Interest Rate Risks

TOPIC 2
Introduction
• Interest Rate risk refers to the risk that a change in the interest rates
might affect (adversely) the earnings of a Financial Institution as well
as the economic value of the financial assets of that FI.

• Interest rate risk is one of the most prominent risk for the
participants in the capital market and might affect them either
directly or indirectly.
• i.e decline in the earnings of an investment bank from its margin loan
portfolio or a decline in the market value of its debt instrument portfolio
• i.e decline in dividend earned by a retail investor due to less earnings of bank
during interest spread congestion.
Interest Rate
• Interest rate, simply put, is the cost of borrowing money from the
borrowers perspective and is the return for lending money from the
lenders perspective.

• Interest rates in an economy change due to changes in the

determinant factors of the interest rate. There are different theories
which have tried to explain the mechanisms which cause a change in
the general level of interest rate in the economy.
• Loanable funds theory
• Fishers Theory
Measuring interest rate risk
• FIs essentially should have interest rate risk measurement systems that capture
all material sources of interest rate risk and that assess the effect of interest rate
changes in ways that are consistent with the scope of their activities.

• There are different models or techniques that can be used to measure the level
of interest risk exposure of a FI. These techniques include:
1. The repricing model / Funding Gap Model
2. Duration based model
3. Simulation
The repricing model
• The repricing, or funding gap, model concentrates on the impact of interest rate
changes on an FI’s net interest income (NII), which is
the difference between an FI’s interest income and interest expense.
• The repricing model functions by calculating the repricing gap and assessing the
impact of a potential change in interest rates on that gap.
• The Repricing Gap refers to the difference between the value of interest rate
sensitive assets (RSA) and interest rate sensitive liabilities (RSL) within a given
maturity bucket.
• So,
What is Rate Sensitive Asset/Liability?
• Any fixed rate asset or liability that will mature within a particular
maturity bucket and this will be repriced at or near current market
interest rates within a maturity bucket.
• Any floating rate asset or liability
• Any interim cash flow (principal repayments/interest repayments)
generated from an asset.
Maturity Buckets for calculating Repricing
Gap
• Financial institutions are typically required to report quarterly the
repricing Gaps for the following time frames
• One day
• More than one day less than 3 months
• More than 3 months, less than 6 months
• More than 6 months, less than 12 months
• More than 12 months, less than 5 years
• More than five years
 Calculating the repricing gap

Positive Gap/Asset Gap = RSA-RSL >0

Negative Gap/ Liability Gap = RSA-RSL <0
Cumulative Gap is the repricing gap of a FI up until a certain maturity cut off period.
It is based on the asset and liability values of all maturity periods prior to the cut off
period.
Calculating the interest rate risk exposure
• Given the Gap, it is easy to investigate the change in the net interest
income of the financial institution due to a change in the interest
rate.

• The greater the “Change in NII” the higher is the interest rate risk
exposure level for that FI.
Example
Over next 6 Months:
Rate Sensitive Liabilities = $120 million
Rate Sensitive Assets = $100 Million

GAP = 100M – 120M = - 20 Million

If rate are expected to decline by 1%

Change in net interest income
= (-20M)(-.01)= $200,000
In class Practice
• Calculate the change in net interest income for the company shown
in one of the previous slides if the interest rate
I. Declines by 2% after 9 months
II. Increases by 2% after 9 months
III. Declines by 2% after 2 months
IV. Increases by 2% after 2 months
GAP Analysis
• Asset sensitive GAP (Positive GAP)
• RSA – RSL > 0
• If interest rates ↑ NII will ↑
• If interest rates ↓ NII will ↓ Reinvestment Risk

• Liability sensitive GAP (Negative GAP)

• RSA – RSL < 0
• If interest rates ↑ NII will ↓ Refinancing Risk
• If interest rates ↓ NII will ↑
Important things to note
• While applying the repricing model, book value accounting is used --
only the income statement is impacted, the impact on the market
value of the assets are not assessed.

• The GAP varies based on the bucket or time frame calculated.

• It assumes that all rates move together.

Summarizing the steps in GAP analysis
1) Select time Interval/maturity buckets

2) Develop Interest Rate Forecast

3) Group Assets and Liabilities by the time interval (according to first

repricing)

4) Forecast the change in net interest income due to change in

interest rate.
Alternative interest rate risk measures based
on GAP
• The repricing gap can be used for calculating two other alternative
measures of interest rate risks.
• These are:
• Repricing model using Cumulative GAP (CGAP)
• CGAP Ratio
• Interest Sensitivity ratio
1. Repricing model using Cumulative GAP (CGAP)

• This model functions in the same way as the repricing model with one
major difference.
• The impact of a change in net interest income is assessed on the
cumulative gap instead of ordinary gap.
• So,
Example
• Calculate the impact of a 1% increase in interest rates for the 1 year
repricing gap/cumulative gap.
Comprehensive Example
• The simplified balance sheet of a ABC Investment bank is given below. Calculate the 1 year
repricing gap/cumulative gap and evaluate the impact of a 1% rise in interest rates. What would
the impact be if the interest rate were to fall by 1%?
• In order to calculate the 1 year
cumulative gap, we must first
identify all RSA and RSL within
the 1 year maturity bucket.

• So we should ask ourselves;

Will or can this asset or
liability have its interest rate
changed within the next year?
If the answer is yes, it is
a rate-sensitive asset or
liability. If the answer is no, it is
not rate sensitive.
Solution
RSA Amount ($m) RSL Amount ($m)
Short term consumer loans 50 3 month CD’s 40
3 month T-Bill 30 3 Month Banker’s Acceptance 20
6 Month Treasury Notes 35 6 month commercial paper 60
30 year floating rate mortgage 40 1 year time deposit 20
Total 155 Total 140

So, the 1 year Cumulative Gap is $15 million (155m – 140 m).
A rise of interest rates by 1% will increase the NII by $150000 (15*0.01).
A fall of interest rates by 1% will decrease the NII by $150000 (15*- 0.01).
2. CGAP Ratio
• The CGAP ratio or GAP ratio is calculated using the formula:
• GAP Ratio = CGAP/Total Assets
• The higher the ratio, the more interest risk exposure a FI has.
• Calculate the CGAP ratio for ABC investment bank for the 1 year
maturity bucket.
• 15/270 = 0.056 or 5.6%
3. Interest Sensitivity Ratio
• Interest Sensitivity Ratio = Rate Sensitive Assets / Rate Sensitive
Liabilities
• The higher this ratio, the greater the interest rate risk exposure of a
company.
• For ABC Investment bank, the Interest sensitivity ratio is 155/140 =
1.107
Real life perspective: Interest Rate risks
Real life perspective: Interest Rate risks
Summary of CGAP analysis impacts
Unequal changes in rate of RSA’s and RSL’s
• Thus far in our calculation we have assumed that the rate of interest
changes by an equal margin for both the RSA’s and RSL’s.
• (in other words, assuming the interest rate spread between rates on
RSAs and RSLs remained unchanged)
• In reality, this is most often not the case. Rather, in practice, we often
see the interest rate of RSA’s and RSL’s to change with differing
magnitudes for various reasons.
• (i.e., the spread between interest rates on
assets and liabilities change along with the levels of these rates).
Unequal changes in rate of RSA’s and RSL’s
• When interest rates change at the same rate for both RSA and RSL,
the impact of the change on the net interest income (NII) is solely due
to the repricing gap/CGAP.
• Thus, we can say that the NII has changed due to the CGAP effects.
• CGAP Effects: The relations between changes in interest rates and
changes in net interest income.
• However, when interest rates change at different magnitude the
impact of the change on the net interest income (NII) is due to both
the CGAP effect and the Spread effect.
Unequal changes in rate of RSA’s and RSL’s
• Spread effect- The effect that a change in the spread between rates
on RSAs and RSLs has on net interest income as interest rates change.

• In general, 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 (between rates on RSAs and RSLs) and changes
in NII.

• Whenever the spread increases (decreases), NII increases

(decreases).
Example
Example
Summary of CGAP Effect and Spread Effect
Strengths of the repricing model
• Easy to understand and calculate

• Allows you to identify specific balance sheet items that are

responsible for risk

• Provides analysis based on different time frames.

Weaknesses of the repricing model
• Market Value Effects
• Basic repricing model the changes in market value. The PV of the future cash
flows should change as the level of interest rates change. (ignores TVM)
• Over aggregation
• Repricing may occur at different times within the bucket (assets may be early
and liabilities late within the time frame)
• Many large banks look at daily buckets.
Weaknesses of the repricing model
• Runoffs
• Periodic payment of principal and interest that can be reinvested and is itself
rate sensitive.
• You can include runoff in your measure of rate sensitive assets and rate
sensitive liabilities.
• Note: the amount of runoffs may be sensitive to rate changes also
(prepayments on mortgages for example
Weaknesses of the repricing model
• Off Balance Sheet Activities
• Basic GAP ignores changes in off balance sheet activities that may also be
sensitive to changes in the level of interest rates.
• Ignores changes in the level of demand deposits
Other Factors Impacting NII
• Changes in Portfolio Composition
• An aggressive position is to change the portfolio in an attempt to take
advantage of expected changes in the level of interest rates. (if rates are ↑
have positive GAP, if rates are ↓ have negative GAP)
• Problem: Forecasting is rarely accurate
• Changes in Volume
• Bank may change in size so can GAP along with it.
• Changes in the relationship between ST and LT
• We have assumes parallel shifts in the yield curve. The relationship between
ST and LT may change (especially important for cumulative GAP)
Practice problems
Practice problems