A Multi-Factor Model for the Valuation and Risk Management of Demand Deposits

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Abstract
We describe the joint dynamics of bond yields and demand deposit rates employing a multi-factor model in an arbitrage-free framework. Using Monte Carlo simulation, we compute the economic value of demand deposit accounts for deposit-issuing banks. We also investigate how this value is affected by market interest rate changes. Our results show that deposit premiums are statistically significant and quite sensitive to the assumption regarding the evolution of deposit balances over time. Deposit liability values also seem to depreciate significantly when market rates increase, thereby offsetting some of the value losses on the asset side.