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Lecture 3

This lecture discusses interest rate risk faced by financial institutions due to mismatches between asset and liability maturities. It introduces the repricing model for measuring interest rate risk, which involves bucketing assets and liabilities by maturity and calculating repricing gaps. Repricing gaps measure the difference between interest earned on rate-sensitive assets and paid on rate-sensitive liabilities, allowing estimation of changes in net interest income from interest rate movements. The lecture also covers duration and convexity measures for quantifying price sensitivity of fixed income securities to interest rate changes. Duration is a weighted average maturity measure incorporating cash flow timing and yields, while convexity accounts for non-linear price responses to rates.

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70 views29 pages

Lecture 3

This lecture discusses interest rate risk faced by financial institutions due to mismatches between asset and liability maturities. It introduces the repricing model for measuring interest rate risk, which involves bucketing assets and liabilities by maturity and calculating repricing gaps. Repricing gaps measure the difference between interest earned on rate-sensitive assets and paid on rate-sensitive liabilities, allowing estimation of changes in net interest income from interest rate movements. The lecture also covers duration and convexity measures for quantifying price sensitivity of fixed income securities to interest rate changes. Duration is a weighted average maturity measure incorporating cash flow timing and yields, while convexity accounts for non-linear price responses to rates.

Uploaded by

Nurfaiqah Amni
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© © All Rights Reserved
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Lecture 3

INTEREST RATE RISK


CHAPTER 8 & 9
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
LEVEL & MOVEMENT OF INTEREST RATES

 Central bank monetary policy strategy


 Movement of interest rates
– Open market operations influence money supply, inflation, and interest rates
– To slow down the economy-tights monetary policy, raising interest rates
– To stimulate the economy – expansionary monetary policy, allows the
interest rate to fall
REPRICING MODEL

 Repricing or funding gap model based on book value accounting cash flow analysis
 Repricing gap – the difference between interest earned on assets and interest paid
on liabilities
 Rate sensitivity means repricing at current rates
 Rate-sensitive asset or liability- An asset or liability that is repriced at or near current
market interest rates within a maturity bucket.
 Refinancing risk- Risk exposure from the cost of rolling over or reborrowing funds will
rise above the returns being earned on asset investments.
 Reinvestment risk- Risk exposure from the returns on funds to be reinvested will fall
below the cost of the funds.
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
REPRICING GAP EXAMPLE
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 = -$100,000


APPLYING THE REPRICING MODEL (CONT..)

 Example II:
• If we consider the cumulative 1-year gap,

• NII = (CGAP) R = (-$15 million)(.01)


• = -$150,000
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
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
GAP RATIO

 May be useful to express interest rate sensitivity in


ratio form as CGAP/Assets, referred to as “gap ratio”
– Provides direction of exposure and scale of the exposure

 Example:
– CGAP/A = $15 million / $270 million = 0.056, or 5.6 percent
EQUAL RATE CHANGES ON RSAS, RSLS

 Example 8-1: Suppose rates rise 1% for RSAs and RSLs. Expected
annual change in NII,
• NII = CGAP ×  R
• = $15 million × .01
• = $150,000
 CGAP is positive, change in NII is positively related to change in
interest rates
 CGAP is negative, change in NII is negatively related to change
in interest rates
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 )

Example 8-2:
• 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
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 runoffs
 Bank continuously originates and retires consumer and mortgage loans
 Runoffs may be rate-sensitive
 Off-balance-sheet items are not included
– Hedging effects of off-balance-sheet items not captured
– Example: Futures contracts
CHAPTER 9:
PRICE SENSITIVITY AND MATURITY

• In general, the longer the term to maturity, the greater


the sensitivity to interest rate changes
• The longer maturity bond has the greater drop in price
because the payment is discounted a greater number
of times
DURATION

• Weighted average time to maturity using the relative present


values of the cash flows as weights
• Combines the effects of differences in coupon rates and
differences in maturity
• Based on elasticity of bond price with respect to interest rate
• The units of duration are years
FEATURES OF DURATION

• Duration and maturity


• Duration increases with maturity of a fixed-income asset/liability,
but at a decreasing rate
• Duration and yield
• Duration decreases as yield increases
• Duration and coupon interest
• Duration decreases as coupon increases
MACAULAY DURATION
• Since the price (P) of the bond equals the sum of the present values
of all its cash flows, we can state the duration formula another way:

• Notice the weights correspond to the relative present values of the


cash flows
SEMIANNUAL CASH FLOWS

• It is important to see that we must express t in years, and the


present values are computed using the appropriate periodic
interest rate. For semiannual cash flows, Macaulay duration, D is
equal to:
DURATION OF ZERO-COUPON BOND

• Zero-coupon bonds: sell at a discount from face value on issue, pay the
face value upon maturity, and have no intervening cash flows between
issue and maturity
• Duration equals the bond’s maturity since there are no intervening
cash flows between issue and maturity
• For all other bonds, duration < maturity because here are intervening
cash flows between issue and maturity
COMPUTING DURATION

• Consider a 2-year, 8% coupon bond, with a face value of $1,000 and


yield-to-maturity of 12%
• Coupons are paid semi-annually
• Therefore, each coupon payment is $40 and the per period YTM is
(1/2) × 12% = 6%
• Present value of each cash flow equals CFt ÷ (1+ 0.06)t where t is
the period number
DURATION OF 2-YEAR, 8% BOND:
FACE VALUE = $1,000,YTM = 12%
ECONOMIC INTERPRETATION

• Duration is a measure of interest rate sensitivity or elasticity of a


liability or asset:
[ΔP/P]  [ΔR/(1+R)] = -D

Or equivalently,
ΔP/P = -D[ΔR/(1+R)] = -MD × ΔR
where MD is modified duration
ECONOMIC INTERPRETATION

• To estimate the change in price, we can rewrite this as:


ΔP = -D[ΔR/(1+R)]P = -(MD) × (ΔR) × (P)

• Note the direct linear relationship between ΔP and -D


LIMITATIONS OF DURATION

• Duration matching can be costly


• Growth of purchased funds, asset securitization, and loan sales markets
have lowered costs of balance sheet restructurings
• Immunization is a dynamic problem
• Trade-off exists between being perfect immunization and transaction costs
• Large interest rate changes and convexity
CONVEXITY

• A measure of the curvature in the relationship between bond prices and bond yields that
demonstrates how the duration of a bond changes as the interest rate changes.
• Convexity is used as a risk-management tool, which helps measure and manage the
amount of interest rate risk & market risk to which a portfolio of bonds is exposed.
• The degree of curvature of the price-yield curve around some interest rate level
• All fixed-income securities are convex.
• Convexity is desirable, but greater convexity causes larger errors in the duration-based
estimate of price changes.
CONVEXITY (CONT..)
TUTORIAL

• Chapter 8: Q. 16,17, 20, 21


• Chapter 9: Q. 3, 4, 5, 7

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