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I am trying to understand how deposits in bank are modelled, and one such modelling approach is replicating portfolio approach as provided in http://www.diva-portal.org/smash/get/diva2:1208749/FULLTEXT01.pdf

Below is the excerpt on how to construct a replicating portfolio

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However I failed to understand how exactly Author wants to build the replicating portfolio. Let say I have a deposit amount $N_t$ at time $t$. And as a process of building replicating portfolio, I consider $2$ time buckets i.e. $6M, 12M$, allocation of total deposit amount into these $2$ buckets are $N_{1,t}, N_{2,t}, \left(N_{1,t} + N_{2,t} = N_t\right)$. And 1st time bucket consists of $6$ instruments with $1M$ maturities and similarly second bucket consist of $12$ instruments with $1M$ maturities. Therefore there are $18$ such instruments.

I failed to understand,

  1. How exactly the principal amounts $N_{1,t}, N_{2,t}$ are allocated into those $18$ instruments?
  2. What those $18$ instrument each with $1M$ maturities are?
  3. How exactly they are mimicking my original deposit?

Any insight on above pointers will be very helpful.

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    $\begingroup$ This paper was published in 2018. As far as I know, all such models pertaining to non-maturity deposits / deposit beta performed very badly after COVID started. $\endgroup$ Jan 12, 2022 at 2:31

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How exactly the principal amounts $N_{1,t}, N_{2,t}$ are allocated into those $18$ instruments?

Weights are found by optimizing some criterion (there are a few) which is described in chapters 2.2.1 in the paper you mention. Basically you run linear regression and find the weights of market rates that explain your NMD interest income without margin.

What those $18$ instrument each with $1M$ maturities are?

They are bonds like instruments paying coupon at maturity or at some time interval. You choose what you want them to be.

How exactly they are mimicking my original deposit?

As you move forward in time, tranches mature and are reinvested at new prevailing market rates. If your replicating portfolio is correctly set-up then interest income on it should be close to your factual portfolio. This helps in balance sheet management i.e. you know repricing periods of NMD therefore you know how to represent those principal amounts in risk measures such as repricing gap or BPV/DV01 and you can easily hedge those risks.

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