Interest rate risk Interest rate and profit GAP Repricing model

Interest rate risk

Part 1
Reading: Saunders, chapter 7 & 8

1/26
Interest rate risk Interest rate and profit GAP Repricing model

Content

Interest rate risk

Interest rate and profit

GAP

Repricing model

2/26
Interest rate risk Interest rate and profit GAP Repricing model

Interest rate risk

3/26
Interest rate risk Interest rate and profit GAP Repricing model

Interest rate movements

• Do interest rates stay the same? Data

4/26
Interest rate risk Interest rate and profit GAP Repricing model

Interest rate movements

• Why do interest rates change?

• Why do financial institutions care about interest rate
movements?

5/26
Interest rate risk Interest rate and profit GAP Repricing model

Interest rate risk

• The chance that a bank’s profit and net worth are negatively
impacted by interest rate movements
• But how can interest rate movements impact a bank’s profit
and net worth?

6/26
Interest rate risk Interest rate and profit GAP Repricing model

Interest rate and profit

7/26
Interest rate risk Interest rate and profit GAP Repricing model

How the bank’s profit is impacted

• A bank’s assets and liabilities have maturities

• Assets and liabilities bear interest rates during their life cycles
• A mismatch in maturities between assets and liabilities lead to
frequent change in interest income and interest expense
→ Change in net interest income

8/26
Interest rate risk Interest rate and profit GAP Repricing model

Example: refinancing risk

9/26
Interest rate risk Interest rate and profit GAP Repricing model

Example: refinancing risk

• At the end of 2022, a bank is having a 2-year loan of $100

million with fixed interest rate of 6%
• The loan is financed with 1-year deposits worth $100 million,
deposit rate of 2%
• At the end of 2023, all market interest rates now increase by 1
percentage point.
→ How the bank’s net interest income is impacted?

10/26
Interest rate risk Interest rate and profit GAP Repricing model

Example: reinvestment risk

11/26
Interest rate risk Interest rate and profit GAP Repricing model

Example: reinvestment risk

• At the end of 2022, a bank is having a 1-year loan of $100

million with fixed interest rate of 6%
• The loan is financed with 2-year deposits worth $100 million,
deposit rate of 2%
• At the end of 2023, all market interest rates now increase by 1
percentage point.
→ How the bank’s net interest income is impacted?

12/26
Interest rate risk Interest rate and profit GAP Repricing model

GAP

13/26
Interest rate risk Interest rate and profit GAP Repricing model

Rate-sensitive assets/liabilities

• A liability is rate-sensitive if it is repriced in a certain time

frame (maturity bucket)
• The liability (e.g., deposit) matures, and the bank has to raise
new funds with new interest rate
• The liability has float interest rate that will be changed during
the time frame

• Similar for assets

14/26
Interest rate risk Interest rate and profit GAP Repricing model

Rate-sensitive assets/liabilities

15/26
Interest rate risk Interest rate and profit GAP Repricing model

Repricing Gap

• Difference between the book value of rate-sensitive assets and

rate-sensitive liabilities in a certain maturity bucket

GAPi = RSAi − RSLi

RSAi : rate-sensitive assets in maturity bucket i

RSLi : rate-sensitive liabilities in maturity bucket i

16/26
Interest rate risk Interest rate and profit GAP Repricing model

GAP for different maturity buckets

17/26
Interest rate risk Interest rate and profit GAP Repricing model

Cumulative Gap

• Cumulative Gap of one year counts RSA and RSL from one
day to 12 months.

18/26
Interest rate risk Interest rate and profit GAP Repricing model

Repricing model

19/26
Interest rate risk Interest rate and profit GAP Repricing model

The repricing model

• When interest rates change, interests from RSA and RSL will
change

∆NIIi = (RSAi − RSLi ) × ∆Ri

= GAPi × ∆Ri

NIIi : Change in net interest income in maturity bucket i

∆Ri : Change in the level of interest rates impacting assets and
liabilities in the ith bucket i

20/26
Interest rate risk Interest rate and profit GAP Repricing model

The repricing model

• With CGAP

∆NIIi = CGAP × ∆Ri

21/26
Interest rate risk Interest rate and profit GAP Repricing model

CGAP effect

• Assume equal change in interest rates on RSA and RSL

• How CGAP affects the relationship between interest rates and
NII

22/26
Interest rate risk Interest rate and profit GAP Repricing model

CGAP effect
• In practice, we see unequal changes in in interest rates on
RSA and RSL Data
• Change in interest rate spread affects NII

23/26
Interest rate risk Interest rate and profit GAP Repricing model

Weakness of the repricing model

• Ignores market value effects of interest rate change: as

interest rates change, value of fixed-income instruments
change too (why?)
• Ignore runoff cashflows: Periodic payments/early payments
the bank received from insensitive assets that still has to be
reinvested

24/26
Interest rate risk Interest rate and profit GAP Repricing model

Weakness of the repricing model

• Over-aggregative: information within a maturity bucket is lost

25/26
 Problem sets

• Chapter 8: 6, 7, 8, 9, 12, 14, 15, 16, 18, 19, 20, Minicase

26/26