lOMoARcPSD|4041866

5. Interest rate risk measurement repricing model

Managing Financial Services Firms (University of Canberra)

StuDocu is not sponsored or endorsed by any college or university

Downloaded by Fatima Mazhar (fatima.mazhar@gscwu.edu.pk)
 lOMoARcPSD|4041866

5. Interest rate risk measurement: repricing mode

Monday, 24 April 2017 11:15 am

Interest rate risk may lead to the eventual risk of insolvency, so it is fundamental to
learn how to measure and manage it. To measure it we study two models
○ Repricing model
○ Duration model

Movements in the interest rates:

The main responsible is the RBA's monetary policy - to achieve its target cash rate
(= rate of interest charged by RBA on overnight loans to banks).
If the RBA targets supply of money (rather than interest rates), then
this volatility can be very high.

The monetary policy is exercised

- "Announcing" the cash rate
- Impacting the cash rate with open market operations (buying or selling
Treasury bonds and notes)
Objective is anyway to achieve the target cash rate!
E.g.
If inflation is too high: RBA increases the cash rate (or sells T-bonds to reduce money); to
promote saving and slow down the economy and prices growth.
If inflation is too low: RBA decreases the cash rate (or buys T-bonds to inject more money) -
to promote consumption and investment, and stimulate the economy.

REPRICING MODEL

Analysis of the gap between future cash outflows and cash inflows:
Repricing gap between interest earned and paid over particular periods
in time ("maturity buckets").
The problem is that it uses "book value accounting": i.e. assets and liabilities are
reported at their book value (cost minus depreciation), …regardless of changes in
market rates!

Maturity buckets are composed according to the rate sensitivity of each asset and
liability

Downloaded by Fatima Mazhar (fatima.mazhar@gscwu.edu.pk)

 lOMoARcPSD|4041866

el

Downloaded by Fatima Mazhar (fatima.mazhar@gscwu.edu.pk)

 lOMoARcPSD|4041866

liability
= here, rate-sensitive means that they are repriced (e.g. reset date for variable
interest rate), or rolled over, within the bucket timeframe.
Maturity buckets are cumulative: so each bucket will also include the
items of the previous bucket (because what was repriced within the
last period is obviously rate-sensitive within a larger timeframe too)
--> The last cumulative bucket (i.e. the whole balance sheet!) will,
by definition, have zero funding gap.

The funding gap tells us the net interest income exposure of the FI within the
period.
[Net interest income (NII)= interest earned - interest paid]
[Net interest margin = (interest earned - interest paid)/assets]

∆𝑵𝑰𝑰 𝒊 = ∆𝑮𝒂𝒑𝒊 ∗ ∆𝑹𝒊 = (𝑅𝑆𝐴/ − 𝑅𝑆𝐿/) ∗ ∆𝑅/

However, this does not take into account loss of market value (capital loss)
due to interest rate changes
(e.g. if interest rates rise, with respect to our security, if we want to sell that
security we will have to discount it so that it pays as much as the market
interest rate; incurring a capital loss).

Rate-sensitive assets
Assets that get repriced or rolled over within the maturity bucket observed.
- Short-term consumer loans (1 year)
- Treasury Notes (less than 6 months; one payment on maturity)
- Treasury Bonds (medium/long-term; coupons semi-annual)
--> depends if interest rates are fixed!
- Floating rate mortgages (rate is reset every 9 months, so < 1 year)

Rate-sensitive liabilities
Liabilities that get repriced or rolled over within the maturity bucket observed.
- Savings accounts (it depends on the type of "core" deposits held by the
institutions: are they mostly long-term? Or sensitive to interest rate changes?
If depositors are "rate shoppers" rather than service shoppers, then they are
likely to withdraw and go elsewhere if the FI's interest rates do not change
accordingly.)
--> in the second case, savings account are in the 1 month
- Term deposits (repriced on rollover)
--> depends how long is the term
- Certificates of deposit (repriced on rollover)

Downloaded by Fatima Mazhar (fatima.mazhar@gscwu.edu.pk)

 lOMoARcPSD|4041866

Downloaded by Fatima Mazhar (fatima.mazhar@gscwu.edu.pk)

 lOMoARcPSD|4041866

- Certificates of deposit (repriced on rollover)

N.B. Demand deposits are NOT rate-sensitive; they hardly bear any interest, and if
they do, it is very low, and it is certainly not what drives depositors to keep their
funds there!
N.B. II. Interest of term deposits > interest of savings.
N.B. III. Equity is sometimes included as a liability in the longest bucket.

The repricing gap

It is thus the difference between the rate-sensitive assets and the rate-sensitive
liabilities
𝐺𝑎𝑝/ = 𝑅𝑆𝐴/ − 𝑅𝑆𝐿/ (for a given maturity bucket i)

CGAP is the cumulative repricing gap.

CGAP effects: relationship between ∆𝑹 and ∆𝑵𝑰𝑰

(These relationship depends indeed on the size of the cumulative repricing gap).
The larger the CGAP (absolutely), the larger the effect on Net Income
(negative or positive!).

CGAP > 0 (RSA > RSL) Positive relationship with interest

If ∆𝑅 > 0 (interest rate rises), then ∆𝑁𝐼𝐼 > 0 (net interest income increases)
If ∆𝑅 < 0 (interest rate falls), then ∆𝑁𝐼𝐼 < 0 (net interest income decreases)

CGAP < 0 (RSA < RSL) Negative relationship with interest

If ∆𝑅 > 0 (interest rate rises), then ∆𝑁𝐼𝐼 < 0 (net interest income decreases)
If ∆𝑅 < 0 (interest rate falls), then ∆𝑁𝐼𝐼 > 0 (net interest income increases)

This is because there is interest rate changes have a positive impact on NII when the
GAP is positive, and a negative impact on NII when the GAP is negative.

So, if interest rate is expected to fall --> we'll want a negative gap!
Or, if interest rate is expected to rise --> we'll want a positive gap!
("CGAP effects")

Unequal change in ∆𝑹 for assets and liabilities

I.e. when we also have an interest spread: difference between rate of interest
earned - rate of interest paid.

The correlation between changes in spread and changes in NII is positive:

Downloaded by Fatima Mazhar (fatima.mazhar@gscwu.edu.pk)

 lOMoARcPSD|4041866

Downloaded by Fatima Mazhar (fatima.mazhar@gscwu.edu.pk)

 lOMoARcPSD|4041866

○ Spread increases:
- When interest rises, interest earned > interest paid --> higher NII
- When interest falls, interest earned > interest paid anyway -->
higher NII

○ Spread decreases:
- When interest rises, interest paid > interest earned --> lower NII
- When interest falls, interest paid > interest earned --> lower NI

Example:
RSA = 155 million = RSL (so no funding gap)
Spread increases: of (0.012 - 0.01) = + 0.002
Difference in NII: [(155*0.012) - (155*0.01)]= 0.31*1000000 = 310'000

Weaknesses of the repricing model

- Ignoring market value effects (because of the book value accounting

assumption)
- Over-aggregation within buckets: assets and liabilities could still mismatch
within the bucket itself;
The only solution is to observe really small buckets - ideally, for 'any
given day'
- Run-offs = periodic cash flows from interest and principal repayment, that
can be therefore reinvested.
They should also be considered as rate-sensitive, since they will be re-
invested!
- Off-balance-sheet activities are also affected by interest changes
E.g. If we have entered a futures, to be hedged from interest rate risk:
the interest rate change will also affect our futures position (in
opposite direction from the spot position, of course).
So there will be positive or negative cash flows depending on the
interest!

APRA regulations require small ADIs to use the repricing method to assess their
interest rate exposure.

Simple comparison with the DURATION GAP:

Downloaded by Fatima Mazhar (fatima.mazhar@gscwu.edu.pk)

 lOMoARcPSD|4041866

Downloaded by Fatima Mazhar (fatima.mazhar@gscwu.edu.pk)

 lOMoARcPSD|4041866

Simple comparison with the DURATION GAP:

DA - k*DL

If the duration gap is positive, it means the same as a negative repricing gap!
i.e. assets have a longer duration than the liabilities, so are more exposed to
interest rate impact on market prices.

Downloaded by Fatima Mazhar (fatima.mazhar@gscwu.edu.pk)

 lOMoARcPSD|4041866

Downloaded by Fatima Mazhar (fatima.mazhar@gscwu.edu.pk)