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Lecture 4.1
Interest Rate Risk
Dollar Gap Analysis

◼ Interest Rate Movements:

- Volatility of interest rate: from 20% in 1981 to 0.5% in 2020 in Canada
- Difficulty in predicting the directions (up or down?) of future rate movements

◼ Interest Rate Risk:

o Net Interest Income, NII
Generally, interest income is based on the positive spread between the interest
rate charged on the loans and the interest rate paid on the deposit:

interests earned interests incurred

L (deposits)
A (loans)

E (equity)

When interest rates change in the market, it affects both sides of balance sheet:
- if interest rate, R, rises, the bank will earn more interest revenue from its loans,
but it will also incur more interest expense on its deposits;
- if interest rate, R, falls, the bank will earn less interest revenue from its loans,
but it will also incur less interest expense on its deposits;
- so the need for focusing on net interest income, NII:
NII = interests earned – interests incurred = (lending – borrowing)t×Rt
ΔNIIt = (Dollar Gap)t × ΔRt

o Example
A = $5 million L = $3 million
Current rates: R Aold = 7% RLold = 3%

NIIold = 5  (7%) – 3  (3%) = $0.26 million

One month later, the rates in the market will change but we do not know if it will
be higher or lower.

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- Suppose it will rise by a magnitude of 1%, then

Future rates: R Anew = 8% RLnew = 4%

R = R new − R old = 1% on both the rates received and paid

NIInew = 5  (8%) – 3  (4%) = $0.28 million > NIIold →  NII > 0

Income will be higher than before the rates jumped.

- But it is also likely to fall by a magnitude of 1%, then

Future rates: R Anew = 6% RLnew = 2%

R = R new − R old = −1% on both the rates received and paid

NIInew = 5  (6%) – 3  (2%) = $0.24 million < NIIold →  NII < 0

Income will be lower than before the rates dropped.
So, if interest rate falls by a magnitude of 1%, this bank will suffer a decrease of
$0.02 million in interest income. It is this potential loss following a change in
interest rate that constitutes the interest rate risk.

o Interest rate risk and its management

We have seen the  NII can be negative (of course can be positive too) following
a move in R, which means that the bank will earn less and incur more in interest.
Interest rate risk management is to ensure that FI would always make the  NII
non-negative. Then the concern for FI is: when will  NII be negative?

◼ Some Notions:
- Repricing: to reset interest rate on assets or liabilities
- Time to repricing: how long before repricing will take place
- Repricing bucket: a grouping of assets and liabilities based on their time to
repricing, t
- Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL): assets and
liabilities that will involve repricing
- Non-Rate Sensitive Assets (NRSA) and Non-Rate Sensitive Liabilities (NRSL):
those that will not be repriced 4

- Permanent NRSA: Property; Equipment; Cash

- Permanent NRSL: Equity; Retained Earnings
- Dollar Gap: difference in dollar amount between the assets and liabilities within
each repricing bucket t
Dollar Gapt = RSAt – RSLt

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- Illustration:

R R
RSA

reprice reprice

t=0 1 2 time

R R

RSL
reprice reprice

t=0 1 2 time

where, the dashed block, , represents Dollar Gap - difference in dollar

amount between the assets (loans) and liabilities (deposits) that will be repriced.

- e.g. RSA = $5 million RSL = $3 million

Dollar Gap = 5 – 3 = $2 million

R = R new − R old = −1% on both the rates received & paid

ΔNII = (Dollar Gap)×ΔR = $2× (–1%) = – $0.02 million

which means that after repricing, the bank’s net income will decrease by $0.02
million.

However, an F.I. has thousands of A’s and L’s repriced at different times, how to
analyze ΔR’s impacts? That is why we need Dollar Gap analysis.

◼ Dollar Gap Analysis

- divide assets and liabilities into different repricing buckets to determine repricing
gap in each bucket
- analyze, for each bucket, the net interest income exposure to an interest rate
change when assets and liabilities will be repriced:
ΔNIIt = (Dollar Gap)t × ΔRt
sign: (+) (+) (+)

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- analyse for each bucket the impact of a change in interest rate on NII, or
- on a cumulative basis, using the average change in interest rate for the cumulated
time period

- Example

(see handout)

◼ The Same Interest Rate Change Can Cause Different Impacts to Different FIs:

When interest rate, R, changes, generating a rise or a fall, its impact on a FI’s
net interest income, NII, depends on the nature of the FI’s balance sheet:

o Case: Zero Dollar Gap

5% Dollar Gap = 0 2%
RSA RSL
$80 $80
NRSA NRSL
A2 L2
A3 L3
. .
. .
.
E
.

This bank has the same amounts of assets/loans ($80) and liabilities/deposits
($80) that will be repriced in one month; all other A’s and L’s have fixed rates.

- today at old rates:

NII = Interests earned – interests incurred = 80  (5%) – 80  (2%) = $2.4
- one month later at new rates:
if R rises by 1%: NII = 80  (6%) – 80  (3%) = $2.4, same as before repricing

if R falls by 1%: NII = 80  (4%) – 80  (1%) = $2.4 same as before repricing

-  R has no impact on NII

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→ So banks having zero dollar gaps are not concerned with any interest rate
movement. Or we say that banks having zero dollar gaps are not exposed to
interest rate risk.

o Case: Positive Dollar Gap

5% Dollar Gap > 0 2%

RSA RSL
$100 $50
NRSA NRSL
A2 L2
A3 L3
. .
. .
.
E
.

This bank has more assets/loans ($100) than liabilities/deposits ($50) that will be
repriced in one month; all other A’s and L’s have fixed rates.

- today at old rates:

NII = Interests earned – interests incurred = 100  (5%) – 50  (2%) = $4
- one month later at new rates:
if R rises by 1%: NII = 100  (6%) – 50  (3%) = $4.5  NII = $0.5
if R falls by 1%: NII = 100  (4%) – 50  (1%) = $3.5  NII = –$0.5
- positive impact on NII if R rises, but negative impact if R falls

→ So banks having positive dollar gaps are concerned with falling interest rates.
Also, we say that banks having positive dollar gaps are exposed to falling interest
rates.

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o Case: Negative Dollar Gap

5% Dollar Gap < 0 2%

RSA RSL
$50 $100
NRSA NRSL
A2 L2
A3 L3
. .
. .
.
E
.

This bank has fewer assets/loans ($50) than liabilities/deposits ($100) that will be
repriced in one month; all other A’s and L’s have fixed rates.

- today at old rates:

NII = Interests earned – interests incurred = 50  (5%) – 100  (2%) = $0.5
- one month later at new rates:
if R rises by 1%: NII = 50  (6%) – 100  (3%) = $0  NII = –$0.5
if R falls by 1%: NII = 50  (4%) – 100  (1%) = $1  NII = $0.5

- positive impact on NII if R falls, but negative impact if R rises

→ So banks having negative dollar gaps are concerned with rising interest rates.
Also, we say that banks having negative dollar gaps are exposed to rising interest
rates.

◼ Direct Refinancing

A simple way to adjust interest rate exposure is direct refinancing.

o Explained
Suppose a bank has fixed-rate liabilities and desires floating-rate liabilities
(why?). It could simply repurchase its fixed-rate liabilities, financing the
repurchase by issuing floating-rate liabilities.