Lecture 7

Interest Rate Risk:

The Repricing Model
 Overview

• The repricing model: An alternative model of

measuring an FI’s exposure to interest rates

• How interest rate changes could affect FI’s net

interest income

• Weaknesses of the repricing model

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 Interest Rate Risk
• The Federal Reserve’s monetary policy is the most
direct influence on the level and movement of short-
term interest rates

• Changes in the Federal Reserve’s target fed funds

rate affect all interest rates throughout the economy
– Expansionary monetary policy involves
decreases in the target fed funds rate
– Contractionary monetary policy involves
increases in the target fed funds rate

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 Interest Rate Risk

• The asset transformation function performed by

financial institutions (FIs) often exposes them to interest
rate risk

• FIs use two main methods to measure interest rate

exposure:
– The repricing model examines the impact of interest rate
changes on net interest income (NII)
– The duration model examines the impact of interest rate
changes on the overall market value of an FI and thus ultimately
on net worth

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 Recap on Duration Model

• Definition and usage of duration – the focus is on the

change in market price

• What if we are interested in other consequences

brought about by the changes in interest rates, for
example, changes in net income?

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 Fed Requirement

• US Federal Reserve requires US commercial banks to

report repricing gaps for assets and liabilities with
maturities of:
– 1 day
– More than 1 day, up to 3 months
– More than 3 months, up to 6 months
– More than 6 months, up to 12 months
– More than 1 year, up to 5 years.
– More than 5 years

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 Repricing Gap Example

Assets Liabilities Gap Cum. Gap

1-day $ 20 $ 30 $-10 $-10
>1day-3mos. 30 40 -10 -20
>3mos.-6mos. 70 85 -15 -35
>6mos.-12mos. 90 70 +20 -15
>1yr.-5yrs. 40 30 +10 -5
>5 years 10 5 +5 0
 A Few Definitions

• Rate sensitive assets (RSA) and Rate sensitive liabilities

(RSL): assets and liabilities whose interest rates will be
repriced (changed) over the planning horizon

• Repricing date: the date on which the interest rate changes

– E.g.: 5-year variable-rate loans with interest rate adjusted every 6
months

• Repricing (funding) gap = RSA – RSL

• Note: any discussion of RSA and RSL is relative to the

planning horizon

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 Rate-Sensitive Assets
Examples:
• Short-term loans
• T-Bills, T-Notes (of various maturities)
• Floating-rate long-term loans

Question:
Will or can this asset have its interest rate changed within the
planning horizon?
•Yes? Rate-sensitive.
• No? Not rate-sensitive.

•For assets with maturity shorter than the planning horizon,

what matters is the reinvestment rate
–Reinvestment rate changes with the market interest rate when
reinvesting.

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 Rate-Sensitive Liabilities
Examples:
• Term deposits (of various maturities).
• All roll-over credits, such as certificates of deposits (CDs), commercial papers

• A certificate of deposit (CD) is a savings account that holds a fixed amount of

money for a fixed period of time, such as six months, one year, or five years, and
in exchange, the issuing bank pays interest.
• Commercial paper (CP) is a unsecured short-term (normally <9 month) debt
instrument issued by large corporations, typically to meet short-term
obligations, such as financing for account receivable.

Question:
Will or can this liability have its interest rate changed within the planning
horizon?
• If Yes, Rate-sensitive.
• If No, Rate-insensitive.

•For liabilities with maturity shorter than the planning horizon, refinance rate
changes with the market interest rate when refinancing (i.e., borrow from market to
finance the liability).

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 Example: Simple FI Balance Sheet

• Instead of the original maturities, need to check the

remaining maturities of assets and liabilities at the time
when the repricing gap is estimated.

• Assume repricing horizon: 1 year

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 Rate-Sensitive Assets
What are the RSAs on the balance sheet (wrt one year repricing horizon)?
• Short-term consumer loans: $50 million.
– Repriced at the end of the year and just make the one-year cut-off.
• Three-month T-bills: $30 million.
– Repriced on maturity (rollover) every three months.
• Six-month T-notes: $35 million.
– Repriced on maturity (rollover) every six months.
• 30-year floating-rate mortgages: $40 million.
– Repriced (i.e., the mortgage rate is reset) every nine months.
– Rate-sensitive assets in the context of the repricing model with a one-year
repricing horizon.

→Total one-year rate-sensitive assets (RSAs) of $155 (=50+30+35+40) million.

• The remaining $115 (=270-155) million of assets are not rate

sensitive over the one-year repricing horizon.

• Exercise: what if we change repricing horizon to two years? How

much is RSA?
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 Rate-Sensitive Liabilities
What are the RSLs on the balance sheet?
• Three-month CDs: $40 million.
– These mature in three months and are repriced on rollover.
• Three-month bankers acceptances: $20 million.
– These also mature in three months and are repriced on rollover.
• Six-month commercial paper: $60 million.
– These mature and are repriced every six months.
• One-year time deposits: $20 million.
– These get repriced right at the end of the one-year gap horizon..

→Total one-year rate-sensitive liabilities (RSLs) of $140 million.

– The remaining $130 million is not rate sensitive over the one-year period.

• Exercise: How much is RSL if we change repricing horizon to two

years?

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 Demand Deposits
Reasons Against Inclusion in RSL
• The explicit interest rate on demand deposits is zero by
regulation
• Many demand deposits act as core deposits for FIs,
meaning they are a long-term source of funds.

Reasons For Inclusion in RSL

• Implicit interest, because FIs do not charge fees that fully
cover their costs for checking services.
• If market interest rates go up, account holders draw down
their demand deposits, forcing the bank to replace them with
higher-yielding, interest-bearing, rate-sensitive funds.
• The opportunity cost of demand deposits is likely to be larger
when market interest rate is high
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 The Repricing Model
• Effect of interest rate change on FI’s net interest income in a
particular repricing bucket

∆NIIi = (RSAi - RSLi) ∆Ri = (GAPi)∆Ri

Where:
∆NIIi = change in net interest income in the i-th bucket,
GAPi = the dollar size of the gap between the book value of assets and
liabilities in maturity bucket i,
∆Ri = the change in the level of interest rates impacting assets and
liabilities in the i-th bucket.

• Repricing Gap (or Funding Gap): The difference between RSA & RSL
– Positive gap (RSA > RSL), exposed to the risk of interest rate
decrease
– Negative gap (RSA < RSL), exposed to the risk of interest rate
increase

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Repricing Gap Illustration

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 The Repricing Model

Example
•Consider the following repricing gaps (in $ million).
• If the overnight interest rate rises by 1%, then:
∆NIIi = $25 million × 0.01 = $250,000.

Repricing bucket Assets Liabilities Gap

1 day $50 $25 $25

1 day to 3 months 10 40 -30

3 to 6 months 50 80 -30
6 to 12 months 30 60 -30
1 to 5 years 70 10 +60
Over 5 years 10 5 +5
$220 $220 0

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 The Cumulative Repricing Gap

• For a specific planning horizon (e.g., one year), what is the effect of
interest rate change on the net interest income?
•
•The Cumulative Gap (CGap): the difference between all RSAs and RSLs
with repricing date shorter than the planning horizon
∆NIIi = (CGAPi)∆Ri

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 Example: Cumulative Gap
•Calculate Cumulative Gap based on the previous table
– The cumulative gap for 1-year horizon is $-65 million

•Assume ∆Ri = 1% is the average rate change that affects assets and
liabilities that can be repriced within a year.
•→ ∆NIIi = (CGAPi)∆Ri = (-$65 million) (0.01) = -$650,000.

Repricing bucket Assets Liabilities Gaps CGap

1 day $50 $25 $25 $25
1 day to 3 months 10 40 -30 -5
3 to 6 months 50 80 -30 -35
6 to 12 months 30 60 -30 -65
1 to 5 years 70 10 +60 -5
Over 5 years 10 5 +5 0
$220 $220 0

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 Unequal Changes in Rates

The Spread Effect

• Definition: The effect that a change in the spread between
rates on RSAs and RSLs has on net interest income as
interest rates change.

• If changes in rates on RSAs and RSLs are not equal, the

spread changes (i.e., RRSA ≠ RRSL)
NII = (RSA × RRSA ) - (RSL × RRSL)

• Further, the changes in interest rates may be different for

assets or liabilities over different repricing buckets.

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 Spread Effect Example

Example:
• Assume that RSAs & RSLs both equal $155 million.
• Suppose that rates rise by 1.2% on RSAs and by 1% on
RSLs (i.e., the spread between the rates on RSAs and
RSLs increases by 1.2% − 1% = 0.2%).
• The resulting change in NII is calculated as:
• NII = (RSA × RRSA ) - (RSL × RRSL)
= Interest revenue - Interest expense
=$155mil*0.2%=$310,000

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 Repricing Model vs Duration Model

• Repricing model focuses on the interest income/cost

effect, while duration model focuses on the value effect.

• Interest income/costs are calculated based on the book

value of assets/liabilities, while duration is used to
calculate the change in the market value.

• Advantage of Repricing model:

– Information value
– Simplicity

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 Weaknesses of the Repricing Model

• Four major shortcomings:

– It ignores market value effects of interest rate changes
– It is over-aggregative
– It fails to deal with the problem of rate-insensitive asset
and liability runoffs and prepayments
– It ignores cash flows from off-balance-sheet activities.

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 Weaknesses of the Repricing Model

1) Market value effects:

– Interest rate changes have a market value effect in addition to an
income effect on asset and liability values.
– Interest rate changes can adversely affect the market value of
assets and liabilities, and thus the net worth of an FI.
– The present value of the cash flows on assets and liabilities
changes, in addition to the immediate interest received or paid on
them, as interest rates change.

• The repricing model ignores the market value effect.

• As such, the repricing model is only a partial measure of interest rate
risk.

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 Weaknesses of the Repricing Model

2) Over-aggregation
• Defining buckets over a range of maturities ignores
information regarding the distribution of assets and
liabilities within those buckets

Example:
• Liabilities may be repriced toward the end of the bucket’s range,
while assets may be repriced toward the beginning, although the
dollar amount may be the same.
• The bank would show a zero repricing gap for the three-month to six-
month bucket.
• The bank’s assets and liabilities are mismatched within the bucket.

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 Example: Over-aggregation

• The bank would show a zero repricing gap for the three-month to six-month bucket.
• However, the bank’s assets and liabilities are mismatched within the bucket.

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 Weaknesses of the Repricing Model

3) The Problem of Runoffs

• Runoffs: Periodic cash flow of interest and principal
amortization payments on long-term assets, such as monthly
payments or pre-payment from 30-year fixed rate mortgage
loans
• The reinvestment of these cash flows is rate-sensitive though
the assets may be rate insensitive.

• Similar runoff issues for long-term liabilities

– Cash outflows,
– Need to raise funds from the market at market interest rate to pay
creditors)

• Solution: Predict the amount of runoffs for the long-term assets

and liabilities, and consider them as RSA/RSL.

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 Weaknesses of the Repricing Model

4) Off-balance-sheet items are not included

• The RSAs and RSLs used in the repricing model generally include only
the assets and liabilities listed on the balance sheet.
• Changes in interest rates will affect the cash flows on off-balance-
sheet instruments as well.

Example
• An FI might have hedged its interest rate risk with an interest rate
futures contract.
• As interest rates change, these futures contracts produce a daily cash
flow that may offset any on-balance-sheet gap exposure.
• These offsetting cash flows from futures contracts are ignored by the
simple repricing model and should be included.

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 Summary

• The Repricing Model

– Rate-Sensitive Assets
– Rate-Sensitive Liabilities
– Equal Changes in Rates on RSAs and RSLs
– 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
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