Chapter 5 Interest Rate Risk - The Repricing Model

Chapter 5 Interest rate risk: the repricing model
Chapter outline
The level and movement of interest rates
The repricing model
Rate-sensitive assets
Rate-sensitive liabilities
Changes to NII—equal changes in rates on RSAs and RSLs
Changes to NII—unequal changes in rates on RSAs and RSLs
Weaknesses of the repricing model
Market value effects
Over-aggregation
The problem of runoffs
Cash flows from off-balance-sheet activities
Appendix 5A: Maturity model (found at the book website)

Appendix 5B: Term structure of interest rates
Learning objectives
5.1 Appreciate the influence that the RBA has on interest rates and why this is the case.
5.2 Learn that at the heart of interest rate risk is the tendency of many modern FIs to
mismatch the maturities of their assets and liabilities (for example, banks normally use
short-term deposits to fund long-term loans) and that this mismatching can give rise to
significant interest rate exposure and insolvency risk.
5.3 Learn the repricing model, repricing gaps and their use in measuring interest rate risk.
5.4 Gain an understanding of rate-sensitive assets and rate-sensitive liabilities.
5.5 Learn the weaknesses of the repricing model.
5.6 Gain an understanding of the problems caused by measuring interest rate risk exposure by
looking only at the maturity mismatch.
5.7 Gain an understanding of the theory behind term structure of interest rates.
Overview of chapter
The second part of the book covering the measurement and management of FI risks
commences with this chapter.
This chapter opens with a discussion of the Reserve Bank of Australia’s (RBA) monetary
policy as this also influences an FI’s interest rate risk. We discuss the RBA’s monetary policy
objective to maintain inflation in a targeted range, and its management of monetary policy
through movements in the target cash rate.
The chapter then introduces the first of three methods of measuring an FI’s interest rate
exposure: the repricing model. The other methods are the maturity model which is found in
Appendix 5A, and the duration model which is the subject of Chapter 6. The repricing model
is the simplest of the interest rate measurement models, and measures interest rate risk by
examining the difference, or gap, between an FI’s rate-sensitive assets and rate-sensitive
liabilities to measure interest rate risk. Because of its use of book values, the repricing model
concentrates on the net interest income effects of rate changes and ignores any market value
effects. In addition, the model ignores important cash flow issues associated with over-
aggregation, runoffs and off-balance-sheet activities. As such, the model does not provide an
accurate picture of an FI’s interest rate risk exposure. More complete measures of interest rate
risk are provided by duration and the duration gap model examined in Chapter 6. In addition,
Appendix 5A compares and contrasts the repricing model with the market value-based
maturity model. While the maturity model is not used by FIs, it was one of the first attempts
to incorporate the impact of interest rate movements on an FI’s total market value, rather than
NII only. In Appendix 5B, the term structure of interest rates is examined for those students
requiring a review of this important introductory finance topic.
Instructor’s Resource Manual t/a Financial Institutions Management 4e by Lange, Saunders & Cornett Page 1 of 12
(c) McGraw-Hill Education (Australia) 2015
Chapter 5 Teaching Suggestions
The first risk to be examined by the book in detail is interest rate risk. There are four chapters
covering this risk, as well as being supported by 10 appendices. Interest rate risk is an
important topic both because it is a common, everyday risk of banks, but also because its
measurement and management is a fundamental part of the normal management of FIs. It is
usually a treasury function—that is, the interest rate risk management is centralised—as for
most risks. Some of the techniques involved in both the management and measurement are
quite difficult, and may not be suited to all courses.
An important lesson in the management of interest rate risk is that it is most effective if
undertaken for the balance sheet for the FI as a whole. It is ineffective if IRR management is
undertaken in bits—that is, retail bank, business bank, institutional bank, etc.—as each part of
the organisation may be making IRR decisions which counter each other. Hence, the risk must
be managed across the bank as a whole.
Having said this, the repricing model which is the subject of Chapter 5 is not difficult and is a
good introduction to interest rate risk, where it is found, how it can be estimated, and what FIs
can do to minimise it. There is nothing particularly technically difficult with the mathematics
in this chapter. This is not the case for Chapter 6 or Appendix 5A, and while the maturity
model may be excluded from any course and referred to for academic interest only, the
duration model should be covered for at least two reasons. First, because banks and other FIs
use the duration model more often than repricing; and second, as it forms the basis for the
measurement of interest rate risk for capital regulatory purposes.
With this introduction, I suggest that you commence the topic interest rate risk by examining
the volatility of interest rates and the impact that such changes will have on the management
of deposits and loans. For example, you could enter into a discussion of the following:
1. If banks issued only fixed-rate loans, what would happen to their profitability if
interest rates rose?
2. If interest rates are rising would banks prefer to raise call deposits only from
customers, or fixed-rate deposits?
3. How should a bank act if the RBA increases/decreases the cash rate? That is,
what changes should banks make to their deposit and loan products? Why should
they make these changes?
You may have started this discussion in the introduction to FI risks (Chapter 4), but it is worth
taking this further at this point so that students understand the importance of minimising the
risk of changing interest rates, and how critical this is.
Before introducing the repricing model specifically, I suggest that you look at a hypothetical
balance sheet of a bank such as that shown in Table 5.2, and examine the nature of rate
sensitivity and repricing. I have found it better to do this prior to the introduction of the model
itself, so that students fully appreciate these fundamental issues before you examine the gap
model itself.
With the knowledge of interest rate sensitivity of assets and liabilities, and the fact that
repricing does not equal maturity, you should then easily explain the model and the gaps—
both simple and cumulative.
Another point worth mentioning at this stage is the fact that the number of gap periods will be
determined by the volatility of interest rates. For example, in the 1980s when interest rates
were highly volatile, banks had many more gap periods and especially in the short end, for
example:
1 day
1–7 days
8–14 days
15–31 days
etc.
The reason for this is that the use of the repricing model is to identify risks—and as rates were
changing rapidly from day to day, then management of the short end was more critical than
the longer end (where in such circumstances gaps were usually matched).
From the examination of gaps, then you could introduce a discussion of the impact on the net
interest income of the bank if there are any gaps. Here, you may wish to start with an
examination of the impact on first assets and then liabilities, and then bring the two together.
Use Table 5.3 to help explain the impact on NII under the circumstances when interest rates
on assets and liabilities change by the same amount. Then move to the more complex
situation when the change is not the same—see Table 5.5 which shows a great deal of
uncertainty. However, the mathematics is simple for any finance student and so each
possibility should be covered.
In all cases, use actual examples—which you may also draw from the book—as this will help
reinforce the lessons.
You should complete the discussion of the repricing model by examining the weaknesses. As
the course is probably an advanced finance course, students should be able to determine some
of the problems with the model and the fact that it relies on book values and not market
values. The discussion of weaknesses is a good introduction to the discussion of the duration
model.
In the 1980s and early 1990s, banks knew about the duration model, but didn’t have the
computational power to use it. In such circumstances, the repricing model was used—even
though it was known to be imprecise. How times have changed!
Note that there is an integrated mini-case at the end of this chapter which provides students
with practice in measuring the various gaps and in using the repricing model to protect an FI
against interest rate movements.
Answers to end-of-chapter questions
Questions and problems
1 How do monetary policy actions made by the Reserve Bank of Australia impact interest
rates? LO 5.1
Through its daily open market operations, such as buying and selling Treasury Bonds and
Treasury Notes, the RBA seeks to influence the money supply, inflation and the level of
interest rates. When the RBA finds it necessary to slow down the economy, it tightens
monetary policy by raising interest rates. The normal result is a decrease in business and
household spending (especially that financed by credit or borrowing). Conversely, if business
and household spending decline to the extent that the RBA finds it necessary to stimulate the
economy it allows interest rates to fall (an expansionary monetary policy). The drop in rates
promotes borrowing and spending.
2 How has the increased level of financial market integration affected interest rates?
LO 5.1, 5.2
Increased financial market integration, or globalisation, increases the speed with which
interest rate changes and volatility are transmitted among countries. The result of this
quickening of global economic adjustment is to increase the difficulty and uncertainty faced
by the RBA Reserve as it attempts to manage economic activity through monetary policy in
Australia. Further, because FIs have become increasingly more global in their activities, any
change in interest rate levels or volatility caused by the actions of other central banks, such as
the US Federal Reserve, more quickly impacts local markets, creating additional interest rate
risk issues for these FIs.
3 What is the repricing gap? In using this model to evaluate interest rate risk, what is meant
by rate sensitivity? On what financial performance variable does the repricing model
focus? Explain. LO 5.3
The repricing gap is a measure of the difference between the dollar value of assets that will
reprice and the dollar value of liabilities that will reprice within a specific time period, where
repricing can be the 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) or because the
asset or liability is a variable rate instrument (e.g. a variable-rate mortgage whose interest rate
is reset every quarter based on movements in a prime rate). Rate sensitivity represents the
time interval where repricing can occur. The model focuses on the potential changes in the net
interest income variable. In effect, if interest rates change, interest income and interest
expense will change as the various assets and liabilities are repriced, that is, receive new
interest rates.
4 What is a maturity bucket in the repricing model? Why is the length of time selected for
repricing assets and liabilities important when using the repricing model? LO 5.3
The maturity bucket is the time window over which the dollar amounts of assets and liabilities
are measured. The length of the repricing period determines which of the securities in a
portfolio are rate-sensitive. The longer the repricing period, the more securities either mature
or will be repriced, and, therefore, the more the interest rate risk exposure. An excessively
short repricing period omits consideration of the interest rate risk exposure of assets and
liabilities that are repriced in the period immediately following the end of the repricing
period. That is, it understates the rate sensitivity of the balance sheet. An excessively long
repricing period includes many securities that are repriced at different times within the
repricing period, thereby overstating the rate sensitivity of the balance sheet.
5(a) The repricing model requires specification of repricing buckets. Why must a bucket time
period be specified? How does the choice of the repricing buckets impact on the
delineation between ratesensitive and fixedrate assets and liabilities? LO 5.3
The length of time over which the repricing gap is to be estimated must be specified in order
to define rate-sensitive assets and rate-sensitive liabilities. The length of the repricing period
determines whether a financial security is either rate sensitive or fixed rate. The longer the
repricing period, the more securities either mature or reprice and therefore the more securities
are classified as rate sensitive.
(b) What determines the optimal length of the repricing period? What are the shortcomings of
very short repricing periods?
An excessively short repricing period omits consideration of the interest rate risk exposure of
assets and liabilities that reprice in the period immediately following the end of the repricing
period. That is, it understates the rate sensitivity of the balance sheet.
(c) What are the shortcomings of very long repricing periods?
An excessively long repricing period includes many securities that are repriced at different
times within the repricing period, thereby overstating the rate sensitivity of the balance sheet.
6 Calculate the repricing gap and impact on net interest income of a 1 per cent increase in
interest rates for the following positions: LO 5.3, 5.4
(a) Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $50 million.
Repricing gap = RSA – RSL = $100 – $50 million = +$50 million.

ΔNII = ($50 million)(0.01) = +$0.5 million
(b) Rate-sensitive assets = $50 million. Rate-sensitive liabilities = $150 million.
Repricing gap = RSA – RSL = $50 – $150 million = –$100 million.

ΔNII = (–$100 million)(0.01) = –$1 million
(c) Rate-sensitive assets = $75 million. Rate-sensitive liabilities = $70 million.

ΔNII = ($5 million)(0.01) = $0.05 million
(d) Compare the interest rate risk exposure of the institutions in parts (a), (b) and (c).
The FIs in parts (a) and (c) are exposed to interest rate declines (positive repricing gap) while
the FI in part (b) is exposed to interest rate increases. However, the FI in (a) has greater
exposure than the FI in part (b). The FI in part (c) has the least (most) amount of interest rate
risk exposure since the absolute value of the repricing gap is the lowest (highest).
7 What is the CGAP effect? According to the CGAP effect, what is the relation between
changes in interest rates and changes in net interest income when CGAP is positive?
When CGAP is negative? LO 5.3, 5.4
The CGAP effect describes the relations between changes in interest rates and changes in net
interest income. According to the CGAP effect, when CGAP is positive the change in NII is
positively related to the change in interest rates. Thus, an FI would want its CGAP to be
positive when interest rates are expected to rise. According to the CGAP effect, when CGAP
is negative the change in NII is negatively related to the change in interest rates. Thus, an FI
would want its CGAP to be negative when interest rates are expected to fall.
8 Which of the following is an appropriate change to make on a bank’s balance sheet when
GAP is negative, spread is expected to remain unchanged and interest rates are expected
to rise? LO 5.3, 5.4
According to the CGAP effect, when CGAP is positive the change in NII is positively related
to the change in interest rates. Thus, an FI would want its CGAP to be positive when interest
rates are expected to rise.
(a) Replace fixed-rate loans with rate-sensitive loans.
Yes. This change will increase RSAs, which will increase GAP.
(b) Replace marketable securities with fixed-rate loans.
No. This change will decrease RSAs, which will decrease GAP.
(c) Replace fixed-rate CDs with rate-sensitive CDs.
No. This change will increase RSLs, which will decrease GAP.
(d) Replace equity with demand deposits.
No. This change will have no impact on either RSAs or RSLs. So, no impact on GAP either.
(e) Replace vault cash with marketable securities.
Yes. This change will increase RSAs, which will increase GAP.
9 If a bank manager was quite certain that interest rates were going to rise within the next
six months, how should the bank manager adjust the bank’s six-month repricing gap to
take advantage of this anticipated rise? What if the manger believed rates would fall in the
next six months? LO 5.3, 5.4
When interest rates are expected to rise, a bank should set its repricing gap to a positive
position. In this case, as rates rise, interest income will rise by more than interest expense. The
result is an increase in net interest income. When interest rates are expected to fall, a bank
should set its repricing gap to a negative position. In this case, as rates fall, interest income
will fall by less than interest expense. The result is an increase in net interest income.
10 Consider the following balance sheet positions for a financial institution: LO 5.3, 5.4
● Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million

(a) Calculate the repricing gap and the impact on net interest income of a 1 per cent increase
in interest rates for each position.
● Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million.
ΔNII = ($100 million)(.01) = +$1.0 million or $1 000 000.
Repricing gap = RSA – RSL = $100 – $150 million = –$50 million.
ΔNII = (–$50 million)(.01) = –$0.5 million or –$500 000.
ΔNII = ($10 million)(.01) = +$0.1 million or $100 000.
(b) Calculate the impact on net interest income on each of the above situations assuming a 1
per cent decrease in interest rates.
● ΔNII = ($100 million)(–.01) = –$1.0 million or –$1 000 000.

● ΔNII = (–$50 million)(–.01) = +$0.5 million or $500 000.
● ΔNII = ($10 million)(–.01) = –$0.1 million or –$100 000.
(c) What conclusion can you draw about the repricing model from these results?
The FIs in parts (1) and (3) are exposed to interest rate declines (positive repricing gap), while
the FI in part (2) is exposed to interest rate increases. The FI in part (3) has the lowest interest
rate risk exposure since the absolute value of the repricing gap is the lowest, while the
opposite is true for the FI in part (1).
11 What are the reasons for not including savings account demand deposits as rate-sensitive
liabilities in the repricing analysis for a commercial bank? What is the subtle but
potentially strong reason for including savings account demand deposits in the total of
rate-sensitive liabilities? Can the same argument be made for other on-demand deposit
accounts? LO 5.3, 5.4
The earnings rate available on savings deposit accounts is very low with interest often paid
only on higher balances. Although some banks offer accounts on which interest can be paid
on total balances, this interest rate seldom is changed and thus the accounts are not really
interest rate sensitive. Whether or not interest is paid on such deposits, savings accounts do
pay implicit interest in the form of not charging fully for cheque, ATM, EFTPOS and other
services. Further, when market interest rates rise, customers draw down their deposit
accounts, which may cause the bank to use higher cost sources of funds. The same or similar
arguments can be made for all on-demand deposit accounts.
12 What is the gap ratio? What is the value of this ratio to interest rate risk managers and
regulators? LO 5.3, 5.4
The gap ratio is the ratio of the cumulative gap position to the total assets of the FI. The
cumulative gap position is the sum of the individual gaps over several time buckets. The value
of this ratio is that it tells the direction of the interest rate exposure and the scale of that
exposure relative to the size of the FI.
13 Which of the following assets or liabilities fit the oneyear rate or repricing sensitivity
test? LO 5.4
(a) 91-day Treasury Notes
(b) Oneyear Treasury Bonds
(c) 20year Treasury Bonds
(d) 20year floating-rate corporate bonds with annual repricing
(e) 30year floating-rate mortgages with annual repricing
(f) 30year floating-rate mortgages with biannual repricing
(g) Overnight interbank funds
(h) Ninemonth fixed-rate term deposits
(i) Oneyear fixed-rate term deposits
(j) Fiveyear floating-rate corporate bonds with annual repricing
(k) Common equity
The following are rate sensitive: (a), (b), (d), (e), (g), (h), (i), (j).
14 What is the spread effect? LO 5.3
The spread effect is the effect that a change in the spread between rates on RSAs and RSLs
has on net interest income as interest rates change. The spread effect is such that, regardless of
the direction of the change in interest rates, a positive relation exists between changes in the
spread and changes in NII. Whenever the spread increases (decreases), NII increases
(decreases).
15 A bank manager is quite certain that interest rates are going to fall within the next six
months. How should the bank manager adjust the bank’s six-month repricing gap and
spread to take advantage of this anticipated rise? What if the manger believes rates will
rise in the next six months? LO 5.3
When interest rates are expected to fall, a bank should set its repricing gap to a negative
position. Further, the manager would want to increase the spread between the return on RSAs
and RSLs. In this case, as rates fall, interest income will fall by less than interest expense. The
result is an increase in net interest income. When interest rates are expected to rise, a bank
should set its repricing gap to a positive position. Again, the manager would want to increase
the spread between the return on RSAs and RSLs. In this case, as rates rise, interest income
will rise by more than interest expense. The result is an increase in net interest income.
16 Consider the following balance sheet for WatchoverU Bank (in millions): LO 5.3, 5.4
Assets $ Liabilities and equity $

Floating-rate mortgages 50 1-year term deposits 70
(currently 10% annually) (currently 6% annually)
30-year fixed-rate loans 50 3-year term deposits 20
(currently 7% annually) (currently 7% annually)
Equity 10
Total assets 100 Total liabilities and equity 100
(a) What is WatchoverU’s expected net interest income at year-end?
Current expected interest income: $50m(0.10) + $50m(0.07) = $8.5m.

Expected interest expense: $70m(0.06) + $20m(0.07) = $5.6m.
Expected net interest income: $8.5m – $5.6m = $2.9m.
(b) What will net interest income be at year-end if interest rates rise by 2 per cent?
After the 200 basis point interest rate increase, net interest income declines to:
50(0.12) + 50(0.07) – 70(0.08) – 20(.07) = $9.5m – $7.0m = $2.5m, a decline of $0.4m.
(c) Using the cumulative repricing gap model, what is the expected net interest income for a
2 per cent increase in interest rates?
WatchoverU’s repricing or funding gap is $50m – $70m = –$20m. The change in net interest
income using the funding gap model is (–$20m)(0.02) = –$.4m.
(d) What will net interest income be at year-end if interest rates on RSAs increase by 2
per cent but interest rates on RSLs increase by 1 per cent? Is it reasonable for changes
in interest rates on RSAs and RSLs to differ? Why?
After the unequal rate increases, net interest income will be 50(0.12) + 50(0.07) – 70(0.07) –
20(.07) = $9.5m – $6.3m = $3.2m, an increase of $0.3m. It is not uncommon for interest rates
to adjust in an unequal manner on RSAs versus RSLs. Interest rates often do not adjust solely
because of market pressures. In many cases the changes are affected by decisions of
management. Thus, you can see the difference between this answer and the answer for part
(a).
17 Use the following data to answer parts (a) through (c). LO 5.3, 5.4
Givebucks
Bank Inc. ($
million)
Assets $ Liabilities $
Rate-sensitive 50 Rate-sensitive 70
Fixed-rate 50 Fixed-rate 20
Equity 10
Note: All ratesensitive assets currently earn 10 per cent interest per annum. All fixedrate
assets earn 7 per cent per annum. Ratesensitive liabilities currently pay 6 per cent per annum,
while fixedrate liabilities offer 6 per cent annual interest.
(a) What is Givebucks Bank’s current net interest income?
Current interest income is $5m + $3.5m = $8.5m.

Interest expense is $4.2m + $1.2m = $5.4m.
Net interest income is currently $8.5m – $5.4m = $3.1m
(b) What will the net interest income be if interest rates increase by 2 per cent?
After the 200 basis point interest rate increase, net interest income declines to 50(0.12) +
50(0.07) – 70(0.08) –20(0.06) = $9.5m – $6.8m = $2.7m.
(c) What is Givebucks’ repricing or funding gap? Use it to check your answer to part (b).
Givebucks’ repricing or funding gap is $50m – $70m = –$20m. The change in net interest
income is (–$20m)(0.02) = –$0.4m.
18 Use the following information about a hypothetical government security dealer named
MP Jorganson to answer parts (a) through (e). (Market yields are in parentheses.) LO 5.3,
5.4
MP Jorganson ($ million)
Assets $ Liabilities $
Cash 10 Overnight interbank borrowing 170
(7.00%)
T-notes 1 month (7.05%) 75 7 year fixed-rate subordinated debt 150
(8.55%)
T-notes 3 months (7.25%) 75
T-notes two-year (7.50%) 50 Equity 15
T-notes 10-year (8.96%) 10
0
Corporate bonds 25
5
(a) What is the repricing or funding gap if the planning period is 30 days? 91 days? Two
years? (Recall that cash is a non-interest earning asset.)
Funding or repricing gap over 30-day planning period = 75 – 170 = –$95 million.
Funding or repricing gap over 91-day planning period = (75+75+25) – 170 = +$5 million.
Funding or repricing gap over two-year planning period = (75+75+25+50) – 170 = +$55
million.
(b) What is the impact over the next 30 days on net interest income if all interest rates rise by
50 basis points?
Net interest income will decline by $475 000.

That is:
ΔNII = FG(ΔR) = –95(0.005) = –$0.475m
(c) If the duration of assets is 3.41 years and the duration of liabilities is 3.5 years, what is
MP Jorganson’s duration gap?
Duration gap = DA – kDL:

DG = 3.41– (3.5) = +0.07 years
(d) What conclusions regarding MP Jorganson’s interest rate risk exposure can you draw
from the duration gap in your answer to part (c)? From the repricing or funding gap (30
days’ planning period) in your answer to part (a)?
MP Jorganson is exposed to interest rate increases. Positive duration gap implies that when
interest rates increase, the market value of equity decreases. Negative repricing or funding
gap implies that when interest rates increase, net interest income decreases.
(e) Approximately how will the market value of the Treasury Note portfolio change if all
interest rates increase by 50 basis points?
Using the duration relationship, the 30-day Treasury Note portfolio:
The 91-day Treasury Note portfolio:
Note that since Treasury Notes are pure discount instruments, duration is equal to the time to
maturity. The total change in the value of the Treasury Note portfolio is: ΔP30 + ΔP91 = $116
million.
19 A bank has the following balance sheet: LO 5.3, 5.4
Assets $ Avg. rate % Liabilities/equity $ Avg. rate %

Rate sensitive 550 000 7.75 Rate sensitive 375 000 6.25
Fixed rate 755 000 8.75 Fixed rate 805 000 7.50
Nonearning 265 000 Non-paying 390 000
Total 1 570 000 Total 1 570 000
Suppose interest rates rise such that the average yield on rate-sensitive assets increases by 45
basis points and the average yield on rate-sensitive liabilities increases by 35 basis points.
(a) Calculate the bank’s repricing GAP and gap ratio.
Repricing GAP = $550 000 – $375 000 = $175 000

Gap ratio = $175 000/$1 570 000 = 11.15%
(b) Assuming the bank does not change the composition of its balance sheet, calculate the
resulting change in the bank’s interest income, interest expense and net interest income.
ΔII = $550 000(.0045) = $2475

ΔIE = $375 000(.0035) = $1312.50
ΔNII = $2475 – $1312.50 = $1162.50
(c) Explain how the CGAP and spread effects influenced the change in net interest income.
The CGAP effect worked to increase net interest income. That is, the CGAP was positive
while interest rates increased. Thus, interest income increased by more than interest expense.
The result is an increase in NII. The spread effect also worked to increase net interest income.
The spread increased by 10 basis points. According to the spread effect, as spread increases,
so does net interest income.
20 A bank has the following balance sheet: LO 5.3, 5.4
Assets $ Avg. rate % Liabilities/equity $ Avg. rate %

Rate-sensitive 225 000 6.35 Rate-sensitive 300 000 4.25
Fixed-rate 550 000 7.55 Fixed-rate 505 000 6.15
Non-earning 120 000 Non-paying 90 000
Total 895 000 Total 895 000
Suppose interest rates rise such that the average yield on rate-sensitive assets increases by 45
basis points and the average yield on rate-sensitive liabilities increases by 35 basis points.
(a) Calculate the bank’s repricing GAP.
Repricing GAP = $225 000 – $300 000 = –$75 000
(b) Assuming the bank does not change the composition of its balance sheet, calculate the net
interest income for the bank before and after the interest rate changes. What is the
resulting change in net interest income?
NIIb = ($225 000(.0635) +$550 000(.0755)) – ($300 000(.0425) + $505 000(.0615))

= $55 812.50 – $43 807.50 = $12 005
NIIa = ($225 000(.0635 + .0045) +$550 000(.0755)) – ($300 000(.0425 + .0035) + $505
000(.0615)) = $56 825 – $44 857.50 = $11 967.50
ΔNII = $11 967.50 – $12 005 = –$37.5
(c) Explain how the CGAP and spread effects influenced this increase in net interest income.
The CGAP effect worked to decrease net interest income. That is, the CGAP was negative
while interest rates increased. Thus, interest income increased by more than interest expense.
The result is a decrease in NII. In contrast, the spread effect worked to increase net interest
income. The spread increased by 10 basis points. According to the spread effect, as spread
increases, so does net interest income. However, in this case, the increase in NII due to the
spread effect was dominated by the decrease in NII due to the CGAP effect.
21 What are some of the weaknesses of the repricing model? How have large banks
solved the problem of choosing the optimal time period for repricing? What is runoff
cash flow, and how does this amount affect the repricing model’s analysis? LO 5.5
The repricing model has four general weaknesses:

(1) It ignores market value effects.
(2) It does not take into account the fact that the dollar value of rate-sensitive assets and
liabilities within a bucket are not similar. Thus, if assets, on average, are repriced earlier
in the bucket than liabilities, and if interest rates fall, FIs are subject to reinvestment risks.
(3) It ignores the problem of runoffs. That is, that some assets are prepaid and some liabilities
are withdrawn before the maturity date.
(4) It ignores income generated from off-balance-sheet activities.
Large banks are able to reprice securities every day using their own internal models so
reinvestment and repricing risks can be estimated for each day of the year. Runoff cash flow
reflects the assets that are repaid before maturity and the liabilities that are withdrawn
unexpectedly. To the extent that either of these amounts is significantly greater than expected,
the estimated interest rate sensitivity of the FI will be in error.
The following questions and problems are based on material in Appendix 5A located on the
book’s website (www.mhhe.com/au/lange4e).
22 What is a maturity gap? How can the maturity model be used to immunise an FI’s
portfolio? What is the critical requirement that allows maturity matching to have
some success in immunising the balance sheet of an FI? LO 5.6
Maturity gap is the difference between the average maturity of assets and liabilities. If the
maturity gap is zero, it is possible to immunise the portfolio so that changes in interest rates
will result in equal but offsetting changes in the value of assets and liabilities. Thus, if interest
rates increase (decrease), the fall (rise) in the value of the assets will be offset by an identical
fall (rise) in the value of the liabilities. The critical assumption is that the timing of the cash
flows on the assets and liabilities must be the same.
23 Nearby Bank has the following balance sheet (in millions): LO 5.6

Cash 60 Demand deposits 140
5-year Treasury Notes 60 1-year certificates of deposit 160
30-year mortgages 200 Equity 20
What is the maturity gap for Nearby Bank? Is Nearby Bank more exposed to an increase
or decrease in interest rates? Explain why?
MA = [0×60 + 5×60 + 30×200]/320 = 19.6875 years, and ML = [0×140 + 1×160]/300 =

0.5333. Therefore, the maturity gap = MGAP = 19.6875 – 0.5333 = 19.1542 years. Nearby
Bank is exposed to an increase in interest rates. If rates rise, the value of assets will decrease
much more than the value of liabilities.
24 County Bank has the following market value balance sheet (in millions, all interest at
annual rates). All securities are selling at par equal to book value. LO 5.6

15-year commercial loan at 10% 160 5-year CDs at 6% interest, balloon payment 210
interest, balloon payment
30-year mortgages at 8% 300 20-year debentures at 7% interest, balloon 120
interest, balloon payment payment
Equity 50
(a) What is the maturity gap for County Bank?
MA = [0×20 + 15×160 + 30×300]/480 = 23.75 years.

ML = [0×100 + 5×210 + 20×120]/430 = 8.02 years.
MGAP = 23.75 – 8.02 = 15.73 years.
(b) What will be the maturity gap if the interest rates on all assets and liabilities increase by 1
per cent?
If interest rates increase 1 per cent, the value and average maturity of the assets will be:
Cash = $20
Commercial loans = $16×PVIFAn=15, i=11% + $160×PVIFn=15,i=11% = $148.49
Mortgages = $24×PVIFAn=30,i=9% + $300×PVIFn=30,i=9% = $269.18
MA = [0×20 + 148.49×15 + 269.18×30]/(20 + 148.49 + 269.18) = 23.54 years
The value and average maturity of the liabilities will be:

Demand deposits = $100
CDs = $12.60×PVIFAn=5,i=7% + $210×PVIFn=5,i=7% = $201.39
Debentures = $8.4×PVIFAn=20,i=8% + $120×PVIFn=20,i=8% = $108.22
ML = [0×100 + 5×201.39 + 20×108.22]/(100 + 201.39 + 108.22) = 7.74 years
The maturity gap = MGAP = 23.54 – 7.74 = 15.80 years. The maturity gap increased because
the average maturity of the liabilities decreased more than the average maturity of the assets.
This result occurred primarily because of the differences in the cash flow streams for the
mortgages and the debentures.
(c) What will happen to the market value of the equity?
The market value of the assets has decreased from $480 to $437.67, or $42.33. The market
value of the liabilities has decreased from $430 to $409.61, or $20.39. Therefore, the market
value of the equity will decrease by $42.33 – $20.39 = $21.94, or 43.88 per cent.
25 If a bank manager is certain that interest rates were going to increase within the next
six months, how should the bank manager adjust the bank’s maturity gap to take
advantage of this anticipated increase? What if the manager believes rates will fall?
Would your suggested adjustments be difficult or easy to achieve? LO 5.6
When rates rise, the value of the longer-lived assets will fall by more than the shorter-lived
liabilities. If the maturity gap is positive, the bank manager will want to shorten the maturity
gap. If the repricing gap is negative, the manager will want to move it towards zero or
positive. If rates are expected to decrease, the manager should reverse these strategies.
Changing the maturity or repricing gaps on the balance sheet often involves changing the mix
of assets and liabilities. Attempts to make these changes may involve changes in financial
strategy for the bank which may not be easy to accomplish. Later in the text, methods of
achieving the same results using derivatives will be explored.
Integrated mini case: Calculating and using the repricing GAP
Allied National Bank’s balance sheet is listed below. Market yields are in parenthesis, and
amounts are in millions.
Assets Million Liabilities and equity Million

Interbank lending (5.05%) 150 Savings accounts (1.5%) 20
3-month T-notes (5.25%) 150 Money market deposit accounts 340
(4.5%) (no minimum balance
requirement)
2-year T-Bonds (6.50%) 100 3-month CDs (4.2%) 120
8-year T-Bonds (7.50%) 200 6-month CDs (4.3%) 220
5-year corporate bonds (floating 50 1-year CDs (4.5%) 375
rate) (8.20%, repriced @ 6
months)
6-month consumer loans (6%) 250 2-year CDs (5%) 425
1-year consumer loans (5.8%) 300 4-year CDs (5.5%) 330
5-year personal loans (7%) 350 5-year CDs (6%) 350
7-month commercial loans (5.8%) 200 Interbank borrowings (5%) 225
2-year commercial loans (floating 275 Overnight repos (5%) 290
rate) (5.15%, repriced @ 6-
months)
15-year variable rate mortgages 200 6-month bank accepted bills 300
(5.8%, repriced @ 6-months) (5.05%)
15-year variable rate mortgages 400 Subordinate notes: 3-year fixed 200
(6.1%, repriced @ year) rate (6.55%)
15-year fixed-rate mortgages 300 Subordinated debt: 7-year fixed 100
(7.85%) rate (7.25%)
30-year variable rate mortgages 225 Total liabilities 3545
(6.3%, repriced @ quarter)
30-year variable rate mortgages 355
(6.4%, repriced @ month)
30-year fixed-rate mortgages 400
(8.2%)
Premises and equipment 20 Equity 400
Total assets $3945 Total liabilities and equity $3945
(a) What is the repricing gap if the planning period is 30 days? 6 months? 1 year? 2
years?
5 years?
Assets Repricing period

Cash $20 Not rate sensitive
Interbank Lending (5.05%) 150 30 days
3-month T-notes (5.25%) 150 6-months
2-year T-bonds (6.50%) 100 2 years
8-year T-bonds (7.50%) 200 Not rate sensitive
5-year corporate bonds (floating 50 6 months
rate) (8.20%, repriced @ 6
months)
6-month consumer loans (6%) 250 6 months
1-year consumer loans (5.8%) 300 1 year
5-year personal loans (7%) 350 5 years
7-month commercial loans (5.8%) 200 1 year
2-year commercial loans (floating 275 6 months
rate) (5.15%, repriced @ 6-
months)
15-year variable rate mortgages 200 6 months
(5.8%, repriced @ 6-months)
15-year variable rate mortgages 400 1 year
(6.1%, repriced @ year)
15-year fixed-rate mortgages 300 Not rate sensitive
(7.85%)
30-year variable rate mortgages 225 6 months
(6.3%, repriced @ quarter)
30-year variable rate mortgages 355 30 days
(6.4%, repriced @ month)
30-year fixed-rate mortgages 400 Not rate sensitive
(8.2%)
Premises and equipment 20 Not rate sensitive
Liabilities and equity Repricing period

Demand deposits $250 Not rate sensitive
Savings accounts (1.5%) 20 30 days
Money market deposits (4.5%) 340 30 days
(no minimum balance
requirement)
3-month CDs (4.2%) 120 6 months
6-month CDs (4.3%) 220 6 months
1-year CDs (4.5%) 375 1 year
2-year CDs (5%) 425 2 years
4-year CDs (5.5%) 330 5 years
5-year CDs (6%) 350 5 years
Fed funds (5%) 225 30 days
Overnight repos (5%) 290 30 days
6-month commercial paper 300 6 months
(5.05%)
Subordinate notes: 3-year fixed 200 5 years
rate (6.55%)
Subordinated debt: 7-year fixed 100 Not rate sensitive
rate (7.25%)
Equity 400 Not rate sensitive
30-day repricing gap: RSAs = $150m + $355m = $505m
RSLs = $20m + $340m + $225m + $290m = $875m
CGAP = $505m – $875m = –$370m
6-month repricing gap: RSAs = $505m + $150m + $50m + $250m + $275m + $200m
+ $225m = $1655m
RSLs = $875m + $120m + $220m + $300m = $1515m
CGAP = $1655m – $1515m = $140m
1-year repricing gap: RSAs = $1655m + $300m + $200m + $400m = $2555m
RSLs = $1515m + $375m = $1890m
CGAP = $2555m – $1890m = $665m
2-year repricing gap: RSAs = $2555m + $100m = $2655m
RSLs = $1890m + $425m = $2315m
CGAP = $2655m – $2315m = $340m
5-year repricing gap: RSAs = $2655m + $350m = $3005m
RSLs = $2315m + $330m + $350m + $200m = $3195m
CGAP = $3005m – $3195m = –$190m
(b) What is the impact over the next six months on net interest income if interest rates on
RSAs increase 60 basis points and on RSLs increase 40 basis points?
ΔNII (6 months) = ΔII (6 months) – ΔIE (6 months) = $1655m(.0060) – $1515m(.0040) =

$3.87m
(c) What is the impact over the next year on net interest income if interest rates on RSAs
increase 60 basis points and on RSLs increase 40 basis points?
ΔNII (1 year) = ΔII (1 year) – ΔIE (1 year) = $2555m(.0060) – $1890m(.0040) = $7.77m
Web questions
26 Go to the Reserve Bank of Australia’s website and to the Bulletin Statistics. Update
Figure 5.1, and describe the movement in short-term and 10-year interest rates since
2011. LO 5.1
The answer will depend on the date of the assignment. At the website, click on ‘Statistics’
then click on ‘Bulletin Statistical Tables’ and select Tables F1 and F2.
27 Go to Westpac’s website and find the latest Westpac New Zealand Disclosure
Statement. Examine the document and discuss the sensitivities of Westpac NZ’s assets
and liabilities to interest rate movements over the period covered by the report, and
the impact that interest rate volatility had on net interest income. LO 5.2, 5.3, 5.4
The answer will depend on the date of the assignment. The September 2011 report is found at
www.westpac.com.au/docs/pdf/aw/September_2011_WNZL_DS.pdf. Alternatively, go to
Westpac’s website (www.westpac.com.au) and then search for the report in the website’s
search function.

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Chapter 5 Interest rate risk: the repricing model

Appendix 5A: Maturity model (found at the book website)

(c) What are the shortcomings of very long repricing periods?

(a) Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $50 million.

Repricing gap = RSA – RSL = $100 – $50 million = +$50 million.

(b) Rate-sensitive assets = $50 million. Rate-sensitive liabilities = $150 million.

Repricing gap = RSA – RSL = $50 – $150 million = –$100 million.

(c) Rate-sensitive assets = $75 million. Rate-sensitive liabilities = $70 million.

Repricing gap = RSA – RSL = $75 – $70 million = +$5 million.

(a) Replace fixed-rate loans with rate-sensitive loans.

(b) Replace marketable securities with fixed-rate loans.

(c) Replace fixed-rate CDs with rate-sensitive CDs.

(d) Replace equity with demand deposits.

(e) Replace vault cash with marketable securities.

● Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million

● ΔNII = ($100 million)(–.01) = –$1.0 million or –$1 000 000.

14 What is the spread effect? LO 5.3

Assets $ Liabilities and equity $

Current expected interest income: $50m(0.10) + $50m(0.07) = $8.5m.

(a) What is Givebucks Bank’s current net interest income?

Current interest income is $5m + $3.5m = $8.5m.

Net interest income will decline by $475 000.

Duration gap = DA – kDL:

Using the duration relationship, the 30-day Treasury Note portfolio:

The 91-day Treasury Note portfolio:

19 A bank has the following balance sheet: LO 5.3, 5.4

Assets $ Avg. rate % Liabilities/equity $ Avg. rate %

(a) Calculate the bank’s repricing GAP and gap ratio.

Repricing GAP = $550 000 – $375 000 = $175 000

ΔII = $550 000(.0045) = $2475

20 A bank has the following balance sheet: LO 5.3, 5.4

Assets $ Avg. rate % Liabilities/equity $ Avg. rate %

(a) Calculate the bank’s repricing GAP.

Repricing GAP = $225 000 – $300 000 = –$75 000

NIIb = ($225 000(.0635) +$550 000(.0755)) – ($300 000(.0425) + $505 000(.0615))

ΔNII = $11 967.50 – $12 005 = –$37.5

The repricing model has four general weaknesses:

Assets $ Liabilities and equity $

MA = [0×60 + 5×60 + 30×200]/320 = 19.6875 years, and ML = [0×140 + 1×160]/300 =

Assets $ Liabilities and equity $

MA = [0×20 + 15×160 + 30×300]/480 = 23.75 years.

The value and average maturity of the liabilities will be:

(c) What will happen to the market value of the equity?

Integrated mini case: Calculating and using the repricing GAP

Assets Million Liabilities and equity Million

Assets Repricing period

Liabilities and equity Repricing period

ΔNII (6 months) = ΔII (6 months) – ΔIE (6 months) = $1655m(.0060) – $1515m(.0040) =

ΔNII (1 year) = ΔII (1 year) – ΔIE (1 year) = $2555m(.0060) – $1890m(.0040) = $7.77m

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