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CHAPTER 8Interest Rate Risk I
Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.
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Overview
This chapter discusses the interest rate risk associated with FIs:– Federal Reserve monetary policy– Repricing model
*Appendices:– *Maturity model– *Term structure of interest rates
Ch 8-2
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Interest Rates and Net Worth
FIs exposed to risk due to maturity mismatches between assets and liabilities
Interest rate changes can have severe adverse impact on net worth– Thrifts, during 1980s
Ch 8-3
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US Treasury Bill Rate, 1965 - 2012
Ch 8-4
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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 (December, 2008) in response to economic crisisTarget rate between 0.0 and ¼ percent
Ch 8-5
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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 Ben Bernanke can have
dramatic effects on world interest rates
Ch 8-6
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Repricing Model
Repricing or funding gap model based on book value
Contrasts with market value-based maturity and duration models in appendix
Ch 8-7
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Repricing Model
Rate sensitivity means repricing at current rates
Repricing gap is the difference between interest earned on assets and interest paid on liabilities
Refinancing risk Reinvestment risk
Ch 8-8
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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 three months to six months– More than six months to twelve months– More than one year to five years– Over five years
Ch 8-9
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Repricing Gap Example
Cum. Assets Liabilities Gap 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
Ch 8-10
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Applying the Repricing Model
NIIi = (GAPi) Ri = (RSAi - RSLi) Ri
Example I: In the one day bucket, gap is -$10 million. If rates rise by 1%,
NII(1) = (-$10 million) × .01 = -$100,000Ch 8-11
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Applying the Repricing Model
Example II: If we consider the cumulative 1-year gap,
NII = (CGAP) R = (-$15 million)(.01)
= -$150,000
Ch 8-12
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Rate-Sensitive Assets Examples from hypothetical balance
sheet:– Short-term consumer loans. Repriced at
year-end, 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 Ch 8-13
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Rate-Sensitive Liabilities
RSLs bucketed in same manner as RSAs
Demand deposits warrant special mention– Generally considered rate-insensitive
(act as core deposits), but there are arguments for their inclusion as rate-sensitive liabilities
Ch 8-14
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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 =
0.056, or 5.6 percent
Ch 8-15
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Equal Rate Changes on RSAs, RSLs
Example: Suppose rates rise 1% for RSAs and RSLs. Expected annual change in NII,
NII = CGAP × R= $15 million × .01= $150,000
With positive CGAP, rates and NII move in the same direction
Change proportional to CGAPCh 8-16
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Unequal Changes in Rates
If changes in rates on RSAs and RSLs are not equal, the spread changes; In this case, NII = (RSA × RRSA ) - (RSL × RRSL )
Ch 8-17
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Unequal Rate Change Example
Spread effect example: RSA rate rises by 1.2% and RSL rate rises by 1.0%
NII = interest revenue - interest expense
= ($155 million × 1.2%) - ($155 million × 1.0%) = $310,000
Ch 8-18
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Restructuring Assets & Liabilities
FI can restructure 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
Ch 8-19
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Restructuring the Gap
Example: Harleysville Savings Financial Corporation at the end of 2008– One year gap ratio was 1.45 percent– Three year gap ratio was 3.97 percent– If interest rates rose in 2009, it would
experience large increases in net interest income
Commercial banks recently reducing gaps to decrease interest rate risk Ch 8-20
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Weaknesses of Repricing Model
Weaknesses:– Ignores market value effects of interest
rate changes– Overaggregative
Distribution of assets & liabilities within individual buckets is not considered
Mismatches within buckets can be substantial
– Ignores effects of runoffsBank continuously originates and retires
consumer and mortgage loansRunoffs may be rate-sensitive
Ch 8-21
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Weaknesses of Repricing Model
Off-balance-sheet items are not included– Hedging effects of off-balance-sheet
items not captured– Example: Futures contracts
Ch 8-22
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*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 Ch 8-23
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*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
Ch 8-24
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*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
Ch 8-25
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*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)Ch 8-26
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*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.
Ch 8-27
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*Duration
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
Ch 8-28
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*Term Structure of Interest Rates
Time to Maturity
Time to Maturity
Time to Maturity
Time to Maturity
YTMYTM
Ch 8-29
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*Unbiased Expectations Theory
Yield curve reflects market’s expectations of future short-term rates
Long-term rates are geometric average of current and expected short-term rates
(1 +1RN)N = (1+ 1R1)[1+E(2r1)]…
[1+E(Nr1)]
Ch 8-30
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*Liquidity Premium Theory
Allows for future uncertainty Premium required to hold long-term
Ch 8-31
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*Market Segmentation Theory
Investors have specific needs in terms of maturity
Yield curve reflects intersection of demand and supply of individual maturities
Ch 8-32
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Web Resources
For information related to central bank policy, visit:Bank for International Settlements www.bis.orgFederal Reserve Bank www.federalreserve.gov
Ch 8-33