F446 Chapter 8 Student Handout (8

th
edition)
Chapter 8: Interest Rate Risk I
The Level and ove!ent o" Interest Rates
The Repri#in$ odel
%eaknesses o" the Repri#in$ odel
The aturit& odel (Chapter 8 e'tension handout)
%eaknesses o" the aturit& odel (Chapter 8 e'tension handout)
( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( (
The Level and ove!ent o" Interest Rates: %hile !an& "a#tors in"luen#e the
level and !ove!ent o" interest rates) it is the #entral *ank+s !onetar& poli#&
strate$& that !ost dire#tl& underlies the level and !ove!ent o" interest rates,
This) in turn a""e#ts an FI+s #ost o" "unds and return on assets,
The #entral *ank in the -nited States is the Federal Reserve (the Fed), Throu$h
its dail& open !arket operations) su#h as *u&in$ and sellin$ treasur& se#urities
the Fed seeks to in"luen#e the !one& suppl&) in"lation) and the level o" interest
rates (parti#ularl& short(ter! interest rates), %hen the Fed "inds it ne#essar& to
slo. do.n the e#ono!&) it ti$htens !onetar& poli#& *& raisin$
interest rates, The nor!al result is a de#rease in *usiness and household
spendin$ (espe#iall& that "inan#ed *& #redit or *orro.in$), Conversel&) i"
*usiness and household spendin$ de#lines to the e'tent that the Fed "inds it
ne#essar& to sti!ulate the e#ono!&) it allo.s interest rates to "all (an
e'pansionar& !onetar& poli#&),
The in#reased level o" "inan#ial !arket inte$ration over the last de#ade has also
a""e#ted interest rates, Finan#ial !arket inte$ration in#rease the speed .ith
.hi#h interest rate #han$es and asso#iated volatilit& are trans!itted a!on$
#ountries) !akin$ the #ontrol o" -,S, interest rates *& the Federal Reserve !ore
di""i#ult and less #ertain than *e"ore, The level and volatilit& o" interest rates
and the in#rease in .orld.ide "inan#ial !arket inte$ration
ake the !easure!ent and !ana$e!ent o" interest rate risk one o" the ke&
issues "a#in$ FI !ana$ers,
The Repri#in$ odel: The repri#in$) or "undin$ $ap) is a si!ple !odel used
*& s!all (thus !ost) FIs in the -nited States, This !odel is essentiall& a *ook
/alue a##ountin$ #ash "lo. anal&sis o" the repri#in$ $ap *et.een the interest
In#o!e earned on an FI+s assets and the interest e'pense paid on its lia*ilities
(or its net interest in#o!e ) over a parti#ular period o" ti!e,
0
F446 Chapter 8 Student Handout (8
th
edition)
-nder the repri#in$ $ap approa#h) #o!!er#ial *anks report 1uarterl& on their
#all reports (interest(rate sensitivit& reports)) .hi#h sho. the repri#in$ $aps "or
assets and lia*ilities .ith various !aturities: For e'a!ple)
20, 0 da&
23, ore than 0 da& to 4 !onths
24, ore than 4 !onths to 6 !onths
24, ore than 6 !onths to 03 !onths
25, ore than 0 &ear to 5 &ears
26, ore than 5 &ears
For 20) assets and lia*ilities *ein$ repri#ed each day are likel& to *e inter*ank
*orro.in$s on the "ederal "unds or repur#hase a$ree!ent !arket,
Rate sensitivity here !eans that the asset or lia*ilit& is repri#ed at or near #urrent
!arket interest rates .ithin a #ertain ti!e hori6on (or !aturit& *u#ket),
Repri#in$ #an *e the result o" a rollover o" an asset or lia*ilit& (e,$,) a loan is paid
o"" at or prior to !aturit& and the "unds are used to issue a ne. loan at #urrent
!arket rates)) or it #an o##ur *e#ause the asset or lia*ilit& is a varia*le rate
instru!ent (e,$,) a varia*le(rate !ort$a$e .hose interest rate is reset ever&
1uarter *ased on !ove!ents in a pri!e rate),
-nder the repri#in$ $ap approa#h) a *ank reports the $aps in ea#h !aturit&
*u#ket *& #al#ulatin$ the rate sensitivit& o" ea#h asset (RS7) and ea#h lia*ilit&
(RSL) on its *alan#e sheet,
Repri#in$ 8ap Ta*le (in 9 !illions)
Cu!ulative
7ssets Lia* (: ;1) 8aps 8ap
20, 0 da& 9 4< 9 3< 9 =0< 9 =0<
23, > 0 da& to 4 !o 4< 5< (0< <
24, > 4 !o to 6 !o 4< 3< =0< =0<
24, > 6 !o to 03 !o 8< 5< =4< 4<
25, > 0 &r to 5 &rs 4< ?< (4< =0<
26, > 5 &rs 4< 4< (0< <
9 35< 9 35<
The #u!ulative repri#in$ $ap over the .hole *alan#e !ust *& de"inition) *e
6ero, 7 ne$ative $ap (RS7 @ RSL) as sho.n *& 23 a*ove) e'poses the FI to
AAAAAAAAAAAAAAAAAA ) in that a rise in these short(ter! rates .ould lo.er the
3
F446 Chapter 8 Student Handout (8
th
edition)
FI+s net interest income sin#e the FI has !ore rate sensitive lia*ilities than assets
in this *u#ket,
I" the FI has a positive di""eren#e *et.een its assets and lia*ilities (like 20
a*ove) a positive $ap)) it is e'posed to reinvest!ent risk in that a drop in rates
over this period .ould lo.er the FI+s net interest in#o!e (interest in#o!e .ill
de#rease *& !ore than interest e'pense),
The e""e#t o" a 0B decrease #an *e deter!ined "or a spe#i"i# #ate$or& (i,e, 0 da&)
"or the previous e'a!ple:
NII
1
C Chan$e in net interest in#o!e in the "irst *u#ket
GAP
1
C Dollar si6e o" the $ap *et.een *ook value o" rate(sensitive
assets and rate(sensitive lia*ilities in !aturit& *u#ket 0
R
1
C Chan$e in the level o" interest rates i!pa#tin$ assets and
lia*ilities in the "irst *u#ket
NII
1
C (GAP
1
)( R
1
) C (RSA
1
E RSL
1
)( R
1
) C (94< E 93< !illion)( E,<0)
C E 90<<)<<<
The FI !ana$er #an also esti!ate #u!ulative $aps (CGAP) over various
repri#in$ #ate$ories or *u#kets, 7 #o!!on #u!ulative $ap o" interest is the 0(&r
repri#in$ $ap, 7$ain) usin$ the previous e'a!ple:
CGAP C (=90<) = (A(0<A) = (AA=0<AA) = (AA=4<AA) C AA=4<AA
!illion
I" R
i
is the avera$e interest rate #han$e a""e#tin$ assets and lia*ilities that #an
*e repri#ed .ithin a &ear is a E 0B) the #u!ulative e""e#t on the *ank+s net
interest in#o!e "or this #u!ulative $roupin$ is:
NII
i
C (CGAP)(R
i
) C (AAA=4<AAAAAAAAA)(A(<,0AAA) C (94<<)<<<
Rate Sensitive Lia*ilities: %hen usin$ a 0 &ear period) so!e lia*ilities) na!el&)
de!and deposits and pass*ook savin$s "all into a $re& area as to .hether the&
should *e in#luded) or e'#luded,
Against Inclusion E the e'pli#it interest rate on de!and deposits is 6ero *&
re$ulation, (For FG% a##ounts) the interest paid *& FIs doesn+t "lu#tuate
dire#tl& .ith #han$es in the $eneral level o" interest rates) espe#iall& i" the& are
risin$,) Further) !an& de!and deposits a#t as #ore deposits "or FIs) !eanin$
the& are a lon$(ter! sour#e o" "unds,
4
F446 Chapter 8 Student Handout (8
th
edition)
For Inclusion E even thou$h e'pli#it interest is not paid on de!and deposits)
there is i!pli#it interest paid) $iven that FIs don+t #har$e "ees that "ull& #over
their #osts "or #he#kin$ servi#es, Further) i" interest rates rise) individuals lo.er
their de!and deposits) "or#in$ the *ank to repla#e the! .ith hi$her(&ieldin$)
interest(*earin$) rate(sensitive "unds,
Si!ilar ar$u!ents "or and a$ainst in#lusion o" retail pass*ook savin$s a##ounts
#an *e !ade, 7lthou$h Federal Reserve Re$ulation H #eilin$s on the !a'i!u!
rates to *e #har$ed "or these a##ounts .ere a*olished in ar#h 0I86) *anks still
adJust these rates onl& in"re1uentl& , Ho.ever) savers tend to .ithdra. "unds
"ro! these a##ounts .hen rates rise) "or#in$ *anks into !ore e'pensive "und
su*stitutions,
Fro! the te't+s list o" rate(sensitive lia*ilities to *e in#luded "or a one(&ear
repri#in$ sensitivit& test (p$ 3<3)) *oth de!and deposits and pass*ook savin$s
.ere e'#luded (in#ludedKe'#luded),
Fro! the "ollo.in$ list deter!ine i" ea#h #o!ponent should or should not *e
in#luded as interest rate(sensitive usin$ a 0 &ear period:
7ssets LesKFo In#l+d a!t
0, S(t #onsu!er loans (0 &r !at) 9 4< Les 4<
3, L(t #onsu!er loans (3 &r !at) 3< Fo
4, 4 !o T(*ills 4< LesAA 4<
4, 6 !o T(*ills 3< FG 3<
5, 4 &r T(notes 6< FoA
6, 0< &r "i'ed(rate !ort$a$es 4< FoA
?, 4< &r "loatin$(rate !ort$a$es
(rate adJusted ever& 6 !o) 5< LesA
9 35< 9AAAA
Lia*ilities (: ;1uit&)
0, ;1uit& #apital 3< Fo
3, De!and deposits 4< FGAA
4, Mass*ook savin$s 4< FoA
4, 4 !o CDs 4< LesAA
5, 4 !o *ankers a##eptan#es 0< LesA
6, 6 !o #o!!er#ial paper 5< LesA
?, 0 &r ti!e deposits 3< AFo
8, 3 &r ti!e deposits 4< FoA AAAAA
9 35< 9AAAA
4
F446 Chapter 8 Student Handout (8
th
edition)
CGAP C RSA E RSL C 9A04< E 903< C 93< !illion
Interest rate sensitivit& #an also *e e'pressed as a per#enta$e o" assets (A)
(t&pi#all& #alled the $ap ratio
CGAP
A
=
$___20_ million
$___250_ million
= 0.08__ = _8__ %

;'pressin$ the repri#in$ $ap in this .a& is use"ul sin#e it tells us
(0) the dire#tion o" the interest rate e'posure (positive or ne$ative CGAP)) and
(3) the s#ale o" that e'posure as indi#ated *& dividin$ the $ap *& the
assets si6e o" the institution
;1ual #han$es in rates on RS7s and RSLs :
0, The larger the a*solute value o" CGAP) the larger the e'pe#ted #han$e in
NII,
3, %hen CGAP is negative) the #han$e in NII is ne$ativel& related to the
#han$e in interest rates,
-ne1ual #han$es in rates on RS7s and RSLs (.hen int rate
RS7
> int rate
RSL
):
The spread e""e#t (the spread *et.een the rates on RSAs and RSLs))
re$ardless o" the dire#tion o" the #han$e in interest rates) a positive
relation o##urs *et.een #han$es in the spread) and the #han$e in NII N.hen(
ever the spread in#reases (de#reases)) NII in#reases (de#reases)O,
The repri#in$ $ap is the !easure o" interest rate risk histori#all& used *& FIs)
and it is still the !ain !easure o" interest rate risk used *& s!all #o!!unit&
*anks and thri"ts, The repri#in$ $ap #an *e used to allo. an FI to stru#ture its
assets and lia*ilities or to $o o"" the *alan#e sheet to take advanta$e o" a
proJe#ted interest rate #han$e,
%eaknesses o" the Repri#in$ odel: The repri#in$ !odel has "our
short#o!in$s:
0, It ignores market value eects o interest rate changes: Sin#e the !odel
uses *ook values) the repri#in$ $ap is onl& a partial !easure o" the true
interest rate e'posure o" an FI,
5
F446 Chapter 8 Student Handout (8
th
edition)
3, !veraggregation "the pro#lem o deining #uckets over a range o maturities$:
The !odel i$nores in"or!ation re$ardin$ the distri*ution o" assets and
lia*ilities .ithin those *u#kets,
4, %he Pro#lem o Runos "the model assumes that all consumer loans mature
in 1 year& or that all conventional mortgages mature in the same '( years$ E
.hen in realit& the FI #ontinuousl& retires #onsu!er and !ort$a$e loans as
it #reates and retires deposits, 7dditionall&) "or lon$(ter! !ort$a$es)
.hen interest rates rise) !an& people !a& dela& repa&in$ their !ort$a$es
(runos are too opti!isti#), Si!ilarl&) .hen interest rates "all) people !a&
prepa& their "i'ed(rate !ort$a$es to re"inan#e at a lo.er interest rate
(runos are understated),
4, %he model ignores cash lo)s rom o*#alance*sheet activities: Chan$es in
interest rates .ill a""e#t the #ash "lo.s on !an& o""(*alan#e(sheet
instru!ents as .ell as the assets and lia*ilities listed on the *alan#e sheet,
FGT;: The rest o" this handout is not #overed in the te't itsel", 7 pd" "ile)
PSaunders Te't 7pp87,pd"Q has *een in#luded in the PResour#esQ se#tion o"
Gn#ourse "or this #ourse,
The aturit& odel: In !ost #ountries) FIs report their *alan#e sheets *& usin$
*ook value a##ountin$ (histori# values are reported "or se#urities pur#hased)
loans !ade) and lia*ilities sold), For -,S, *anks) invest!ent assets (i,e,) those
e'pe#ted to *e held to maturity) are re#orded at #ook value) .hile those assets
e'pe#ted to *e used "or tradin$ (tradin$ se#urities or availa#le*or*sale se#urities)
are reported a##ordin$ to !arket value , The !arket value a##ountin$ approa#h
re"le#ts e#ono!i# realit&, This pra#ti#e o" valuin$ se#urities at their !arket
value is re"erred to as marking to market,
;'a!ple: Consider the value o" a *ond .ith 0 &ear to !aturit&) a "a#e value o"
90)<<< to *e paid at !aturit&) an annual #oupon rate o" 00B o" the "a#e a!ount)
and a #urrent &ield to !aturit& o" 00B, 8iven that the #oupon rate e1uals the
&ield to !aturit&) the "air !arket value o" the 0 &ear *ond is 90)<<<,<<, I" the
re1uired &ield on the *ond rises to 03B) the !arket value o" the *ond .ill "all ,
The e'a#t !arket value #an *e "ound *&:
6
F446 Chapter 8 Student Handout (8
th
edition)
M/ C AAAAAAAAAA C (II0,<?
F/ C 0<<<
M!t C 00<
F C 0
R C 03
7s a result) in a !arket value a##ountin$ "ra!e.ork) risin$ interest rates
$enerall& de#rease (in#reaseKde#rease) the !arket value o" *oth assets and
lia*ilities,
I" the *ond o" the pre#edin$ e'a!ple had a 3 or 4 &ear !aturit& .ith the sa!e
annual #oupon rate) the sa!e in#rease in !arket interest rates "ro! 00B to 03B
.ould have a !ore ne$ative (positiveKne$ative) e""e#t on the !arket value o" the
*ond+s !arket value "or

P
3
R
and P
4
R
:
M/ C S C (I84,0 M/ C S C (I?5,I8
F/ C 0)<<< F/ C 0)<<<
M!t C 00< M!t C 00<
F C 3 F C 4
R C 03 R C 03
?
P = 4<
= 3<
= 0<
<
E 0<
E 3<
E 4<
0 3 4
aturit& o"
the *ond
F446 Chapter 8 Student Handout (8
th
edition)
This e""e#t is not a linear #han$e) sin#e
P
1 R=12% ( )
B
P
FV
B
= 991.07___ 1, 000.00 = _-8.93_____
P
2 R=12% ( )
B
P
1 R=12% ( )
B
= 983.1____ 991.07_ = -7.97
P
3 R=12% ( )
B
P
2 R=12% ( )
B
= 975.98 983.1 = -7.12
Su!!ari6in$) "or an FI+s "i'ed(in#o!e assets and lia*ilities:
0, 7 rise ("all) in interest rates $enerall& leads to a "all (rise) in the !arket
value o" an asset or lia*ilit&,
3, The longer the !aturit& o" a "i'ed(in#o!e asset or lia*ilit&) the lar$er the
"all (rise) in !arket value "or an& $iven interest rate in#rease (de#rease),
4, The "all in the value o" lon$er(ter! se#urities in#reases at a diminishing
rate "or an& $iven in#rease in interest rates,
The aturit& odel .ith a Mort"olio o" 7ssets and Lia*ilities: Let +
A
*e the
.ei$hted(avera$e !aturit& o" an FI+s assets and +
L
the .ei$hted(avera$e
!aturit& o" an FI+s lia*ilities) su#h that:
+
i
C ,
i0
+
i0
= ,
i3
+
i3
= , , , = ,
in
+
in

.here +
i
C %ei$hted(avera$e !aturit& o" an FI+s assets (lia*ilities))
i C A or L
,
i-
C I!portan#e o" ea#h asset (lia*ilit&) in the asset (lia*ilit&)
port"olio as !easured *& the !arket value o" that asset
(lia*ilit&) position relative to the !arket value o" all the
assets (lia*ilities)
+
i-
C aturit& o" the -th asset (lia*ilit&)
This e1uation sho.s that the !aturit& o" a port"olio o" assets or lia*ilities is a
.ei$hted avera$e o" the !aturities o" the assets or lia*ilities that #onstitute that
port"olio,
8
F446 Chapter 8 Student Handout (8
th
edition)
In a port"olio #onte't) the sa!e three prin#iples prevail as "or an individual
se#urit&:
0, 7 rise in interest rates $enerall& redu#es the !arket (*ookK!arket)
values o" an FI+s asset and lia*ilit& port"olios,
3, The lon$er the !aturit& o" the asset or lia*ilit& port"olio) the lar$er the
"all (riseK"all) in value "or an& $iven interest rate in#rease,
4, The "all in value o" the asset or lia*ilit& port"olio in#rease (in#reasesK
de#reases) .ith its !aturit& at a di!inishin$ rate,
8iven the pre#edin$) the net e""e#t o" risin$ or "allin$ interest rates on an FI+s
*alan#e sheet depends on the e'tent and dire#tion in .hi#h the FI !is!at#hes the
!aturities o" its asset and lia*ilit& port"olios, That is) the e""e#t depends on
.hether its maturity gap) +
A
E +
L
) is $reater than) e1ual to) or less than 6ero,
+
A
E +
L
> <: The !aturit& o" assets is longer than the !aturit& o" lia*ilities,
This is the #ase o" !ost #o!!er#ial *anks and thri"ts, %hen interest rates rise)
the !arket value o" *oth assets and lia*ilities "all, Ho.ever) .ith assets havin$
lon$er !aturities than lia*ilities) the asset !arket values .ill de#rease !ore
(!oreKless) than the lia*ilit& !arket values, 8iven the *alan#e sheet identit&)
;1uit& C 7ssets E Lia*ilities
i" asset !arket values are de#reasin$ !ore (!oreKless) than the lia*ilit& !arket
values) the FI+s e1uit& .ill "all (riseK"all), 8iven that FI+s are hi$hl& levered) this
#ould #ause FIs to *e#o!e e#ono!i#all& insolvent,
Fro! the previous dis#ussion) one !i$ht in"er that the *est .a& "or an FI to
immuni.e) or prote#t itsel" "ro! interest rate risk is "or its !ana$ers to !at#h the
!aturities o" its assets and lia*ilities) that is) to #onstru#t its *alan#e sheet so that
its !aturit& $ap) the di""eren#e *et.een the .ei$hted(avera$e !aturit& o" its
assets and lia*ilities) is 6ero (+
A
E +
L
C <
I
F446 Chapter 8 Student Handout (8
th
edition)
%eaknesses o" the aturit& odel: The !aturit& !odel has t.o !aJor
short#o!in$s:
0, It does not account or the degree o leverage in the FI/s #alance sheet:
7ssu!e the FI is set up as:
7ssets Lia*ilities : ;1uit&
7 C 905< (+
A
C 0 &r) L C 903< (+
L
C 0 &r)
AAAA ; C 4<
905< 905<
The 905< !illion in assets is invested in 0(&ear) IB #oupon *onds) and the 903<
!illion in lia*ilities are all in 0(&ear deposits pa&in$ IB, ;ven .ith
(+
A
E +
L
C <)) a 0B rise in interest rates results in
7ssets Lia*ilities : ;1uit&
7 C 9AAACC(048,64A"vC05< p!t C04,5 nC0 iC0< L C 9008,I0
AAAAA ;C3I,?4
9A048,46 9A048,64
The drop in e1uit& value is due to the "a#t that not all the assets (*onds) .ere
"inan#ed .ith deposits) *ut rather e1uit& .as used to to "inan#e a portion o" the
FI+s assets, 7s interest rates in#reased) onl& 9A03< !illion in deposits .ere
dire#tl& a""e#ted) .hile 905< !illion in assets .ere dire#tl& a""e#ted,
3, %he model ignores the timing o the cash lo)s rom the FI/s assets and
lia#ilities: Suppose an FI lends 98< to a #orporate *orro.er at a 0<B annual
interest rate) re1uirin$ that hal" the loan .ith interest due is to *e paid a"ter 6
!onths) and the last hal" to *e o"") a$ain .ith interest due at the end o" the &ear,
This loan is supported *& a 98<) 0 &ear) 0<B) CD that the FI has issued to a
depositor, Gn !aturit& at the end o" the &ear) the FI .ill repa& the depositor 98<
plus 98 interest,
7t the end o" 6 !onths) the #orporate *orro.er pa&s *a#k 944) .hi#h is loaned to
a se#ond #orporate *orro.er *& the FI at 0<B annual interest "or 6 !onths,
7t the end o" the &ear) the FI re#eives 9A43A "ro! the "irst #orporate *orro.er)
and 9A46,3A "ro! the se#ond #orporate *orro.er) "or a total a!ount o" 9A 88,3 ,
7"ter pa&in$ the depositor 988) the FI has a (*e"ore(ta') pro"it o" 9A<,3 , This
pro"it results "ro! the FI *ein$ a*le to reinvest part o" the prin#ipal and interest
0<
F446 Chapter 8 Student Handout (8
th
edition)
over the last 6 !onths o" the &ear,
I" the interest rate over the last 6 !onths had "allen to 8B) a""e#tin$ onl& the
se#ond loan) at the end o" the &ear) the FI re#eives 943A "ro! the "irst #orporate
*orro.er) and 9A45,?6 "ro! the se#ond *orro.er) .hi#h results in a loss o" E
9A<,34 ,
Despite the !at#hin$ o" !aturities) the FI is still e'posed to interest rate risk
*e#ause the timing o" the cash lo)s on the deposit and loan are not per"e#tl&
!at#hed,
00