Chapter 8

Interest Rate Risk I

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

 8-2
Overview

 This chapter discusses the interest rate

risk associated with financial
intermediation:
 Federal Reserve monetary policy

 Repricing model

 Maturity model

 Duration model

 *Term structure of interest rate risk

 *Theories of the term structure of

interest rates
 8-3
Loanable Funds Theory

 Interest rates reflect supply and demand

for loanable funds
 Shifts in supply or demand generate
interest rate movements as market
forces establish a new equilibrium
 8-4
Determination of Equilibrium Interest Rates
 8-5
Level & Movement of Interest Rates
 Federal Reserve Bank: U.S. central bank
 Open market operations influence money
supply, inflation, and interest rates
 Actions of Fed in response to 2001 attacks
on World Trade Center
 Lowered interest rates 11 times during the year
 June 2004- August 2006
 inflation concerns take prominence
 17 consecutive increases in interest rates
 8-6

Central Bank and Interest Rates

 Target is primarily short term rates
 Focus on Fed Funds Rate in particular

 Interest rate changes and volatility increasingly

transmitted from country to country
 Statements by Federal reserve Chairman (Jerome

Powel) can have dramatic effects on world interest

rates.
 The level and volatility of interest rates and the
increase in worldwide financial market integration
make the measurement and management of interest
rate risk one of the key issues facing FI managers.
Interest Rate on US 91 day T-bill (1965 – 8-7

2012)
 8-8
Pakistan 6 month T-bill Rate (1990 – 2018)
 8-9
Pakistan 6 month T-bill rate
 Interbank Rate in Pakistan remained unchanged at 6.35
percent in May from 6.35 percent in April of 2018.

 Interbank Rate in Pakistan averaged 9.92 percent from

1991 until 2018, reaching an all time high of 17.42
percent in May of 1997 and a record low of 1.21 percent
in July of 2003.
 8-10
Measuring Interest Rate Risk
 Three models for measuring asset
liability gap exposure of Financial
Institution:

1) The repricing (or funding gap) model

2) The maturity model
3) The duration model
 8-11
Repricing Model
 Repricing or funding gap model based
on book value.
 Contrasts with market value-based
maturity and duration models
recommended by the Bank for
International Settlements (BIS).
 Rate sensitivity means time to repricing.

 Repricing gap is the difference between

the rate sensitivity of each asset and the
rate sensitivity of each liability: RSA -
RSL.
 8-12
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 3 three months to six months.
 More than six months to twelve months.
 More than one year to five years.
 Over five years.
 8-13
Repricing Gap Example

Assets Liabilities Gap Cum. Gap

1-day $ 20 $ 30 $-10 $-10
>1day-3mos. 30 40 -10 -20
>3mos.-6mos. 70 85 -15 -35
>6mos.-12mos. 90 70 +20 -15
>1yr.-5yrs. 40 30 +10 -5
>5 years 10 5 +5 0
 8-14
Re-pricing Gap
 A negative gap (RSA<RSL) exposes the FI to
refinancing risk, in that a rise in these short-term rates
would lower the FI’s net interest income since the FI
has more rate-sensitive liabilities than assets in this
bucket.
 In other words, assuming equal changes in interest
rates on RSAs and RSLs, interest expense will
increase by more than interest revenue.
 Conversely, if FI has positive gap (RSA>RSL) then it is
exposed to reinvestment risk. Hence, a drop in rates
over that period would lower the FI’s net interest
income; that is, interest income will decrease by more
than interest expense.
 8-15
Applying the Repricing Model

 DNIIi = (GAPi) DRi = (RSAi - RSLi) DRi

Example:
In the one day bucket, gap is -$10 million. If
rates rise by 1%,
DNII(1) = (-$10 million) × .01 = -$100,000.
 8-16
Applying the Repricing Model
 Example II:
If we consider the cumulative 1-year gap,

DNII = (CGAPone year) DR

= (-$15 million)(.01)
= -$150,000.
 8-17
Applying the repricing model – Practice Q1

Consider the following balance sheet positions for a

depository institution:

1) Rate-sensitive assets = $200 million. Rate-sensitive

liabilities = $100 million
2) Rate-sensitive assets = $100 million. Rate-sensitive
liabilities = $150 million
3) Rate-sensitive assets = $150 million. Rate-sensitive
liabilities = $140 million
a. Calculate the repricing gap and the impact on net
interest income of a 1 percent increase & decrease in
interest rates for each position.
 8-18
Applying the repricing model - Practice

1) Repricing gap = RSA - RSL = $200 - $100 million

= +$100 million.
DNII = ($100 million)(.01)
= +$1.0 million, or $1,000,000.
1) Repricing gap = RSA - RSL = $100 - $150 million
= -$50 million.
DNII = (-$50 million)(.01)
= -$0.5 million, or -$500,000.

Repricing gap = RSA - RSL = $150 - $140 million

= +$10 million.
DNII = ($10 million)(.01)
= +$0.1 million, or $100,000.
 8-19
Applying the repricing model - Practice

DNII = ($100 million)(-.01)

= -$1.0 million, or -$1,000,000.

DNII = (-$50 million)(-.01)

= +$0.5 million, or $500,000.

DNII = ($10 million)(-.01)

= -$0.1 million, or -$100,000.
 8-20
Rate Sensitive Assets/Liability
 8-21
Rate-Sensitive Assets
1) Short-term consumer loans: $50 million. These are
repriced at the end of the year and just make the one-
year cutoff.
2) Three-month T-bills: $30 million. These are repriced
on maturity (rollover) every three months.
3) Six-month T-notes: $35 million. These are repriced
on maturity (rollover) every six months.
4) 30-year floating-rate mortgages: $40 million. These
are repriced (i.e., the mortgage rate is reset) every
nine months. Thus, these long-term assets are rate-
sensitive assets in the context of the repricing model
with a one-year repricing horizon.
 Total Rate Sensitive Assets = 155 Million
 8-22
Rate-Sensitive Liabilities
1. Three-month CDs: $40 million. These mature in three
months and are repriced on rollover.
2. Three-month bankers acceptances: $20 million.
These also mature in three months and are repriced
on rollover.
3. Six-month commercial paper: $60 million. These
mature and are repriced every six months.
4. One-year time deposits: $20 million. These get
repriced right at the end of the one year gap horizon.
 Rate Sensitive Liabilities = 140 million
 Demand Deposits & Pass book saving accounts (Rate
insensitive)
 8-23
One – year Repricing gap
Cumulative one-year repricing gap (CGAP) for the bank
is:

CGAP = One-year rate-sensitive assets - One-year rate-

sensitive liabilities
= RSA - RSL
= $155 million - $140 million
= $15 million
 8-24
CGAP Ratio
 May be useful to express CGAP in ratio
form as,
CGAP/Assets.
 Provides direction of exposure and
 Scale of the exposure.
 Example:
 CGAP/A = $15 million / $270 million = 0.56,
or 5.6 percent.
 8-25
Gap Ratio
 FIs calculate a gap ratio defined as rate-
sensitive assets divided by rate-sensitive
liabilities.
 A gap ratio greater than 1 indicates that there
are more rate sensitive assets than liabilities.
Thus, the FI is set to see increases in net
interest income when interest rates increase.
 A gap ratio less than 1 indicates that there are
more rate sensitive liabilities than assets.
Thus, the FI is set to see increases in net
interest income when interest rates decrease.
 8-26
Equal Rate Changes on RSAs, RSLs

 Example: Suppose rates rise 1% for

RSAs and RSLs. Expected annual
change in NII,
DNII = CGAP × D R
= $15 million × .01
= $150,000
 With positive CGAP, rates and NII move
in the same direction.
 Change proportional to CGAP
 8-27
CGAP Effects

 It is evident from this equation that the larger the

absolute value of CGAP, the larger the expected
change in NII.
 In general, when CGAP is positive, the change in NII is
positively related to the change in interest rates. Thus,
an FI would want its CGAP to be positive when interest
rates are expected to rise.
 In general then, when CGAP is negative, the change in
NII is negatively related to the change in interest rates.
Thus, an FI would want its CGAP to be negative when
interest rates are expected to fall.
 8-28
CGAP effects for equal changes
 8-29
CGAP Effects – Practice Q2
 8-30
CGAP Effects - Practice
Part a)
Current expected interest income:
=$50m(0.10) + $50m(0.07)
= $8.5m.
Expected interest expense:
=$70m(0.06) - $20m(0.07)
= $5.6m.
Expected net interest income:
=$8.5m - $5.6m
= $2.9m.
 8-31
CGAP Effects - Practice
Part b)
 After the 200 basis point interest rate
increase, net interest income declines to:
= 50(0.12) + 50(0.07) - 70(0.08) - 20(.07)
= $9.5m - $7.0m
= $2.5m, a decline of $0.4m.
 8-32
CGAP Effects - Practice
Part c)
Wachovia’s' repricing or funding gap is
$50m - $70m = -$20m.

The change in net interest income using

the funding gap model is
(-$20m)(0.02)
= -$.4m.
 8-33
CGAP Effects - Practice
Part d)
After the unequal rate increases, net interest
income will be
50(0.12) + 50(0.07) - 70(0.07) - 20(.07)
= $9.5m - $6.3m
= $3.2m, an increase of $0.3m.
It is not uncommon for interest rates to adjust in
an unequal manner on RSAs versus RSLs.
Interest rates often do not adjust solely because
of market pressures. In many cases the changes
are affected by decisions of management.
 8-34
Unequal Changes in Rates

 If changes in rates on RSAs and RSLs

are not equal, the spread changes. In this
case,
DNII = (RSA × D RRSA ) - (RSL × D RRSL )
 8-35
Spread Effect - Example
 To understand spread effect, assume for
a moment that RSAs equal RSLs equal
$155 million. Suppose that rates rise by
1.2 percent on RSAs and by 1 percent on
RSLs (i.e., the spread between the rates
on RSAs and RSLs increases by 1.2
percent - 1 percent = 0.2 percent).
 8-36
Unequal Rate Change Example
Spread effect example:
RSA rate rises by 1.2% and RSL rate rises
by 1.0%
DNII = D interest revenue - D interest
expense
= ($155 million × 1.2%) - ($155 million ×
1.0%)
= $310,000
 8-37
Spread Effect - Example
 Suppose that for the FI with 155 million in RSAs
& 140 million in RSLs, interest rates fall by 1
percent on RSAs and by 1.2 percent on RSLs.
 Calculate change in NII:
 8-38
Spread Effect - Example
 Suppose that for the FI with 155 million in RSAs
& 140 million in RSLs, interest rates fall by 1
percent on RSAs and by 1.2 percent on RSLs.
 Calculate change in NII:

 NII

= [$155 million * (-0.01)] - [$140 million *(-0.012)]

= - $1.55 million - (-$1.68 million)
= $0.13 million or $130,000
 8-39
Spread effects
 8-40
Restructuring Assets & Liabilities
 The FI can restructure its assets and
liabilities, on or off the balance sheet, to
benefit from projected interest rate
changes.
 Positive gap: increase in rates increases NII
 Negative gap: decrease in rates increases
NII
 8-41
Weaknesses of Repricing Model

 Weaknesses:
 Ignores market value effects and off-
balance sheet (OBS) cash flows
 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.
Ignores Off – balance sheet Assets & liabilities
Q3: Which of the following assets or liabilities fit8-42
the one-year rate or repricing sensitivity test?
3-month U.S. Treasury bills
1-year U.S. Treasury notes
20-year U.S. Treasury bonds
20-year floating-rate corporate bonds with annual
repricing
30-year floating-rate mortgages with repricing every two
years
30-year floating-rate mortgages with repricing every six
months
Overnight fed funds
9-month fixed rate CDs
1-year fixed-rate CDs
5-year floating-rate CDs with annual repricing
Common stock
Which of the following assets or liabilities fit 8-43

the one-year rate or repricing sensitivity test?

3-month U.S. Treasury bills Yes
1-year U.S. Treasury notes Yes
20-year U.S. Treasury bonds No
20-year floating-rate corporate bonds with annual
repricing Yes
30-year floating-rate mortgages with repricing every two
years No
30-year floating-rate mortgages with repricing every six
months Yes
Overnight fed funds Yes
9-month fixed rate CDs Yes
1-year fixed-rate CDs Yes
5-year floating-rate CDs with annual repricing Yes
Common stock No
 8-44
Repricing Model – Practice Q4
 8-45
Repricing model – Practice Q5
 What are the reasons for not including
demand deposits as rate-sensitive
liabilities in the repricing analysis for a
commercial bank? What is the subtle but
potentially strong reason for including
demand deposits in the total of rate
sensitive liabilities? Can the same
argument be made for passbook savings
accounts?
 8-46
Re-pricing Model Practice Q6
 8-47
Re-pricing Model Practice Q6
 8-48
Re-pricing Model Practice
(a) Repricing gap using a 30-day planning period
= $75 - $170
= -$95 million.

 Repricing gap using a 3-month planning period

= ($75 + $75) - $170
= -$20 million.

 Repricing gap using a 2-year planning period

= ($75 + $75 + $50 + $25) - $170
= +$55 million
 8-49
Re-pricing Model Practice
If interest rates increase 50 basis points, net
interest income will decrease by $475,000.

 DNII = CGAP(DR)
= -$95m.(.005) = -$0.475m.

 If interest rates decrease by 75 basis points,

net interest income will increase by $712,500.
 DNII = CGAP(DR)
= -$95m.(-.0075) = $0.7125m.
 8-50
Re-pricing Model Practice
The repricing gap over the 1-year planning
period
= ($75m. + $75m. + $10m. + $20m. +
$25m.) - $170m.

= +$35 million.
 8-51
Re-pricing Model Practice
If interest rates increase 50 basis points, net
interest income will increase by $175,000.

DNII = CGAP(DR)
= $35m.(0.005) = $0.175m.

 If interest rates decrease 75 basis points, net

interest income will decrease by $262,500.

DNII = CGAP(DR)
= $35m.(-0.0075) = -$0.2625m.
 8-52
Re-pricing Model Practice Q7
 8-53
Re-pricing Model Practice
 Repricing GAP
= $550,000 - $375,000
= $175,000

 Gap ratio
= $175,000/$1,570,000
= 11.15%
 8-54
Re-pricing Model Practice
DII = $550,000(.0045)
= $2,475

DIE = $375,000(.0035)
= $1,312.50

DNII = $2,475 - $1,312.50

= $1,162.50
 8-55
Re-pricing Model Practice Q8
 8-56
Re-pricing Model Practice Q8
Repricing gap using a 30-day planning period
= $150 - $340
= -$190 million.
 Repricing gap using a 3-month planning period
= ($150 + $150) - $340
= -$40 million.
 Reprising gap using a 2-year planning period

= ($150 + $150 + $100 + $50) - $340

= $110 million.
 8-57
Re-pricing Model Practice Q8
DII = ($150m. + $150m.)(.005)
= $1.5m.

DIE = $340m.(.006)
= $2.04m.

DNII = $1.5m. – ($2.04m.)

= -$.54m.
 8-58
Re-pricing Model Practice Q8
DII = ($150m. + $150m. + $100 + $50)(.005)
= $2.25m.

DIE = $340m.(.0075)
= $2.55m.

DNII = $2.25m. – ($2.55m.)

= -$.30m.
 8-59
*The Maturity Model

 Explicitly incorporates market value effects.

 For fixed-income assets and liabilities:
 Rise (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.
 Fall in value of longer-term securities increases
at diminishing rate for given increase in interest
rates.
 8-60
Maturity of Portfolio*
 Maturity of portfolio of assets (liabilities)
equals weighted average of maturities of
individual components of the portfolio.
 Principles stated on previous slide apply to
portfolio as well as to individual assets or
liabilities.
 Typically, maturity gap, MA - ML > 0 for most
banks and thrifts.
 8-61
*Effects of Interest Rate Changes
 Size of the gap determines the size of
interest rate change that would drive net
worth to zero.
 Immunization and effect of setting

MA - ML = 0.
 8-62
Maturity Model – Practice Q9
 8-63
Maturity Model – Practice Q9
MA = [0*20 + 5*60 + 200*30]/320
= 19.69 years

ML = [0*140 + 1*160]/300
= 0.533.

MGAP = 19.69 – 0.533 = 19.16 years.

Nearby bank is exposed to an increase in
interest rates. If rates rise, the value of assets
will decrease much more than the value of
liabilities
 8-64
Maturity Model – Practice Q10
 8-65
Maturity Model – Practice Q10
MA = [0*20 + 15*160 + 30*300]/480
= 23.75 years.

ML = [0*100 + 5*210 + 20*120]/430

= 8.02 years.

MGAP = 23.75 – 8.02

= 15.73 years.
 8-66
Maturity Model – Practice Q10
If interest rates increase one percent, the value and
average maturity of the assets will be:
 Cash = $20

 Commercial loans

FV = 160, PMT = 0.1*160 = 16, N = 15, I=11%,

Solve for PV = 148.49
 Mortgages:

FV = 300, PMT = 24, I = 9%, N = 30,

Solve for PV = 269.17

MA = [0*20 + 148.49*15 + 269.17*30]/(20 + 148.49 + 269.17)

= 23.53 years
 8-67
Maturity Model – Practice Q10
The value and average maturity of the liabilities will be:
 Demand deposits = $100

 CDs

FV = 210, PMT = 0.06*210 = 12.6, N = 5, I=7%,

Solve for PV = 201.39
 Debentures

FV = 120, PMT = 0.07*120 = 8.4, N = 20, I=8%,

Solve for PV = 108.22
ML = [0*100 + 5*201.39 + 20*108.22]/(100 + 201.39 +
108.22) = 7.74 years

The maturity gap = MGAP

= 23.60 – 7.74 = 15.86
 8-68
Maturity Model – Practice Q10
 The market value of the assets has decreased
from $480 to $437.66 or by $42.34.

 The market value of the liabilities has

decreased from $430 to $409.61 or by 20.69.

 Therefore, the market value of the equity will

decrease by $42.34 - $20.69 = $21.65.
 8-69
*Maturities and Interest Rate Exposure

 If MA - ML = 0, is the FI immunized?
 Extreme example: Suppose liabilities consist of
1-year zero coupon bond with face value $100.
Assets consist of 1-year loan, which pays back
$99.99 shortly after origination, and 1¢ at the
end of the year. Both have maturities of 1 year.
 Not immunized, although maturity gap equals
zero.
 Reason: Differences in duration**

**(See Chapter 9)
 8-70
*Maturity Model
 Leverage also affects ability to eliminate
interest rate risk using maturity model
Example:
Assets: $100 million in one-year 10-percent
bonds, funded with $90 million in one-year 10-
percent deposits (and equity)
Maturity gap is zero but exposure to interest rate
risk is not zero.
8-71
 8-72
Maturity Gap Model – Practice Q11
Part (a)

MA = [2*$175 + 15*$165]/$340
= 8.31 years
 8-73
Maturity Gap Model – Practice Q11
Part (b)

ML = [1*$135 + 5*$160]/$295
= 3.17 years
 8-74
Maturity Gap Model – Practice Q11
Part (c)

MGAP = 8.31- 3.17

= 5.14 years
 8-75
Maturity Gap Model – Practice Q11
Part (d)

Gunnison Insurance is exposed to interest rate

risk. If interest rates rise, net worth will decline
because the average maturity of the assets is
higher than the average maturity of the liabilities.
The opposite holds true if interest rates fall (That
is, net worth will increase.)
 8-76
Maturity Gap Model – Practice Q11
Part (e)
T-notes:
FV = 175, PMT = 8.75, I = 7%, N = 2,
Solve for PV = 168.67
Munis:
FV = 165, PMT = 14.85, I = 11%, N = 15,
Solve for PV = 141.27

Total assets = $168.67 + $141.27 = $309.94 

DA = -$30.06 or -8.84 percent
 8-77
Maturity Gap Model – Practice Q11
Part (e)
Commercial Paper:
FV = 135, PMT = 6.075, I = 6.5%, N = 1,
Solve for PV = 132.46
Note:
FV = 160, PMT = 12.8, I = 10%, N = 5,
Solve for PV = 147.87

Total liabilities = $132.46 + $147.87 = $280.33 

DL = -$14.67 or -4.97 percent
 8-78
Maturity Gap Model – Practice Q11
Part (f)
DE = DA - DL
= -$30.06 – (-$14.67)
= -$15.39  -34.2 percent
 8-79
Maturity Gap Model – Practice Q11
Part (g)
 The value of liabilities will be lower with semi-
annual compounding, increasing the value of
net worth.
 The one-year CP will decline in value to
$132.426. The five-year note will decline in
value to $147.645.
 The value of equity will increase to $29.869 =
($168.67 + $141.27) - ($132.426 + $147.645).
 8-80
Maturity Gap Model - Practice Q12
 8-81
Maturity Gap Model - Practice Q12
 The maturity gap is 1 year – 1 year = 0.
The maturity gap model would state that
the portfolio is immunized against
changes in interest rates because assets
and liabilities are of equal maturity
 8-82
Maturity Gap Model - Practice Q12
Principal received in six months $500,000
Interest received in six months
(.03 x $1,000,000) $30,000
Total $530,000

Principal received at the end of the year $500,000

Interest received at the end of the year
(.03 x $500,000) $15,000
Future value of interest received in six months
($530,000 x 1.03*) $545,900
Total principal and interest received $1,060,900
 8-83
Maturity Gap Model - Practice Q12

Principal and interest paid on deposits

($1,000,000 x 0.0575) $1,057,500
Net interest income received $3,400
 8-84
Maturity Gap Model - Practice Q12
If interest rates increase 2 percent, then the
reinvestment benefits of cash flows in six months will be
higher:

Principal received in six months $500,000

Interest received in six months
(.03 x $1,000,000) $30,000
Total $530,000
 8-85
Maturity Gap Model - Practice Q12
Principal received at the end of the year $500,000
Interest received at the end of the year
(.03 x $500,000) $15,000
Future value of interest received in six months
($530,000 x 1.04) $551,200
Total principal and interest received $1,066,200

Principal and interest paid on deposits

($1,000,000 x 0.0575) $1,057,500

Net interest income received $8,700

 8-86
Maturity Gap Model - Practice Q12
If interest rates decrease by 2 percent, then reinvestment
income is reduced.
Principal received in six months $500,000
Interest received in six months
(.03 x $1,000,000) $30,000
Total $530,000
Principal received at the end of the year $500,000
Interest received at the end of the year
(.03 x $500,000) $15,000
Future value of interest received in six months
($530,000 x 1.02) $540,600
Total principal and interest received $1,055,600
 8-87
Maturity Gap Model - Practice Q12

Principal and interest paid on deposits

($1,000,000 x 0.0575) $1,057,500

Net income received $-1,900

 8-88
Pertinent Websites
For information related to central bank
policy, visit:
Bank for International Settlements:
www.bis.org
Federal Reserve Bank:
www.federalreserve.gov