FIN 6002 – Session 24

Pradeepta Sethi
TAPMI
 Interest Rate Risk
• By performing maturity-transformations, banks often
mismatch the maturities of their assets and
liabilities. This exposes them to interest rate risk.
• For most financial institutions, interest rate risk is the
primary contributor to market risk.
• Interest rate risk
• is the risk where changes in market interest
rates affect a bank’s financial position.
• unexpected changes in interest rates which can
significantly alter a bank’s profitability and
market value of equity.
• Interest rate risk management is extremely
important because no one can consistently forecast
interest rates accurately.
• A bank’s asset and liability management committee
(ALCO), is responsible for measuring and
monitoring interest rate risk.
 Interest Rate Risk

¢ In terms of earnings,

l if interest rates rise, will the bank’s net

interest income (NII) rise or fall?

l If interest rates fall, will the bank’s NII rise

or fall?

¢ Interest rate risk arises largely from liabilities

and assets that do not reprice coincidentally.

¢ As such, the interest yield and market value of

the loans can vary over time much differently
than the interest cost and market value of
liabilities - resulting in a change in NII and
economic value of stockholder's equity.
 Interest rate risk

Refinancing Reinvestment Market value

risk risk risk
What happens when interest rate changes

• Scenario 1: Using short term liabilities to fund long

term assets.

• Assume a bank is using 1-year deposit to fund 5-

year loan. The interest rate on the deposit is 7% &
the interest rate on the loan is 9%.

• In the 1st year the bank will book a profit of 2%.

• However, the profit for the subsequent years are

uncertain as the bank has to look for another deposit
or rolling over the same deposit. If the level of
interest rates does not change for all the years, then
the bank can lock in profit at 2%.

• Here the bank is potentially exposing itself to

refinancing risk. The liabilities cannot be refinanced
at the same rate - risk of interest expense getting
higher than interest income.
What happens when interest rate changes
• Scenario 2: Using long term liabilities to fund short
term assets.

• Assume a bank is using 5-year deposit to fund 1-

year loan. The interest rate on the deposit is 7% &
the interest rate on the loan is 9%.

• In the 1st year the bank will book a profit of 2%.

• However, the profit for the subsequent years are

uncertain as the bank has to find a way to reinvest
the deposit.

• Here the bank is potentially exposing itself to

reinvestment risk - risk that the return on funds to
be reinvested will fall below the cost of funds.

• The bank faces uncertainty about the interest rate at

which it can reinvest funds borrowed for a longer
period.
What happens when interest rate changes

• Market value of an asset or liability is conceptually

equal to the present value of current and future cash
flows from that asset or liability.

• Therefore, rising interest rates increase the discount

rate on those cash flows and reduce the market
value of that asset or liability.

• Conversely, falling interest rates increase the market

values of assets and liabilities.

• Moreover, mismatching maturities by holding longer-

term assets than liabilities means that when interest
rates rise, the market value of the bank’s assets falls
by a greater amount than its liabilities.
 Measures of Interest Rate Risk

¢ Banks use two basic models to assess

interest rate risk.

¢ The first, GAP and earnings sensitivity

analysis, emphasizes income statement
effects by focusing on how changes in interest
rates and the bank’s balance sheet affect NII
and net income.

¢ The second, duration gap and economic value

of equity analysis, emphasizes the market
value of stockholders equity by focusing on
how these same types of changes affect the
market value of assets versus the market
value of liabilities.
 Measures of risk Measurement tools

I. GAP & Earnings Sensitivity

Analysis

• % Change in Net • GAP Analysis

Measures of Interest Income • Earnings
Sensitivity
Interest Rate Analysis

Risk II. EVE Analysis

• % Change in • Duration Analysis
Economic Value • Rate Shock
of Equity (EVE) Analysis
 • GAP and earnings sensitivity analysis
represent measures of risk.

• The basic performance target is NII (or

net income).

Measures of • Both measures signal whether a bank is

Interest Rate positioned to benefit or lose from rising

versus falling rates and how big a
Risk change in earnings is possible.

• Interest rate changes may either raise or

lower NII depending on the
characteristics of a bank’s assets and
liabilities.
 Why will a bank’s NII change
from one period to the next?

• In general, three factors potentially cause

a bank’s NII to rise or fall – rate,
composition & volume effects

• unexpected changes in interest rates

• changes in the mix, or composition, of

assets and/or liabilities, and

• changes in the volume of earning

assets and the volume of interest-
bearing liabilities.
 • In general, an asset or liability is
normally classified as rate
sensitive within a time interval if
it is repriced at or near
Rate current market interest rates.

sensitivity • For example if the asset/liability

• matures or rolled over.

• represents an interim or
partial principal payment.
• The interest rate applied to
the outstanding principal
balance changes
contractually during the
interval or when some base
rate or index changes
during the time interval with
which it is linked.
 Traditional static gap models attempt to
measure how much interest rate risk a bank
evidences at a fixed point in time by comparing
the rate sensitivity of assets with the rate sensitivity
of liabilities. This is also known as repricing gap.

Static GAP focuses on managing NII in the

short run.

The objective is typically to measure expected NII

Gap and then identify strategies to stabilize or improve
it.

analysis Interest rate risk is measured by calculating GAPs

over different time intervals based on aggregate
balance sheet data at a fixed point in time —
hence, the term static GAP.

The balance sheet is assumed not to change so

that only rate changes affect earnings.

GAP values are then examined to infer how much

NII will change if rates change.
 Develop an interest rate forecast.

Select a series of sequential time intervals for

determining what amount of assets and liabilities
are rate sensitive within each time interval.

Gap Group assets and liabilities into these time

intervals, or “buckets,” according to the time until
analysis the first repricing.

Calculate GAP. A bank’s static GAP equals the

dollar amount of RSAs minus the dollar amount of
RSLs for each time interval.

Forecast NII given the assumed interest rate

environment and assumed repricing characteristics
of the underlying instruments.
 GAP measures balance sheet values.

It represents the relative principal amounts of

assets or liabilities that management expects
to reprice within the relevant time interval.

Expected interest income and interest

expense components of cash flows are ignored
Gap in the GAP measure.

analysis GAP = RSAs – RSLs

The periodic GAP compares RSAs with RSLs
within each single time bucket.

The cumulative GAP compares RSAs with RSLs

over all time buckets from the present through
the last day in each successive time bucket.
 Asset Liability

100 100

3-year term loan @ fixed 1-month time deposit

rate 5%, quarterly @ 1%
payment

• 3-year fixed-rate loan financed with a 1-month

time deposit.
Gap • Assume that rates will rise to 50 basis points
analysis over the next month - spread will fall, reverse
will happen in case of interest rate falling.

• In this case, the term loan is not rate sensitive,

whereas the 1-month time deposit is.

• The bank’s one-month GAP equals to − 100.

• The sign of GAP indicates whether the bank is

positioned to benefit or lose when rates
increase or decrease.
 • In this example, the negative sign indicates
that the bank has more RSLs than RSAs.
• The magnitude of the GAP provides
information regarding how much NII may
change when rates change.
• In this example, the amount of risk the bank
takes may be indicated by comparing the –100
to the bank’s asset base.

Gap • A bank with 500 million in assets and a −100

million one-year GAP has much greater risk,

analysis ceteris paribus, than a bank with 5000 million

in assets and a − 100 million one-year GAP.
• Management can alter the size of the GAP to
either hedge NII against changing interest
rates or speculatively try to increase NII.
• Directly adjusting the amounts of RSAs and
liabilities, or by taking an off-balance sheet
position such as with forwards, futures, option
contracts and interest rate swaps, to change
the effective GAP.
 • The sign of GAP (positive or negative) indicates
the nature of the bank’s interest rate bet.

• The GAP measure compares the value of a

bank’s assets that reprice within an interval to
the value of liabilities that reprice within the
same time frame.
Factors
affecting NII Negative GAP

• Bank has more RSLs than RSAs – refinancing

risk
Changes in
• When interest rates rise during the time
level of interval, the bank pays higher rates on all

interest rate repriceable liabilities and earns higher yields on

all repriceable assets.
• If all rates rise by equal amounts at the same
time, both interest income and interest expense
rise, but interest expense rises more because
more liabilities are repriced.
• NII thus declines, as does the bank’s NIM.
 Negative GAP

• When interest rates fall during the interval,

Factors more liabilities than assets are repriced at
affecting NII the lower rates such that interest expense
falls more than interest income falls.

Changes in • In this case, both NII and NIM increase.

level of • A bank with a negative GAP is said to be

liability sensitive - more liabilities are
interest rate expected to reprice versus assets, and
interest expense is expected to change
more than interest income.
 Positive GAP

• A positive GAP indicates that a bank has

more RSAs than RSLs across same time
interval – reinvestment risk
Factors
• When rates rise, interest income
affecting NII increases more than interest expense
because more assets are repriced such
that NII similarly increases.
Changes in
level of • Rate decreases have the opposite effect.
Because interest income falls more than
interest rate interest expense, NII falls.

• Such a bank is labeled as asset sensitive

- More assets than liabilities are expected
to reprice, and interest income changes
more than interest expense.