = the date of the kth FOMC meeting.
The second process step is to use this formulation for the forward rate to build up the equations for the
prices of the 1-month and 3-month futures contracts. As described in 9.5.2 – CME SOFR Futures
above, the settlement price for both futures contracts in defined as 1- R, where R is (1) The arithmetic
average of the daily SOFR rates in the contract month for the 1-month futures and (2) The geometric
average (compounded) of the daily SOFR rates in the CRQ for the 3-month futures. The prices for 4
different use cases needs to be defined, as follows:
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• 1-month futures – For a future contract month. The valuation date is ≤ Start Date for the relevant
contract month.
• 1-month futures – For the current contract month. The valuation date is ϵ[Start Date, End Date] for
the relevant contract month.
• 3-month futures – For a future CRQ. The valuation date is ≤ Start Date for the relevant CRQ.
• 3-month futures – For the near-term contract. The valuation date is ϵ[Start Date, End Date] for the
relevant CRQ.
1-month futures – For a future contract month
1
• ̂m
P 1 (t
0 , θ) = 1 − R = 1 − N1 ∗ ∑tϵT1m f(t, θ)
m
• m = the ordinal number assigned to the future contract month.
• ̂
Pm1 (t
0 , θ) = the estimated price of the 1-month futures contract for the contract month m on the
valuation date t 0 where the valuation date is earlier than the contract month. The time
sequencing of the valuation date relative to the dates in the pricing period are illustrated in
Exhibit 65 below.
• R = the relevant average of realized, daily SOFR rates for contract month = m.
• t 0 = the valuation date on which the estimated futures price is calculated.
• t = the time index variable used to reference the projected SOFR daily rate. In this instance,
where the contract month is in the future, t 0 < t.
• Tm 1
= the vector of value calculation dates for the 1-month contract during contract month m. The
dimensionality of the vector will be the number of business days in contract month m.
• Nm 1
= the total number of calendar days in contract month m.
• θ = the vector of changes to the FFR during the contract month m. The dimensionality of the
vector will correspond to the number of discrete FOMC meetings expected to occur in contract
month m.

EXHIBIT 65 – Illustration of the valuation date and the future price estimation dates

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1-month futures – For the current contract month

• ̂01 (t 0 , θ) = 1 − R = 1 − 11 ∗ [∑tϵT1− rt + ∑tϵT1+ f(t, θ)]

P N0 0 0

• m = 0 since the relevant contract month is the front or current month.

• ̂
P01 (t, θ) = the estimated price of the 1-month futures contract for the current contract month on
the valuation date t 0 . The time sequencing of the valuation date relative to the dates in the pricing
period are illustrated in Exhibit 66 below.
• R = the relevant arithmetic average of (1) realized, daily SOFR rates and (2) projected SOFR
daily rates for the current contract month.
• t 0 = the valuation date on which the estimated futures price is calculated.
• t = the time index variable used to reference both (1) The realized SOFR daily rate and (2) The
projected SOFR daily rate. For this use case, the valuation date t 0 ∈ (Start Date, End Date).
• T01− = the vector of business days that have passed and are < t 0 .
• T01+ = the vector of business days that are in the future and ≥ t 0 .
• N01 = the total number of calendar days in the current contract month.
• rt = the realized SOFR daily rates for the days in the contract month that have passed and are
contained within T01− .
• f(t, θ) = the projected SOFR daily rate for the days in the contract month that are contained within
T01+ .
• θ = the vector of changes to the FFR during the current contract month. The dimensionality of
the vector will correspond to the number of discrete FOMC meetings remaining in the current
contract month.

EXHIBIT 66 – Illustration of the valuation date and the future price estimation dates

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3-month futures – For a future CRQ

• ̂q3 (t 0 , θ) = 1 − R = 1 − 360
P
f(t,θ)∗n
∗ [∏tϵT3q (1 + 360 t) − 1]
N3
q

• q = the ordinal number assigned to the future CRQ.

• ̂q3 (t 0 , θ) = the price of the 3-month futures contract for CRQ q on the valuation date t 0 .
P
• R = the relevant geometric average of projected daily SOFR rates for CRQ q.
• t 0 = the valuation date on which the estimated futures price is calculated.
• t = the time index variable used to reference the projected SOFR daily rate.
• Tq3 = the vector of business dates in CRQ q.
• Nq3 = the number of calendar days in CRQ q.
• nt = the number of calendar days between t and the next business day. If f(t, θ) is projected to
occur on a weekend or holiday, then nt is the number of calendar days for which f(t, θ) applies.
• f(t, θ) = the projected SOFR daily rate for date t ≥ t 0 in CRQ q.
• θ = the vector of changes to the FFR during CRQ q. The dimensionality of the vector will
correspond to the number of discrete FOMC meetings remaining in CRQ q.
3-month futures – For the current CRQ
360 rt ∗nt f(t,θ)∗n
• ̂
P03 (t 0 , θ) = 1 − R = 1 − N3 ∗ [{∏tϵT3−
0
(1 + 360 ) ∏tϵT3+
0
(1 + 360 t)} − 1]
0
• q = 0, and is the ordinal number assigned to the current CRQ.
• t 0 = the valuation date. t 0 ϵ[Start Date, End Date] in CRQ 0.
• ̂q3 (t 0 , θ) = the price of the 3-month futures contract on the valuation date t 0 for the current CRQ
P
(q=0).
• R = the geometric average of (1) realized SOFR daily rates and (2) projected SOFR daily rates
for CRQ 0.
• t 0 = the valuation date.
• t = the time index variable used to reference both (1) The realized SOFR daily rate and (2) The
projected SOFR daily rate.
• T03− = the vector of business days in the CRQ that occur on or before the valuation date t 0 .
• T03+ = the vector of business days in the CRQ that occur after the valuation date t 0 .
• N03 = the number of calendar days in the CRQ corresponding to the front-quarter contract.
• nt = the number of calendar days for which (1) The realized SOFR daily rate rt applies in the
period on or before the valuation date and (2) the projected SOFR daily rate f(t, θ) applies in the
period after the valuation date.
• rt = the realized SOFR daily rates for the business days in the CRQ that have passed.
• f(t, θ) = the projected SOFR daily rate for date t ≥ t 0 in CRQ q.
• θ = the vector of changes to the FFR during CRQ 0. The dimensionality of the vector will
correspond to the number of discrete FOMC meetings remaining in CRQ 0.
The third process step is to specify the optimization structure that is used to estimate the theta vector
{θ} that solves the optimization. The optimization structure is described below:
2 2 1/2 1
• min θ {∑m=6 1 1 ̂1 2 3 3 ̂3
m=0 wm ∗ (Pm − Pm (θ)) + ∑q=0 wq ∗ (Pq − Pq (θ)) } + λ ∗ (∑k FOMC dates(θk )2 )2

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 • This optimization problem statement is to select the values of the theta vector {θ} that minimize
the sum of the following elements → (1) The mean squared errors between the observed 1-
month futures price and the estimated 1-month futures price for the first 7 monthly contracts, (2)
The mean squared errors between the observed 3-month futures price and the estimated 3-
month futures price for the first 3 quarterly contracts, and (3) The penalty function that imposes
the assumption of FOMC policy gradualism.
• wm1
and wq3 are weighting coefficients for the two error terms that can be selected by the modeler
to assign varying weights to the different contracts used in the calculation. EXAMPLE: If the
modeler wished to ascribe a higher weight to the months/quarters for which she believed
the observed future prices are more accurate.
The fourth and final process step is to use the estimated theta vector {θ} results from the optimization
exercise to project the compounded future SOFR rates, which allows us to calculate the projected term
rates for the relevant time period in the future (e.g., 1-month, 3-month, or 6-month). The formula used
to project the term dates is given below:
360 ̂ )∗nt
f(t;θ
• h(T) = (∏tεT̃(T) (1 + ) − 1)
T 360
• T = the future time period that corresponds to the length of the respective term rate.
• ̃(T) = the period of future business days that starts on the first accrual date (e.g., first business
T
day after the valuation date) and ends on the same calendar day in a month that is either 1-
month, 3-months, or 6-months in the future.
• h(∗) = the projected, compounded SOFR rate a period T.
• θ̂ = the estimated theta vector that results from solving the optimization problem.
• f(t; θ̂) = the projected daily SOFR rate on day t that results from using the estimated theta vector.
• nt = the number of calendar days for which (1) the realized daily SOFR rate rt applies in the
period before the valuation date and (2) the forward rate f(t, θ) applies in the period on or after
the valuation date.

9.5.5 – SOFR usage considerations

There are 3 fundamental choices in determining how to use SOFR…these are described below in
Exhibit 67.
Usage Potential choices Description
element
Averaging • Compound interest • 1-month futures use simple; 3-month futures use compound.
methodology averaging • Compounding better reflects the time value of money.
• Simple interest
averaging

Payment Notice • In advance • The payment structure references an average of the SOFR daily rates observed before
• In arrears the interest period has begun.
• The payment structure references an average of the SOFR rate during the current
interest period and will only be known when the period is over.

Underlying Market • SOFR (U.S. Treasury • The UST repo market has been deep and highly liquid for many years.
Repo Market) • The SOFR futures market is still in its early stages and is not yet deep or liquid enough
• SOFR Derivatives to produce an IOSCO-compliant benchmark rate.
(SOFR futures)

EXHIBIT 67 – SOFR usage considerations

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For cash products, there are 4 different versions of SOFR-based rates, as follows:
• Published Simple or Compound Average of the SOFR Daily Rate set in advance; and
• Published forward-looking SOFR Term Rate set in advance; and
• Simple Average of the SOFR Daily Rate set in arrears; and
• Compound Average of the SOFR Daily rate set in Arrears.
For those use cases in which SOFR is calculated in arrears, Exhibit 68 below captures the range of
different payment structures:

EXHIBIT 68 – Different “in arrears” calculation schemes for SOFR rates

Section 10.0 – Risk-Neutral Dynamics

10.1 – Background and Overview
The purpose of this section is to provide the reader with the basic technical background for risk neutral
probabilities and their use in valuing different types of derivative securities. This is not an in-depth
treatment of risk neutrality concepts – just the basics.
The first step is to define important terminology:
• Arbitrage Free Market
• Arbitrage is the process of an investor taking advantage of price differences across markets for
the same underlying product through (1) Buying the less costly instance of the product and (2)
Selling the more costly instance of the product with the goal of making a “riskless profit”.
• “Riskless” means that arbitrage strategies are typically zero-cost to enter and implement and
result in the investor obtaining a guaranteed positive profit at his/her investment horizon.
• In the capital markets, the “products” to which arbitrage techniques are applied are investment
assets – bond, equities, derivatives, etc.

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 • Theoretically, the existence of arbitrage opportunities will be observed by market participants,
and through the execution of the “buy the cheap and sell the expensive” strategies by many such
participants, the cheaper instance of the given asset will increase in price and the expensive
instance of the same asset will decrease in price. This price adjustment process should eliminate
the arbitrage opportunity over time.
• The concept of “arbitrage free” markets in which the above-described opportunities do not exist
is a theoretical construct and is undoubtedly violated in the real world on a regular basis.
• But this framework forms the basis of derivative valuation techniques.
• Complete Market
• Also known as an “Arrow Debreu” market.
• Requires that two conditions be satisfied:
• Transacting in the capital markets involves negligible transaction costs that can be ignored
when valuing different assets.
• There is a determinable price for every asset in every future state of the world.
• Stochastic Process
• A family of random variables {X1 , X2 , X3 , … , XN } that is indexed by a parameter θ. θ can represent
any type of indexing variable (e.g., time, members of a population, a set of manufactured
products, etc) but in finance and econometric applications is typically taken to mean points in
time (e.g., a time series sequence).
• If θ is a set of discrete points in time, then the stochastic process {Xi , 0 ≤ i ≤ N} is referred to as
a “discrete time” stochastic process.
• If θ is some portion of the real number line, and so represents an infinite number of points in
time, then the stochastic process is referred to as “continuous time” and is depicted using the
notation X(t).
• Law of One Price
• The law of one price is an economic concept that states that the price of an identical asset or
commodity will have the same price globally, regardless of location, when certain factors are
considered.
• The law of one price assumes a “frictionless market”, where there are no transaction costs,
transportation costs, or legal restrictions, the currency exchange rates are the same, and that
there is no price manipulation by buyers or sellers.
• The law of one price exists because differences in prices for the same asset in different markets
would eventually be eliminated due to the existence of the risk-free arbitrage opportunity.
• Arrow Debreu Securities (AD securities)
• A “primitive” or “primary” security that pays $1 (or 1 unit of any currency depending on the usage)
if a given future state occurs and $0 in all other future states.
• Redundant Security
• A security for which the payoff can be replicated using a linear combination of other “primary” or
“primitive” securities.
• The process of constructing a portfolio of primary securities to match the expected payoffs of a
redundant security is known as portfolio replication.
• This concept ties in with the assumption of arbitrage-free markets → if the expected future cash
flows for the replicating portfolio and the redundant security are identical, then the two must have
the same market value. Otherwise, there would be an opportunity for an investor to realize an
arbitrage profit.
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 • In a complete market, every redundant security has a unique arbitrage-free price.
• State Prices
• Given a stochastic process with a time index (e.g., a time series), the state price is the market
observed price at time 0 of the AD security that pays $1 at some future time step.
• Markov Chain/Markov Process
• A stochastic process that describes a sequence of random variables (RV) in which the probability
of the next RV in the sequence attaining a specific value is conditioned only on the value realized
by the current RV in the sequence. This attribute is often referred to as a “memoryless property.”
• Discrete time Markov process:
• A discrete-time Markov chain is a sequence of random variables X1 , X2 , X3 . .. with the Markov
property, namely that the probability of moving to the next state depends only on the present
state and not on the previous states:
• Pr(XN+1 = x|X1 = x1 , X2 = x2 , X3 = x3 , … , XN = xN ) = Pr(XN+1 = x|XN = xN )
• Continuous time Markov process:
• The sequence {X(t), t ≥ 0} is a continuous time stochastic process that takes on values only
for positive values of time. The sequence will additionally be a Markov chain if (1) Upon
1
entering state i, the amount of time spent in state i is exponentially distributed with mean v
i
(~EXP(−vi )).
• When the process leave state i, it next enters state j with some probability pij , and pij satisfies
(1) pij ≥ 0, (2) ∑j pij = 1.
• The interpretation of the 2nd condition is that once the process leaves state i, it can only jump
to one of the finite set of states signified by the index j. When all of the probabilities of the
process moving from state i to one of the state j values are summed, the sum is equal to 1
→ all of the possible transitions from i to a future state j are spanned.
• Martingale
• A time sequence of random variables (RVs) for which, at a particular time, the conditional
expectation of the value of the next RV in the sequence is equal to the realized value of the
current RV in the sequence.
• Discrete time martingale:
• E[|XN |] < ∞
• E[XN |x1 , x2 , x3 , … , xN ] = xN
• E[Xi ] = xi ➔ realized value of Xi
• Continuous time martingale:
• E[|Xt |] < ∞
• E[Xt |xτ , τ ≤ s] = xs
• Risk Neutral probability
• The probability of a future outcome that has been adjusted for risk.

10.2 – One-period model

Exhibit 69 below illustrates the evolution of the economy over a single period. This type of presentation
is referred to as a multinomial tree model. The most common example of a multinomial tree model is

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the binomial tree in which the number of states in the next time step is always 2…typically an “up” and
“down” state.
In my example below, there are 5 future states in the next time step, and each state represents a
stylized realization of the “economy”. An “economy” state translates to a unique combination of
economic and financial variables that serve to uniquely characterize the way that most people think
about the economy – Gross Domestic Product, Inflation, Interest Rates, Unemployment Rate, Credit
Spreads, Projected Equity Returns, etc.

EXHIBIT 69 – 1-period multinomial tree used

Assume that AD securities are available in the market for each of the 5 states, and further assume that
the yield curve at t=0 is flat with all rates = 0.00%. Then portfolio can be designed at time 0 of 1 unit of
each of the 5 AD securities, and this portfolio will guarantee a payoff at t=1 of $1. Let A(i, 0) denote the
price of the AD security at t=0 that pays $1 in state i at t=1. The set of A(i, 0) values are known as “state
prices” and are defined above in 10.1 – Overview and background.
The next step in the process is to understand the factors that determine the observed market prices for
each of the AD securities at t=0. Each price will be determined by the supply/demand forces for each
security, and the supply/demand forces in turn will depend on the following factors:
• The relative investor preferences for holding money in each of the 5 states at t=1; and
• The relative investor preferences for holding money at t=0 or t=1; and
• The estimated probabilities of each of the 5 states occurring at t=1.
Assume interest rates are 0 (in other words, assume that the investor has no temporal preference as
to “when” they hold the $1), and consider the other two factors – (1) Investor preferences and (2)
Probabilities – as a form of risk adjustment on the AD security cash flows. On the assumption that a
complete market exists (definition above in 10.1 – Overview and background), a portfolio of all 5 AD

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securities can be constructed at t=0, and this portfolio ensures a payoff of $1 at t=1with certainty. On
that basis, the following expression can be written:

• Price = ∑i=5
i=1 A(i, 0) = 1, or the sum of the prices paid for each of the AD securities at t=0 must sum
to $1
This formulation can be generalized to the use case where (1) There are N states at t=1 and (2) Again
there is a complete market in which AD securities for each state are available for purchase. Since the
sum of the AD prices at t=0 is equal to 1, the AD prices have the following attributes:

• ∑i=N
i=1 A(i) = 1➔ A(i) ≤ 1, A(i) ≥ 0, ∀i

On this basis, the AD security prices are referred to as risk neutral probabilities. It is important to note
that the prices for individual AD securities do not need to be separately calculated –the observed market
values for each of these securities can be used in performing the above calculations. The risk-
adjustments are implicitly reflected in the observed market prices.
If a non-zero interest rate assumption is added, the above equation is revised as follows:
∑i=5
i=1 A(i,0)
• Price = 1+R

In this instance, the expression for the AD security prices no longer sums to 1, and therefore the AD
security price for state i can no longer be considered as the risk neutral probability. The security price
must be adjusted for the interest compounding factor:
• q(i) = the risk neutral probability for state i at t=1 = A(i, 0) ∗ (1 + R), ∀i
• ∑i=5
i=1 q(i) = 1

The final step in this analysis of the 1-period model is to illustrate the valuation mechanics for a more
complex (e.g., redundant security). The following assumptions are used in building up the valuation
model:
• The market is complete – there are AD securities for each future state available for purchase to
investors; and
• There are 5 states at t = 1: and
• The 1-period discount rate is R; and
• The redundant security pays (1) $N in state 1 and 2, (3) $K in states 3 & 4, and (3) $0 in state 5;
and
• Define X(i) as the payoff from the redundant security in state i.
Then the price for the redundant security can be defined using the following equation:
1 1
• θ = 1+R ∗ ∑i=5 Q
i=1 X(i) ∗ q(i) = 1+R ∗ E [X]
• E Q [X] = the expectation for X under the risk neutral probability measure.
An examination of the above steps makes clear that the risk neutral probability measure, by design,
incorporates all of the “market risk information”. To conclude the analysis of 1-period models – risk
neutral probabilities can be interpreted as compounded AD security prices or compounded state prices.

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Section 11.0 – Financial Statement Impacts (Banks and Insurers)
11.1 – Background and overview
A given financial institution, either a depository institution like a bank or credit union, or an insurance
firm, is vulnerable to interest rate risk when the interest rate sensitivities on the two sides of the balance
sheet are not equal. There are substantial structural differences between the balance sheets of banks
and insurers (particularly life insurers). Each type of firm is discussed in more detail in the following
sections.

11.2 Bank Financial Statements

Banks, both retail and commercial, are financial intermediaries that source capital from depositors,
investors, and retained earnings and invest that capital into different types of loans to borrowers and
marketable securities.

There are two primary types of risk that impact a bank’s financial results:

• Interest rate risk involves managing the spread between (1) Interest earned on loans and other
invested assets and (2) The interest paid on wholesale and retail sources of funding. This spread is
referred to as the Net Interest Margin (NIM) and is a critical entry on a bank’s income statement.
• Credit Risk is the likelihood that a borrower will default on its loan resulting in the bank losing some
portion of the principal lent to the borrower.

A bank’s liabilities (deposits) typically have a shorter maturity than a bank’s assets (loans and
marketable securities), and so a bank benefits when the yield curve is positively sloped – this will lead
to the bank earning higher yields on assets (longer maturity) than its pays on deposits (shorter maturity).
In addition to the general curvature of the yield curve (upward, downward, flat) impacting a bank’s NIM,
the rate of change of the yield curve’s slope also impacts the NIM.

For example, if the economy is slowing, interest rates decrease across the yield curve. But if short-term
rates decline faster than long-term rates, and the bank maintains a stable stock of asset and liability
balances, then the bank’s NIM will increase on account of receiving higher yields on loans and
marketable securities and paying out lower credited rates on deposits.

Conversely, if the interest rates are declining, but long-term rates are declining faster than short-term
rates, and again if the bank maintains a stable stock of asset and liability balances, then the bank’s
NIM will decline.

Changing interest rates may also have an impact, albeit indirectly, on non-interest income as well. For
example, a bank may pursue the strategy of originating a large volume of mortgages, packaging and
selling these mortgages into the secondary market, and only retaining the Mortgage Servicing Rights
(MSRs). But by selling off the mortgages, the bank eliminates the capital strain that comes with holding
the mortgages on the balance sheet, and the direct interest rate risk to the Net Interest Margin. But it
also becomes vulnerable to the indirect interest rate risk that comes with holding MSRs. An increase in
interest rates could result in a decrease in the volume of newly originated mortgages, and this in turn
would result in a decrease in the MSR fee income.

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Another key determinant in a bank successfully managing interest rate risk is the proportion to total
deposits that core, retail deposits represent. Core deposits are also referred to as non-maturity deposits
on account of not having a fixed, contractually specified maturity date. Because of that, core depositors
could withdraw their funds very quickly in the event of an interest rate shock and create a liquidity
crunch for the bank. To avoid these types of scenarios, it is important to understand and precisely
model the “stickiness” of core deposits, or the propensity of depositors (both retail and wholesale) to
NOT withdraw their funds when interest rates pop. One key parameter used in modeling depositor
behavior is Beta, or the ratio of the change in (1) The product credited rate to (2) The underlying market
interest rate.

11.2.1 - Bank balance sheet

Banks hold a variety of assets on their balance sheets – Exhibit 70 the table below summarizes the
typical assets on a bank’s balance sheet:

Section Asset Type Description

Cash Cash • Due from Fed
• Due from other banks
• Interest-bearing deposits in other banks

Cash Fed Funds Sold • Unsecured loans of reserve balances on deposit with the Fed.

Cash Due From Banks • Deposits with other banks

Current Certificates of • On deposit with other banks

Deposit
Investments Investment • Securities that are classified as Trading, Held to Maturity (HTM), or Available for Sale (AFS)
Securities
Investments Marketable • US Treasury and other US Government securities
Securities • Exchange-listed corporate bonds and equities
• Asset-backed securities

Investments Repurchase • One party sells an interest-bearing security in its inventory for cash (the borrower - REPO) and the other
Agreement party takes possession of the security in exchange for cash (the lender – REVERSE REPO).
(REPO) • REPOS tend to be short-dated transactions (overnight) and the rate charged on the amount lent is called
the repo rate. The repo rate typically tracks the Fed Funds rates.

Loans Loans or • Extensions of credit from lender to borrower. Includes commercial loans, construction loans, mortgages,
receivables consumer loans, home equity loans, personal loans, etc.
• Loan balances are shown net of Allowance for Loan and Lease Losses (ALLL)

Loans Mortgage • Banks that originate and sell primary residential mortgages into the secondary market often retain servicing
Servicing Rights rights – this means that the bank will continue to provide administrative services – collecting principal and
(MSRs) interest payments, remitting tax payments, remitting insurance payments – while not taking direct interest
rate and credit risk on the underlying mortgage.

Other Fixed Assets • Land and buildings

Assets • Equipment
• Motor vehicles

Other Investments • Investments in subsidiaries

Assets
Other Other Assets • Bank-Owned Life Insurance (BOLI)
Assets • Foreclosed property held by bank

Other Intangibles and • Account use to track excess of purchase prices over book value for acquisitions – under US GAAP, banks
Assets Good Will are required to perform goodwill impairment tests.

EXHIBIT 70 – Bank Balance Sheet (Asset side)

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Similarly, Exhibit 71 below summarizes the typical liabilities on a bank’s balance sheet:

Section Liability Type Description

Current Core (Retail) Deposits • All interest-bearing and non-interest-bearing deposits excluding CDs > $100,000. Includes
checking, money market, time and other savings, and time deposits.
• Represents the primary source of funding for a bank and are sourced through the retail branch
network.

Current Brokered (Wholesale) • Funds sourced through deposit products sold to brokers rather than retail deposits sourced
Deposits through branch networks. Includes CDs > $100,000

Current Commercial Paper (CP) • Short-term negotiable promissory notes with maturities ranging from 30 to 270 days.

Current Fed Funds purchased • Short-term unsecured borrowings that typically mature daily.

Current FHLB borrowings • Fully collateralized by loans on the bank’s balance sheet.

Current Dividend Payable • Preferred stock dividend paid in arrears

Long-Term Notes payable

Long-Term Mortgages payable
Long-Term Subordinated debt • Not typically issued by a federal agency, subordinated to depositor’s claims, and has an
original term to maturity of > 5 years.

Long-Term Accrued/Deferred Taxes

Stockholder’s Common Shares • Authorized and outstanding.
Equity
Stockholder’s Preferred Stock • Form of ownership with higher priority on dividends and asset distributions than common
Equity stockholders.

Stockholder’s Retained Earnings

Equity
Stockholder’s Subordinated, perpetual
Equity notes
EXHIBIT 71 – Bank Balance Sheet (Liability Side)

11.2.2 - Bank Income Statements

Exhibit 72 below captures the major categories of income and expenses for a bank. Net Interest
Income is one of the major drivers of a bank’s overall operating income and is highly linked with the
level and direction movement of the yield curve.

Section Category Description

Income Interest income • Generated by the bank’s loan assets – credit cards, consumer loans, mortgage loans,
etc.

Expense Interest • Represents the direct costs of funds and is attributable to credited rates paid on various
Expense forms of retail and wholesale deposit accounts.

Net Interest Income Income • The difference between Interest Income and Interest Expense.

Non-Interest Income Income • Derived from non-interest sources – account fees, transaction fees, mortgage servicing
fees, brokerage fees, etc.

Other Income Income • Dividend from 3rd-party investments; Capital gains/losses; Foreign Exchange;
Commissions; Sale of investments.

Total Income Income • Net Interest Income + Non-Interest Income + Other Income

Non-Interest Expense/Operating Expense • Personnel costs; Branch operating expenses; capital investment projects;
Expenses
Operating Income Income • Total Income less operating expenses before loan loss provisions and taxes.

Non-recurring items Expense • Material one-time events that are unlikely to occur; gain/loss on asset sales.

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 Provision for Loan Losses (ALLL) Expense • Liability account that serves as a reserve against actual and anticipated credit losses on
a bank’s loan portfolio.

Income Taxes Expense • Current taxation on taxable income for the fiscal year.

EXHIBIT 72 – Bank income statement

11.3 Insurer Financial Statements

The composition of an insurer’s balance sheet is dramatically different than banks and credit unions.
Insurers are classified into two buckets – (1) Life, Annuity and Health (LAH) insurers and (2) Property
and Casualty (P&C) insurers. Insurers are not depository institutions, and so do not rely on retail and
wholesale deposits like a bank or credit union for sourcing funds. The “source of funds” for an insurer
comes from the premiums paid on the different types of policies that it sells – life insurance, annuities,
health insurance, homeowners, auto, umbrella, etc. So, the liability profile for insurers, broadly
construed, is much more heterogeneous than for depository institutions. The focus of this section will
be on LAH insurers. The interest rate risk profile of LAH insurers’ liabilities spans the spectrum from
very interest rate sensitive (universal life (UL), interest sensitive whole life, deferred annuities (DA)) to
minimally interest rate sensitive (term life, short-term health, major medical, etc).

One of the main sources of profitability for a life insurer is the spread between (1) The investment return
earned on invested assets (typically bonds and other fixed income assets) and (2) The credited rate
paid on “interest sensitive” liabilities. And unlike depository institutions that typically “borrow short and
lend long,” the assets and liabilities of LAH insurers typically have much longer durations, and both
sides of the balance sheet are more balanced than depository institutions.

Periods of low interest rates can have an adverse impact on insurer’s balance sheets in the form of
spread compression, or a decline in the difference between (1) Average asset earned rates and (2)
Average credited rates. This can particularly be a problem when market rates have sunk below the
minimum guarantees that are found in interest sensitive liability contracts – this can cause LAH insurers
to earn negative spreads. This is not a sustainable condition and would require the LAH insurer to earn
positive spreads on the other “risk components” that make up an LAH insurer’s operational cashflows
– (1) Spreads between insurable risk charges (e.g., mortality and morbidity) and the related costs and
(2) Spreads between expense charges and the actual expenses incurred.

An LAH insurer would benefit from a gradual increase in both the level and slope of the yield curve
(increase in spread between short and long rates) in that maturing long-term assets could be rolled
over into high-yielding long-term assets, and increasing asset earned rates would enable the LAH
insurer to increase the credited rates on interest sensitive liabilities. But if the interest rate increase
were quicker and more dramatic (a “shock”), there could be an adverse impact on a LAH insurer’s
performance – policyholders of interest rate sensitive contracts (UL and DA primarily) could potentially
surrender their contracts in pursuit of higher credited rates offered by competitors. In this instance, the
LAH insurer could find itself liquidating the assets backing these surrendered policies at a loss (due to
the increased interest rates). Typically, UL and DA policies have a feature known as surrender charges
if a policyholder surrenders their policy for a certain period after issue (known as the surrender period),
then the LAH insurer will assess a charge against the funds paid to the surrendering policyholder to
mitigate this interest rate risk. But surrender charges, by themselves, will seldom completely offset the
capital loss described above if the interest rate shock is unusually large.
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Section 12.0 – Nationally Recognized Statistical Rating Agencies
(NRSROs)
12.1 – Background and overview
A key element in determining the credit spread for a given “risky” bond is the credit rating assigned to
that issuer by each of the three main Credit Rating Agencies (CRAs) – Standards & Poor’s (S&P), Fitch,
and Moody’s. These 3 agencies and 7 others globally come under the classification Nationally
Recognized Statistical Rating Agency (NRSRO). The label NRSRO is assigned by the US Securities
and Exchange Commission (SEC) through an application process that is codified in law in the Credit
Rating Agency Reform Act of 2006 (“Rating Agency Act”). Applications are made on Form NRSRO to
the Office of Credit Ratings (OCR). The OCR was mandated by the Dodd Frank Wall Street Reform
and Consumer Protection Act (“Dodd Frank Act”) and was established in June 2012.

An NRSRO is defined to be a credit rating agency that issues credit ratings with respect to certain types
of individual issues and issuers that are “certified by qualified institutional buyers.” The specific types
of issues/issuers are defined in the Securities and Exchange Act of 1934 Section 15E (a) (1) (B) (ix)
and include:

• Financial institutions, brokers, and dealers; and

• Insurance companies; and
• Corporate issuers; and
• Issuers of asset-backed securities; and
• Issuers of government securities, municipal securities, or securities issued by a foreign government;
and
• A combination of one or more categories of obligors that could be bucketed into 1 of the 5 categories
above.

There are 10 NRSROs currently registered with the SEC – summarized in Exhibit 73:

NRSRO Categories of ratings Where located? Website

AM Best Rating Services (ii), (iii), and (iv) Oldwick, NJ www.ambest.com
DBRS, Inc (i) through (v) Chicago, Il www.dbrs.com
Egan Jones Ratings Company (i) through (iii) Haverford, PA www.egan-jones.com
Fitch Ratings (i) through (v) New York, NY www.fitchratings.com
HR Ratings de Mexico SA de CV (i), (iii), and (v) Mexico City www.hrratings.com
Japan Credit Rating Agency, Ltd. (i), (ii), (iii), and (v) Tokyo www.jcr.co.jp
Kroll Bond Rating Agency, Inc. (i) through (v) New York, NY www.krollbondratings.com
Moody’s Investors Service, Inc. (i) through (v) New York, NY www.moodys.com
Morningstar Credit Ratings, LLC. (i), (iii), and (iv) New York, NY ratingagency.morningstar.com
S&P Global Ratings (i) through (v) New York, NY www.spratings.com
Exhibit 73 – Top 10 NRSROs

Additional background is provided below regarding the ratings methodologies for Standard & Poor’s
below.

12.2 Standard and Poor’s

S&P issues two types of credit ratings – general-purpose and special-purpose.

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12.2.1 – General purpose
General-purpose ratings are referred to as “traditional” credit ratings and cover the broadest set of
credit risk factors and are not limited in scope. They cover ratings for both individual issues and issuers.
Since the focus of this brief is on the interest rate risk of individual fixed income investments, the
discussion is limited to S&P’s ratings on individual issues.

Issuer credit rating is a forward-looking assessment of the creditworthiness of a particular issuer with
respect to a specific financial obligation, a specific class of financial obligations, or a specific financial
program. The rating accounts for the issuer’s financial capacity and willingness to meet its commitments
as they come due, and accounts for the financial wherewithal of any firms that are providing credit
enhancement to the underlying issue. Issue credit ratings are either short-term or long-term. Long-term
ratings are based on the following factors:

• The likelihood of payment and

• The provisions of the legal contract underpinning the issue; and
• The relative position of the obligation in the event of the issuer’s bankruptcy or reorganization.

Issue ratings are an assessment of the default risk for a particular issue, and as such take account of
the relative seniority of the obligation.

12.2.2 – Special Purpose

Special purpose ratings can cover either individual capital market transactions or specific entities.
Exhibit 74 below captures the different types of special purpose ratings:

Rating type Description

Dual Ratings • Assigned to debt issues that have a put option or demand feature.
• The first component addresses the likelihood of repayment, and the second component
addresses the demand feature.

Fund Credit Quality Ratings • Forward-looking view of the overall credit quality of a fixed-income investment fund.

Fund Volatility Ratings • Forward-looking view of a fixed-income fund’s volatility of returns relative to reference index that
is composed of government securities in the fund’s base currency.

Insurance Financial • Forward-looking assessment of the creditworthiness of an insurer that underwrites policies that
Enhancement Ratings are used as credit enhancement or financial guarantees.

Insurer Financial Strength • Forward-looking assessment of an insurer’s ability to meet its future obligations under the terms
Ratings and conditions of the policies and contracts that are currently active and on the books.

Municipal Short-Term Note • Assessment of the liquidity factors and market access risks unique to the notes.
Ratings
Principal Stability Fund • Also known as a money market rating. Forward-looking assessment of a fixed-income fund’s
Ratings capacity to maintain stable principal and to limit exposure to principal losses to credit risk.

Mid-Market Evaluation • Forward-looking assessment of the creditworthiness of a mid-market company relative to other
Ratings mid-market companies.

Recovery Ratings • Focus solely on expected recovery in the event of a payment default of a specific issue.

S&P Underlying Rating • Assessment about the stand-alone capacity of an issuer to meet its obligations on a credit-
enhanced debt issue without taking account of the form and effect of the credit enhancement.

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 Swap Risk Ratings • Forward-looking assessment of the likelihood of loss associated with a specific swap transaction
entered by two counterparties.

Counterparty Instrument • Forward-looking assessment of the creditworthiness of an issuer of a securitization structure with
Ratings respect to a specific financial obligation.

Exhibit 74 – Different types of ratings offered by S&P

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Appendix A – Terms of Reference
Term Definition Source
Accrued Interest • The amount of interested earned to-date but not yet paid on a bond. Miscellaneous
• A use case that would require the calculation of the accrued interest is when a coupon-bearing
bond is being bought/sold in between coupon payment dates.
• The bond buyer must compensate the bond seller for the interest that has accrued from the last
coupon payment date to the sale date.

Basel III • The third Basel Accord, a framework that sets international standards for bank capital adequacy, Wikipedia
stress testing, and liquidity requirements.
• Augmenting and superseding parts of the Basel II standards, it was developed in response to the
deficiencies in financial regulation revealed by the financial crisis of 2007–08. It is intended to
strengthen bank capital requirements by increasing minimum capital requirements, holdings of
high-quality liquid assets, and decreasing bank leverage.
• Basel III was published by the Basel Committee on Banking Supervision in November 2010 and
was scheduled to be introduced from 2013 until 2015; however, implementation was extended
repeatedly to 1 January 2022 and then again until 1 January 2023, in the wake of the COVID-19
pandemic.

Benchmark • Includes all stages and processes involved in the production and dissemination of a Benchmark, IOSCO
Administration including:
• Collecting, analyzing and/or processing information or expressions of opinion for the
purposes of the determination of a Benchmark; and
• Determining a Benchmark through the application of a formula or another method of
calculating the information or expressions of opinions provided for that purpose; and
• Dissemination to users, including any review, adjustment, and modification to this process.

Benchmark • An organization or legal person that controls the creation and operation of the Benchmark IOSCO
Administrator Administration process, whether it owns the intellectual property relating to the Benchmark. It has
responsibility for all stages of the Benchmark Administration process, including:
• The calculation of the Benchmark; and
• Determining and applying the Benchmark Methodology; and
• Disseminating the Benchmark.

British Bankers • Also known as BBA. A trade association that represents the views of those involved in the Investopedia
Association banking and financial services industry within the U.K.
• The BBA includes 200 member banks with headquarters in over 50 countries and operations in
180 jurisdictions throughout the world. Eighty percent of global systemically important banks are
members of the BBA.

Depository Trust • US-based corporation that acts as a centralized clearing and settlement company for different Corporate Finance
Clearing Corporation asset classes. It provides its market participants with a range of settlement services to facilitate Institute
(DTCC) obligations emanating from their trading activities in various investment markets.
• Other than the post-settlement services, the DTCC provides custody to securities and tax-related
services to its members. The corporation was established in 1999 with the combined roles of the
National Securities Clearing Corporation (NSCC) and the Depository Trust Company (DTC).
• Both the NSCC and DTC are subsidiaries of the DTCC and are tasked with clearing trades to
facilitate transactions and providing depository services to members, respectively.
• Principal users are the owners of the DTCC, implying that they are the dealer-brokers of
transactions in the financial markets.

Designated Contract • Exchanges that may list for trading futures or option contracts based on all types of commodities CFTC site
Markets (DCM) and that may allow access to their facilities by all types of traders, including retail customers.
• Some DCMs have been operating for many years as traditional futures exchanges, while others
are new markets that were only recently designated as contract markets by the CFTC.

Eurodollar futures • Eurodollar futures are interest-rate-based financial futures contracts specific to the Eurodollar, Charles Schwab
which is simply a U.S. dollar on deposit in commercial banks outside of the United States.
• CME interest rate futures contracts are traded using a price index, which is derived by subtracting
the futures' interest rate from 100.00. For instance, an interest rate of 5.00 percent translates to
an index price of 95.00 (100.00-5.00 = 95.00). Given this price index construction, if interest rates
rise, the price of the contract falls and vice versa.

Fallback terms • Contractual provisions that provide an alternative settlement mechanism for financial transactions Federal Home
(e.g., LIBOR-based cash products such as adjustable-rate notes, floating rate notes, etc) if the Loan Bank
relevant LIBOR index is no longer available.
• At a minimum, fallback provisions should address the following considerations:
• Define triggering events; and
• Identify a replacement index; and

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 • Define the spread adjustment between LIBOR and the replacement index to account for the
differences between these two benchmarks

Federal Funds Rate • The interest rate at which depository institutions (banks and credit unions) lend reserve balances Wikipedia
(FFR) to other depository institutions overnight on an uncollateralized basis. Reserve balances are
amounts held at the Federal Reserve to maintain depository institutions' reserve requirements.
Institutions with surplus balances in their accounts lend those balances to institutions in need of
larger balances. The federal funds rate is an important benchmark in financial markets.
• The effective federal funds rate (EFFR) is calculated as the effective median interest rate of
overnight federal funds transactions during the previous business day. It is published daily by the
Federal Reserve Bank of New York.
• The federal funds target range is determined by a meeting of the members of the Federal Open
Market Committee (FOMC) which normally occurs eight times a year about seven weeks apart.
The committee may also hold additional meetings and implement target rate changes outside of
its normal schedule.

Federal Open • Consists of twelve members--the seven members of the Board of Governors of the Federal Federal Reserve
Market Committee Reserve System; the president of the Federal Reserve Bank of New York; and four of the site
(FOMC) remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.
• The rotating seats are filled from the following four groups of Banks, one Bank president from
each group: Boston, Philadelphia, and Richmond; Cleveland and Chicago; Atlanta, St. Louis, and
Dallas; and Minneapolis, Kansas City, and San Francisco.
• Non-voting Reserve Bank presidents attend the meetings of the Committee, participate in the
discussions, and contribute to the Committee's assessment of the economy and policy options.
• The FOMC holds eight regularly scheduled meetings per year. At these meetings, the Committee
reviews economic and financial conditions, determines the appropriate stance of monetary policy,
and assesses the risks to its long-run goals of price stability and sustainable economic growth.

Financial Conduct • The FCA regulates the conduct of 50,000 firms in the United Kingdom to ensure that the UK Financial Conduct
Authority financial markets are honest, competitive, and fair. This mandate is accomplished by focusing on Authority
the following key objectives:
• Protecting consumers – The FCA protects consumers from the harm caused by bad conduct
in financial services; and
• Enhancing Market Integrity – The FCA aims to support a healthy and successful financial
system; and
• Promoting Competition – The FCA promotes effective competition in the interests of
consumers and take action to address concerns.

Interbank Loan • A loan that one bank makes to another. Interbank loans may be made to ensure that banks meet Financial-
their capital requirements at the end of each day. Dictionary.com
• Interbank loans involving a central bank may be a way to control the money supply. Interbank
loans must be repaid with interest in a stated period, often within a day. In such cases, interbank
loans are called overnight loans.

Interest Rate Swaps • An interest rate swap is a forward contract in which one stream of future interest payments is Investopedia
exchanged for another based on a specified principal amount.
• Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice
versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower
interest rate than would have been possible without the swap.
• The principal upon which the interest payments are based is known as the “Notional Amount” and
is not exchanged between the two counterparties to the swap.
• Settlement dates are the dates on which fixed or variable interest rate payments are made. The
settlement dates for the variable rate and the fixed rate can be different but are often the same.
• The notional amount can exhibit 1 of the 3 patterns during the swap term:
• Level – Remains at the initial level and does not change.
• Accreting – Increases above the initial level.
• Amortizing – Decreases below the initial level.
• The swap rate is determined at inception (time 0) such that the present value to each counterparty
to the swap is $0, or a swap is a “zero cost to enter” derivative.

International • The international body that brings together the world's securities regulators and is recognized as IOSCO.org
Organization of the global standard setter for the securities sector. IOSCO develops, implements, and promotes
Securities adherence to internationally recognized standards for securities regulation.
Commissions • It works intensively with the G20 and the Financial Stability Board (FSB) on the global regulatory
(IOSCO) reform agenda.

International • Interest Rate products that have an original maturity of less than 366 days, trade in what is Chicago
Monetary Market commonly referred to as the “Money Market”. The IMM index is the pricing convention and the IMM Mercantile
(IMM) date is the date of expiration for these products. Exchange (CME)
• There are several features that distinguish money market products from longer dated interest rate
products like notes and bonds.
• Bonds and notes pay a periodic interest to their holders, these are known as coupon payments. For
example, a U.S. Treasury ten-year note with a coupon of three percent (3%) will pay semi-annually

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 roughly half of its coupon, about one and a half percent (1.50%), of the principal amount to the
holder.
• Money market instruments, like T-bills, CDs, commercial paper do not make periodic payments,
and they trade in yield terms.
• IMM dates refer to when quarterly Eurodollar, FX, and MAC Swap futures contracts at CME Group
expire.
• These contracts stop trading the Monday preceding the third Wednesday of a March quarterly cycle.
This means the third Wednesday of March, June, September, and December.

International Swaps • A private trade organization whose members, banks, transact in the Over the Counter (OTC) Investopedia
Dealer Association derivatives market. This association helps to improve the market for privately negotiated (OTC)
(ISDA) derivatives by identifying and reducing risks in that market.
• For three decades, the industry has used the ISDA master agreement as a template for entering
into a contractual obligation for derivatives, creating a basic structure and standardization where
there were only bespoke transactions before.

IOSCO Principles • In July 2013, IOSCO published its Final Report, Principles for Financial Benchmarks (Final Report), IOSCO.org
for Financial which sets out Principles that are intended to create an overarching framework of standards for
Benchmarks Benchmarks used in financial markets.
• Specifically, the IOSCO Board sought to articulate policy guidance that addresses conflicts of
interest in Benchmark-setting processes, as well as transparency and openness when considering
issues related to Benchmark transition.
• The Principles were endorsed by the Financial Stability Board (FSB) as global standards for
Administrators to ensure the integrity of Benchmarks through transparent, effective methodologies
and robust systems of governance and accountability.
• The Principles were also endorsed by the G20 Leaders at the St Petersburg Summit in September
2013.

LIBOR • Also known as the London Interbank Offer Rate. IG Group

• A benchmark that dictates daily interest rates on loans and financial instruments around the world.
• To calculate LIBOR, the Intercontinental Exchange (ICE) asks banks around the world to provide
the rates at which they would offer a short-term loan to each other. It then averages each response
to give the daily LIBOR figure.
• Financial companies around the world then use the LIBOR figure to calculate their own interest
rates on loans, mortgages, credit cards and financial derivative prices.

National Authority • Refers to a relevant governmental authority such as a central bank, which might not be a Market or IOSCO
Regulatory Authority, but which has responsibility for or a governmental interest in Benchmark
policies.

Primary Market • The market where newly issued bonds are sold, either to institutional investors through an Miscellaneous
underwriter (if a corporate bond), or directly to retail customers (Treasury securities).

Reference Rate • A benchmark interest rate that is used, either directly or with modifications – for calculating a Miscellaneous
transactional interest, or the rate actually used to price actual transactions – consumer loans, credit
cards, derivative transactions, bond coupon rates, etc.

Repurchase • A repurchase agreement (repo) is a form of short-term borrowing for dealers in government Investopedia
Agreement (REPO) securities. In the case of a repo, a dealer sells government securities to investors, usually on an
overnight basis, and buys them back the following day at a slightly higher price. That small
difference in price is the implicit overnight interest rate. Repos are typically used to raise short-term
capital. They are also a common tool of central bank open market operations.
• For the party selling the security and agreeing to repurchase it in the future, it is a repo; for the party
on the other end of the transaction, buying the security and agreeing to sell in the future, it is a
reverse repurchase agreement.
• Specific to the US Treasury repo market, people and financial institutions borrow money using
Treasury debt as collateral.

Secondary Market • The market where existing, or on-the-run bonds, are traded after issue. Miscellaneous
• This market operates on an Over the Counter (OTC) basis, and investors, both retail and
institutional, can participate in this market by placing buy or sell orders with a broker.

Swap Rate • The fixed interest rate that is paid on a fixed-for-floating Interest Rate Swap. Miscellaneous
• The swap rate will be determined at the inception of the swap and does not change during the term
of the swap.
• The counterparty to the IRS that pays the swap rate is known as the “swap-rate payer.” Similarly,
the counterparty to the IRS that receives the swap rate is known as the “swap-rate receiver.”

Tri-party Treasury • A measure of rates on overnight, specific-counterparty tri-party general collateral repurchase Federal Reserve
general collateral agreement (repo) transactions secured by Treasury securities. Bank of New York
Rate (TGCR) • General collateral repo transactions are those for which the specific securities provided as collateral
are not identified until after other terms of the trade are agreed.

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 • The TGCR is calculated as a volume-weighted median of transaction-level tri-party repo data
collected from the Bank of New York Mellon. Each business day, the New York Fed publishes the
TGCR on the New York Fed website at approximately 8:00 a.m. ET.

Yield-to-Call (YTC) • This value is calculated in the same way as the YTM, but instead of using the bond’s maturity date, Miscellaneous
the present value calculation uses the bond’s call date.
• A callable bond is a bond that provides the issuer with the “option” to repay the face amount of the
bond to the investor before maturity given certain interest rate conditions.
• The YTC on a given bond is a function of the coupon rate, asset class, time to call, and market price
of the underlying bond.

Yield-to-Maturity • This value represents the return that an investor will realize if they purchase and hold a bond to Miscellaneous
(YTM) maturity. The YTM on a given bond is a function of the coupon rate, asset class, time to maturity,
and market price of the underlying bond.

Yield-to-Worst • This lesser of the YTM or YTC on a callable bond. Miscellaneous

(YTW) • The YTW represents the lowest yield that the investor can realize if the bond does not default.

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Appendix B – IOSCO Best Practice Principles
Primary Sub- Description
principle principle
Governance Overall • The Administrator should retain primary responsibility for all aspects of the Benchmark determination
Responsibility of process. For example, this includes:
the Administrator
• Development: The definition of the Benchmark and Benchmark Methodology.
• Determination and Dissemination: Accurate and timely compilation, publication, and distribution
of the Benchmark.
• Operation: Ensuring appropriate transparency over significant decisions affecting the compilation
of the Benchmark and any related determination process, including contingency measures in the
event of absence of or insufficient inputs, market stress or disruption, failure of critical
infrastructure, or other relevant factors; and
• Governance: Establishing credible and transparent governance, oversight, and accountability
procedures for the Benchmark determination process, including an identifiable oversight function
accountable for the development, issuance, and operation of the Benchmark.

Governance Oversight of Third • Where activities relating to the Benchmark determination process are undertaken by third parties - for
Parties example collection of inputs, publication or where a third-party acts as Calculation Agent - the
Administrator should maintain appropriate oversight of such third parties. The Administrator (and its
oversight function) should consider adopting policies and procedures that:

• Clearly define and substantiate through appropriate written arrangements the roles and
obligations of third parties who participate in the Benchmark determination process, as well as the
standards the Administrator expects these third parties to comply with.
• Monitor third parties’ compliance with the standards set out by the Administrator.
• Make Available to Stakeholders and any relevant Regulatory Authority the identity and roles of
third parties who participate in the Benchmark determination process; and
• Take reasonable steps, including contingency plans, to avoid undue operational risk related to the
participation of third parties in the Benchmark determination process.

Governance Conflicts of Interest • To protect the integrity and independence of Benchmark determinations, Administrators should
for Administrators document, implement, and enforce policies and procedures for the identification, disclosure,
management, mitigation, or avoidance of conflicts of interest.
• Administrators should review and update their policies and procedures as appropriate.
• Administrators should disclose any material conflicts of interest to their users and any relevant
Regulatory Authority, if any.

Governance Control Framework • An Administrator should implement an appropriate control framework for the process of determining
for Administrators and distributing the Benchmark.
• The control framework should be appropriately tailored to the materiality of the potential or existing
conflicts of interest identified, the extent of the use of discretion in the Benchmark setting process and
to the nature of Benchmark inputs and outputs.
• The control framework should be documented and available to relevant Regulatory Authorities, if any.
• A summary of its main features should be published or made Available to Stakeholders.

Governance Internal Oversight • Administrators should establish an oversight function to review and provide challenge on all aspects of
the Benchmark determination process. This should include consideration of the features and intended,
expected, or known usage of the Benchmark and the materiality of existing or potential conflicts of
interest identified.
• The oversight function should be conducted either by a separate committee, or other appropriate
governance arrangements.
• The oversight function and its composition should be appropriate to provide effective scrutiny of the
Administrator. Such oversight function could consider groups of Benchmarks by type or asset class, if
it otherwise complies with this Principle.

Quality of the Benchmark Design • The design of the Benchmark should seek to achieve, and result in an accurate and reliable
Benchmark representation of the economic realities of the Interest it seeks to measure and eliminate factors that
might result in a distortion of the price, rate, index, or value of the Benchmark.
• Benchmark design should consider the following generic non-exclusive features, and other factors
should be considered, as appropriate to the Interest:
• Adequacy of the sample used to represent the Interest.
• Size and liquidity of the relevant market (for example whether there is sufficient trading to provide
observable, transparent pricing).
• Relative size of the underlying market in relation to the volume of trading in the market that
references the Benchmark.
• The distribution of trading among Market Participants (market concentration).
• Market dynamics (e.g., to ensure that the Benchmark reflects changes to the assets underpinning
a Benchmark).

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Quality of the Data Sufficiency • The data used to construct a Benchmark determination should be sufficient to accurately and reliably
Benchmark represent the Interest measured by the Benchmark and should:
• Be based on prices, rates, indices, or values that have been formed by the competitive forces of
supply and demand to provide confidence that the price discovery system is reliable; and
• Be anchored by observable transactions entered at arm’s length between buyers and sellers in
the market for the Interest the Benchmark measures for it to function as a credible indicator of
prices, rates, indices, or values.

Quality of the Hierarchy of Data • An Administrator should establish and publish or make available clear guidelines regarding the
Benchmark Inputs hierarchy of data inputs and exercise of expert judgment used for the determination of Benchmarks. In
general, the hierarchy of data inputs should include:
• Where a Benchmark is dependent upon Submissions, the Submitters’ own concluded arms-length
transactions in the underlying interest or related markets.
• Reported or observed concluded arm’s-length transactions in the underlying interest.
• Reported or observed concluded arm’s-length transactions in related markets.
• Firm (executable) bids and offers; and
• Other market information or expert judgments.

Quality of the Transparency of • The Administrator should describe and publish with each Benchmark determination, to the extent
Benchmark Benchmark reasonable without delaying an Administrator publication deadline:
Determinations • A concise explanation, sufficient to facilitate a Stakeholder’s or Market Authority’s ability to
understand how the determination was developed, including, at a minimum, the size and liquidity
of the market being assessed (meaning the number and volume of transactions submitted), the
range and average volume and range and average of price, and indicative percentages of each
type of market data that have been considered in a Benchmark determination; terms referring to
the pricing Methodology should be included (i.e., transaction-based, spread-based or
interpolated/extrapolated);
• A concise explanation of the extent to which and the basis upon which expert judgment if any,
was used in establishing a Benchmark determination.

Quality of the Periodic Review • The Administrator should periodically review the conditions in the underlying Interest that the
Benchmark Benchmark measures to determine whether the Interest has undergone structural changes that might
require changes to the design of the Methodology.
• The Administrator also should periodically review whether the Interest has diminished or is non-
functioning such that it can no longer function as the basis for a credible Benchmark.

Quality of the Content of the • The Administrator should document and publish or make Available the Methodology used to make
Methodology Methodology Benchmark determinations.
• The Administrator should provide the rationale for adopting a particular Methodology. The Published
Methodology should provide sufficient detail to allow Stakeholders to understand how the Benchmark
is derived and to assess its representativeness, its relevance to Stakeholders, and its appropriateness
as a reference for financial instruments.

Quality of the Changes to the • An Administrator should publish or make available the rationale of any proposed material change in its
Methodology Methodology Methodology, and procedures for making such changes. These procedures should clearly define what
constitutes a material change, and the method and timing for consulting or notifying Subscribers (and
other Stakeholders where appropriate, considering the breadth and depth of the Benchmark’s use) of
changes.
• Those procedures should be consistent with the overriding objective that an Administrator must ensure
the continued integrity of its Benchmark determinations. When changes are proposed, the
Administrator should specify exactly what these changes entail and when they are intended to apply.
• The Administrator should specify how changes to the Methodology will be scrutinized, by the oversight
function.

Quality of the Transition • Administrators should have clear written policies and procedures, to address the need for cessation of
Methodology a Benchmark, due to market structure change, product definition change, or any other condition which
makes the Benchmark no longer representative of its intended Interest.
• These policies and procedures should be proportionate to the estimated breadth and depth of contracts
and financial instruments that reference a Benchmark and the economic and financial stability impact
that might result from the cessation of the Benchmark.
• The Administrator should consider the views of Stakeholders and any relevant Regulatory and National
Authorities in determining what policies and procedures are appropriate for a particular Benchmark.
• These written policies and procedures should be Published or Made Available to all Stakeholders.

Quality of the Submitter Code of • The Administrator should develop guidelines for Submitters (“Submitter Code of Conduct”), which
Methodology Conduct should be available to any relevant Regulatory Authorities, if any and published or Made Available to
Stakeholders.
• The Administrator should only use inputs or Submissions from entities which adhere to the Submitter
Code of Conduct and the Administrator should appropriately monitor and record adherence from
Submitters.
• The Administrator should require Submitters to confirm adherence to the Submitter Code of Conduct
annually and whenever a change to the Submitter Code of Conduct has occurred.

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Quality of the Internal Controls • When an Administrator collects data from any external source the Administrator should ensure that
Methodology over Data there are appropriate internal controls over its data collection and transmission processes.
Collection • These controls should address the process for selecting the source, collecting the data, and protecting
the integrity and confidentiality of the data.
• Where Administrators receive data from employees of the Front Office Function, the Administrator
should seek corroborating data from other sources.

Accountability Complaints • The Administrator should establish and publish or make available a written complaints procedures
Procedures policy, by which Stakeholders may submit complaints including concerning whether a specific
Benchmark determination is representative of the underlying Interest it seeks to measure, applications
of the Methodology in relation to a specific Benchmark determination(s), and other Administrator
decisions in relation to a Benchmark determination.

Accountability Audits • The Administrator should appoint an independent internal or external auditor with appropriate
experience and capability to periodically review and report on the Administrator’s adherence to its
stated criteria and with the Principles. The frequency of audits should be proportionate to the size and
complexity of the Administrator’s operations.
• Where appropriate to the level of existing or potential conflicts of interest identified by the Administrator
(except for Benchmarks that are otherwise regulated or supervised by a National Authority other than
a relevant Regulatory Authority), an Administrator should appoint an independent external auditor with
appropriate experience and capability to periodically review and report on the Administrator’s
adherence to its stated Methodology.
• The frequency of audits should be proportionate to the size and complexity of the Administrator’s
Benchmark operations and the breadth and depth of Benchmark use by Stakeholders.

Accountability Audit Trail • Written records should be retained by the Administrator for five years, subject to applicable national
legal or regulatory requirements on:
• All market data, Submissions and any other data and information sources relied upon for
Benchmark determination.
• The exercise of Expert Judgment made by the Administrator in reaching a Benchmark
determination.
• Other changes in or deviations from standard procedures and Methodologies, including those
made during periods of market stress or disruption.
• The identity of each person involved in producing a Benchmark determination; and
• Any queries and responses relating to data inputs.

Accountability Cooperation with • Relevant documents, Audit Trails, and other documents subject to these Principles shall be made
Regulatory readily available by the relevant parties to the relevant Regulatory Authorities in conducting their
Authorities regulatory or supervisory duties and handed over promptly upon request.

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