Transcript Interest Rate Risk I Chapter 8

Interest Rate Risk I
Chapter 8
Financial Institutions Management, 3/e
By Anthony Saunders
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Central Bank and Interest Rate Risk
• Effects of interest rate targeting.
» Lessens interest rate risk
• October 1979 to October 1982, nonborrowed
reserves target regime.
• Implications of return to reserves target policy:
» Increases importance of measuring and managing
interest rate risk.
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Repricing Model
• Repricing or funding gap model based on book
value.
• Contrasts with market value-based maturity and
duration models.
• Rate sensitivity means time to repricing.
• Repricing gap is the difference between the rate
sensitivity of each asset and the rate sensitivity
of each liability: RSA - RSL.
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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 3 three months to six months.
More than six months to twelve months.
More than one year to five years.
Over five years.
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Repricing Gap Example
Assets
1-day
$ 20
>1day-3mos.
30
>3mos.-6mos. 70
>6mos.-12mos. 90
>1yr.-5yrs.
40
>5 years
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Liabilities
$ 30
40
85
70
30
5
Gap Cum. Gap
$-10 $-10
-10
-20
-15
-35
+20
-15
+10
-5
+5
0
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Applying the Repricing Model
• DNIIi = (GAPi) DRi = (RSAi - RSLi) Dri
• Example: In the one day bucket, gap is -$10 million.
If rates rise by 1%,
DNIIi = (-$10 million) × .01 = -$100,000.
• Example II: If we consider the cumulative 1-year
gap,
DNIIi = (CGAPi) DRi = (-$15 million)(.01)
= -$150,000.
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Rate-Sensitive Assets

Examples from hypothetical balance sheet:
• Short-term consumer loans. If 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.
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Rate-Sensitive Liabilities
RSLs bucketed in same manner as RSAs.
 Demand deposits and passbook savings
accounts warrant special mention.

• Generally considered rate-insensitive, but there
are arguments for their inclusion as ratesensitive liabilities.
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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.
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Weaknesses of Repricing Model

Weaknesses:
• Ignores market value effects
• Overaggregative
» Distribution of assets & liabilities within individual
buckets is not considered. Mismatches within
buckets can be substantial.
• Ignores effects of runoffs
» Bank continuously originates and retires consumer
and mortgage loans. Runoffs may be rate-sensitive.
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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.
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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, MA - ML > 0 for most banks and
thrifts.
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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.

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Maturity Matching 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 maturities are equal.
• Reason: Differences in duration.
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*Term Structure of Interest Rates
YTM
YTM
Time to Maturity
Time to Maturity
Time to Maturity
Time to Maturity
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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.

_
_
~
~
RN = [(1+R1)(1+E(r2))…(1+E(rN))]1/N - 1
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*Liquidity Premium Theory
Allows for future uncertainty.
 Premium required to hold long-term.

*Market Segmentation Theory
Investors have specific needs in terms of
maturity.
 Yield curve reflects intersection of demand and
supply of individual maturities.

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