Capital Markets Examiner School, Providence, RI

Option Risk – Securities Portfolio

 The first place is in the securities portfolio.

 Many US Agency bonds (and Muni's too) have call options.

 When rates fall they are likely to call creating an overall lower return for the portfolio.

 When rates rise the portfolio acts more like a fixed-rate bond portfolio and there is less positive change income.

Option Risk – Loan Portfolio

 The second place you commonly find option risk is in the bank's loan portfolio...prepayment risk.

 Prepayments cause a change in interest income that is similar to call options.

 When rates fall prepayments tend to increase making the bank look more "asset sensitive".

 When rates rise, prepayments tend to slow down making the bank look more "liability sensitive".