Capital Markets Examiner School, Providence, RI

Option Risk - Deposits

 The third place you commonly find option risk is in the bank's core deposit portfolio.

 The rates on these deposits are administered by bank management. Management will reprice these deposits differently when rates rise vs. when rates fall.

 The timing and amount of repricing changes depends on market rate changes. (This may also apply to the bank's CD rates).

Option Risk – FHLB Advances

 Finally, the last place you commonly see option risk is in the bank's FHLB advances.

 The FHLB offers a wide range of "convertible" advances these days. When rates fall, the bank is stuck with a longer-term fixed rate instrument.

 When rates rise, the FHLB decides to convert the debt to a variable rate. Exactly the opposite behavior of the callable security. The cash flow timing changes as rates change.