MANAGEMENT OF FINANCIAL INSTITUTIONS ASSIGNMENT REPORT ON

GAP ANALYSIS: MEASURING ITNTEREST RATE RISK

SUBMITTED TO DR. AJAY PRAKASH ASSOCIATE PROFESSOR

SUBMITTED BY ADITYA SINGH MBA (FINANCE) ROLL NO. 04

DEPARTMENT OF BUSINESS ADMINISTRATIION, UNIVERSITY OF LUCKNOW

What is GAP analysis?

A Gap is the difference between the assets and liabilities of a company within a given period of time. This mismatching of assets and liabilities occurs due to the fluctuating rate of interest in the market. This fluctuation generates the GAP between the matching of assets and liabilities. Put in a simple way, it is the difference between the interest enjoyed by the company upon its assets and the interest paid by the company upon its liabilities. Now this GAP when analyzed for the sake of measuring the level of liquidity of the firm is known as GAP Analysis. GAP analysis, also known as the re-pricing model, is essentially a book value accounting cash flow analysis of the re-pricing gap between the interest revenue earned on an FIs assets and the interest paid on its liabilities over some particular period. Gap analysis was widely adopted by financial institutions during the 1980s. When used to manage interest rate risk, it was used in tandem with duration analysis. Both techniques have their own strengths and weaknesses. For doing a GAP analysis we would require determining which assets and liabilities will have their interest rate change as market interest rates change. We call them Rate Sensitive Assets and Rate Sensitive Liabilities. Let us see some of the examples of a FIs Rate Sensitive Assets and Liabilities:

Rate Sensitive Assets assets with maturity less than one year variable-rate mortgages short-term commercial loans Portion of fixed-rate mortgages (say 20%)

Rate Sensitive Liabilities money market deposits variable-rate Cash Deposits short-term Cash Deposits federal funds short-term borrowings portion of checkable deposits portion of savings

Why GAP analysis is done?

GAP analysis is being done to measure the effective change in Interest Rate of the Assets and Liabilities that are sensitive and have a checkpoint on Interest Rate Risk. INTEREST RATE RISK: The potential loss from unexpected changes in interest rates which can significantly alter a FIs 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. The major factors behind the determination of Interest Rate are following: An inflation free or we can say risk free rate of interest Inflation: It has been said that the observed (nominal) rate of interest is really made up of two components, the real rate of interest and the inflation rate. The nominal rate of interest, the real rate of interest (in a zero inflation environment), the inflation rate expected to prevail over the interest period are the components of both these.

The length of investment: Investors may require a liquidity premium to encourage them to invest in funds for differing periods of time. The liquidity premium is traditionally positive, giving rise to a normally shaped upward-sloping yield curve. FIs typically ride the yield curve by borrowing at shorter maturities and lending at longer maturities. Credit risk: If there is a positive probability that less than 100 percent of principal and accrued interest will be repaid, then the FI will adjust the interest rate upwards so that the expected value of payments equals or exceeds the expected value of comparable risk-free loans. Government, corporate, and private demand for credit: Interest is simply the price for credit. The higher the demand for credit, the higher its price (all other factors being equal). Central bank monetary policy: By influencing the cost and availability of short-term funding, the central bank indirectly controls the supply of credit. All other things being equal, the higher the money supply, the lower interest rates are. The problem is that all other things do not remain equal. Particularly, increasing the money supply will probably increase expected inflationwhich increases interest rates.

ALCO (Assets and Liabilities Management Committee)

The ALCOs primary responsibility is interest rate risk management arises through the changing rate of interest in the market. The ALCO coordinates the Financial Institutions strategies to achieve the optimal risk/reward trade-off and so as to minimize the risk and keep an optimum level of liquidity with the FI. A risk-management committee in a bank or other lending institution that generally comprises the senior-management levels of the institution. The ALCO's primary goal is to evaluate, monitor and approve practices relating to risk due to imbalances in the capital structure. For example, the ALCO will have responsibility for setting limits on the arbitrage of borrowing in the short-term markets, while lending long-term instruments. Among the factors considered are liquidity risk, interest rate risk, operational risk and external events that may affect the bank's forecast and strategic balance-sheet allocations. The ALCO will generally report to the board of directors and will also have regulatory reporting responsibilities.

Types of Interest Rate Risk

Spread Risk Price Risk

Spread Risk (Reinvestment Rate Risk)

Reinvestment risk is one of the main genres of financial risk. The term describes the risk that a particular investment might be canceled or stopped somehow, that one may have to find a new place to invest that money with the risk being there might not be a similarly attractive investment available. This primarily occurs if bonds (which are portions of loans to entities) are paid back earlier than expected. Due to that, the risk resulting from the fact that interest or dividends earned from an investment may not be able to be reinvested in such a way that they earn the same rate of return as the invested funds that generated them. For example, falling interest rates may prevent bond coupon payments from earning the same rate of return as the original bond. Pension funds are also subject to reinvestment risk especially with the short-term nature of cash investments there is always the risk that future proceeds will have to be reinvested at a lower interest rate. Changes in interest rates will change the FIs cost of funds as well as the return on their invested assets. They may change by different amounts.

Price Risk
Changes in interest rates may change the market values of the banks assets and liabilities by different amounts. The risk of a decline in the value of a security or a portfolio is also known as Price Risk. It is the biggest risk faced by all investors. Although price risk specific to a stock can be minimized through diversification, market risk cannot be diversified away. The longer is duration, the larger is the change in value for a given change in interest rates.

Example for GAP analysis

Question: A bank makes a Rs. 10,000 four-year car loan to a customer at fixed rate of 8.5%. The bank initially funds the car loan with a one-year Rs. 10,000 CD at a cost of 4.5%. The banks initial spread is 4%. 4 Year Car Loan I Year Cash Deposit What is the banks risk? Solution: RSA 1yr = 0, RSL 1yr = 10,000 GAP 1yr = 0 - 10,000 = -10,000 The banks one year funding GAP is -10,000 If interest rates rise (fall) in 1 year, the banks margin will fall (rise) 8.5% 4.5%

Duration Gap Analysis

Question:

Solution: The basic equation for determining the change in market value for assets or liabilities is: % Change in Value = DUR x [i / (1 + i)] or Change in Value = DUR x [i / (1 + i)] x Original Value Consider a change in rates from 10% to 15%. Using the value from Table 1, we see: Assets: Asset Value = 2.7 .05/(1 + .10) 100m = 12.3m Liabilities: Liability Value = 1.03 .05/(1 + .10) 95m = 4.5m Net Worth: NW NW = Assets Liabilities = 12.3m (4.5m) = 7.8m

For a rate change from 10% to 15%, the net worth of First National Bank will fall, changing by 7.8m. Recall from the balance sheet that First National Bank has Bank capital totaling 5m. Following such a dramatic change in rate, the capital would fall to 2.8m.

Stepwise process of GAP Analysis

Develop an interest rate forecast Select a series of time buckets or intervals for determining when assets and liabilities will reprice Group assets and liabilities into these buckets Calculate the GAP for each bucket Forecast the change in net interest income given an assumed change in interest rates

Factors affecting Net Interest Income

Changes in the level of interest rates Changes in the composition of assets and liabilities Changes in the volume of earning assets and interest-bearing liabilities outstanding Changes in the relationship between the yields on earning assets and rates paid on interest-bearing liabilities

Summary
GAP Summary Change in Interest Income Increase > Decrease > Increase Decrease Increase Decrease < < = =

GAP Positive Positive Negative Negative Zero Zero

Change in Interest Income Increase Decrease Increase Decrease Increase Decrease

Change in Interest Expense Increase Decrease Increase Decrease Increase Decrease

Change in Net Interest Income Increase Decrease Decrease Increase None None

Strengths of GAP analysis

Easy to understand Works well with small changes in interest rates

Weaknesses of GAP analysis

Ex-post measurement errors Ignores the time value of money Ignores the cumulative impact of interest rate changes Typically considers demand deposits to be non-rate sensitive Ignores embedded options in the banks assets and liabilities\ Over aggregation Runoffs

GAP Ratio = RSAs/RSLs A GAP ratio greater than 1 indicates a positive GAP A GAP ratio less than 1 indicates a negative GAP A GAP ratio far from zero will increase the risk of the FI

BIBLIOGRAPHY
http://www.investopedia.com/terms/a/asset-liability-committee.asp#axzz24APNiZWO http://en.wikipedia.org/wiki/Reinvestment_risk http://www.investopedia.com/terms/p/pricerisk.asp#axzz24APNiZWO http://www.freequality.org/documents/training/GapAnalysis%5B2%5D.ppt http://userpage.fu-berlin.de/~ballou/koch/pres/CHAP05.ppt http://ewp.rpi.edu/hartford/~stoddj/FinancialModels/MishkinPpt/Mishkin_PPT_CH24.ppt http://ihome.cuhk.edu.hk/~b100534/Courses/sau_ch09.pdf www.riskglossary.com www.investinganswers.com