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Overview

Methods of measuring interest rate risk: Repricing model Maturity model Duration model Interest rate risk has an impact on: Net Interest Income Net Worth Non-interest Income Interest rate risk also effects firm’s capital to asset ratio, business volume, product mix, pricing of assets and liabilities

8-2

Overview

To mitigate the interest rate risk, the structure of balance sheet has to be managed: Asset Restructuring: On balance sheet restructuring of pricing of loans and product mix Liability restructuring: On balance sheet funding strategies that involve changes in maturity mix and rate characteristics Off balance sheet strategies involving derivatives etc

Repricing Model

8-3

Repricing or funding gap model based on book value. Contrasts with market value-based maturity and duration models recommended by the Bank for International Settlements (BIS). Rate sensitivity means time/frequency of repricing asset and liabilities Repricing gap is the difference between the rate sensitivity of each asset and the rate sensitivity of each liability: RSA – RSL.

Maturity Buckets

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**Commercial banks must report repricing gaps for assets and liabilities with maturities of:
**

One day. More than one day to three months. More than 3 three months to six months. More than six months to twelve months. More than one year to five years. Over five years.

-5yrs. 40 30 >5 years 10 5 Gap Cum. 30 40 >3mos. 70 85 >6mos.-12mos. 90 70 >1yr. Gap $-10 $-10 -10 -20 -15 -35 +20 -15 +10 -5 +5 0 .Repricing Gap Example 8-5 Assets Liabilities 1-day $ 20 $ 30 >1day-3mos.-6mos.

000. . If rates rise by 1%. Example II: If we consider the cumulative 1-year gap. gap is -$10 million.01 = -$100.01) = -$150. DNII = (CGAPone year) DR = (-$15 million)(.000.Applying the Repricing Model 8-6 DNIIi = (GAPi) DRi = (RSAi .RSLi) DRi Example: In the one day bucket. DNII(1) = (-$10 million) × .

Six-month T-notes repriced on maturity every 6 months.Rate-Sensitive Assets 8-7 Examples from hypothetical balance sheet: Short-term consumer loans. Three-month T-bills repriced on maturity every 3 months. If repriced at yearend. Which maturity bucket will you place them in? . would just make one-year cutoff. 30-year floating-rate mortgages repriced (rate reset) every 9 months.

which is interest rate sensitivity expressed as a percentage of Assets Gap Ratio helps . Current accounts pay zero interest. 8-8 Generally considered rate-insensitive (act as core deposits) CGAP is cumulative one year repricing GAP Gap ratio is CGAP/Assets.Rate-Sensitive Liabilities RSLs bucketed in same manner as RSAs.

8-9 Generally considered rate-insensitive (act as core deposits) .Rate-Sensitive Liabilities RSLs bucketed in same manner as RSAs. Current accounts pay zero interest.

CGAP/Assets.6 percent. Example: .CGAP Ratio 8-10 May be useful to express CGAP in ratio form as. Provides direction of exposure and Scale of the exposure.56. CGAP/A = $15 million / $270 million = 0. or 5.

rates and NII move in the same direction. RSLs 8-11 Example: Suppose rates rise 2% for RSAs and RSLs.000 With positive CGAP. Expected annual change in NII.01 = $150. DNII = CGAP × D R = $15 million × .Equal Rate Changes on RSAs. Change proportional to CGAP .

(RSL × D RRSL ) . In this case. the spread changes. DNII = (RSA × D RRSA ) .Unequal Changes in Rates 8-12 If changes in rates on RSAs and RSLs are not equal.

0% DNII = D interest revenue .000 .0%) = $310.D interest expense = ($155 million × 1.($155 million × 1.Unequal Rate Change Example 8-13 Spread effect example: RSA rate rises by 1.2%) .2% and RSL rate rises by 1.

Positive gap: increase in rates increases NII Negative gap: decrease in rates increases NII Example: Macatawa Bank’s one-year repricing gap ratio of -5. on or off the balance sheet. Effect of rising interest rates during the year: .23 percent. to benefit from projected interest rate changes.Restructuring Assets & Liabilities 8-14 The FI can restructure its assets and liabilities.

Runoffs may be ratesensitive. Ignores interest flows and associated reinvestment risks coupons and interest payments Uses accouting date Ignores market value effects and off-balance sheet (OBS) cash flows. . basis and yield curve risks are not accounted for. embedded options Distribution of assets & liabilities within individual maturity buckets is not considered.Weaknesses of Repricing Model 8-15 Weaknesses: Only measures repricing risks. Bank continuously originates and retires consumer and mortgage loans and demand deposits/passbook account balances can vary.

.Earnings at Risk 8-16 An assessment of potential impact of firm’s various gap positions on income statement during the full year is called EAR.

the greater the effect of interest rate changes on market price. The longer the maturity. . Fall in value of longer-term securities increases at diminishing rate for given increase in interest rates. For fixed-income assets and liabilities: Rise (fall) in interest rates leads to fall (rise) in market price.*The Maturity Model 8-17 Explicitly incorporates market value effects.

Typically. MA . Principles stated on previous slide apply to portfolio as well as to individual assets or liabilities.ML > 0 for most banks. . maturity gap.Maturity of Portfolio* 8-18 Maturity of portfolio of assets (liabilities) equals weighted average of maturities of individual components of the portfolio.

8-19 . Immunization and effect of setting MA .ML = 0.*Effects of Interest Rate Changes Size of the gap determines the size of interest rate change that would drive net worth to zero.

and 1¢ at the end of the year.*Maturities and Interest Rate Exposure 8-20 If MA . Not immunized. which pays back $99. although maturity gap equals zero. is the FI immunized? Extreme example: Suppose liabilities consist of 1-year zero coupon bond with face value $100. Both have maturities of 1 year. Reason: Differences in duration .99 shortly after origination.ML = 0. Assets consist of 1-year loan.

Timings of cash flows is not accounted for . funded with $90 million in one-year 10percent deposits (and equity) Maturity gap is zero but exposure to interest rate risk is not zero.*Maturity Model 8-21 Weaknesses of maturity model It does not take into account leverage in a bank’s balance sheet Example: Assets: $100 million in one-year 10-percent bonds.

*Duration 8-22 The average life of an asset or liability The weighted-average time to maturity using present value of the cash flows. relative to the total present value of the asset or liability as weights. .

and both are currently priced at $1000. Example: Suppose the zero coupon yield curve is flat at 12%.85 in ten years.Price Sensitivity and Maturity 8-23 The longer the term to maturity. Bond A pays $1762.34 in five years. Bond B pays $3105. . the greater the sensitivity to interest rate changes.

84/(1.53 10 = $914..12)10 Now suppose the interest rate increases by 1%.94 Bond B: P = $3105. Bond A: P = $1762.13)5 = $956. 8-24 Bond A: P = $1000 = $1762. .13) The longer maturity bond has the greater drop in price.34/(1.34/(1.84/(1.12)5 Bond B: P = $1000 = $3105.Example continued..

.Coupon Effect 8-25 Bonds with identical maturities will respond differently to interest rate changes when the coupons differ. more of the bond’s value is generated by cash flows which take place sooner in time. With higher coupons. This is more readily understood by recognizing that coupon bonds consist of a bundle of “zero-coupon” bonds.

089 $1.000 $1.Price Sensitivity of 6% Coupon Bond r n 40 20 10 2 $802 $864 $919 $981 $1.019 $471 $299 $170 $37 8% 6% 4% Range 8-26 .273 $1.000 $1.000 $1.163 $1.000 $1.

231 $1.085 $1.149 $1.Price Sensitivity of 8% Coupon Bond r n 40 20 10 2 $828 $875 $923 $981 $1.000 $1.000 $1.019 $403 $274 $162 $38 10% 8% 6% Range 8-27 .000 $1.000 $1.

Remarks on Preceding Slides The longer maturity bonds experience greater price changes in response to any change in the discount rate. 8-28 The 6% bond shows greater changes in price in response to a 2% change than the 8% bond. The range of prices is greater when the coupon is lower. The first bond is riskier. .

.Duration 8-29 Duration Combines the effects of differences in coupon rates and differences in maturity. Based on elasticity of bond price with respect to interest rate.

Duration Duration D = Snt=1[Ct• t/(1+r)t]/ Snt=1 [Ct/(1+r)t] Where 8-30 D = duration t = number of periods in the future Ct = cash flow to be delivered in t periods n= term-to-maturity & r = yield to maturity. .

(weighted by respective fraction of the PV of the bond as a whole). at maturity. duration equals maturity since 100% of its present value is generated by the payment of the face value. . For a zero coupon bond.Duration 8-31 Duration Weighted sum of the number of periods in the future of each cash flow.

Simplicity 2. .Advantages to Duration Measure: 1. Can be used to determine elasticity between price and YTM: (DP/P)/(Dr/r) = -D[r/(1+r)] We can rewrite this as: DP = -D[P/(1+r)] Dr 8-32 Note the direct relationship between DP and -D.

Negative Convexity. Convexity.Limits to Duration Measure 8-33 Duration relationship may not hold if the bond has a call or prepayment provision. .

we can find the change in value of equity using duration. DE = [-DAA + DLL] DR/(1+R) or DE = -[DA .Immunizing Balance Sheet of an FI 8-34 Duration Gap: From the balance sheet. In the same manner used to determine the change in bond prices. E=A-L.DLk]A(DR/(1+R)) . Therefore. DE=DA-DL.

Duration and Immunizing 8-35 The formula shows 3 effects: Leverage adjusted D-Gap The size of the FI The size of the interest rate shock .

. L = 90 and E = 10. Adjust DA . (Rates change by 1%). Methods of immunizing balance sheet. A = 100.1] = .3(90/100)]100[. DE = -[DA .$2.01/1. DL = 3 years and rates are expected to rise from 10% to 11%. Also. Find change in E.DLk]A[DR/(1+R)] = -[5 .09.An example: 8-36 Suppose DA = 5 years. DL or k.

. Immunizing the entire balance sheet need not be costly. Duration can be employed in combination with hedge positions to immunize.*Limitations of Duration 8-37 Only works with parallel shifts in yield curve. Immunization is a dynamic process since duration depends on instantaneous R.

If there are large changes in R. We can improve on the estimate using a Taylor expansion. In practice.*Convexity 8-38 The duration measure is a linear approximation of a non-linear function. . Recall that duration involves only the first derivative of the price function. the expansion rarely goes beyond second order (using the second derivative). the approximation is much less accurate.

CX = Scaling factor × [capital loss from 1bp rise in yield + capital gain from 1bp fall in yield] 8 Commonly used scaling factor is 10 .*Modified duration 8-39 DP/P = -D[DR/(1+R)] + (1/2) CX (DR)2 or DP/P = -MD DR + (1/2) CX (DR)2 Where MD implies modified duration and CX is a measure of the curvature effect. .

53785-1. . CX = 108[DP-/P + DP+/P] = 108[(999.000)] = 28.000 + (1.000)/1.000.46243-1.000. 8% yield. six-year maturity Eurobond priced at $1.*Calculation of CX 8-40 Example: convexity of 8% coupon.000)/1.

Management of Interest rate risk 8-41 Use of derivatives Forward and futures contracts Swaps Options Caps and Floors Swaptions FRAs .

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