Managing interest rate risk : a comparison of the effectiveness of forecasting and volatility models

Thesis (M.Sc. (Information Technology))--North-West University, Vaal Triangle Campus, 2006.lnterest rate risk is one of the most important types of risk to which banks are inherently exposed. lnterest rates determine a bank's profitability and have an effect on a bank's liquidity and investment portfolio. It is, therefore, extremely important to be able to predict interest rates accurately and manage interest rate risk effectively. In trying to manage interest rate risk, banks rely on Asset and Liability Committees (ALCOs). They also make use of several strategies, which are described (Gap, Earnings Sensitivity Analysis, Duration Gap and Market Value of Equity sensitivity analysis). The first step for these strategies, on which later steps depend, is to make interest rate forecasts. Forecasting plays such a crucial role because many significant decisions depend on the anticipated future values of specific variables. Forecasts may be produced in various different ways. The method chosen depends on the reason for and the importance of the forecasts as well as on the costs of alternative forecasting methods. In an attempt to manage interest rate risk by being able to predict the next rates correctly, several different models are used to try and predict interest rates for two data sets, namely: BA (Bankers' Acceptances, which is money market data) and Esc (Eskom, which is capital market data). They each have their place in the South African financial system, which is described in general. The chosen simple forecasting models that are used are: naive, moving average and exponential smoothing models. The aim is to try to predict the direction of the next interest rate (UP, CONSTANT, or DOWN) while supplying a point prediction of the next rate (one-step ahead). The "best" simple forecasting models are determined by specific set criteria (percentage of correct direction predictions, mean squared error and tracking signals). For the same time series, more advanced models are taken into account where the aim is to try to find an interval wherein the future interest rates (not only in the short-term but in the longer-term as well) are most likely to lie, using models based on the data, as well as first differences. For the long-term forecasts, two types of more advanced models are used, namely: Box-Jenkins models (where, specifically, nonseasonal second-order autoregressive or AR(2) models are examined); and volatility models that are found using a new technique that creates an interval by using different volatility estimates. The word 'volatility' used throughout the study refers to models with a fixed volatility function and not dynamic volatility as in models such as the ARCH and GARCH types. In this study, the range from simple to more complex time series models with constant volatility are considered. The former, simple models and AR(2) models are referred to as forecasting models, the latter more advanced models are referred to as volatility estimates. Short- and long-term predictions are, thus, made for each time series, at different specifically chosen points. A comparison of the effectiveness of the forecasting and volatility models is made.Master