Interest Rate Risk I Chapter 8

Financial Institutions Management, 3/e By Anthony Saunders

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Central Bank and Interest Rate Risk

Effects of interest rate targeting.
Lessens interest rate risk

October 1979 to October 1982, nonborrowed reserves target regime. Implications of return to reserves target policy:
Increases importance of measuring and managing interest rate risk.

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Repricing Model
Repricing or funding gap model based on book value. Contrasts with market value-based maturity and duration models. Rate sensitivity means time to repricing. Repricing gap is the difference between the rate sensitivity of each asset and the rate sensitivity of each liability: RSA - RSL.
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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 3 three months to six months. More than six months to twelve months. More than one year to five years. Over five years.
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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 Gap Cum. Gap $-10 $-10 -10 -20 -15 -35 +20 -15 +10 -5 +5 0

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Applying the Repricing Model

DNIIi = (GAPi) DRi = (RSAi - RSLi) Dri
Example: In the one day bucket, gap is -$10 million. If rates rise by 1%, DNIIi = (-$10 million) .01 = -$100,000. Example II: If we consider the cumulative 1-year gap, DNIIi = (CGAPi) DRi = (-$15 million)(.01) = -$150,000.
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Rate-Sensitive Assets

Examples from hypothetical balance sheet:

Short-term consumer loans. If 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.
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Rate-Sensitive Liabilities
RSLs bucketed in same manner as RSAs. Demand deposits and passbook savings accounts warrant special mention.

Generally considered rate-insensitive, but there are arguments for their inclusion as ratesensitive liabilities.

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CGAP Ratio

May be useful to express CGAP in ratio form as, CGAP/Assets.

Provides direction of exposure and Scale of the exposure.

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Weaknesses of Repricing Model

Weaknesses:
Ignores market value effects 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.
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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.
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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, MA - ML > 0 for most banks and thrifts.
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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.

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Maturity Matching 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 maturities are equal. Reason: Differences in duration.
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*Term Structure of Interest Rates

YTM

YTM

Time to Maturity

Time to Maturity

Time to Maturity
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Time to Maturity
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*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.
_ _
~ ~

RN = [(1+R1)(1+E(r2))(1+E(rN))]1/N - 1

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*Liquidity Premium Theory

Allows for future uncertainty. Premium required to hold long-term.

*Market Segmentation Theory

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

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