How does yield curve risk differ from parallel rate risk in ALM?

Question

AcadiFi · Accepted Answer

Yield curve risk arises from non-parallel shifts: steepener, flattener, short-rate up, short-rate down, and humped changes. Duration captures only the parallel component; curve risk shows up in the residual between full-revaluation EVE and duration-implied EVE. A flattener — short rates rise, long rates fall or stay flat — typically hurts banks that fund long assets with short liabilities because funding costs jump while long-duration asset yields do not rise. Example: bank holds $1B of 10-year mortgages at 4% funded by $1B of 3-month deposits. A 100 bp flattener where short rates jump 150 bp and long rates fall 50 bp raises deposit cost by 150 bp immediately but raises the mark-to-market of mortgages (long rates fell), so EVE actually improves if you only look at assets. However NII is crushed: deposit cost jumped, asset yield is locked. This illustrates the EVE/NII tension. A steepener benefits NII (wider net interest margin on new origination) but can hurt EVE of floater-heavy banks. Modeling yield curve risk requires multi-factor term structure models like principal component analysis: level, slope, curvature components typically explain over 95% of yield curve variance, so basing scenarios on shocks to these factors is more realistic than parallel-only. Basel standardized scenarios include steepener and flattener specifically to capture this.

How does yield curve risk differ from parallel rate risk in ALM?

Master Part II with our FRM Course

Related Questions

Practice Questions