Interest Rate Risk

Interest Rate Risk: Income Side

Interest Rate Risk The risk to an institution's

income resulting from adverse movements in
interest rates
Many bank liabilities are of very short maturity
(such as saving deposits) whose interest
changes with market interest rates.
Many bank assets are long-term and interest
income may not change as market interest rate
rises.
When market interest rates rise, bank income
will decline.

Net Interest Margin: HK

HK: Net Interest Margin: Local & Foreign Retail Bank
%
2.4

2.3

2.2

2.1

2.0

1.9

1.8

1.7

1.6

1.5
Mar-1998

Mar-2000

Source: CEIC Database

Mar-2002

Mar-2004

Mar-2006

What is the impact of monetary

policy on bond markets?

Interest Rate Risk: Balance Sheet

Perspective
An asset (or a liability) represents a set of
payments that must be made at times in
the future.
Define PVT as the present value of a
future payments made to an asset or a set
of assets in T periods.

 Useful Approximation
FACE
PV
(1 i )T

PV
i
T
PV
1 i

Duration Measure of Interest Rate Risk

Define market value, MV, of an
asset or a set of assets as the
sum of present values derived
from payments made in each
future period.

MV PVt

Define the duration of an asset as d

d

t 1

PVt
t

MV
t 1

The % change of the market value

of an asset to a change in the
MV
i
interest rate is approximately
d
proportional to the duration of an
MV
1 i
asset.

Example
5 period fixed
payment loan of
100.
Interest rate: 10%
Rises to 11%

Measuring Interest Exposure

Calculate the duration of a
banks assets, dA. Calculate
the duration of a banks
liabilities, dL.
An increase in the interest
rate will have the following
effect on assets and
liabilities.
Calculate the GAP as a
function of duration of
assets and liabilities.

A
i
d A
A
1 i

L
i
d L
L
1 i

L
D GAP d A d L
A

An increase in interest rates

changes the value of a banks assets
and liabilities.
NW A L A L L

A
A
A
A
L A
i
i L
L i

d A
dL
d A d L
1 i
1 i A
A 1 i

NW NW NW

A
NW
A
NW
EM GAP
NW

i
GAP

1 i
i

1 i

Managing Interest Rate Risk

A bank which has a large stock of assets which
will pay a fixed interest rate may face losses if
market interest rates rise.
Since deposits must be redeemed at any time,
the bank must offer market interest rates. If
market interest rates rise, loan spreads will be
cut.
Banks may use asset and liability management
to match the sensitivity of assets and liabilities to
interest rates.

Responses to a perceived risk of a rise in

interest rates.
If interest rates are expected to rise, banks
would like to reduce their long-term fixed
interest rate assets and lock in current low
interest rates by increasing their stock of
long-term liabilities
Asset Management: Increase holdings of
short-term loans or securities.
Liabilities Management: Sell long-term
certificates of deposit.

Floating Rate Loans

Fixed payment loans have a constant payment based on a
fixed interest rate.
Floating rate loan payments are based on an interest rate
that changes as some benchmark interest rate changes
A HK$ floating rate loan will be quoted as a spread over
Hong Kong InterBank Offered Rate (HIBOR), the rate at
which banks lend aggregate balances to each other.
A US$ floating rate Euroloan will be typically quoted as a
spread over London InterBank Offered Rate (LIBOR).

Swaps
Basic (plain vanilla) interest rate swap is
agreement by two parties to exchange
interest rate payments on a notional
principal.
One party pays a fixed interest rate for a
pre-determined period of time. Another
party pays a floating rate equivalent to
some benchmark interest rate (LIBOR,
etc.)

Schedule of Dealer Quotes

Source: Koch and Macdonald, Management of Banking

The dealer will pay LIBOR for the next 2 years to the
customer if the customer will pay a fixed interest rate of
4.05%. The dealer will pay a fixed rate of 4.04% if the
customer will pay LIBOR.

Swaps and Hedging

If a bank has long-term fixed rate assets
and short-term liabilities, they face interest
rate risk. Solution: Swap income from fixed
rate assets for floating rate from dealer.
A pension fund with long-term obligations
may like to lock in fixed income at a higher
rate than LT treasuries. They may also
swap income from floating rate assets for
fixed income from a dealer.

Interest Rate Swaps are Quickly

Growing in Importance

Source: BIS International Financial Statistics http://www.bis.org/statistics/derstats.htm

Advantages of Swaps vs.

Futures
Swap terms can be tailored to individual
needs whereas futures are standarized.
OTOH, futures markets usually more liquid
than swap.
Swaps typically available for longer-terms
while Futures are short-term.
Exchange guarantees futures while

Market Risk

Market Risk : Risk to banks liquidity and/or

assets from movements in asset prices
1. Exchange Rate Risk The potential
fluctuations in the value of assets or liabilities
denominated in foreign currencies due to
fluctuations in the exchange rate.
2. Collateral Risk - The risk to the value of
assets used as collateral for loans.

Exchange Rate Risk

International banks often issue liabilities and assets in a
variety of different currencies. If there is an imbalance, a
change in the exchange rate can affect firms balance
sheets.
Example 1 : In Hong Kong, banks accept large foreign
currency deposits but less demand for US$ loans in
Hong Kong.
Example 2: In Argentina, fixed exchange rate with the US
dollar (EX = 1) has led Argentine banks to engage in
large scale off-shore borrowing denominated in dollars
and on-shore borrowing in pesos. What happens to
Argentine banks if the peso is devalued?

 Balance Sheets Prior to Devaluation

Assets
Loans
P$125

Liabilities
Borrowings US$100 (=
P$100)
Net Worth P$25

Balance Sheets After Devaluation (EX = .

8)
Assets
Loans
P$125

Liabilities
Borrowings US$100 (=
P$125)
Net Worth P$0

Managing Exchange Rate Risk

Asset and Liability Management: Hong Kong
Banks Borrow and Lend to Foreign Banks to
Match Currencies of Liabilities and Assets..
Source:HKMA Millions of HK$ ,2001.
Total Assets
HK$ Assets
-Loans to Customers
-Advances Due from Banks
-Securites and Other
Foreign Currency Assets
-Loans to Customers
-Advances Due from Banks
-Securites and Other

6241252
2662668
1502813
120477
1039378
3578585
606001
2160909
811675

Total Liabilities and Capital

HK$ Liabilities
-Deposits
-Due to Banks Abroad
-Other
Foreign Currency Liabilities
-Deposits
-Due to Banks Abroad
-Other

6241252
2849549
1830474
171007
848068
3391704
1605443
1349723
436537

Foreign Currency Forwards

Forward Contracts: Agreements made
today (t) for an exchange of currency to be
made at some future date (in T periods).
Price, Ft,T determined at time t
No money exchanged until time T

Forward contracts are Over-the-Counter

(i.e. not traded on an organized exchange)
Banks are major dealers of FC Forwards.

Pricing Forward Contracts

Spot Rate, St = #DCU
Two strategies to invest for
per FCU
two periods
Foreign interest rate
1. Deposit in domestic
for maturity period T,
economy, return in DCU =
it,T
(1+it,T)
Domestic interest rate
2. Buy foreign currency,
for maturity period T,
deposit in FC account, sell
it,T
FC forward at rate, Ft,T.,
Arbitrage implies equal returns for these
two strategies.

1
(1 itF,T )T Ft ,T
St

(1 it ,T )T Ft ,T

return in DCU 1

St

(1 it ,T )T

St
F T
(1 it ,T )

(1 itF,T )T Ft ,T

Currency Forwards:
Mostly short-run

Source: BIS International Financial Statistics http://www.bis.org/statistics/derstats.htm