11/23/16

CHAPTER 8
Interest Rate Risk I

Copyright 2014 by the McGraw-Hill Companies, Inc. All rights reserved.

Overview
This chapter discusses the interest rate
risk associated with FIs:
Federal Reserve monetary policy
Repricing model
*Appendices:
*Maturity model
*Term structure of interest rates
Ch 8-2

11/23/16

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
Thrifts, during 1980s

Ch 8-3

US Treasury Bill Rate, 1965 - 2012

Ch 8-4

11/23/16

Level & Movement of Interest Rates

Federal Reserve Bank: U.S. central
bank
Open market operations influence money
supply, inflation, and interest rates
Actions of Fed (December, 2008) in
response to economic crisis
w Target rate between 0.0 and percent

Ch 8-5

Central Bank and Interest Rates

Target is primarily short term rates
Focus on Fed Funds Rate in particular

Interest rate changes and volatility

increasingly transmitted from country
to country
Statements by Ben Bernanke can have
dramatic effects on world interest rates

Ch 8-6

11/23/16

Repricing Model
Repricing or funding gap model based
on book value
Contrasts with market value-based
maturity and duration models in
appendix

Ch 8-7

Repricing Model
Rate sensitivity means repricing at
current rates
Repricing gap is the difference
between interest earned on assets and
interest paid on liabilities
Refinancing risk
Reinvestment risk
Ch 8-8

11/23/16

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
Ch 8-9

Repricing Gap Example

Assets
1-day
$ 20
>1day-3mos. 30
>3mos.-6mos. 70
>6mos.-12mos. 90
>1yr.-5yrs.
40
>5 years
10

Liabilities
$ 30
40
85
70
30
5

Cum.
Gap
Gap
$-10
$-10
-10
-20
-15
-35
+20
-15
+10
-5
+5
0
Ch 8-10

11/23/16

Applying the Repricing Model

DNIIi = (GAPi) DRi = (RSAi - RSLi) DRi
Example I:
In the one day bucket, gap is -$10
million. If rates rise by 1%,
DNII(1) = (-$10 million) .01 = -$100,000
Ch 8-11

Applying the Repricing Model

Example II:
If we consider the cumulative 1-year
gap,
DNII = (CGAP) DR = (-$15 million)(.01)
= -$150,000

Ch 8-12

11/23/16

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
Ch 8-13

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 ratesensitive liabilities

Ch 8-14

11/23/16

CGAP Ratio
May be useful to express CGAP in ratio
form as CGAP/Assets
Provides direction of exposure and
Scale of the exposure

Example:
CGAP/A = $15 million / $270 million =
0.056, or 5.6 percent

Ch 8-15

Equal Rate Changes on RSAs, RSLs

Example: Suppose rates rise 1% for RSAs
and RSLs. Expected annual change in
NII,
DNII = CGAP D R
= $15 million .01
= $150,000
With positive CGAP, rates and NII move
in the same direction
Change proportional to CGAP
Ch 8-16

11/23/16

Unequal Changes in Rates

If changes in rates on RSAs and RSLs are
not equal, the spread changes; In this
case,
DNII = (RSA D RRSA ) - (RSL D RRSL )

Ch 8-17

Unequal Rate Change Example

Spread effect example:
RSA rate rises by 1.2% and RSL rate rises
by 1.0%
DNII = D interest revenue - D interest expense
= ($155 million 1.2%) - ($155 million 1.0%)
= $310,000

Ch 8-18

11/23/16

Restructuring Assets & Liabilities

FI can restructure assets and liabilities,
on or off the balance sheet, to benefit
from projected interest rate changes
Positive gap: increase in rates increases
NII
Negative gap: decrease in rates
increases NII

Ch 8-19

Restructuring the Gap

Example: Harleysville Savings Financial
Corporation at the end of 2008
One year gap ratio was 1.45 percent
Three year gap ratio was 3.97 percent
If interest rates rose in 2009, it would
experience large increases in net interest
income

Commercial banks recently reducing

gaps to decrease interest rate risk
Ch 8-20

10

11/23/16

Weaknesses of Repricing Model

Weaknesses:
Ignores market value effects of interest rate
changes
Overaggregative
w Distribution of assets & liabilities within individual
buckets is not considered
w Mismatches within buckets can be substantial

Ignores effects of runoffs

w Bank continuously originates and retires
consumer and mortgage loans
w Runoffs may be rate-sensitive
Ch 8-21

Weaknesses of Repricing Model

Off-balance-sheet items are not
included
Hedging effects of off-balance-sheet
items not captured
Example: Futures contracts

Ch 8-22

11

11/23/16

*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
Ch 8-23

*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, maturity gap, MA - ML > 0 for
most banks and thrifts
Ch 8-24

12

11/23/16

*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

Ch 8-25

*Maturities 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 maturity gap
equals zero
Reason: Differences in duration**
**(See Chapter 9)
Ch 8-26

13

11/23/16

*Maturity Model
Leverage also affects ability to
eliminate interest rate risk using
maturity model
Example:
Assets: $100 million in one-year 10-percent
bonds, funded with $90 million in one-year
10-percent deposits (and equity)
Maturity gap is zero but exposure to interest
rate risk is not zero.
Ch 8-27

*Duration
The average life of an asset or liability
The weighted-average time to
maturity using present value of the
cash flows, relative to the total present
value of the asset or liability as weights

Ch 8-28

14

11/23/16

*Term Structure of Interest Rates

YTM

YTM

Time to Maturity

Time to Maturity

Time to Maturity

Time to Maturity
Ch 8-29

*Unbiased Expectations Theory

Yield curve reflects markets
expectations of future short-term rates
Long-term rates are geometric
average of current and expected
short-term rates
(1 +1RN)N = (1+ 1R1)[1+E(2r1)][1+E(Nr1)]

Ch 8-30

15

11/23/16

*Liquidity Premium Theory

Allows for future uncertainty
Premium required to hold long-term

Ch 8-31

*Market Segmentation Theory

Investors have specific needs in terms
of maturity
Yield curve reflects intersection of
demand and supply of individual
maturities

Ch 8-32

16

11/23/16

Web Resources
For information related to central bank
policy, visit:
Bank for International Settlements
www.bis.org
Federal Reserve Bank
www.federalreserve.gov

Ch 8-33

17