Interest Rate Risk Part 1
Interest rate
Level and movement; mainly CB monetary policy (short-term rates feed through to interest rate terms structure), financial market integration means volatility changes to interest rates transmitted rapidly among countries
Term structure; relation between term terms of debt instruments of identical default risk | yield curve; display the term structure of interest rates
Interest rate risk of FIs; asset transformation causing maturity mismatch between assets and liabilities which are affected by interest rate changes
Net worth (market value of equity) affected; measured by Duration Model
Net increase income (NII) affected; measured by Repricing Model
Yield curves 📈 to reflect risk-reward relationship with holding securities for longer periods of time
Reinvestment risk; where asset maturity < liability maturity, liabilities at a fixed rate, however new asset return may be below liability fixed interest rate
Refinancing risk; where liability maturity < asset maturity, if interest rates rise then re-finance costs are higher but profits remain same so loss of NII
Repricing Model; identify maturity bucket | identify RSA and RSL on B/S | GAP * ∆R
Repricing gap; difference between amounts of assets and liabilities whose interest rates will be repriced or changed over a certain period
Risk-sensitive assets (RSA); assets with maturities within the certain period that need to be re-invested
Risk-sensitive liabilities (RSL); liabilities with maturities within the certain period that will require re-financing
Reasons for repricing :
Asset/liability rollover
Asset/liability with variable-rate that changes based on market movements
∆NII=(GAP) x ∆R=(RSA-RSL) x ∆R :
∆R=change in level of interest rates impacting assets/liabilities within the specified time bucket
GAP=(RSA-RSL)=repricing gap within the specified time bucket
∆NII= change in net interest income within the specified time bucket
Negative repricing gap (RSA<RSL); refinancing risk if interest rate rises which lowers FI's NII
Positive repricing gap (RSA>RSL); reinvestment risk if drop in interest rate which lowers FI's NII
If interest rates projected to decrease, ✅ maintain negative repricing gap to increase NII :
If interest rates projected to increase, ✅ maintain positive repricing gap to increase net interest income
Cumulative gap; sum of repricing gaps in narrower intervals contained by the broader interval
⚠ Demand deposits and passbook savings accounts are generally considered to be rate-insensitive
Alternative expressions: ♻
CGAP/Assets
Scale of that exposure
Direction of interest rate exposure
Gap ratio; RSA/RSL
Gap ratio <1 ✅ FI exposed to refinancing risk
Gap ratio >1 ✅ FI exposed to reinvestment risk
♻∆NII=(RSA x ∆R𝑟𝑠a) -(RSL x ∆R𝑟𝑠𝑙)
∆NII=(RSA-RSL) x ∆R𝑟𝑠a + RSL x (∆R𝑟𝑠a-∆R𝑟𝑠𝑙)
♻ Spread effect: RSL x (∆R𝑟𝑠a-∆R𝑟𝑠𝑙)
♻ CGAP effect; (RSA-RSL) x ∆R𝑟𝑠a
If change in interest rates on RSA and RSL unequal then spread effect in addition to GAP effect
Change in spread is always positively related to change in net interest income
If CGAP effect and Spread effect in opposite directions then change in net income not predictable without knowing size of CGAP and Change in spread
Weaknesses
⚠ repricing model ignores market value effect- implicitly assuming a book value accounting approach so only partial measure of FI's true interest rate risk exposure
⚠ ignores info regarding distribution of assets/liabilities within each time bucket i.e. assets/liabilities may be repriced at different times within the time bucket ✅ reduce range to reduce impact of this problem
⚠ PV of cash flows of assets/liabilities change in addition to immediate interest received/paid on them as interest rate changes
⚠ ignores runoff cash flows
⚠ progression of assets/liabilities from their original maturities shorten their actual time to maturity and time period before needing to re-finance or re-invest
⚠ ignores cash flows from Off-Balance-Sheet Activities
Market value effect/interest rates
Change in interest=change in market value of assets/liabilities or essentially net worth of FI.
Duration model
ΔP approx dP/dR ΔR
P=sum (t periods) C/1+r
dP/dR= -sum (t periods) [C/(1+r)^t+1] * t
D=sum (t periods) PV/P*t
ΔP= - DP(ΔR/1+R)