INTEREST RATE RISK

(CH 8 & 9)
FIN544 SPRING 2016
DR. SHAMSUDDIN AHMAD
INDEPENDENT UNIVERSITY, BANGLADESH

INTEREST RATE RISK

While performing their asset transformation function, FIs often mismatch
the maturities of their assets and liabilities. Such a mismatch exposes
them to interest rate risk.
When the maturity of its liabilities is less than the maturity of its assets,
an FI is short-funded.
When the maturity of its liabilities is longer than the maturity of its assets,
an FI is long-funded.
When an FI is short-funded, it potentially exposes itself to refinancing
risk the risk that the cost of rolling over or re-borrowing funds will rise
above the returns being earned on asset investments.
When an FI is long-funded, it potentially exposes itself to reinvestment
risk the risk that the return on funds to be reinvested will fall below the
cost of the funds.

INTEREST RATE RISK (CONTD)

In addition to potential refinancing or reinvestment risk, an FI also faces
market value risk, when interest rates change.
Market value risk is the risk that the market values of its assets and liabilities
will differ due to a change in interest rate.
The market value (or fair value) of an asset or liability is conceptually equal to
the present value of current and future cash flows from that asset or liability.
When interest rates rise, the discount rate increases thereby reducing the
future cash flows and thus the market value of the assets and liabilities.
When interest rates fall, the discount rate decreases thereby increasing the
future cash flows and thus the market value of the assets and liabilities.
However, the values of the assets and liabilities do not change by the same
amount when the interest rate changes, thereby giving rise to market value
risk.

MODELS TO MEASURE INTEREST

RATE RISK
Monetary policy affect the level of interest rates as do
financial market integration which increases the speed with
which interest rate changes are transmitted among countries.
BIS requires depository institutions to have interest rate risk
measurement systems in place to assess the effects of
interest rate changes on both earnings and economic value.
The three ways (or models) of measuring the asset-liability
gap exposure of an FI are:
The repricing (or funding gap) model which concentrates on the
impact of interest rate changes on an FIs net interest income (NII).
The duration model

THE REPRICING MODEL

The repricing or funding gap model is essentially a book value accounting cash flow
analysis

of the repricing gap between the interest income earned on an FIs assets and
the interest expense paid on its liabilities over a particular period of time.
The repricing gap for assets and liabilities is calculated for the following maturity
buckets: One day; three months; six months; 12 months; five years; and more than
five months.
Under the repricing gap approach, a bank reports the gaps in each maturity bucket by
calculating the rate sensitivity of each asset (RSA) and each liability (RSL) on its
balance sheet.
Rate sensitivity means that the asset or liability is repriced at or near current market
interest rates within a certain time horizon (or maturity bucket).
A negative gap in any bucket, where RSA is lower than RSL, exposes the FI to
refinancing risk. Conversely, a positive gap in any bucket (RSA>RSL) exposes the FI to
reinvestment risk.
(EXAMPLE IN CLASS)

THE REPRICING MODEL (Contd)

Rate-sensitive assets for one year are typically: short-term consumer loans; three-month TBills; six-month T-Notes; 30-year floating rate mortgages (housing loans). Assume that
they total Tk.155 million out of total assets of Tk.270.
Rate-sensitive liabilities for one year are typically: three-month CDs; three-month bankers
acceptances; six-month commercial paper; one-year time deposits. Assume that they total
Tk.140 million out of total liabilities of Tk.270.
Therefore, the cumulative one-year repricing gap (CGAP) is: CGAP = RSA-RSL = 155-140 =
15 million. And, the Gap Ratio = CGAP/Total Assets = 15/270 = .056 = 5.6%, gives both
the direction and scale of the exposure. CGAP provides a measure of an FIs interest rate
sensitivity.
For equal changes in rates on RSAs and RSLs, if CGAP is positive, NII will rise when interest
rates rise since interest income rises more than interest expense, and vice versa.
For unequal changes in rates on RSAs and RSLs, the spread gives the direction of the
change in NII. If the spread increases when interest rates rise, NII increases. If spread
decreases, when interest rates rise, NII decreases.
Spread effect = a positive relationship between changes in the spread and changes in NII.

ABC Bank Ltd.

Balance Sheet as at Dec 31, 2015
ASSETS
Cash30
Money at Call 20
3-month T-Bills 20
6-month T-Bills 20
Loans (floating rate p.a.)
100
House Building loans (15yrs) 60
Total

250

Liabilities
Overnight Repo

10

Current Deposits

50

Savings Deposits

20

FDR for 3 months

30

FDR for 6 months

60

FDR for 1 year

60

EQUITY

20

Total

250

Questions
What is the Repricing Gap if the planning period is: One
day; 3 months; 6 months; 1 year?
What is the CGAP over one year?
What is the impact on NII for the following changes:
Interest rates
days
Interest rates
months
Interest rates
months
Interest rates
one year

will increase by 50 basis points over the next 30

will decrease by 10 basis points over the next 3
will increase by 20 basis points over the next 6
will increase by 40 basis points over the next

WEAKNESSES OF REPRICING MODEL

Market value effects: Interest rate changes cause a change in the present
values of cash flows from assets and liabilities, thus changing their market
prices.
Over-aggregation: FIs assets and liabilities may be mismatched within the
buckets. Thus, liabilities may be repriced toward the end of the buckets
range, while assets may be repriced toward the beginning. Thus, changes in
cash flows will not be measured accurately by the repricing gap approach.
The problem of runoffs: Prepayment of long term loans and
quarterly/monthly installments of principal and interest produce a runoff
cash flow from rate-insensitive portfolio that can be reinvested at current
market rates.
Cash flows from off-balance-sheet activities caused by interest rate changes
are ignored.

Duration
Duration is the weighted-average time to maturity on the loan using the
relative present values of the cash flows as weights.
In economic terms, it is the interest elasticity of a securitys price to small
interest rate changes.
Features of Duration:
Duration increases with the maturity of a fixed-income security, but at a decreasing
rate.
Duration decreases as the yield on a security increases.
Duration decreases as the coupon or interest payments increases.

Risk Management with Duration

Duration is equal to the maturity of an immunized security
Duration gap is used by FIs to measure and manage the interest rate risk of an
overall balance sheet.

Duration Example
Consider a loan of 100 be to repaid every six months at
50 plus interest at 15%. This loan is refinanced with a
one-year FDR paying 15% interest p.a.
CFa = 50 + 7.50 = 57.50. PVa = 57.5/(1.075) = 53.49
CFb = 50 + 3.75 = 53.75. PVb = 53.75/(1.075)2 =
46.51
CFa + CFb = 111.25.
PVa + PVb = 100.00
Weights: Xa = PVa/PVa+PVb = 53.49/53.49+46.51 = .
5349
Weights: Xb = PVb/PVa+PVb = 46.51/53.49+46.51 = .
4651

Duration of a Zero-Coupon Bond

Zero-coupon bonds sell at a discount from face value on
issue, pay the face value on maturity, and have no
intervening cash flows (such as coupon payments)
between issue and maturity. The price of such a bond is
equal to the present value of the single, fixed payment
on the bond that is received on maturity.
The Duration of a zero-coupon bond equals its maturity.
For any other bond that pays some cash flows prior to
maturity, its Duration will always be less than its
maturity.

Difficulties in Applying the Duration

Model
Duration matching can be costly. In principle an FI manager can change
the duration of its assets and liabilities to immunize the FI against interest
rate risk, but actual restructuring of the balance sheet can be both time
consuming and costly.
Immunization is a dynamic problem: Interest rates can keep changing over
the maturity period of the asset or liability. Moreover, the duration of a
bond changes as time passes and it changes at a different rate than does
real or calendar time.
Large interest rate changes causes less accurate measures of interest rate
sensitivity. Duration measures the price sensitivity of fixed-income
securities for small changes in interest rates of the order of one basis
point. For large interest rate increases, duration over predicts the fall in
bond prices, while for large interest rate decreases, it underpreedicts the
increase in bond prices.