2012

Managing Interest Rate Risk

Prateek Rastogi 1121028 Dhruv Chopra 1121030

Harsh Cariappa 1121031

Why to manage IRR Interest rate risk should be managed where fluctuations in interest rate impact on the organization's profitability. In an organization where the core operations are something other than financial services, such financial risk should be appropriately managed, so that the focus of the organisation is on providing the core goods or services without exposing the business to financial risks An adverse movement in interest rate risk may potentially: increase borrowing costs for borrowers; reduce returns for investors reduce profitability of financial services providers such as banks; and reduce the net present value (NPV) of organizations due to the effect of changes in the discount rate (Interest rate) on the value of financial instruments, hedges and the return on projects.

Impact of adverse movements in interest rates on organizations

Borrowers in general concerned about rising rates Increased cost of funds =
Profitability = market Ability to Ability to Chance

value

undertake capital expenditure pay dividends

of a breach of borrowing covenants margins due to deterioration in financial ratios

Borrowing (initially)

NPV (net worth) due to a higher discount rate being applied to fixed

interest loans and associated hedges (the opposite applies where rates fall) Investors in general concerned about falling rates Reduced cost of funds =
Profitability = market Ability to

value

pay returns to stakeholders e.g. unit holders in a trust

 Competitive

returns = ability to attract investors

(initially) NPV (net worth/unit prices) due to the lower discount rate being

applied to investments and Associated hedges (the opposite applies when rates increase)
Ability to

meet future outgoings e.g. superannuation.

Methods to measure interest rate risk

There are many ways to measure interest rate risk which can range from very simple measures to very sophisticated Measures which are mathematically complex and require significant computing power. This guide provides some examples of the simpler measures which can be applied and understood by most organizations. Sensitivity analysis Simple analysis measurement of the impact of small changes of interest rates on the accounting income or economic value. For example, if interest rates increase by 1 percent now, what will be the impact on the accounting income? Usually calculated on spreadsheets Advanced measurement of the impact of multiple changes in interest rates and other related variables on the entitys financial health. For example, if the entity is 50 per cent hedged and interest rates increase by 1 per cent and earnings before interest, tax, depreciation and amortization (EBITDA) fall by 10 per cent, what will be the impact on the entitys interest cover ratio? This information may be presented in a tabular form. Stress test modeling the impact of a large change in interest rates on borrowings or investments in accounting terms or risk outcomes. This type of measurement is frequently used by financial institutions.

Repricing profiles (graphical representation of the interest reset of assets and liabilities over time) For entities this may be a graphical representation of the interest repricing of assets or liabilities over time.

Market Risk: Interest rate Risk in UNION BANK Asset Liability Management Policy and Treasury Policy aid the management in mitigating the Market Risk in the Banking and trading books. Overall responsibility of managing the market risk lies with the Asset Liability Committee (ALCO). The Committee meets regularly and decides on the size, mix, tenor, pricing and composition of various assets and liabilities. It primarily does identication, measurement, monitoring and management of liquidity and interest rate risk. It uses tools such as Ratio analysis, Gap analysis reports - Structural liquidity, Dynamic Liquidity, Interest Rate Sensitivity, Value at Risk, Duration Gap Analysis etc for management of liquidity and interest rate risks. The fundamental focus is to add value both from the earnings perspective and from the economic value perspective. Bank has an independent mid office positioned in treasury and reporting to risk management. It ensures compliance in terms of exposure analysis, limits xed and calculation of risk sensitive parameters like Value at Risk, PVO1, Duration, Defeasance Period, etc. Bank uses Traditional Gap Analysis (TGA) to assess the Impact on the Net Interest Income (NII) of the bank in short runs, i.e. up to end of Financial Year. Banks investment portfolio is monitored on basis of duration analysis. VaR methodology is followed for dated securities under SLR and Equities. Prudential limits for VaR have been xed and monitored on a daily basis and reported to the Top Management. Bank also uses Duration Gap Analysis (DGA) to assess long-term impact of changes in interest rate on Market Value of Equity (MVE) in terms of RBI Guidelines.

Interest rate risk in the banking book (IRRBB) (a) Qualitative Disclosures Interest rate risk is the risk where changes in market rates might adversely affect bank financial condition resulting in impact on earnings (Net Interest Income) and Banks Net Worth. Bank holds assets, liabilities and off balance sheet items with different maturities o repricing dates and linked to different benchmark rates. This creates exposure to unexpected changes in level of interest rates. Framework: Bank has formed Asset Liability Management Committee (ALCO), headed by Chairman and Managing Director, which is responsible for evolving appropriate system and procedures for identi cation and analysis of liquidity/market risk and laid down ALM policy of the bank. The ALCO is assisted by a dedicated ALM Desk and an independent MidOffice. Supervisory Committee of the Board of Directors on ALM and Risk Management oversees the functioning of ALCO and also implementation of the system for Asset Liability Management (ALM) and reviews its functions periodically and provides directions. Traditional Gap Analysis (TGA) is used to measure and monitor Interest rate risk through Rate Sensitive Gap (RSG). Impact of changes in interest on Net Interest Income (NII) is computed. Limit on RSG up to 1 Year is xed to limit impact of interest rate changes from earning perspective.

Interest rate sensitivity statement is prepared as on the last reporting Friday of each month. ALCO reviews the same on monthly basis. Impact of changes in broad categories of assets and liabilities, i.e. deposits, advances, investments and others upto the end of the nancial year is worked out. In terms of RBI guidelines, Bank also carries out Duration Gap Analysis (DGA) on quarterly basis to capture impact of changes in interest rates on economic value of banks assets and liabilities in banking book and thereby on Market Value of Equity (MVE). The impact is worked out assuming 200 bps parallel shifts in yield curve. (b) Quantitative Disclosures The impact of earnings and economic value of equity assuming a percentage shift in interest rates is as under:

Sources: Union Bank Annual Report 2011-2012 Understanding Interest Rate Risk in CPA Australia Managing Interest Rate risk in banks by Dr. Vighneshwara Swamy Basal Committee Report on Banking Supervision