Interest Rate Risk

Management
 Overview

z Managing interest rate risk

z Principles for establishing a conducive
interest rate risk management environment.
environment
z Operating a sound interest rate management
process
Managing
g g Interest Rate Risk
 Introduction

zInterest rate risk management is mainly

hi d on repositioning
hinged iti i the
th strategic
t t i gap to
t
desired levels.
z This can be done in broadly 3 ways,
namely;y;
z 1) Pricing strategy
z 2) Asset-Liability
Asset Liability restructuring
z 3) Derivative strategy
 Introduction

zFor strategic reasons, the gap repositioning

would be done, typically, within the context
p
of the expected change
g in interest rates.
z The following broad strategy can be used;
Current E[IR]
Strategic Move
Position Movement
U
Upward
d A
Approach
h li
limit
it
Asset
sensitive
iti Reduce gap/switch to
book Downward liability sensitive
b k
book
Reduce g gap/switch
p to
Liability Upward liability sensitive
sensitive book
book
D
Downward
d A
Approach
h li
limit
it
 Introduction
z Thus the strategies can be broadly classified
into 2:
1) Strategies where we are approaching asset
sensitive gap limit
2)) Strategiesi where
h we are approaching
hi
liability sensitive gap limit.
 Pricing Strategy
z 1) Strategies which contribute to
approaching
hi the
th liability
li bilit sensitive
iti gap limit
li it
include:
z Making interest rates on short term deposits
more attractive relative to long g term
deposits
z Increasing the interest rate on long term
loans.
 Pricing Strategy
z Strategies which contribute to approaching
the asset sensitive gap limit include:
1) Making interest rates on short term deposits
less attractive relative to long term deposits.
2)) Loans on long
l term loans
l to be
b re-priced
i d
more regularly.
 Pricing Strategy
z The ability to implement the pricing
strategy will mainly depend on:
1) the interest rate elasticity of demand for the
assets and liabilities.
2)) the
h value
l and d number
b off positions
ii that
h the
h
financial institution has ability to change the
interest rate.
 Volume Strategy
zThe relatively fastest way of repositioning a
gap is through purchasing and / or selling
th required
the i d amountt off assets.
t
z The strategy of approaching the liability
sensitive
i i gap limit
li i would ld generally
ll involve
i l
purchasing more longer term instruments
and less short term instruments.
instruments
z The strategy of approaching an asset
sensitive
iti gap limit
li it wouldld generally
ll involve
i l
purchasing more shorter term instruments
and less long term instruments.
instruments
 Derivative Strategy

z Instead of repositioning the gap, hedging against

adverse
d movements in i interest
i rates can be
b done
d
through interest rate derivatives.
z The most common types of derivative instruments
used in developed financial markets include:
z Forward rate agreements: These are contracts
traded over-the-counter that a certain rate will
apply to a certain principal during a specified
future pperiod of time.
 Derivative Strategy

z Interest rate futures: These are standardized

f
forwardd contracts that
h are traded
d d on a derivative
d i i
exchange.
z Interest rate swaps: These are contracts where 2
parties agree to exchange interest payments
ONLY on the same principal amount.
z As no p principal
p is exchanged,
g , the size and
composition of the balance sheet of the 2 parties
remains unchanged.
g
 Derivative Strategy

z Suppose we have a liability sensitive gap and we

anticipate an increase in interest rates.
rates Instead of
adjusting the gap, we buy a swap where we agree
to pay the other party a fixed interest rate.
rate
z If interest rates indeed increase, we get a net
positive payment from the swap deal which will
offset the decline in net interest income.
z If interest rates however decline,
decline we make a net
positive payment on the swap deal , which will
offset an increase in net interest income.
 Derivative Strategy

z Suppose we have an asset sensitive gap and we

anticipate a decrease in interest rates.
rates Instead of
adjusting the gap, we buy a swap where we agree
to pay the other party a variable interest rate.
rate
z If interest rates indeed decrease, we get a net
positive payment from the swap deal which will
offset the decline in net interest income.
z If interest rates however increase,
increase we make a net
positive payment on the swap deal , which will
offset an increase in net interest income.
Principles for establishing a
conducive interest rate risk
management environment.
 Principle 1
z The board of directors should have overall
responsibility for approving policies and
strategies
g to be used to manageg interest rate
risk.
 Principle 2
z Senior management has the responsibility
of:
f
– developing the policies and procedures for
identifying,
id if i measuring,
i monitoring
i i andd
controlling interest rate risk
– ensuring
i that
h the
h strategiesi andd policies
li i usedd to
manage interest rate risk are appropriate and
effective.
effective
z
 Principle 3
zFI’s should identify the interest rate risk
inherent in new products and activities and
ensure that these are subject
j to controls and
adequate procedures before being
introduced or undertaken.
undertaken
z Major hedging or risk management
activities should first be approved in
advance byy the board.
Operating
O ti A Sound
S d IInterest
t t
Rate Risk Management
Process
 Principle 1

zFIs should CLEARLY define the

individuals and / or committees responsible
g g interest rate risk.
for managing
z The management of interest rate function
should be clearly independent from the
position taking functions of the financial
institution.
 Principle 2
z The analysis and interest risk management
activities should be delegated to competent
staff with the technical knowledgeg and/or
experience consistent with the nature and
scope of the FIs
FIs’ activities.
activities
 Principle 3
zFIs must have information systems that
capture all the material sources of interest
rate risk.
z The assumptions underlying the system
should be clearly understood by
management.
 Principle 4
zFIs must establish and enforce operating
li it and
limits d other
th practices
ti th t maintain
that i t i
exposures within levels consistent with their
i
internall policies.
li i
z Such limits should be appropriate
pp p to the
size, complexity, and equity of the FI.
z Limits can be set on individuals,
individuals business
units, portfolios or instrument types.
 Principle 5
z FIs should use stress testing when setting or
reviewing limits and policies.
 Principle 6
zInterest rate risk reporting should be timely
and should be provided to the board of
directors and management.
directors, management
z The basic structure of the reports should
include the following information;
z 1) Summary of aggregate interest rate
exposures
z 2) Report on compliance with limits and
p
policies.
z 3) Results on stress tests
Any Questions?