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Overview

Methods of measuring interest rate risk: Repricing model Maturity model Duration model Interest rate risk has an impact on: Net Interest Income Net Worth Non-interest Income Interest rate risk also effects firms capital to asset ratio, business volume, product mix, pricing of assets and liabilities

8-2

Overview

To mitigate the interest rate risk, the structure of balance sheet has to be managed: Asset Restructuring: On balance sheet restructuring of pricing of loans and product mix Liability restructuring: On balance sheet funding strategies that involve changes in maturity mix and rate characteristics Off balance sheet strategies involving derivatives etc

Repricing Model

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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/frequency of repricing asset and liabilities Repricing gap is the difference between the rate sensitivity of each asset and the rate sensitivity of each liability: RSA RSL.

Maturity Buckets

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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.

Repricing Gap Example

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Assets Liabilities 1-day $ 20 $ 30 >1day-3mos. 30 40 >3mos.-6mos. 70 85 >6mos.-12mos. 90 70 >1yr.-5yrs. 40 30 >5 years 10 5

Gap Cum. Gap $-10 $-10 -10 -20 -15 -35 +20 -15 +10 -5 +5 0

Applying the Repricing Model

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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.

Example II: If we consider the cumulative 1-year gap,

DNII = (CGAPone year) DR = (-$15 million)(.01) = -$150,000.

Rate-Sensitive Assets

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Examples from hypothetical balance sheet:

Short-term consumer loans. If repriced at yearend, would just make one-year cutoff. Three-month T-bills repriced on maturity every 3 months. Six-month T-notes repriced on maturity every 6 months. 30-year floating-rate mortgages repriced (rate reset) every 9 months. Which maturity bucket will you place them in?

Rate-Sensitive Liabilities RSLs bucketed in same manner as RSAs. Current accounts pay zero interest.

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Generally considered rate-insensitive (act as core deposits) CGAP is cumulative one year repricing GAP Gap ratio is CGAP/Assets, which is interest rate sensitivity expressed as a percentage of Assets Gap Ratio helps

Rate-Sensitive Liabilities RSLs bucketed in same manner as RSAs. Current accounts pay zero interest.

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Generally considered rate-insensitive (act as core deposits)

CGAP Ratio

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May be useful to express CGAP in ratio form as, CGAP/Assets.

Provides direction of exposure and Scale of the exposure. CGAP/A = $15 million / $270 million = 0.56, or 5.6 percent.

Example:

Equal Rate Changes on RSAs, RSLs

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Example: Suppose rates rise 2% 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

Unequal Changes in Rates

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If changes in rates on RSAs and RSLs are not equal, the spread changes. In this case, DNII = (RSA D RRSA ) - (RSL D RRSL )

Unequal Rate Change Example

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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

Restructuring Assets & Liabilities

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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 Example: Macatawa Banks one-year repricing gap ratio of -5.23 percent.

Effect of rising interest rates during the year:

Weaknesses of Repricing Model

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Weaknesses: Only measures repricing risks, basis and yield curve risks are not accounted for. Ignores interest flows and associated reinvestment risks coupons and interest payments Uses accouting date Ignores market value effects and off-balance sheet (OBS) cash flows, embedded options Distribution of assets & liabilities within individual maturity buckets is not considered. Bank continuously originates and retires consumer and mortgage loans and demand deposits/passbook account balances can vary. Runoffs may be ratesensitive.

Earnings at Risk

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An assessment of potential impact of firms various gap positions on income statement during the full year is called EAR.

*The Maturity Model

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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.

Maturity of Portfolio*

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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.

*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.

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*Maturities and Interest Rate Exposure

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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

*Maturity Model

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Weaknesses of maturity model

It does not take into account leverage in a banks balance sheet Example: Assets: $100 million in one-year 10-percent bonds, funded with $90 million in one-year 10percent deposits (and equity) Maturity gap is zero but exposure to interest rate risk is not zero. Timings of cash flows is not accounted for

*Duration

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The average life of an asset or liability The weighted-average time to maturity using present value of the cash flows, relative to the total present value of the asset or liability as weights.

Price Sensitivity and Maturity

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The longer the term to maturity, the greater the sensitivity to interest rate changes. Example: Suppose the zero coupon yield curve is flat at 12%. Bond A pays $1762.34 in five years. Bond B pays $3105.85 in ten years, and both are currently priced at $1000.

Example continued...

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Bond A: P = $1000 = $1762.34/(1.12)5 Bond B: P = $1000 = $3105.84/(1.12)10

Now suppose the interest rate increases by 1%.

Bond A: P = $1762.34/(1.13)5 = $956.53 10 = $914.94 Bond B: P = $3105.84/(1.13) The longer maturity bond has the greater drop in price.

Coupon Effect

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Bonds with identical maturities will respond differently to interest rate changes when the coupons differ. This is more readily understood by recognizing that coupon bonds consist of a bundle of zero-coupon bonds. With higher coupons, more of the bonds value is generated by cash flows which take place sooner in time.

Price Sensitivity of 6% Coupon Bond

r n 40 20 10 2 $802 $864 $919 $981 $1,000 $1,000 $1,000 $1,000 $1,273 $1,163 $1,089 $1,019 $471 $299 $170 $37 8% 6% 4% Range

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Price Sensitivity of 8% Coupon Bond

r n 40 20 10 2 $828 $875 $923 $981 $1,000 $1,000 $1,000 $1,000 $1,231 $1,149 $1,085 $1,019 $403 $274 $162 $38 10% 8% 6% Range

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Remarks on Preceding Slides The longer maturity bonds experience greater price changes in response to any change in the discount rate. The range of prices is greater when the coupon is lower.

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The 6% bond shows greater changes in price in response to a 2% change than the 8% bond. The first bond is riskier.

Duration

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Duration

Combines the effects of differences in coupon rates and differences in maturity. Based on elasticity of bond price with respect to interest rate.

Duration Duration D = Snt=1[Ct t/(1+r)t]/ Snt=1 [Ct/(1+r)t] Where

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D = duration t = number of periods in the future Ct = cash flow to be delivered in t periods n= term-to-maturity & r = yield to maturity.

Duration

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Duration

Weighted sum of the number of periods in the future of each cash flow, (weighted by respective fraction of the PV of the bond as a whole). For a zero coupon bond, duration equals maturity since 100% of its present value is generated by the payment of the face value, at maturity.

Advantages to Duration Measure: 1. Simplicity 2. Can be used to determine elasticity between price and YTM: (DP/P)/(Dr/r) = -D[r/(1+r)] We can rewrite this as: DP = -D[P/(1+r)] Dr

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Note the direct relationship between DP and -D.

Limits to Duration Measure

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Duration relationship may not hold if the bond has a call or prepayment provision.

Convexity. Negative Convexity.

Immunizing Balance Sheet of an FI

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Duration Gap:

From the balance sheet, E=A-L. Therefore, DE=DA-DL. In the same manner used to determine the change in bond prices, we can find the change in value of equity using duration. DE = [-DAA + DLL] DR/(1+R) or DE = -[DA - DLk]A(DR/(1+R))

Duration and Immunizing

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The formula shows 3 effects:

Leverage adjusted D-Gap The size of the FI The size of the interest rate shock

An example:

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Suppose DA = 5 years, DL = 3 years and rates are expected to rise from 10% to 11%. (Rates change by 1%). Also, A = 100, L = 90 and E = 10. Find change in E. DE = -[DA - DLk]A[DR/(1+R)] = -[5 - 3(90/100)]100[.01/1.1] = - $2.09. Methods of immunizing balance sheet.

Adjust DA , DL or k.

*Limitations of Duration

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Only works with parallel shifts in yield curve. Immunizing the entire balance sheet need not be costly. Duration can be employed in combination with hedge positions to immunize. Immunization is a dynamic process since duration depends on instantaneous R.

*Convexity

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The duration measure is a linear approximation of a non-linear function. If there are large changes in R, the approximation is much less accurate. Recall that duration involves only the first derivative of the price function. We can improve on the estimate using a Taylor expansion. In practice, the expansion rarely goes beyond second order (using the second derivative).

*Modified duration

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DP/P = -D[DR/(1+R)] + (1/2) CX (DR)2 or DP/P = -MD DR + (1/2) CX (DR)2 Where MD implies modified duration and CX is a measure of the curvature effect. CX = Scaling factor [capital loss from 1bp rise in yield + capital gain from 1bp fall in yield] 8 Commonly used scaling factor is 10 .

*Calculation of CX

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Example: convexity of 8% coupon, 8% yield, six-year maturity Eurobond priced at $1,000. CX = 108[DP-/P + DP+/P] = 108[(999.53785-1,000)/1,000 + (1,000.46243-1,000)/1,000)] = 28.

Management of Interest rate risk

8-41

Use of derivatives

Forward and futures contracts Swaps Options Caps and Floors Swaptions FRAs