Modelling NMDs - A Review

Abstract

In this article we are going to review the modelling of NMDs via replicating portfolios due to the revived interest in NMDs in the context of the interest rate risk of the banking book (IRRBB). The main goal is to provide a self contained presentation of the replicating portfolio approach from scratch. It intends to clarify the underlying assumptions and the methodology of the replicating portfolio approach, i.e. it derives the theory from simple basic principles while collecting all relevant information in one place. Because using this model is a major methodological decision we will pay particular attention to the challenges this modelling approach is exposed to in a low interest environment, which is characterised by a pronounced regime switch with respect to the interest rates of the eligible investment products.