Behavioral Value Adjustments

45 Pages Posted: 28 Mar 2017

See all articles by Matteo Bissiri

Matteo Bissiri

Cassa Depositi e Prestiti S.p.A.

Riccardo Cogo

Cassa Depositi e Prestiti S.p.A.

Date Written: March 27, 2017

Abstract

Assets or liabilities with embedded prepayment/extension options can be subject to behavioral risk, due to the unpredictable exercise strategy followed by the option holder who does not act purely on the strength of financial convenience. When seen from the viewpoint of the option seller, such behavior results in a lower option value and an additional source of uncertainty in future cash flows. In this paper we propose a general framework to model behavioral risk by taking advantage of a full parallel with credit portfolio modeling and by combining the features of option-based and intensity models. Our approach is micro-structural, meaning that the aggregate prepayment rate derives from the sum of individual decisions. In principle, a detailed characterization of the behavior of a pool of investors can be performed depending on available data. A particular emphasis is placed on the precise definition of behavioral risk and on the modeling of non-market factors, which may contribute significantly to the variance of future cash flows. Finally, we discuss the calibration of a behavioral risk premium and the pricing of contracts with embedded options by introducing the concept of behavioral risk adjustment (bVA), in line with the recent development of XVA methodology.

Keywords: behavioral risk, prepayment mortgage, MBS. RMBS, XVA, CVA, KVA, credit risk, embedded option, OAS, IRRBB, Basel

JEL Classification: G02, G12, G13, B24, B25

Suggested Citation

Bissiri, Matteo and Cogo, Riccardo, Behavioral Value Adjustments (March 27, 2017). Available at SSRN: https://ssrn.com/abstract=2941815 or http://dx.doi.org/10.2139/ssrn.2941815

Matteo Bissiri (Contact Author)

Cassa Depositi e Prestiti S.p.A. ( email )

Italy

Riccardo Cogo

Cassa Depositi e Prestiti S.p.A. ( email )

Italy

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