Chapter 8

Interest Rate
Risk I

Copyright 2010 McGraw-Hill Ryerson Ltd., All Rights Reserved.

Prepared by Lois Tullo, Schulich School of Business, York University

Chapter Outline

This chapter looks at techniques used by FIs to

measure interest rate risk:
Monetary policy
Repricing model
Maturity model
Duration model
Term structure of interest rate risk
Theories of the term structure of interest rates
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Loanable Funds Theory

Interest rates reflect supply and demand for

loanable funds
Shifts in supply or demand generate interest
rate movements as market forces establish a
new equilibrium

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Determination of Equilibrium Interest Rates

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Bank of Canada & Interest Rates

Bank of Canada
Sets target ranges for inflation then adjusts the
overnight rate to achieve its inflation target.
Current target overnight rate = 0.5%

Bank rate is the rate the BOC charges for one-day

loans it makes to Fis
Current bank rate = 0.75%

BOC pays attention to the action of other central

banks, mainly the Federal Reserve in the US.
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CAD & US Central Bank Rates

Recent

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Central Bank and Interest Rates

Target is primarily short term rates.
Focus on BOC overnight Rate in particular.

Interest rate changes and volatility

increasingly transmitted from country to
country.
Statements by Fed Chair Ben Bernanke can have
dramatic effects on world interest rates
Notice May 2013

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Central Bank and Interest Rates

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Central Bank and Interest Rates

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Central Bank and Interest Rates

10.00

8.00

6.00
rate
4.00

2.00

0.00

-2.00
0

10

15

Term

20

25

30

United States Treasury Constant Maturity - 09/29/2015

United States Treasury Constant Maturity - 7/28/2000
United States Treasury Constant Maturity - 5/25/1990

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Repricing Model
Repricing or funding gap model based on book value.
Repricing gap is the difference between the rate
sensitivity of each asset and the rate sensitivity of
each liability: RSA - RSL.
Specifically it is the gap between the interest revenue
earned on assets and the interest paid on liabilities (called
Net Interest Income) over a fixed time period

Rate sensitivity means the interest rate paid or earned

is liable to change over that time period

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Repricing Model
If RSA < RSL => Refinancing risk
If RSA > RSL => Reinvestment risk
Contrasts with market value-based maturity and
duration models recommended by the Bank for
International Settlements (BIS).

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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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Maturity Buckets
Repricing will occur as a result of a rollover of
an asset or liability:
.e.g. a loan is paid off at or prior to maturity and the
funds are used to issue a new loan at current market
rates

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Repricing Gap Example

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Applying the Repricing Model

NII = Change in Net Interest Income
NIIi = (GAPi) Ri = (RSAi - RSLi) ri
GAPi = Dollar size of gap between BV of RSAa
and RSLs in maturity bucket i

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Applying the Repricing Model

Example:
In the one day bucket, gap is -$10 million. If rates rise
by 1%,
NII(1) = (-$10 million) .01 = -$100,000.

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Applying the Repricing Model

Example II:
We can also consider the cumulative 1-year gap,
NII = (CGAPone year) R = (-$15 million)(.01)
= -$150,000.
R being the average interest rate change affecting
assets and liabilities that can be repriced within a
year
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Rate-Sensitive Assets
Table 8.2: a hypothetical balance sheet

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Rate-Sensitive Assets
Example from (Table 8.2):
Short-term consumer loans. If repriced at year-end,
would just make one-year cutoff.
3-month T-bills repriced on maturity every 3 months.
6-month T-bills repriced on maturity every 6 months.
25-year floating-rate mortgages repriced (rate reset)
every 6 months.
=> Total 1-year RSAa = $155 million
Remaining $115m not rate sensitive over 1 yr repricing horizon
(i.e. a change in interest rates will not affect the size of the
interest revenue generated by these assets over the next year.
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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 (act as core
deposits), but there are arguments for their
inclusion as rate-sensitive liabilities because
individuals may draw down their demand deposits

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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.

Example:
CGAP/A = $15 million / $270 million = 0.056, or
5.6 percent.
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Equal Rate Changes on RSAs, RSLs

Example: Suppose rates rise 1% for RSAs and
RSLs. Expected annual change in NII,
NII = CGAP R
= $15 million .01
= $150,000
With positive CGAP, rates and NII move in the
same direction.
Change proportional to CGAP.
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Equal Rate Changes on RSAs,

RSLs

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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 )

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Unequal Rate Change Example

Spread effect example:
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

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Example of Rate Changes

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Interest Rate vs. Spread

Changes

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Restructuring Assets & Liabilities

The FI can restructure its 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

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Weaknesses of Repricing Model

Weaknesses:
Over-aggregation
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.

Ignores market value effects and off-balance sheet

(OBS) cash flows.
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The Over Aggregation Problem

(Figure 8-3)

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The Run-Off Problem

Runoff
Periodic cash flow of interest and principal
amortization payments on long-term assets,
such as conventional mortgages, that can be
reinvested at market rates.

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Off Balance Sheet Items

RSAs and RSLs used in the basic re-pricing
model include only the assets and liabilities
listed on the balance sheet. Changes in
interest rates will affect the cash flows on
many off-balance-sheet (OBS) instruments as
well.

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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, maturity gap, 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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Maturities and Interest Rate Exposure

If MA - ML = 0, is the FI immunized?
Extreme example: Suppose liabilities consist of 1year 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)
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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.

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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.

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Term Structure of Interest Rates

YTM

YTM

Time to Maturity

Time to Maturity
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Time to Maturity

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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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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Liquidity Premium Theory

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

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The Relationship Between the Liquidity

Premium and Expectations Theory

Chapter Summary
This chapter looked at techniques
used by FIs to measure interest rate
risk:
Monetary policy
Repricing model
Maturity model
Duration model
Term structure of interest rate risk
Theories of the term structure of interest
rates
45
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Pertinent Websites
For information related to central bank policy,
visit:
Bank for International Settlements: www.bis.org
Federal Reserve Bank: www.federalreserve.gov

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