Chapter 14 Interest Rate Risk Measurement Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger.
Download ReportTranscript Chapter 14 Interest Rate Risk Measurement Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger.
Chapter 14 Interest Rate Risk Measurement Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 1 Learning Objectives • Describe interest rate risk and its forms • Identify the components of an interest rate risk exposure management system • Explain the interest rate risk management principle of asset repricing before liabilities • Describe the interest rate risk measurement models repricing gap analysis, duration (and convexity) • Outline internal and external interest rate risk management techniques Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 2 Chapter Organisation 14.1 14.2 14.3 14.4 Introduction Interest Rate Risk Exposure Management Systems Assets Repriced Before Liabilities Principle (ARBL) 14.5 Pricing Financial Securities Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 3 Chapter Organisation (cont.) 14.6 14.7 14.8 14.9 Repricing Gap Analysis Duration Convexity Interest Rate Risk Management Techniques 14.10 Summary Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 4 14.1 Introduction • Chapter 13 considered the – Macro-economic context of interest rates – Loanable funds approach to interest rate determination – A number of theories that explain the shape of the yield curve • Unknown is the timing and extent of interest rate changes • Interest rate risk needs to be managed Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 5 Chapter Organisation 14.1 14.2 14.3 14.4 Introduction Interest Rate Risk Exposure Management Systems Assets Repriced Before Liabilities Principle (ARBL) 14.5 Pricing Financial Securities Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 6 14.2 Interest Rate Risk • Interest rate risk takes two forms – Reinvestment risk – Impact of a change in interest rates on a firm’s future cash flows Price risk Impact of a change in interest rates on the value of a firm’s assets and liabilities An inverse relationship exists between interest rates and security prices i.e. a rise in interest rates results in a fall in the value of an asset or liability, or vice versa Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 7 14.2 Interest Rate Risk (cont.) • Interest rate risk exposures may also be described as – Direct – Reinvestment and price risk Indirect Relate to the future actions of market participants e.g. a rise in interest rates causes borrowers to seek new loans elsewhere and/or repay existing loans Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 8 14.2 Interest Rate Risk (cont.) • Interest rate risk exposures may also be described as (cont.) – Basis Occurs when pricing differentials exist between markets e.g. futures market and the underlying physical market Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 9 Chapter Organisation 14.1 14.2 14.3 14.4 Introduction Interest Rate Risk Exposure Management Systems Assets Repriced Before Liabilities Principle (ARBL) 14.5 Pricing Financial Securities Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 10 14.3 Exposure Management Systems • An exposure management system involves structured procedures that enable a firm to effectively measure and manage risk, including – – – Forecasting Strategies and techniques Management and reporting systems Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 11 14.3 Exposure Management Systems (cont.) • Forecasting – A firm needs to understand factors that will impact upon risk exposures and its environment A firm must know the current structure of its balance sheet and forecast future changes in its assets, liabilities and equities with regard to • • • Future business activity growth Future interest rates Future financing needs, and use of debt financing Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 12 14.3 Exposure Management Systems (cont.) • Strategies and techniques – The strategies and techniques used relate to the types of interest cash flows associated with a firm’s assets and liabilities, and include Monitoring and adjusting the maturity structure of assets and liabilities, taking into account the term structure of interest rates • Maturity structure is the relative proportion of assets and liabilities maturing at different time intervals Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 13 14.3 Exposure Management Systems (cont.) • Strategies and techniques (cont.) – The strategies and techniques used relate to the types of interest cash flows associated with a firm’s assets and liabilities, and include (cont.) Specified proportions of fixed-interest versus floatinginterest debt Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 14 14.3 Exposure Management Systems (cont.) • Strategies and techniques (cont.) – The strategies and techniques used relate to the types of interest cash flows associated with a firm’s assets and liabilities, and include (cont.) Liability diversification—where a firm raises funds from a range of different sources, thereby reducing its exposure to potential interest changes in a particular market Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 15 14.3 Exposure Management Systems (cont.) • Strategies and techniques (cont.) – Two broad interest rate risk management techniques, internal and external methods, are discussed later Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 16 14.3 Exposure Management Systems (cont.) • Management reporting – Policies and procedures need to provide clear instructions on The type of information to be reported Frequency of reports Report hierarchy Delegation and staff responsible to act on the reports The need for audit and review of policies and procedures Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 17 Chapter Organisation 14.1 14.2 14.3 14.4 Introduction Interest Rate Risk Exposure Management Systems Assets Repriced Before Liabilities Principle (ARBL) 14.5 Pricing Financial Securities Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 18 14.4 Assets Repriced Before Liabilities Principle (ARBL) • Repricing of assets and liabilities is essential in interest rate risk measurement and management – Positive ARBL gap exists when assets are repriced before liabilities For e.g., if interest rates are forecast to rise • • A bank increases the interest rate on loans (assets) before increasing the rate on deposits (liabilities) A firm increases the price of its goods before or at the same time as interest rates rise on its loan Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 19 14.4 Assets Repriced Before Liabilities Principle (ARBL) (cont.) • Repricing of assets and liabilities is essential in interest rate risk measurement and management (cont.) – Negative ARBL gap exists when liabilities are repriced before assets For e.g., if interest rates are forecast to fall • A bank lowers the interest rate on deposits (liabilities) before lowering the rate on loans (assets) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 20 14.4 Assets Repriced Before Liabilities Principle (ARBL) (cont.) • A firm should measure its ARBL interest rate sensitivity of its balance sheet assets and liabilities over a range of planning periods Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 21 Chapter Organisation 14.1 14.2 14.3 14.4 Introduction Interest Rate Risk Exposure Management Systems Assets Repriced Before Liabilities Principle (ARBL) 14.5 Pricing Financial Securities Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 22 14.5 Pricing Financial Securities • The effect of interest rate risk on the price of discount securities and fixed-interest corporate/government bonds can be demonstrated using calculations discussed in Chapters 9, 10 and 12 face value 365 Price yield 365 days to maturity 100 Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger (14.1) 23 14.5 Pricing Financial Securities (cont.) – Example 1: A company is to issue a ninety-day bank bill, with a face value of $500,000 yielding 9.5 per cent per annum. What amount will the company raise on the issue? $500 000 365 Price 365 (0.0950 90) 182 500 000 373.55 $488 555.75 Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 24 14.5 Pricing Financial Securities (cont.) – Example 1 (cont.): If the company has a rollover facility in place for this bill, it is exposed to interest-rate risk at the next repricing date, the rollover date, in ninety-days time. If the yield at the next rollover date is 9.25 per cent per annum the company will xxx. $500000 365 P rice 365 (0.0925 90) 182500 000 373.325 $488850.20 – In this example the cost of borrowing has fallen by $294.45. Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 25 Chapter Organisation (cont.) 14.6 14.7 14.8 14.9 Repricing Gap Analysis Duration Convexity Interest Rate Risk Management Techniques 14.10 Summary Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 26 14.6 Repricing Gap Analysis • Repricing gap analysis is the monitoring of the interest rate sensitivities of assets and liabilities over specified planning periods – Interest rate sensitivity relates to the repricing of an asset or liability within the planning period The longer the planning period, the more likely a security is to be rate sensitive Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 27 14.6 Repricing Gap Analysis (cont.) • The repricing gap is rate sensitive assets minus rate sensitive liabilities – Three groupings of assets and liabilities assist in determining the repricing gap Interest-sensitive assets financed by interest-sensitive liabilities Fixed-interest assets financed by fixed-interest liabilities and equities Interest-sensitive assets financed by fixed-interest liabilities Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 28 14.6 Repricing Gap Analysis (cont.) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 29 14.6 Repricing Gap Analysis (cont.) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 30 14.6 Repricing Gap Analysis (cont.) Change in profitability = Gap x change in rates x period (14.3) = $15 billion x 0.005 x 1 = $75 million Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 31 Chapter Organisation (cont.) 14.6 14.7 14.8 14.9 Repricing Gap Analysis Duration Convexity Interest Rate Risk Management Techniques 14.10 Summary Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 32 14.7 Duration • Duration is another tool for the measurement and management of interest rate risk exposures – – It is a measure in years, that considers the timing and present values of cash flows associated with a financial asset or liability Duration is calculated as the weighted average time over which cash flows occur, where weights are the relative present values of the cash flows Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 33 14.7 Duration (cont.) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 34 14.7 Duration (cont.) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 35 14.7 Duration (cont.) • Duration can also be used to determine the dollar impact of a change in interest rates on the price of a security using equation 14.5 C ( n) (1 i ) D C (1 i ) N i n t 1 N t t 1 n (14.5) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 36 14.7 Duration (cont.) • Duration can also be used to determine the dollar impact of a change in interest rates on the price of a security using equation 14.5 (14.5 [cont.]) where : C dollar value of cash flows at time t t n the number of periods until the cash flow is due i current maket yield expressed as a decimal N number of cash flows Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 37 14.7 Duration (cont.) • The duration of a portfolio of securities is the weighted duration of each asset or liability in the portfolio – Given a forecasted change in interest rates, the dollar change in the equity position of a firm can be calculated from equation 14.6 Δr% % price - duration (1 r ) where r is the current yield before the interest rate changes, or is forecast to change. Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger (14.6) 38 14.7 Duration (cont.) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 39 Chapter Organisation (cont.) 14.6 14.7 14.8 14.9 Repricing Gap Analysis Duration Convexity Interest Rate Risk Management Techniques 14.10 Summary Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 40 14.8 Convexity • Convexity is curvature in the price/yield curve – – This overcomes the limitation of the duration method which reflects a linear relationship between yield and price Convexity is illustrated in the following example A 2% interest rate change on one-year, two-year and threeyear bonds that have a face value of $1000 and pay a fixed annual coupon of 8% p.a. Figure 14.1 illustrates that the percentage change in price relationships for the one, two and year bonds is not linear, but convex Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 41 14.8 Convexity (cont.) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 42 14.8 Convexity (cont.) • Figure 14.2 indicates the difference in the price of the following bond using the duration and convexity approaches, assuming a forecast interest rate rise of 2% – $1000 bond paying 5% coupon pa, maturing in four years, currently yielding 5% p.a. • The problem with duration can be compensated for by adjusting for convexity % price = - duration [r%] + 0.5(convexity)(r2) (14.8) (1+r) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 43 14.8 Convexity (cont.) Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 44 Chapter Organisation (cont.) 14.6 14.7 14.8 14.9 Repricing Gap Analysis Duration Convexity Interest Rate Risk Management Techniques 14.10 Summary Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 45 14.9 Interest Rate Risk Management Techniques • Interest rate risk management techniques also include internal and external methods – Internal methods involve the restructuring of a firm’s balance sheet and associated cash flows Asset and liability portfolio restructuring • E.g. a funds manager sells part of its bond portfolio and invests the funds in shares or property Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 46 14.9 Interest Rate Risk Management Techniques (cont.) • Interest rate risk management techniques also include internal and external methods (cont.) – Internal methods (cont.) Asset and liability repricing • E.g. seek fixed-rate funds in periods when interest rates are rising Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 47 14.9 Interest Rate Risk Management Techniques (cont.) • Interest rate risk management techniques also include internal and external methods (cont.) – Internal methods (cont.) Cash flow timing • Change the timing of cash flows to minimise the effect of interest rate changes or to take advantage of forecast rate movements by • E.g. switching from one security to another with different frequency of interest payments Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 48 14.9 Interest Rate Risk Management Techniques (cont.) • Interest rate risk management techniques also include internal and external methods (cont.) – Internal methods (cont.) Reduced reliance on interest rates • E.g. introduction of other fees on loans by a bank Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 49 14.9 Interest Rate Risk Management Techniques (cont.) • Interest rate risk management techniques also include internal and external methods (cont.) – Internal methods (cont.) Prepayment and pre-redemption conditions • E.g. early payment penalties to discourage borrowers repaying floating-rate loans early in periods of rising interest rates Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 50 14.9 Interest Rate Risk Management Techniques (cont.) • Interest rate risk management techniques also include internal and external methods (cont.) – External methods External methods involve strategies outside the balance sheet • Primarily involve the use of derivative products allowing a party to lock in a price today that will apply at a specified future date i.e. futures contracts, forward rate agreements, interest options and swaps Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 51 Chapter Organisation (cont.) 14.6 14.7 14.8 14.9 Repricing Gap Analysis Duration Convexity Interest Rate Risk Management Techniques 14.10 Summary Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 52 14.10 Summary • Interest rate risk is the sensitivity of the value of balance sheet assets and liabilities and cash flow to movements in interest rates • Interest rate risk exists in the form of reinvestment risk and price risk • A firm must establish an effective interest rate exposure management system Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 53 14.10 Summary (cont.) • ARBL is a basic principle of interest rate risk management • Models for measuring interest rate risk include repricing gap analysis, duration (and convexity) • A range of internal and external interest rate risk management techniques exist Copyright Copyright 2003 2003 McGraw-Hill McGraw-Hill Australia Australia Pty Ltd PtyPPTs Ltd t/a PPT Slides t/a Financial Institutions, FinancialInstruments Accountingand by Willis Markets 4/e by Christopher Viney Slides Slidesprepared preparedbyby Anthony Kaye Watson Stanger 54