Managing Interest Rate Risk

Interest Rate Risk

The potential loss from unexpected changes in interest rates which can significantly
alter a banks profitability and market value of equity.
When a banks assets and liabilities do not reprice at the same time, the result is a
change in net interest income.
The change in the value of assets and the change in the value of liabilities will
also differ, causing a change in the value of stockholders equity
Banks typically focus on either
!et interest income or
The market value of stockholders" equity
#sset and $iability %anagement &ommittee '#$&()
The #$&(s primary responsibility is interest rate risk management.
The #$&( coordinates the banks strategies to achieve the optimal
risk*reward trade+off.
Repricing Model
,ate sensitivity means time to repricing
,ate+sensitive assets those assets that will mature or reprice in a given time
period
,ate+sensitive liabilities those liabilities that will mature or reprice in a given
time period
-xample
Which of the following assets or liabilities fit the one-year rate or repricing
sensitivity test?
(1) 91-day !"! #reas$ry bills
(%) 1-year !"! #reas$ry notes
(&) %'-year !"! #reas$ry bonds
(() %'-year floating-rate corporate bonds with ann$al repricing
()) &'-year floating-rate *ortgages with repricing every two years
(+) &'-year floating-rate *ortgages with repricing every si, *onths
(-) .vernight fed f$nds
(/) 9-*onth fi,ed rate 01s
(9) 1-year fi,ed-rate 01s
(1') )-year floating-rate 01s with ann$al repricing
(11) 0o**on stock
,epricing gap is the difference between the rate sensitivity of each asset and the rate
sensitivity of each liability ,.# / ,.$
%easuring 0nterest ,ate ,isk with 1#2
-xample
2 bank *akes a 31'4''' fo$r-year car loan to a c$sto*er at fi,ed rate of
/!)5! #he bank initially f$nds the car loan with a one-year 31'4''' 01 at a
cost of (!)5! #he bank6s initial spread is (5!
3
What is the bank6s 1-year 728 with the a$to loan?
R"2
1yr
9 3'
R":
1yr
9 31'4'''
728
1yr
9 3' - 31'4''' 9 -31'4'''
#he bank6s one year f$nding 728 is -1'4'''
If interest rates rise (fall) in 1 year4 the bank6s *argin will fall (rise)
,epricing or funding gap model based on book value, and focuses on managing net
interest income in the short+run
%aturity buckets &ommercial banks must report repricing gaps for assets and
liabilities with maturities of
(ne day
%ore than one day to three months
%ore than 4 three months to six months
%ore than six months to twelve months
%ore than one year to five years
(ver five years
,epricing gap example
#ssets $iabilities 1ap &um. 1ap
3+day 5 67 5 47 5+37 5+37
83day+4mos. 47 97 +37 +67
84mos.+:mos. ;7 <= +3= +4=
8:mos.+36mos. >7 ;7 ?67 +3=
83yr.+=yrs. 97 47 ?37 +=
8= years 37 = ?= 7
#pplying the repricing model
!00
i
@ '1#2
i
) ,
i
@ ',.#
i
+ ,.$
i
) r
i
0n the one day bucket, gap is +537 million. 0f rates rise by 3A,
!00
i
@ '+537 million) B 7.73 @ +5377,777
0n the :mos. / 36mos. bucket, gap is 567 million. 0f rates rise by 3A,
!00
i
@ '567 million) B 7.73 @ 5677,777
0f we consider the cumulative 3+year gap,
!00
i
@ '&1#2
i
) ,
i
@ '+53= million)'7.73)@ +53=7,777
-qual changes in rates on ,.#s and ,.$s
-xample .uppose rates rise 6A for ,.#s and ,.$s. -xpected annual change in
!00,
!00 @ &1#2 B ,@ +53= million B 7.76 @ +5477,777
With positive &1#2, rates and !00 move in the same direction
Cnequal changes in ,ates
0f changes in rates on ,.#s and ,.$s are not equal, the spread changes. 0n this
case,
!00 @ ',.# B ,
,.#
) + ',.$ B ,
,.$
)
6
Cnequal rate change example
0f ,.# rate rises by 3.6A and ,.$ rate rises by 3.7A
!00 @ interest revenue + interest expense
@ '5637 million B 3.6A) + '566= million B 3.7A)
@ 56.=6million / 6.6=million @ 56;7,777
The D0 can restructure its assets and liabilities, on or off the balance sheet, to benefit
from proEected interest rate changes.
2ositive gap increase in rates increases !00
!egative gap decrease in rates increases !00
#dvantages and disadvantages of repricing model
#dvantages
-asy to understand
Works well with small changes in interest rates
Fisadvantages
0gnores market value effects and off+balance sheet cash flows
(veraggregative distribution of assets G liabilities within individual
buckets is not considered. %ismatches within buckets can be substantial
0gnores effects of runoffs
The %aturity %odel
-xplicitly incorporates market value effects.
Dor fixed+income assets and liabilities
,ise 'fall) in interest rates leads to fall 'rise) in market price.
The longer the maturity, the greater the effect of interest rate changes on market
price.
-xample 0mpact of maturity on change in loan 'bond) value
:oan 2 :oan ;
Mat$rity 1 years % year
<ace val$e 31'' 31''
2nn$al co$pon 1'5 1'5
If c$rrent *arket interest rate is 1'54 *arket val$es of the two bonds
=2 9 (1''>1')?(1>'!1') 9 31''
=; 9 1'?(1>'!1') > (1'>1'')?(1>'!1')
%
9 31''
If *arket interest rate increases by 154 to 1154 *arket val$es of the two bonds
=62 9 (1''>1')?(1>'!11) 9 399!1'
=6; 9 1'?(1>'!11) > (1'>1'')?(1>'!11)
%
9 39/!%9
%aturity of portfolio of assets 'liabilities) equals weighted average of maturities of
individual components of the portfolio
Typically, %
#
+ %
$
8 7 for most banks and thrifts
.iHe of the gap determines the siHe of interest rate change that would drive net
worth to Hero
0mmuniHation and effect of setting
%
#
+ %
$
@ 7
0f %
#
+ %
$
@ 7, is the D0 immuniHedI
4
-xtreme example .uppose liabilities consist of 3+year Hero coupon bond with
face value 5377. #ssets consist of 3+year loan, which pays back 5>>.>> shortly
after origination, and 3J at the end of the year. Both have maturities of 3 year
!ot immuniHed, although maturities are equal
,eason Fifferences in duration
9