Professional Documents
Culture Documents
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.and bank profitability .and measure of risk the behavior of interest rates
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Bank profitability
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The degree to which bank assets and liabilities are interest rate sensitive
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ALM approach
Bank create assets and liabilities of different maturities and sizes Priced differently NII Re-pricing concept- Assets and liabilities falls due for re-pricing on different dates Banks assets and liabilities are seldom matched by size and maturity- mismatch or gap Cause interest rate risk - explain with example
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Negative or positive (absolute figures) Ratio of gap to RSA Ratio of RSA and RSL
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10
Cash
20
20
100
100
20
20
Investments
180
100
80
100
500
960
1200
300
320
400
600
2820
600 720
600 4520
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Saving deposit
180
370
550
Term deposit
100
100
150
50
500
900
Certificate of deposit
100
50
50
200
Borrowings
920
250
450
200
200
2020
Other liabilities
100
100
Net worth TOTAL Gap Cumulative gap 1320 80 80 400 0 80 650 -250 -170 250 250 80 1100 0 80
700 4520 0 0
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GAP
GAP Ratio (RSA/RSL) NII Decrease in interest rate Change in NII ( GAP X Change in interest rate)
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2 200 2% -0.4
200
2 400 2% -4
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used Easy to understand Risk sensitive assets and liabilities can be identified and GAP easily calculated
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50 100 50
50
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Loans
Investments Other assets Total RSA
400
200 100 700
100%
75% 95%
400
150 95 645
GAP
Total assets GAP as % of total assets
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-100
1000 10
5
1000 0.5
21 -0.05
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Calculate duration of various RSA and RSL Calculate weighted average duration of liabilities Calculate weighted average duration of assets Calculate duration GAP(DGAP) Calculate expected NII Forecast changes in banks MVE under various interest rate environments
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Bank need to forecast interest rate movement Aggressive strategy is to keep the gap position open where it is profitable or To keep the gap ZERO ( with some tolerance level) so that NII is protected DO behavioral analysis of customers to safeguard against embedded option risk Know impact on MVE through duration gap analysis for long term perspective
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Financial derivatives
Contingent contracts Underlying assets like currency, stock indices, interest rate instruments, commodities etc. Pricing and trading is complex and prone to high risk Shift the risk from seller to buyer Improve the liquidity of underlying instruments Hedger use derivatives to protect their assets from erosion in value due to market volatility
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Used to lower credit risk and add liquidity also Will discuss some widely used concepts
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Swap deals
Firm A Fixed rate 12% Floating Rate PLR+2%
10%
PLR+0.5%
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Swap deals
A Firm Pay to PLR + 2% lender Receive PLR from B from other Pay to other 9.75% from A Net effect
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B Firm 10%
9.75% to A
PLR from A PLR+ 0.25% floating
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11.75% fixed
Advantage of swap to B
Asset liability is matched Cost is reduced in floating market Eliminate interest rate risk It constituted a off balance sheet transaction
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Advantage of swap to A
Asset liability is matched Lower cost from fixed rate market Capacity to borrow from fixed rate market remain intact It constituted a off balance sheet transaction
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Future contracts are traded in recognized exchanges which assumes responsibility of settlement When underlying security is interest bearing security it is known as interest rate future say 90 days treasury bills Transfer interest rate risk from hedger to speculator
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Asset Sensitive
Buy interest rate future if it expects interest rates to fall Sell interest rate future if it expects interest rates to rise
Gap
Liability sensitive
Sell interest rate future if it expects interest rates to fall Buy interest rate future if it expects interest rates to rise
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An OTC contract Resemble a swap agreement but difference is that it is single settlement vs series of settlement Agreement to settle interest rate differentials Typical forward contract Notional principal amount and no commitment to borrow or lend by parties Buyer to pay fixed and receive floating Seller to pay floating and receive fixed Cash settlement is done if actual rate of interest differ to forecasted rates Bank use FRA to lock in fixed interest rate expenses ( deposits) to floating rate deposits or fixed interest rate advances to floating rate advances
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Bond price-Sensitivity
Inflation GDP growth Liquidity in market Interest rates Fiscal policies Unemployment Money supply
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Bond Valuation
Interest rate for residual term of maturity keep changing Value of bonds rests on movement of interest rates When market rate and coupon rate are same, bonds trade at par When market rate rises over coupon rate, bonds trade at discount and When market rate falls over coupon rate bonds trade at premium
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Bond theorems
Price of bond is inversely relates to the yield Increase in price of bond when interest rate goes down by certain % is greater than decrease in its price when interest rates goes up by the same %- This is called convexity
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Bonds theorems
Longer the term to maturity of a bond higher will be its price sensitivity Between two bonds of same maturity but different coupons, the bond will lower coupon will experience more price sensitivity than with higher coupon
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Duration
Reinvestment of coupons also generate income Two opposite effects: Fall in price of bonds due to rise in interest rates and extra income generated due to reinvestments of coupon may get neutralize during life of security Measured through weighted average life of a fixed income security It is also a measure of price sensitivity measure of a bond to changes in interest rates
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Modified duration
Duration does not accurately changes in price of bonds arising from larger changes in interest rates Hence modified duration = Duration/ 1+ yield
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Investment reserves
Provision for depreciation in AFS and HFT in excess of required amount in any year should be credit to P & L account and same amount transferred to Reserve & Surplus Included in Tier 2 capital of the bank Investment fluctuations reserves @ minimum 5% of investment portfolio ( only HFT and AFS)
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Price or YTM published by FIMMDA Sate government securities based on YTM and marked 25 bps above the yield of central government securities
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