Measurement of Risk

Unit - 2
 Probability and Distribution of
Asset Prices
• Probability is about interpreting and understanding the
random events of life, and since we live in absolute
randomness, its usefulness becomes quite clear. 

• Probability is the long-term chance that a certain outcome

will occur from some random process. 

• It basically tells us how often different kinds of events will

happen.
• Numerically speaking, a probability is a number that ranges from 0

(meaning there is no way an event is going to happen) to 1 (which means

the event will happen for sure), and if you take all the possible outcomes

and add them up, you sum to 1.

• The bigger the value of the probability, the more likely the event is to occur.

• So for example, you’d say that the probability of rain tomorrow is 40%

(stated as “P(rain)=0,4”), or the probability of a car theft in a particular

region is 2% (defined as “P(car theft)=0,02”). In the first case you’re

interested in the variable “rain”, and in the second in the variable “car

theft”. These variables, as well as any other that is a result of a random

process, are referred to as “random variables”.

 Random Variable

• A random variable is a variable that is subject to random variations so

that it can take on multiple different values, each with an associated

probability.

• It doesn’t have a specific value, but rather a collection of potential values.

After a measurement is taken and the specific value is revealed, then the

random variable ceases to be a random variable and becomes data.

• Usually, past data is used as a proxy of what’s likely to happen, but this is

not always applicable (e.g. for new events with no history), or can be

misleading when extreme events occur.

 Some real life examples of the use of
probabilities are:

• Finance: By estimating the chance that a given

financial asset will fall between or within a

specific range, it’s possible to develop trading

strategies to capture that predicted outcome.

 Probability Distribution

• A probability distribution is a list of all of the possible

outcomes of a random variable, along with its

corresponding probability values. 

• It is confined to a certain range derived from the

statistically possible maximum and minimum values.

• Distributions can be of two types: discrete and continuous.

 Discrete vs. Continuous Distributions

• Discrete refers to a random variable drawn from a finite set of

possible outcomes. A six-sided die, for example, has six discrete
outcomes.

• A continuous distribution refers to a random variable drawn from

an infinite set. Examples of continuous random variables include
speed, distance, and some asset returns.

• A discrete random variable is illustrated typically with dots or

dashes, while a continuous variable is illustrated with a solid line. 
 Types of Probability Distribution
• Uniform Distribution - all outcomes have an equal chance of occurring.

• Binomial Distribution - reflects a series of "either/or" trials, such as a

series of coin tosses.
• Lognormal Distribution - stock prices are distributed lognormally

• Poisson Distribution - used to estimate how many times an event is

likely to occur within the given period of time
• Student's T Distribution - has a slightly "fatter tail" than the normal
distribution.
• Beta Distribution - Is a type of probability distribution which
represents all the possible value of probability.
• Academics, financial analysts and fund managers alike may
determine a particular stock's probability distribution to evaluate
the possible expected returns that the stock may yield in the
future.

• The stock's history of returns, which can be measured from any

time interval, will likely be composed of only a fraction of the
stock's returns, which will subject the analysis to sampling error.

• By increasing the sample size, this error can be dramatically

reduced.
 Probability Distributions Used in Investing

• Stock returns are often assumed to be normally distributed but in reality,

they exhibit kurtosis with large negative and positive returns seeming to

occur more than would be predicted by a normal distribution.

• In fact, because stock prices are bounded by zero but offer a potential

unlimited upside, the distribution of stock returns has been described

as log-normal.

• Probability distributions are often used in risk management as well to

evaluate the probability and amount of losses that an investment portfolio

would incur based on a distribution of historical returns. 

 Expected return on an investment

• The expected return on an investment is the expected value of

the probability distribution of possible returns it can provide to
investors. The return on the investment is an unknown variable
that has different values associated with different probabilities.

• Expected return is calculated by multiplying potential outcomes

(returns) by the chances of each outcome occurring, and then
calculating the sum of those results (as shown below).
• In the short term, the return on an investment can be considered
a random variable that can take any values within a given range.

• The expected return is based on historical data, which may or may not
provide reliable forecasting of future returns. Hence, the outcome is not
guaranteed.

• Expected return is simply a measure of probabilities intended to show

the likelihood that a given investment will generate a positive return, and
what the likely return will be.

• The purpose of calculating the expected return on an investment is to

provide an investor with an idea of probable profit vs risk. This gives the
investor a basis for comparison with the risk-free rate of return.
 Calculating Expected Return for a Single
Investment

• Let us take an investment A, which has a 20% probability of giving a 15% return

on investment, a 50% probability of generating a 10% return, and a 30%

probability of resulting in a 5% loss. This is an example of calculating a discrete

probability distribution for potential returns.

• The probabilities of each potential return outcome are derived from studying

historical data on previous returns of the investment asset being evaluated. The

probabilities stated, in this case, might be derived from studying the performance

of the asset over the previous 10 years. Assume that it generated a 15% return on

investment during two of those 10 years, a 10% return for five of the 10 years,

and suffered a 5% loss for three of the 10 years.

The expected return on investment A would then be calculated as
follows:

• Expected Return of A = 0.2(15%) + 0.5(10%) + 0.3(-5%)

• (That is, a 20%, or .2, probability times a 15%, or .15, return;

plus a 50%, or .5, probability times a 10%, or .1, return; plus a
30%, or .3, probability of a return of negative 5%, or -.5)

• = 3% + 5% – 1.5%

• = 6.5%

• Therefore, the probable long-term average return for

Investment A is 6.5%.
 Modelling Risk

• A risk model is a mathematical representation of a system,

commonly incorporating probability distributions. Models
use relevant historical data as well as “expert elicitation” from
people versed in the topic at hand to understand the probability
of a risk event occurring and its potential severity.

• Gathering the right data is one of the two greatest challenges of

risk modeling; the second is getting decision makers comfortable
enough with the models and their underlying assumption to use
them when making meaningful decisions.
 Types of risk models

• Covariance matrix

• multi-factor model

• Value at risk
 Markowitz model - Return of a portfolio
https://financetrain.com/how-to-calculate-portfolio-risk-and-return/

• The expected return of a portfolio represents weighted average of the expected

returns on the securities comprising that portfolio with weights being the proportion
of total funds invested in each security (the total of weights must be 100).
• Expected Return=WA×RA+WB×RB+WC×RC

WA = Weight of security A
RA = Expected return of security A
WB = Weight of security B
RB = Expected return of security B

WC = Weight of security C
RC = Expected return of security C​
• If a portfolio contained four equally-weighted
assets with expected returns of 8, 10, 12, and
14%,
• The portfolio's expected return would be:
• (8% x 25%) + (10% x 25%) + (12% x 25%) +
(14% x 25%) = 11%
 Normal and lognormal distributions

• The normal, or Gaussian, distribution is usually the first choice when

modeling asset returns.
• Empirically, the normal distribution provides a rough, first-order
approximation to the distribution of many random variables: rates of
changes in currency prices, rates of changes in stock prices, rates of changes
in bond prices, changes in yields, and rates of changes in commodity prices.
• All of these are characterized by many occurrences of small moves and
fewer occurrences of large moves. This provides a rationale for a
distribution with more weight in the center, such as the bell-shaped normal
distribution. For many applications, this is a sufficient approximation.
 Time Aggregation

• It is often necessary to translate parameters

over a given horizon to another horizon. For
example, we have data for daily returns, from
which we compute a daily volatility that we
want to extend to a monthly volatility. This is a
time aggregation problem
• In order to convert the daily volatility to
annual volatility just multiply the daily
volatility number with the square root of time.
• Likewise to convert the annual volatility to
daily volatility, divide the annual volatility by
square root of time.
Consider a stock with daily returns that follow a random
walk. The annualized volatility is 34%. Estimate the
weekly volatility of this stock assuming that the year has
52 weeks.
• a. 6.80%

• b. 5.83%
• c. 4.85%

• d. 4.71%
• Assuming a random walk, we can use the
square root of time rule.
• The weekly volatility is then 34% × 1/ √ 52 =
4.71%.
 Risk of the Portfolio

• The portfolio's risk is a complicated function of the variances

of each security and the correlations of each pair of securities.
• To calculate the risk of a four-security portfolio, an investor
needs each of the four share’s variances and six correlation
values, since there are six possible two-security combinations
with four securities.
 Risk of a Portfolio
• The formula to calculate the risk of the portfolio with two stocks
using modern portfolio approach:

= Portfolio standard deviation

Percentage of total portfolio value in stock A

Percentage of total portfolio value in stock B

Standard deviation of stock A

= Standard deviation of stock B

= Correlation coefficient of stock A and B

Consider a portfolio with 40% invested in asset X and 60% invested

in asset Y. The mean and variance of return on X are 0 and 25

respectively. The mean and variance of return on Y are 1 and 121

respectively. The correlation coefficient between X and Y is 0.3.

What is the nearest value for portfolio volatility?

a. 9.51
b. 8.60
c. 13.38
d. 7.45
 Solution
The variance of the portfolio is given by

• =

• =

• =

• =7.45
Stocks of X ltd. and Y ltd. have yielded the following returns for the
past two years:

Years Return (%) – X ltd. Return (%) – Y Ltd.

2019 12 14
2020 18 12

Required:
• What is the expected return on a portfolio made up of 60% of X and
40% of Y?
• Find out the standard deviation of each stock.
• What is the covariance and co-efficient of correlation between stock X
and Y?
• What is the risk of a portfolio made up of 60% of X and 40% of Y?
• Click the below YouTube link for the solution
to the problem in the previous slide
• https://youtu.be/IOKWuKhCR8I
 Exponentially Weighted Moving Average

• The Exponentially Weighted Moving Average (EWMA) is a quantitative or statistical

measure used to model or describe a time series. The EWMA is widely used in

finance, the main applications being technical analysis and volatility modeling.

• The moving average is designed as such that older observations are given lower

weights. The weights fall exponentially as the data point gets older – hence the

name exponentially weighted.

• The only decision a user of the EWMA must make is the parameter alpha. The

parameter decides how important the current observation is in the calculation of

the EWMA. The higher the value of alpha, the more closely the EWMA tracks the

original time series.

• The exponentially weighted moving average is widely used in computing

the return volatility in risk management. There are various methods of

computing the return volatility of a price series, like the historical

standard deviation method, the EWMA models, and the GARCH model.

• The standard deviation method weighs all observations equally and

often understates the volatility.

• The GARCH model is a complex statistical model based on the EWMA

model. The EWMA model strikes the perfect balance between

complexity and accuracy; hence, it is a very popular approach to

estimating volatility.
 Volatility can be estimated using the EWMA by
following the process:

• Step 1: Sort the closing process in descending order of dates, i.e., from the current to the
oldest price.

• Step 2: If today is t, then the return on the day t-1 is calculated as (St / St–1) where St is the
price of day t.
• Step 3: Calculate squared returns by squaring the returns computed in the previous step.
• Step 4: Select the EWMA parameter alpha. For volatility modeling, the value of alpha is 0.8
or greater. The weights are given by a simple procedure. The first weight (1 – a); is the
weights that follow are given by a * Previous Weight.
• Step 5: Multiply the squared returns in step 3 to the corresponding weights computed in
step 4. Sum the above product to get the EWMA variance.
• Step 6: Finally, the volatility can be computed as the square root of the variance calculated
in step 5.
 Exponential weighted moving average
A bank uses the exponentially weighted moving average (EWMA)
technique with of 0.9 to model the daily volatility of a security. The
current estimate of the daily volatility is 1.5%. The closing price of the
security is USD 20 yesterday and USD 18 today. Using continuously
compounded returns, what is the updated estimate of the volatility?

a. 3.62%

b. 1.31%

c. 2.96%

d. 5.44%
• The log return is ln(18/20) = −10.54%.

• The new variance forecasts is h = 0.90 × (1.52)

+ (1 − 0.90) × 10.542 = 0.001313,
• or taking the square root, 3.62%.
Using a daily Risk Metrics EWMA model with a decay
factor = 0.95 to develop a forecast of the conditional
variance, which weight will be applied to the return
that is four days old?
a. 0.000
b. 0.043

c. 0.048
d. 0.950
 Solution

• The weight of the last day is (1 − 0.95) = 0.050.

For the day before, this is 0.05 × 0.95, and for
four days ago, 0.05 × 0.953 = 0.04287.
Until January 1999 the historical volatility for the Brazilian real versus the

U.S. dollar had been very small for several years. On January 13, Brazil

abandoned the defense of the currency peg. Using the data from the close

of business on January 13, which of the following methods for calculating

volatility would have shown the greatest jump in measured historical

volatility?

a. 250-day equal weight

b. Exponentially weighted with a daily decay factor of 0.94

c. 60-day equal weight

d. All of the above

 Measurement of Credit Risk

• The five C's of credit is a system used by lenders to gauge

the creditworthiness of potential borrowers.

• The system weighs five characteristics of the borrower and

conditions of the loan, attempting to estimate the chance
of default and, consequently, the risk of a financial loss for
the lender.

• The five C's of credit are character, capacity, capital,

collateral, and conditions.
• The first C is character—the applicant's credit history.

• The second C is capacity—the applicant's debt-to-income ratio.

• The third C is capital—the amount of money an applicant has.

• The fourth C is collateral—an asset that can back or act as

security for the loan.

• The fifth C is conditions—the purpose of the loan, the amount

involved, and prevailing interest rates.
• There are many sources of credit risk. The amount of credit risk

depends upon the agreement between bank and its customers.

• For example, in a loan, the amount that the customer owes to a

bank is fixed, whereas in a line of credit, the customer chooses

how much to borrow periodically.

• An agreement between a bank and a customer that gives rise to

a credit exposure is called a credit structure or a credit facility.

– Risk measurement for a single credit facility

– Risk measurement for a credit portfolio

 Risk Measurement of a single facility

There are 3 parameters that are important in

quantifying the credit risk
Expected Loss = PD * EAD * LGD
• Probability of Default (PD)

• Exposure at Default (EAD)

• Loss Given Default (LGD)
 Probability of default

• What is the likelihood that the counter-party

will default on its obligation either over the
life of the obligation or over some specified
horizon, such as a year? Calculated for a one-
year horizon, this may be called the expected
default frequency.
 Exposure at Default

• EAD is the predicted amount of loss a bank may

be exposed to when a debtor defaults on a loan.
Banks often calculate an EAD value for each loan
and then use these figures to determine their
overall default risk. EAD is a dynamic number
that changes as a borrower repays a lender. 
• Exposure at default is the total value of a loan that a bank is
exposed to when a borrower defaults.

• For example, if a borrower takes out a loan for Rs.100,000 and

two years later the amount left on the loan is Rs.75,000, and
the borrower defaults, the exposure at default is Rs. 75,000.

• When analyzing default risk, banks will often calculate the EAD

on a loan, as it aims to predict the amount the bank will be
exposed to when a borrower defaults.

• Exposure at default (EAD) constantly changes as a borrower

pays down their loan.
 Loss Given Default

• In the event of a default, the fraction of exposure that can be

recovered through bankruptcy proceedings or some other form
of settlement is deducted from the total exposure at default.
• The LGD is the amount that’s impossible to recover after selling
(salvaging) the underlying asset following a default event.
• LGD = 1 – Recovery Rate
 Loss given Default

• Imagine a borrower takes out a Rs. 40,00,000 loan for a house.

After making installment payments on the loan for a few years,
the borrower faces financial difficulties and defaults when the
loan has an outstanding balance, or exposure at default, of Rs.
30,00,000. The bank forecloses on the house and is able to sell it
for Rs. 24, 00,000.

• The net loss to the bank is Rs. 6,00,000 (30,00,000 – 24,00,000)

• and the LGD is 20% (30,00,000 – 24,00,000)/30,00,000)

• In this scenario, the expected loss would be
calculated by the following equation:
• Expected Loss = PD * EAD * LGD

• probability of default (100%) X exposure at

default (Rs. 30,00,000) X LGD (20%) =
Rs.6,00,000.
• If the financial institution were projecting out a
potential but not certain loss, the expected loss
would be different.
• Using the same figures from the scenario above, but
assuming only a 50% probability of default, the
expected loss calculation equation is LGD (20%) X
probability of default (50%) X exposure at default
(Rs.30,00,000) = Rs.3,00,000
 Question

• Let us assume that ABC Bank Ltd has lent a loan of Rs.250,00,000

to a company that is into the real estate business. According to

the bank’s internal rating scale, the company has been rated at A,

taking into account the cyclicality witnessed in the industry. The

probability of default and loss given default corresponding to the

internal rating is 10% and 40%, respectively. Determine the

expected loss for ABC Bank Ltd based on the given information
 Solution

• Exposure at default, EAD = Rs.250,00,000

• Probability of default, PD = 10%

• Loss Given Default = 40%

• Expected Loss = PD* EAD * LGD

• = 10% * 250,00,000 * 40%

• Total Loss = Rs. 10,00,000

 Question

• A Canadian bank recently disbursed a 2 million loan, of

which 1.6 million is currently outstanding. According to
the bank’s internal rating model, the beneficiary has a
2% chance of defaulting over the next year. In case that
happens, the estimated loss rate is 30%. Determine the
expected loss figures for the bank.
 Solution

• Exposure at default, EAD = Rs.16,00,000

• Probability of default, PD = 2%

• Loss Given Default = 30%

• Expected Loss = PD* EAD * LGD

• = 2% * 16,00,000 * 30%

• Total Loss = Rs. 9600

 Question
Company XYZ takes business loan from Bank
ABC
• Loan Amount = 50 lakh
• Collateral Pledged = 20 Lakhs
What is expected loss if probability of default is
90%?
 Solution

• EAD = 50 lakh
• PD = 0.90 or 90%
• LGD = (50 lakhs – 20 lakhs = 30 lakhs)

=(30/50)*100 = 60% or 0.60

• Expected Loss = PD * EAD * LGD

= 90% * 50 lakh * 60%

= 27 lakhs
 Question
• You have granted an unsecured loan to a company. This loan will be paid off by a single

payment of Rs. 50 million. The company has a 3% chance of defaulting over the life of

the transaction and your calculations indicate that if it defaults you would recover 70%

of your loan from the bankruptcy courts. If you are required to hold a credit reserve

equal to your expected credit loss, how great a reserve should you hold

a. Rs. 450,000

b. Rs. 750,000

c. Rs. 1,050,000

d. Rs. 1,500,000
 Drawdown in Line of Credit
• Within the context of banking, a drawdown commonly refers to the gradual

accessing of part or all of a line of credit.

• The arrangement with a bank can be either personal or business-related.

• For example, a construction company may be approved for financing to build a

housing development, but it only gradually accesses the financing funds as it

completes portions of the project. The lender may put time or project completion

restrictions on such an arrangement. An example of a time restriction would be a

stipulation that the borrower can only access a certain percentage of the funds every

three months. Project completion restrictions would require the borrower to show

completion of a specified amount of the total project before releasing additional

financing.
 Unexpected Loss

• Unexpected loss is the average total loss over and above the expected
loss. It’s the variation in the expected loss. It is calculated as the
standard deviation from the mean at a certain confidence level.
• Once a bank determines its expected loss, it sets aside credit reserves
in preparation. However, for unexpected loss, the bank must estimate
the excess capital reserves needed subject to a predetermined
confidence level. This excess capital needed to match the bank’s
estimate of unexpected loss is known as economic capital.
• Unexpected Loss =
A bank has booked a loan with total commitment of Rs. 50,000 of which

80% is currently outstanding. The default probability of the loan is assumed

to be 2% for the next year and loss given default (LGD) is estimated at 50%.

The standard deviation of LGD is 40%. Drawdown on default (i.e., the

fraction of the undrawn loan) is assumed to be 60%. The expected and

unexpected losses (standard deviation) for the bank are

a. Expected loss = Rs. 500, unexpected loss = Rs. 4,140

b. Expected loss = Rs. 500, unexpected loss = Rs. 3,220

c. Expected loss = Rs. 460, unexpected loss = Rs. 3,220

d. Expected loss = Rs. 460, unexpected loss = Rs. 4,140

• First, we compute the exposure at default.

• 80% × Rs. 50,000 = Rs. 40,000 + drawdown on

default, which is 60% × Rs.10,000 = Rs. 6,000,
• EAD = Rs.46,000.
• The expected Loss = PD * EAD * LGD

• = 2% * 46,000 * 50%
• Expected Loss = Rs. 460
• Unexpected Loss =

= 0.0032 + (0.0196 * 0.25)

=
=
Unexpected Loss = 4140
• An investor holds a portfolio of Rs. 100 million. This portfolio consists of

A-rated bonds (Rs. 40 million) and BBB-rated bonds (Rs. 60 million).

Assume that the one-year probabilities of default for A-rated and BBB-

rated bonds are 3% and 5%, respectively, and that they are independent.

If the recovery value for A-rated bonds in the event of default is 70% and

the recovery value for BBB-rated bonds is 45%, what is the one-year

expected credit loss from this portfolio?

a. Rs. 16,72,000

b. Rs. 18,42,000

c. Rs. 20,10,000

d. Rs. 22,18,000
Suppose Bank Z lends EUR 1 million to X and EUR 5 million
to Y. Over the next year, the PD for X is 0.2 and for Y is 0.3.
The loss given default is 40% for X and 60% for Y. What is
the expected loss of default in one year for the bank?
a. EUR 0.72 million
b. EUR 0.98 million
c. EUR 0.46 million
d. EUR 0.64 million
 Measurement of Market Risk

• Sensitivity Analysis

• Scenario Analysis

• Stress Testing
• Value At Risk (VAR)
 Sensitivity Analysis

• Sensitivity Analysis is also referred to as a what-if analysis.

• It is a useful tool to determine how the changes in the market

could affect the value of the portfolio.

• The market risk factors are market variables like interest rates,
credit spreads, equity prices, exchange rates, etc.

• Sensitivity analysis determines how different values of an

independent variable affect a particular dependent variable under
a given set of assumptions.
 Scenario Analysis

• Scenario analysis involves a thorough look at a wide range of

possible outcomes—including those on the downside. This

allows risk managers to identify, prepare for, and manage risk

exposures.

• Both likely scenarios and unlikely worst-case events can be

tested in this fashion—often relying on computer simulations.

• Scenario analysis can apply to investment strategy as well as

corporate finance.
 Scenario Analysis

• This is similar to sensitivity analysis in the sense that this

approach also tries to determine the portfolio value if the market
risk factors change.

• However in this approach, instead of changing the risk factors

one by one, different scenarios with simultaneous changes in all
risk factors are considered.

• In scenario analysis, expert opinion is used to create a limited set

of worse case scenarios. Each scenario corresponds to a specific
type of market crisis, like crash of equity market, increase in oil
prices, increase in interest rates, etc.
• There are many different ways to approach scenario
analysis. A common method is to determine the standard
deviation of daily or monthly security returns and then
compute what value is expected for the portfolio if each
security generates returns that are two or three standard
deviations above and below the average return.

• This way, an analyst can have a reasonable amount of

certainty regarding the change in the value of a portfolio
during a given time period, by simulating these extremes.
 Advantages & Disadvantages of Scenario
Analysis

• The biggest advantage of scenario analysis is

that it acts as an in-depth examination of all
possible outcomes.
• Because of this, it allows managers to test
decisions, understand the potential impact of
specific variables, and identify potential risks.
 Difference between scenario analysis and
sensitivity analysis
• Scenario analysis looks at a wide range of possible
outcomes, but it analyzes the effect of manipulating all
variables at the same time. The result is typically a base-
case scenario, a best-case scenario, and a worst-case
scenario.

• On the other hand, sensitivity analysis assesses the impact

of changing just one variable at a time.
 Stress Testing

• The purpose of stress testing is to examine the impact of

extreme events on the portfolio.

• This test thus deals with the ability of the business to

survive extreme conditions and implement changes in

strategy.

• It provides a deeper understanding of the risk and

thereby prepares a ground for better protection.

 Measurement of Interest Rate Risk for Asset
Liability Management

• Banks and financial intuitions need to measure ALM interest rate

risk for two reasons:
– To establish the amount of economic capital to be held against such risks.
– To reduce such risks.

• Banks use three alternative approaches to measure ALM interest

rate risk.
– Gap Analysis
– Rate-Shift Analysis
– Simulation Methods
 Gap Analysis
• The last 20 years have seen an increased volatility of interest rates
when compared to the 1950’s or 1960’s.
• Interest rate risk arises in bank operations because banks assets and
liabilities generally have their interest rates reset at different times.
• This leaves net interest income (interest earned on assets less interest
paid on liabilities) vulnerable to changes in market interest rates.
• The magnitude of interest rate risk depends on the degree of mismatch
between the changes in asset and liability interest rates.
• One way to measure the direction and extent of the asset-liability
mismatch is through gap analysis.
 Gap Analysis
• The interest rate gap measures a firm's exposure to interest
rate risk.
• The gap is the distance between assets and liabilities.

• The most commonly seen examples of an interest rate gap are

in the banking industry.
• A bank borrows funds at one rate and loans the money out at
a higher rate.
• The gap, or difference, between the two rates represents the
bank's profit.
• The interest rate gap helps determine a bank or
financial institution’s exposure to interest rate risk.
• A negative gap, which is an interest rate gap that is
less than one, is when rate-sensitive liabilities are
greater than rate-sensitive assets, while a positive
gap, which is greater than one, is the opposite.
• Hedging can be used to reduce the risk of a large
interest rate gap.
Formula and Calculation of the Interest Rate Gap:
• IRG=IBA − IBL
• IRG = Interest rate gap

• IBA = Interest Bearing Assets

• IBL = Interest bearing liabilities​
 What the Interest Rate Gap
Can Tell You

• A negative gap, or a ratio less than one, occurs when a

bank's interest rate sensitive liabilities exceed its interest
rate sensitive assets.
• A positive gap, or greater than one, is the opposite, where
a bank’s interest rate sensitive assets exceed its interest
rate sensitive liabilities. A positive gap means that when
rates rise, a bank’s profits or revenues will likely rise.
• There are two types of interest rate gaps: fixed and
variable.
• Each measures the difference between rates on assets
and liabilities and is an indicator of interest rate risk.
• Determination of the differential spans a given period
for both fixed and variable interest rate gaps.
• Interest rate gaps can also apply to the difference in
interest rates on government securities between two
different countries.
• A negative gap may not always be a negative for
a financial institution.
• That is, as interest rates fall, banks earn less from
interest-rate-sensitive assets; however, they also
pay less on their interest-related liabilities.
• Banks that have a higher level of liabilities than
assets are the ones that see more of a strain on
their bottom line from a negative gap.
 Rate- Shift Scenarios

• Rate-shift scenarios attempt to capture the behavior of customers as a result

of a given change in interest rates.

• For example, if the rates are expected to go up by 1%, what will be the effect

on the bank’s cash flow?

• An increase in interest rates may result in an increase in mortgage

prepayments and inflow of more deposits.

• Then the NPV of this new set of cash flows is calculated using the new rates.

• This helps in arriving at the changes in earnings and value expected under

different interest rate scenarios.

 Simulation
• In this technique, the impact of various risks like market
risk, interest rate risk, etc. on a bank’s financial position,
asset values, earnings or net income is examined.
• Banks use balance sheet simulation models to gauge
the effect of market interest rate variations on reported
earnings/economic values over different time zones.