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Gap model, NII and interest rate gaps, Gap Management and hedging,
Economic value of the banking book, Convexity Risk
Interest rate risk : In mismatching the maturities of assets and liabilities as
part of their asset transformation function, Fis expose themselves to interest
rate risk
Market risk : this adds another dimension to interest rate risk. It results from
the trading activity. It is an incremental risk. It is the risk of volatility in
earnings/ value of asset due to variation in the market factors such as
interest rate, investment rates and currency rates.
• It is the risk of volatility in earnings/ value of asset due to variation in
the market factors such as interest rate, investment rates and
currency rates.
• Relevant only after 1991-92 : The impact of this risk in the financial
system was not felt when there were regulatory restrictions on banks.
Banks became conscious of this risk only after the introduction of the
financial sector reforms and deregulation of interest rates
• 1956 many bank failure period of consolidation 1964 RBI
regulating the spread
• Banks are now free to fix the rate of interest on their assets and
liabilities. Hence it is necessary for them to know the behaviour of the
interest rates. There are four theories2 that explain the behaviour of
interest rates.
• Pure expectations theory advocates that forward rates (the market
may be a spot market where currencies are bought and sold for
immediate delivery at rates referred to as spot rates and forward
markets where currencies are bought and sold now for future delivery
at forward rates) are the unbiased estimators of expected spot rates.
The present market yield curve can provide information, about the
expectations of the market on future interest rates.
• As the economy moves through a business / economic cycle, the yield
curve changes rather frequently. At the beginning of an economic
expansion, the yield curve is upward sloping (short term interest rates
lower than long term rates). As the expansion proceeds, short-term
rates tend to rise faster than long-term rates, so the yield curve shifts
upwards and flattens out. Near the business cycle peak, the yield
curve can become downward sloping (inverted) and short-term yield
rates can become higher than long-term yields.
• The Liquidity Theory argues that the rates for the long term will be
higher than the rates for the short term and hence an upward sloping
curve. Interest represents the cost of funds and reward to the lender
who could have utilised the money for consumption. The lender is
willing to forgo the liquidity for which he must be rewarded. The
longer the period of giving up this liquidity, the higher the returns.
• The Preferred Habitat Theory agrees with the concept of liquidity
premium, but argues that it cannot be extended across all the
maturities. While the maturity pattern of borrowing and lending
depends on the constraints of the individuals, which will vary from
person to person, the payment of premium to induce them to change
their preferred maturity will be effective only upto a certain extent,
beyond which even enhanced premium will not induce them to
change their maturity.
• Market Segmentation Theory is a replica of the preferred habitat
theory without the flexibility, which it assumes. This theory states
that players in different markets are there due to their asset liability
maturity patterns and the interest rates are governed by the supply
and demand factors in each of the segments The players are not
induced by premium to shift their maturity.
• While all the above theories do provide insights into the factors that
influence interest rates, no single theory can explain reality. Again
what is long term for some, may be short term for others. There
cannot be strict guidelines for forecasting of interest rates. It is
necessary to have a view about the future. An estimate of the change
in interest rates in terms of its direction can only be attempted.
Determinants of interest rate
• Free market determination: The demand for any instrument is
influenced not only by its own rate but also rates of competing
instruments and the level of wealth of the investor. The own rate
positively and competing rates negatively influence the demand. The
supply side of the instrument is linked negatively to its own rate but
positively to interest rates on the issuers other liabilities. The total
debt and its change also influence the supply side of the instrument.
Then there are the systemic factors such as statutory preemption and
the liquidity position of the banking industry.
• Managed rate determination: In case the rates are fixed by one party
to the contract, the amount to be borrowed / lent will be determined
by the other party to the contract. If banks fix the PLR, the quantity of
the loan to be borrowed will be determined by the borrower,
depending on the PLR and interest rates on other types of
borrowings. Similarly if banks have to invest in assets on which
interest rates are determined purely by market forces, then the
deposit rate of banks will also be affected by the rates on instruments
competing for funds of the depositors.
Perspective of interest rate risk
• Impact on the NII ( the earnings perspective ) and the impact on the
balance sheet ( The economic value perspective)
• The risk from the former is measured as a change in the NII and the
later as a change in the value of assets and liabilities
Yield Curve
The yield curve is an analysis of the relationship between the
yields (interest rate) and different periods to maturity
Graphical relationship between yield and maturity
Yield is measured on the vertical axis and term to maturity is on
the horizontal
Yield curve Shape
Upward-sloping: long-term rates are above short-term rates
Flat: short and long-term rates are the same
Inverted: long-term rates are below short-term rates
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Term Structure of Interest Rate
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Types of Interest rate risks- General
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Rate Sensitive
Assets /
Liabilities (in
INR Mn) 1M 1-3M 3-6M 6M-1Y
Rate sensitive
Assets 1000 800 500 700
Rate sensitive
Liabilities 800 1200 600 300
Calculate the impact on account of a 0.5% increase in the interest rates. You may
take the average maturity in every gap
Interest Rate Risk (IRR)
GAP RISK
Rate Sensitive Assets /
Liabilities (in INR Mn) 1M 1-3M 3-6M 6M-1Y
Rate sensitive Assets 1000 800 500 700
Rate sensitive Liabilities 800 1200 600 300
Gap 200 -400 -100 400
Impact of 0.5% Increase in
Interest Rate 0.92 -1.67 -0.31 0.5
Cumulative Impact 0.92 -0.75 -1.06 -0.56
Basis Risk
• Basis risk describes the impact of relative changes in interest rates for
the assets and liabilities that have similar tenors but are priced using
different interest rate indices (bases) [e.g. an asset priced off Libor
funded by a liability priced off MIBOR)
• Basis risk, also described as spread risk, arises when assets and
liabilities are priced off different yield curves and the spread between
these curves shifts
• When interest rates change, these differences can give rise to
unexpected changes in the cash flows and earnings spread between
assets, liabilities of similar maturities or repricing frequencies
Rate Sensitive Assets &
Liabilities (amount
in INRMn) Exposure Δ Interest Rate
Re-Pricing Assets
Call Money 40 0.20%
Loan/Advances 60 1%
Total Re-pricing Assets 100
Re-Pricing Liabilities
Certificate of Deposit 10 0.50%
Term Deposit 90 0.75%
Total Re-pricing Liabilities 100
Basis Risk
40
Yield Curve Risk
• Arises due to the changes in the slope and shape of the yield curve
resulting in unanticipated shifts of the Yield Curve causing adverse effects
on a bank's income or underlying economic value
• Change of slope of the yield curve result in change in interest rates in
varying magnitude across different maturity periods
41
Yield Curve Risk
42
Embedded Options Risk:
This risk is on account of risk arising out of pre-payment of assets or
premature closure of liabilities
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EVE perspective
EVE MVA-MVL
Maturity
GAP Analysis
Duration
GAP Analysis
Maturity Gap Analysis
Positive gap
Negative gap
Zero or balanced gap
GAP Summary
Gap position Change in Change in interest Change in Change in net
interest rate income interest interest
expense income
Recession Encourage fixed rate loans Raise short term sources Negative gap
of funds
Depression Sell fixed rate loans and Borrow long term fixed Positive gap
investments to rates
supplement income
Increase RSA in
anticipation of higher
interest rates when
recovery occurs
Assessing the target gap for a Bank.
• The bank should first assess the percentage change in spread that is
acceptable to the bank, depending on the burden (non interest
income-non interest expenditure) and the targeted profit
• Targeted gap = (Delta C* RSA*NII)/ delta r
• where Delta c = tolerable percentage variation in spread
• Delta r= change in interest rate envisaged
• RSA = risk sensitive assets
Duration Gap Analysis
Matching the duration of assets and liabilities instead of matching the
time until pricing is another way to approach gap management.
It is a more sophisticated cash flow analytical tool used to primarily
measure the sensitivity of the market value of the net worth to
changes in interest rate
Duration analysis is based on Macaulay’s concept of duration, which
measures the average life time of a security’s stream of payments
Bond Duration
Duration (also known as Macaulay Duration) of a bond is a
measure of the time taken to recover the initial investment
in present value terms. In simplest form, duration refers to
the time taken for a bond to recoup its own purchase price
under time value concept of money
Duration is expressed in number of years
It measures the weighted average time taken to receive all
the cash flows of a bond (Wt. is the PV of cash flows)
• Higher the Yield to maturity, shorter the duration (term of the bond
remaining constant) and vice versa
• The higher the coupon rate of a bond, the shorter the duration (term
of the bond remaining constant) and vice versa
• Duration is always less than or equal to the overall life (to maturity) of
the bond
• Only a zero coupon bond (a bond with no coupons) will have duration
equal to its maturity
• 1.9434
• Calculate the duration of a two year corporate loan paying 6 percent
interest annually, selling at par. The $30000000 loan is 100 percent
amortising with annual payments
• First ascertain the annual coupon. For that use PMT option in excel
• 16363107
• 1.4854
• An FI purchases a $9.982 million pool of commercial loans at par. The
loans have an interest rate of 8%, a maturity of 5 years, and annual
payments of principal and interest that will exactly amortise the loan
at maturity. What is the duration of the asset
PV PVn
1 2500056 0.925926 2314867 2314867
2 2500056 0.857339 2143395 4286790
3 2500056 0.793832 1984625 5953875
4 2500056 0.73503 1837616 7350463
5 2500056 0.680583 1701496 8507481
12500280 3.99271 9981999 28413476
2.846472
Duration and interest risk management
• An insurer has to make a guaranteed payment of 1469 on a lumpsum
investment of 1000 at an annual compounded rate of 8%
• Two options
Buy a zero coupon bond of 5 years. Maturity and duration is equal in
the case of a zero coupon bond
• Given a face value of 1000 and 8% yield, the current price =
1000/(1.08)^5 = 680.58.
• He needs to buy 1.469 of these bonds to get a sale proceed of 1469
• (680.58*1.469)
• If 5 year Duration bonds are not available, then he has to invest in
appropriate duration bonds to hedge interest rate risk
• When yield = coupon, price is equal to face value irrespective of
maturity or duration
• So the insurer can buy any maturity bond which has a coupon equal
to yield (which is 8%) and sell this bond at end of 5 years
• The concept of duration helps in immunising the interest rate risk by
holding an investment till the end of duration instead of maturity. Thus
matching the duration of assets and liabilities instead of matching the time
until re-pricing is another way to approach gap management.
• Additional data required to calculate the duration gap are the market
yields/ costs for different categories of assets and liabilities. The duration of
each assets and liability can then be pooled together for assets and
liabilities. The duration of non rate sensitive assets and liabilities is zero.
The floating assets and liabilities can be treated as zero coupon
instruments (non-interest bearing) maturing at the time of next repricing.
• The analysis starts by discounting the balance sheet’s future cash
flows to their present value. The present value calculations are then
used to determine the duration of the cash flows. The duration of
assets and liabilities are calculated using weighted average method.
Once this is done, the duration gap can be worked out with the help
of the following formula.10
• E= A-L …….5
• DE * E = (DA*A- DL* L) ……………..6
• DA is the summation of each of the duration of assets weighted by its share in the
total assets. DL is same measure for liabilities and DE is the measure for equity. If
DE is positive, then the value of equity is exposed to increase in interest rate (if
rates increase, then the value declines and vice versa). If DE is negative, then the
value of equity is exposed to decrease in interest rate (if rates decrease then the
value increases and vice versa). If DE is zero, then the interest rate risk is
completely eliminated.
• Interest rate risk index is the duration of equity multiplied by ratio of
equity to asset. (DE * E/A). It is intended to indicate the response of the
bank’s equity to asset ratio to a change in interest rates.
Substituting L=A-E in equation (6)