Implementation of a Funds Transfer Pricing model with stochastic interest rates

Abstract: The subject of Funds Transfer Pricing (FTP) is widely known within the banking in- dustry, despite this there is a lack of consensus on how to allocate the costs and benets to the users and suppliers of liquidity. A common practice in nancial institutions, in particular before the nancial crisis, was to charge business units a liquidity charge that was based on the average or the historic cost of funds, which did not properly re ect the liquidity risk for each specic business unit. Today practitioners are introducing more rigorous FTP approaches to better allocate the cost/benet of liquidity arising products to business units11. The aim of this thesis is to implement and further develop a theoretical FTP model which will seek to, in as detailed manner as possible, transfer the liquidity costs/benets arising from nancial products back to the originator. This will result in a more transparent view of the liquidity costs/benets associated with an institutions assets and liabilities and thus enhance its ability to take more informed decisions regarding the actual protability of the products. The focus will also be to model a benchmark rate which will serve as a proxy for the risk-free interest rate, which is one of the key underlying components in the total cost of funding, using a stochastic interest rate model. By examining the relationship between the FTP rate, the total cost of funding and the risk-free interest rate one is able to use the interest rate model together with interest rate scenarios to make predictions for future FTP rates and funding costs. The information provided by the simulation together with the scenarios can be an input for strategic funding decisions for the institution, e.g. how much is the expected cost of funding for a certain project under dierent scenarios looking two years ahead? Incorporating this information when considering future business opportunities can help banks in assessing the risk when measuring the protability of future funding agreements due to the uncertainty in the funding costs.