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DEFINITION:
Interest rate risk is the risk (variability in value) borne by an
interest-bearing asset, such as a loan or a bond, due to
variability of interest rates. In general, as rates rise, the price
of a fixed rate bond will fall, and vice versa. Interest rate risk
is commonly measured by the bond's duration
Libor:
1) Repricing risk:
Repricing risk results from differences in the timing of rate changes
and the timing of cash flows that occur in the pricing and maturity of a
bank’s assets, liabilities, and off-balance-sheet instruments.Repricing
risk is often the most apparent source of interest rate risk for a bank
and is often gauged bycomparing the volume of a bank’s assets that
mature or reprice within a given time period with the volume of
liabilities thatdo so. Some banks intentionally take repricing risk in
their balance sheet structure in an attempt to improve earnings.
3) Basis risk:
Basis risk arises from a shift in the relationship of the
rates in different financial markets or on different financial
instruments. Basis risk occurs when market rates for different financial
instruments, or the indices used to price assets and liabilities, change
at different times or by different amounts. For example, basis risk
occurs when the spread between the three-month Treasury and the
three-month London interbank offered rate (Libor) changes. This
change affects a bank’s current net interest margin through changes in
the earned/paid spreads of instruments that are being repriced. It also
affects the anticipated future cash flows from such instruments, which
in turn affects the underlying net economic value of the bank.
4)Option risk:
Option risk arises when a bank or a bank’s customer has the right (not
the obligation) to alter the level and timing of the cash flows of an
asset, liability, or off-balance-sheet instrument. An option gives the
option holder the right to buy (call option) or sell (put option) a
financial instrument at a specified price (strike price) over a specified
period of time. For theseller (or writer) of an option, there is an
obligation to perform if the option holder exercises the option.
2) Risk appetite
3) Intra-group management
Measureme
nt of interest rate risk
Financial institutions to measure their exposure to interest
rate risk based on a methodology commensurate with their
risk profile and size, and the nature and complexity of their
activities.
GAP:
(i)POSITIVE GAP:
(ii)NEGATIVE GAP:
POSITIVE GAP:
Maturity or repricing Mismatch in a bank's assets and
liabilities where there are more assets maturing or repricing
in a given period than liabilities. A bank with a positive gap is
asset sensitive.A positive interest rate gap means that more
assets than liabilities are due to be repriced in a particular
time interval.
NEGATIVE GAP:
Repricing or duration mismatch in which interest sensitive
liabilities exceed interest sensitive assets. A bank whose
interest sensitive liabilities reprice more quickly than interest
sensitive assets is said to be liability sensitive
NOTE:
During a period of falling interest rates, a positive gap would
tend to adversely affect net interest income, while a
negative gap would tend to result in an increase in net
income. During a period of rising interest rates, a positive
gap would tend to result in an increase in net interest
income while a negative gap would tend to affect net
interest income adversely.
Calculating interest rate risk
1. Repricing Model
2. Duration Model
3.Measuring the mismatch of the interest sensitivity gap of
assets and liabilities, by classifying each asset and liability
by the timing of interest rate reset or maturity, whichever
comes first.
If RSA < RSL and interest rates increase, the FI's net income will decrease,
because the interest expense on deposits will rise faster than interest income
on loans. Formula:
We can also calculate cumulative gaps (CGAP) over a certain period, e.g. 1
YR:
Rules:
1. When RSA > RSL, then CGAP > 0.
2. When RSA < RSL, then CGAP < 0.
3. If CGAP > 0, if interest rates rise (fall), NII will rise (fall).
4. If CGAP < 0, when interest rate rise (fall), NII will fall (rise).
.
Unequal changes in Rates on RSAs and RSLs are possible in some periods,
(Prime Rate for RSAs and CD rate for RSLs). Formula:
Spread Effect, where interest rates rise faster for RSAs (1.2%) than for RSLs
(1%), and cause an increase in NII of $310,000 on $155m of both Assets and
Deposits . The larger the spread between (RSA - RSL), the greater the effect
on NII when interest rates change.
1. Does not account for balance sheet changes in the market value (PVA and
PVL) of the bank when interest rates change
2. Within a given time period (bucket), e.g. 1-5 years, the dollar values of
RSAs and RSLs may be equal (indicating no interest rate risk), but the assets
may be repriced early, and the liabilities repriced late, within the bucket time
period, exposing the FI to interest rate risk not accurately captured by the
Repricing Model. “Ignores CF patterns within a maturity bucket,” e.g. one-
year ARM rates might be re-set on a different date than the maturity patterns
of 1 year CDs.
Δ% PV Security = - D * ΔR / (1 + R)
FI's exposure to interest rate risk can be measured by its Duration Gap,
which takes into account the usual duration/maturity mismatch: DA > DL.
ΔE = ΔA - ΔL
ΔA = A * - DA * (ΔR)
(1 + R)
ΔL = L * - DL * (ΔR)
(1 + R)
and through substitution and rearranging we have (see footnote 11 on p. 614)
2. Size of FI, measured by Assets (A$). The larger the size of FI, the greater
the risk exposure from a change in interest rates, i.e., the greater the change
in E, or market value.
3. Size of interest rate shock, ΔR. The greater the ΔR, the
greater the ΔE.
Note: Interest rate shocks (changes) are "exogenous" or external to the bank,
beyond its control, caused by _________________________________.
Bank can control its duration gap, but can't control general level of interest
rates.
Using Duration Gap. a) If Duration Gap is POS (DA > DL), the bank is
worried about an INCREASE in interest rates, because an INCREASE in
interest rates will DECREASE the Value of the Bank (E). Interest Rates and
Bank Value are inversely (neg.) related.
b) If Duration Gap is NEG (DA < DL), the bank is worried about a
DECREASE in interest rates, because a DECREASE in interest rates will
DECREASE the Value of the Bank (E). Interest Rates and Bank Value are
directly (pos) related.
Duration Gap is Pos (DA= 5 YRs and DL = 3 YRs). If interest rates rise from
10% to 11%, the value of the bank will fall by -$2.09m, from $10m to
$7.91m. Net Worth to Asset (E/A) has fallen from 10% to 8.29% ($7.91m /
$95.45m). Note: This is only a 1% increase in interest rates.
We get the same result considering A and L separately:
To counter this effect, the bank could adjust the Duration Gap to immunize
against interest rate changes/risk. Setting DA = DL won't result in 100%
immunization because A > L ($100m > $90m),(if DA = DL = 5 yrs.). FI
would will still be exposed to interest rate risk, bank value would fall by -
$0.45m if interest rate rise by 1%.
Immunization formulas:
a. A * DA = L * DL
x = DL = 5.556 years
b. DA = (L / A) * DL and
DA = k * DL (where k = L / A)
5 = .90 x
x = DL = 5.556 years
Result of immunization is ΔE = 0
$100m X = $90m * Y
SUMMARY:
A * DA > L * DL
Decrease DA, increase DL, and/or increase L (assuming that A will not
change)
Point: Duration Model can be used to immunize bank against interest rate
risk, i.e., the bank value (ΔE = 0) will be unaffected by
interest rate changes. Duration model is endorsed by the
Bank for International Settlements (BIS) to measure and
monitor interest rate risk for banks.
Managing Interest
rate:
1) Interest rate swap
A swap is a derivative in which one party
exchanges a stream of interest payments for another party's
stream of cash flows. Interest rate swaps can be used by
hedgers to manage their fixed or floating assets and
liabilities. They can also be used by speculators to replicate
unfunded bond exposures to profit from changes in interest
rates. Interest rate swaps are very popular and highly liquid
instruments.
Structure
In an interest rate swap, each counterparty agrees to pay
either a fixed or floating rate denominated in a particular
currency to the other counterparty. The fixed or floating rate
is multiplied by a notional principal amount (say, USD 1
million). This notional amount is generally not exchanged
between counterparties, but is used only for calculating the
size of cashflows to be exchanged.
Hedging :
The expects financial institutions to adequately manage their
matching activities and, as necessary, to offset gaps in a
prudent manner through corrective measures, in particular,
hedging, which enables institutions to mitigate interest rate
risk within established limits.
In periods of wide interest rate fluctuations, sound interest
rate management should enable the institution to avoid
predatory selling of its income-bearing assets and liabilities
or the use of hedging instruments that are costly or have
unfavourable conditions.
Where necessary, the institution should employ hedging to
mitigate its interest rate risk exposure, by:
• using appropriate financial instruments consistent with the
type and scope of its operations, the competence and
expertise of its personnel, and the capacity of its data
processing and reporting systems;
Evaluation of
Interest Rate Exposures
Interest rates impact are observed in two prespective:
a)EARNING PROSPECTIVE
b)ECONOMIC PROSPECTIVE
a)EARNING PROSPECTIVE :
The earnings perspective considers
how interest rate changes will affect a bank’s reported earnings. For
example, a decrease in earnings caused by changes in interest rates
can reduce earnings, liquidity, and capital. This perspective focuses on
risk to earnings in the near term, typically the next one or two years.
Fluctuations in interest rates generally affect reported earnings
through changes in a bank’s net interest income.
Net interest income will vary because of
differences in the timing of accrual changes (repricing risk), changing
rate and yield curve relationships (basis and yield curve risks), and
options positions. Changes in the general level of market interest rates
also may cause changes in the volume and mix of a bank’s balance
sheet products. For example, when economic activity continues to
expand while interest rates are rising, commercial loan demand may
increase while residential mortgage loan growth and prepayments
slow.
b)ECONOMIC PROSPECTIVE:
The economic perspective provides a
measure of the underlying value of the bank’s current position and
seeks to evaluate the sensitivity of that value to changes in interest
rates. This perspective focuses on how the economic value of all bank
assets, liabilities, and interest-rate-related, off-balance-sheet
instruments change with movements in interest rates. Its reflects the
impact of variation in the interest rate on the economic value of an
instituition.economic value of the bank can be viewed as the present
value of future cash flow.
The economic value of these instruments equals the present value of
their future cash flows. By evaluating changes in the present value of
the contracts that result from a given change in interest rates, one can
estimate the change to a bank’s economic value (also known as the
economic value of equity).
How to
Control Interest Rate Risk:
1: Interest Rate Risk Measurement Systems :
It is
essential that banks have interest rate risk measurement
systems that capture all material sources of interest rate risk
and that assess the effect of interest rate changes in ways
that are consistent with the scope of their activities. The
assumptions underlying the system should be clearly
understood by risk managers and bank management.
2: Operating limits :
Banks must establish and enforce
operating limits and other practices that maintain exposures
within levels consistent with their internal policies.
3: Collapse :
Banks should measure their vulnerability
to loss under stressful market conditions including the
breakdown of key assumptions - and consider those results
when establishing and reviewing their policies and limits for
interest rate risk
4: Adequate Information :
Banks must have adequate
information systems for measuring,monitoring, controlling,
and reporting interest rate exposures. Reports must be
provided on a timely basis to the bank's board of directors,
senior management and,
where appropriate, individual business line managers.
5: Internal Controls:
Banks must have an adequate system of internal
controls over their interest rate risk management process. A
fundamental component of the internal control system
involves regular independent reviews and evaluations of the
effectiveness of the system and, where necessary, ensuring
that appropriate revisions or enhancements to internal
controls are made. The results of such reviews should be
available to the relevant supervisory authorities
7: Capital adequacy:
Banks must hold capital commensurate with the
level of interest rate risk they undertake.