Abstract:
Banks and financial institutions record core banking activities (taking deposits and making
loans) on the balance sheet of the banking book, but trading book (trading and investment) pursuits
are recorded off-balance-sheet. Both books are subject to considerable risk from numerous
sources, but regulatory capital reserves - to shield from unexpected market moves - are not required
for the banking book as they are for the trading book. Both of these substantial shortcomings
will be addressed in the near future. The 2005 initiation of new global accounting standards
will ensure that trading book derivative fair values are recorded and reported on the balance
sheet while the new Basel accord, due for full implementation in 2007, will regulate the calculation
and reservation of capital required for the banking book. These changes are expected to better
regulate and manage the transparency of financial institutions' activities and so prevent large
scale economic disasters or deliberate corporate fraud. Institutions not compliant with the new
rules will face severe financial losses, regulatory fines and possible debilitating legal action.
One of the most commonly-used tools for measuring and managing interest rate risk, the
Macaulay duration, has enjoyed almost unchallenged success, but it employs severely restrictive
and unrealistic assumptions which constrain its usefulness and reliability in the rapidly-changing
world of defaultable securities, those with embedded derivatives and instruments with perpetual
maturities. Robust measures which more accurately approximate interest rate risk by relaxing
unrealistic assumptions are required.
Applications which significantly improve the accuracy of the Macaulay duration are considered
as well as a new look at the duration problem in general. The influence of a more accurate duration
measure on duration gap provides a significantly improved economic Market Value of Equity.
The role of this enhanced measure is crucial for risk management as well as regulatory and
accounting compliance.
