Lecture 3

INTEREST RATE RISK

CHAPTER 8 & 9
 INTEREST RATES AND NET WORTH

 FIs exposed to risk due to maturity mismatches between

assets and liabilities

 Interest rate changes can have severe adverse impact on

net worth
 LEVEL & MOVEMENT OF INTEREST RATES

 Central bank monetary policy strategy

 Movement of interest rates
– Open market operations influence money supply, inflation, and interest rates
– To slow down the economy-tights monetary policy, raising interest rates
– To stimulate the economy – expansionary monetary policy, allows the
interest rate to fall
 REPRICING MODEL

 Repricing or funding gap model based on book value accounting cash flow analysis
 Repricing gap – the difference between interest earned on assets and interest paid
on liabilities
 Rate sensitivity means repricing at current rates
 Rate-sensitive asset or liability- An asset or liability that is repriced at or near current
market interest rates within a maturity bucket.
 Refinancing risk- Risk exposure from the cost of rolling over or reborrowing funds will
rise above the returns being earned on asset investments.
 Reinvestment risk- Risk exposure from the returns on funds to be reinvested will fall
below the cost of the funds.
 MATURITY BUCKETS

 Commercial banks must report repricing gaps for assets and

liabilities with maturities of:
– One day
– More than one day to three months
– More than three months to six months
– More than six months to twelve months
– More than one year to five years
– Over five years
REPRICING GAP EXAMPLE
 APPLYING THE REPRICING MODEL

• NIIi = (GAPi) Ri = (RSAi - RSLi) Ri

 Example I:
• In the one day bucket, gap is -$10 million. If rates rise
by 1%,

• NII(1) = (-$10 million) × .01 = -$100,000

 APPLYING THE REPRICING MODEL (CONT..)

 Example II:
• If we consider the cumulative 1-year gap,

• NII = (CGAP) R = (-$15 million)(.01)

• = -$150,000
 RATE-SENSITIVE ASSETS

 Examples from hypothetical balance sheet:

– Short-term consumer loans. Repriced at year-end, would just make
one-year cutoff
– Three-month T-bills repriced on maturity every 3 months
– Six-month T-notes repriced on maturity every 6 months
– 30-year floating-rate mortgages repriced (rate reset) every 9 months
 RATE-SENSITIVE LIABILITIES

 RSLs bucketed in same manner as RSAs

 Demand deposits warrant special mention
– Generally considered rate-insensitive (act as core
deposits), but there are arguments for their inclusion as
rate-sensitive liabilities
 GAP RATIO

 May be useful to express interest rate sensitivity in

ratio form as CGAP/Assets, referred to as “gap ratio”
– Provides direction of exposure and scale of the exposure

 Example:
– CGAP/A = $15 million / $270 million = 0.056, or 5.6 percent
 EQUAL RATE CHANGES ON RSAS, RSLS

 Example 8-1: Suppose rates rise 1% for RSAs and RSLs. Expected
annual change in NII,
• NII = CGAP ×  R
• = $15 million × .01
• = $150,000
 CGAP is positive, change in NII is positively related to change in
interest rates
 CGAP is negative, change in NII is negatively related to change
in interest rates
 UNEQUAL CHANGES IN RATES

 If changes in rates on RSAs and RSLs are not equal, the spread changes;
 In this case,
• NII = (RSA ×  RRSA ) - (RSL ×  RRSL )

Example 8-2:
• RSA rate rises by 1.2% and RSL rate rises by 1.0%

NII =  interest revenue -  interest expense

= ($155 million × 1.2%) - ($155 million × 1.0%)
= $310,000
 WEAKNESSES OF REPRICING MODEL

 Weaknesses:
– Ignores market value effects of interest rate changes
– Overaggregative
 Distribution of assets & liabilities within individual buckets is not considered
 Mismatches within buckets can be substantial
– Ignores effects of runoffs
 Bank continuously originates and retires consumer and mortgage loans
 Runoffs may be rate-sensitive
 Off-balance-sheet items are not included
– Hedging effects of off-balance-sheet items not captured
– Example: Futures contracts
 CHAPTER 9:
PRICE SENSITIVITY AND MATURITY

• In general, the longer the term to maturity, the greater

the sensitivity to interest rate changes
• The longer maturity bond has the greater drop in price
because the payment is discounted a greater number
of times
 DURATION

• Weighted average time to maturity using the relative present

values of the cash flows as weights
• Combines the effects of differences in coupon rates and
differences in maturity
• Based on elasticity of bond price with respect to interest rate
• The units of duration are years
 FEATURES OF DURATION

• Duration and maturity

• Duration increases with maturity of a fixed-income asset/liability,
but at a decreasing rate
• Duration and yield
• Duration decreases as yield increases
• Duration and coupon interest
• Duration decreases as coupon increases
MACAULAY DURATION
• Since the price (P) of the bond equals the sum of the present values
of all its cash flows, we can state the duration formula another way:

• Notice the weights correspond to the relative present values of the

cash flows
 SEMIANNUAL CASH FLOWS

• It is important to see that we must express t in years, and the

present values are computed using the appropriate periodic
interest rate. For semiannual cash flows, Macaulay duration, D is
equal to:
 DURATION OF ZERO-COUPON BOND

• Zero-coupon bonds: sell at a discount from face value on issue, pay the
face value upon maturity, and have no intervening cash flows between
issue and maturity
• Duration equals the bond’s maturity since there are no intervening
cash flows between issue and maturity
• For all other bonds, duration < maturity because here are intervening
cash flows between issue and maturity
 COMPUTING DURATION

• Consider a 2-year, 8% coupon bond, with a face value of $1,000 and

yield-to-maturity of 12%
• Coupons are paid semi-annually
• Therefore, each coupon payment is $40 and the per period YTM is
(1/2) × 12% = 6%
• Present value of each cash flow equals CFt ÷ (1+ 0.06)t where t is
the period number
DURATION OF 2-YEAR, 8% BOND:
FACE VALUE = $1,000,YTM = 12%
 ECONOMIC INTERPRETATION

• Duration is a measure of interest rate sensitivity or elasticity of a

liability or asset:
[ΔP/P]  [ΔR/(1+R)] = -D

Or equivalently,
ΔP/P = -D[ΔR/(1+R)] = -MD × ΔR
where MD is modified duration
 ECONOMIC INTERPRETATION

• To estimate the change in price, we can rewrite this as:

ΔP = -D[ΔR/(1+R)]P = -(MD) × (ΔR) × (P)

• Note the direct linear relationship between ΔP and -D

 LIMITATIONS OF DURATION

• Duration matching can be costly

• Growth of purchased funds, asset securitization, and loan sales markets
have lowered costs of balance sheet restructurings
• Immunization is a dynamic problem
• Trade-off exists between being perfect immunization and transaction costs
• Large interest rate changes and convexity
 CONVEXITY

• A measure of the curvature in the relationship between bond prices and bond yields that
demonstrates how the duration of a bond changes as the interest rate changes.
• Convexity is used as a risk-management tool, which helps measure and manage the
amount of interest rate risk & market risk to which a portfolio of bonds is exposed.
• The degree of curvature of the price-yield curve around some interest rate level
• All fixed-income securities are convex.
• Convexity is desirable, but greater convexity causes larger errors in the duration-based
estimate of price changes.
CONVEXITY (CONT..)
 TUTORIAL

• Chapter 8: Q. 16,17, 20, 21

• Chapter 9: Q. 3, 4, 5, 7