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According to the BCBS framework, embedded behavioral options within wholesale customer agreements that are separated from the bank's assets or liabilities are subject to a comprehensive revaluation process. This revaluation accounts for six distinct interest rate shock scenarios for each currency. As a result, banks are required to employ option evaluation methods to accurately price the behavioral interest rate option risk. Specifically, this pertains to wholesale fixed-rate loans, where borrowers may opt for prepayment, and wholesale flexi deposits, where depositors may choose early redemption, both of which carry inherent risks.

My question is, which option instruments should be used to do the risk pricing? Is swaption an appropriate choice to consider?

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  • $\begingroup$ A Swaption is an option on an interest rate swap. The optionality you refer to are callable and putable options. I'd have to read the guidelines again but I think in the case of prepayment and early redemption, this is usually a volume assumption based on models (using historical data). $\endgroup$
    – AKdemy
    Commented Jul 7 at 10:01
  • $\begingroup$ @Akdemy Hi, Thank you for answering my question! Following the BCBS instructions, the prepayment and early redemption risk of retail positions should be calculated in the method of behavioral modeling, which is indeed a volume assumption based on historical data modeling. But in the wholesale positions context, the BCBS also recommend banks to strip the embedded options out and then evaluate the fair value of those options. $\endgroup$
    – Slowman Karllenschütz
    Commented Jul 8 at 8:03
  • $\begingroup$ I don't agree with your answer, as consumer behaviour can get quite complicated, much more so than corporate bonds. If a corporation issues a callable bond, and if it can exercise a call that is in the money - if it can refinance more cheaply because its credit has improved of interest rates have gone down - then you can assume that it will exercise. Conversely, it is safe to assume that a corporation would not exercise an out of the money make-whole call - although occasionally they do. Conversely, considering (U.S.) residential mortgages, a homeowner may have a very goof deal on the (cont) $\endgroup$
    – Dimitri Vulis
    Commented Dec 9 at 13:06
  • $\begingroup$ a good deal on their existing mortgage, but sell the house anyway, which involves prepaying the current mortgage. But also a lot of times homeowners pass on the opportunity to refi, especially if the saving is small. A competent model validator or regulator would frown on a model of consumer behavior that treats them like swaptions or callable bonds. $\endgroup$
    – Dimitri Vulis
    Commented Dec 9 at 13:14

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In fact, the bond option pricing method can also be used to evaluate the wholesale behavioural optionality by treating the deposits and loans as option embedded bonds by assuming that they have a clear maturity and strike dates list.

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