The Puzzler
The interest rate risk margin calculation is quantifying the margin for a "shock". Up or down- this is why we take the absolute value I believe.
Duration of an asset or liability provides an approximate % change in the asset or liability.
We we take this duration* Value of that asset or liability * the interest rate change you are testing (for OSFI, we use 1.25%). Fun fact, this is just the dollar duration formula:
Dollar duration =duration * Fair value *interest rate change
So when the puzzler asks why we would add a margin when the assets increases more than the liabilities, is it because the dollar duration could represent an increase or decrease? I believe this is why we take the absolute value however maybe I am interpreting it incorrectly?
So in the example given the information below is working under the assumption that interest rates increase by 1.25%,
A = 5.0
B = 90 x 1.25% x 3.0 = 3.375
So,
F = | A – B | = | 5.0 – 3.375 | = 1.625
Assets increase more than liabilities.
But if interest rates decrease, then Assets would go down more than liabilities would go down which we would want to add more capital for.
Comments
Hi @arbruder,
Thanks for posting. I think what you're saying may be similar to what @bulubala said in his post here:
His idea was that taking the absolute value makes sense if interest rates go down, which is I think what you're saying too. Maybe it's just as a simple as that. Taking the absolute value works whether the interest rate goes up or down. It may sometimes overestimate the margin (as when assets go up more than liabilities) but it will always provide a baseline margin for all cases.
I will link to your post from the wiki. Thx!