interest rate risk - vfccu.orgwhat is interest rate risk? threat that a change in market interest...
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Interest Rate Risk Lisa Boylen
VP ALM Services
Session Objectives • Understand the risk associated with
changes in interest rates • Gain a basic understanding of the various
sources of interest rate risk
What is INTEREST RATE RISK?
Threat that a change in market interest rates may:
• Reduce net interest income • Adversely affect the economic values of
financial assets and liabilities • Impair capital, elevating the risk of
insolvency • Impair liquidity
IRR – Why is it Important? The majority of our assets and liabilities
are financial instruments We buy and sell money Income - We sell loans and receive interest. Expense - We buy shares and pay a dividend
The income we earn is therefore affected by future economic
circumstances and future interest rates.
SOURCES OF INTEREST RATE RISK • Repricing Risk • Basis Risk • Yield Curve Risk • Option Risk
REPRICING RISK Repricing risk is the risk resulting when
assets and liabilities have different average maturities or repricing dates.
Earnings change when there is a change in the level of rates.
WHAT CAUSES REPRICING RISK? Borrowing short term to fund long-term assets
• Problematic when rates rise Borrowing long term to fund short-term assets
• Problematic when rates fall
Repricing Risk Example
Balance Sheet
Year 1 Year 2 – Fed Raises
Rates 1%
Rate Income/ Expense
Rate
Income/ Expense
$5,000,000 15 year Mortgage 5.25% $262,500 5.25% $262,500
$5,000,000 1 Year Certificate 2.00% $100,000
3.00% $150,000
Net Interest Income 3.25% $162,500 2.25% $112,500
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BASIS RISK
• This is the risk from unequal movements in interest rates on a credit union’s assets and liabilities with the same maturity or repricing.
Basis Risk Example ASSET Home Equity Line of Credit
• Loan Rate = Prime + 1 • Resets Annually • Initial Rate
Ø Prime 3.25% Ø Spread 1.00% Ø Rate 4.25%
LIABILITY Member Certificate
• 1 Year Maturity • Renewable Annually at
Prevailing Rate • Initial Rate
Ø 1.50%
Basis Risk Example
Balance Sheet
Year 1 Year 2 – Prime Increases 1%
Year 3 – Prime Decreases 1.5%
Rate Income/ Expense
Rate
Income/ Expense
Rate Income/ Expense
$5M HELOC 4.25% $212,500 5.25% $262,500 3.75% $187,500
$5M 1 Year Certificate
1.50% $75,000
2.00% $100,000 1.25% $62,500
Net Interest Income
2.75% $137,500 3.25% $162,500 2.50% $125,000
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Yield Curve Risk
• Risk of short-term rates changing by more or less than the change in long-term rates.
• Rule of Thumb • Short term rates are often more volatile than
intermediate and long-term rates.
YIELD CURVE RISK
Yield Curve Risk Example
Balance Sheet
Year 1 Year 2 – Fed Raises
Fed Funds 3%
Rate Income/ Expense
Rate
Income/ Expense
$5,000,000 15 year Mortgage Matures in Year 2
5.25% $262,500 6.00% $300,000
$5,000,000 1 Year Certificate 2.00% $100,000
4.00% $200,000
Net Interest Income 3.25% $162,500 2.00% $100,000
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OPTION RISK
Option risk is the risk of adverse
consequences from customer decisions to exercise options in products, such as
prepay loans
CAUSES OF OPTION RISK
Option risk arises whenever credit union
products give customer the right, but not the obligation, to alter the quantity or
the timing of cash flows
EXAMPLES OF OPTION RISK • Contractual Options
§ Call/Put options in securities § Interest rate caps, floors
• Ambiguous Options § Loan prepayments/payoffs § Revolving balance accounts, credit cards, lines of
credit § Withdrawal of shares § “Implicit” rate caps and floors
Review Questions Interest rate risk refers to the risk that the
credit union’s earnings and capital may be affected by changes in market interest rates
q True q False
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Review Questions Which of the following are sources of
interest rate risk (Select all that apply) q Yield Curve Risk q Option Risk q Credit Risk q Repricing Risk q Reputation Risk q Basis Risk
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