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Interest Rate Risk Part 1 (Repricing Model; identify maturity bucket |…
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
Yield curves :chart_with_upwards_trend: to reflect risk-reward relationship with holding securities for longer periods of time
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
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
Alternative expressions: :recycle:
CGAP/Assets
Scale of that exposure
Direction of interest rate exposure
Gap ratio; RSA/RSL
Gap ratio <1 :check: FI exposed to refinancing risk
Gap ratio >1 :check: FI exposed to reinvestment risk
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
Negative repricing gap (RSA<RSL); refinancing risk if interest rate rises which lowers FI's NII
If interest rates projected to decrease, :check: maintain negative repricing gap to increase NII :
Positive repricing gap (RSA>RSL); reinvestment risk if drop in interest rate which lowers FI's NII
If interest rates projected to increase, :check: maintain positive repricing gap to increase net interest income
∆NII= change in net interest income within the specified time bucket
:recycle:∆NII=(RSA x ∆R𝑟𝑠a) -(RSL x ∆R𝑟𝑠𝑙)
∆NII=(RSA-RSL) x ∆R𝑟𝑠a + RSL x (∆R𝑟𝑠a-∆R𝑟𝑠𝑙)
:recycle: Spread effect: RSL x (∆R𝑟𝑠a-∆R𝑟𝑠𝑙)
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
:recycle: CGAP effect; (RSA-RSL) x ∆R𝑟𝑠a
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
Cumulative gap; sum of repricing gaps in narrower intervals contained by the broader interval
:warning: Demand deposits and passbook savings accounts are generally considered to be rate-insensitive
Weaknesses
:warning: 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
:warning: 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 :check: reduce range to reduce impact of this problem
:warning: PV of cash flows of assets/liabilities change in addition to immediate interest received/paid on them as interest rate changes
:warning: ignores runoff cash flows
:warning: 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
:warning: 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= - D
P
(ΔR/1+R)