Chapter 8

Interest Rate Risk I

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 8-2

Central Bank & Interest Rate Risk

 Federal Reserve Bank: U.S. central bank
 Open market operations influence money supply,
inflation, and interest rates
 Oct-1979 to Oct-1982, nonborrowed reserves
target regime – did not work
 Implications of reserves target policy:
 Increases importance of measuring and managing
interest rate risk.
 Effects of interest rate targeting.
 Lessens interest rate risk
 Greenspan view: Risk Management
 Focus on Federal Funds Rate
 Simple announcement of Fed Funds increase,
decrease, or no change.

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 8-3

Repricing Model
 Repricing or funding gap model based on
book value.
 Contrasts with market value-based maturity

and duration models recommended by the

Bank for International Settlements (BIS).
 Rate sensitivity means time to repricing.

 Repricing gap is the difference between the

rate sensitivity of each asset and the rate

sensitivity of each liability: RSA - RSL.
 Refinancing risk

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 8-4

Maturity Buckets
 Commercial banks must report repricing
gaps for assets and liabilities with maturities
of:
 One day.
 More than one day to three months.
 More than 3 three months to six months.
 More than six months to twelve months.
 More than one year to five years.
 Over five years.

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 8-5

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

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 8-6
Repricing Gap

Dollar GAP Spread Effect R Direction of NII

Positive Positive Increase Increase

Negative Increase Ambiguous

Positive Decrease Ambiguous

Negative Decrease Decrease

Negative Positive Increase Ambiguous

Negative Increase Decrease

Positive Decrease Increase

Negative Decrease Ambiguous

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 8-7

Applying the Repricing Model

 NIIi = (GAPi) Ri = (RSAi - RSLi) ri

Example:
In the one day bucket, gap is -$10 million. If rates
rise by 1%,
NII(1) = (-$10 million) × .01 = -$100,000.

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 8-8

Applying the Repricing Model

 Example II:
If we consider the cumulative 1-year gap,

NII = (CGAPone year) R = (-$15 million)(.01)

= -$150,000.

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 8-9
Repricing Model

Assets ($ Mill) Liabilities & Equity

Investments under 1 year @ 5% $ 100 Deposits < 1 year @ 4% $ 900
Loans < 1 year @ 7% $ 350 All Long Term Liabilities @ 7% $ 500
Variable rate loans
(rate reset in 6 months) @ 6.5% $ 300 Equity $ 200
Fixed Rate Assets > 1 year Total $1,600
maturity @ 8% $ 850
Total $1,600

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 8-10

CGAP Ratio
 May be useful to express CGAP in ratio
form as,
CGAP/Assets.
 Provides direction of exposure and
 Scale of the exposure.
 Example:
 CGAP/A = $15 million / $270 million = .056, or
5.6 percent.

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 8-11

Unequal Changes in Rates

 If changes in rates on RSAs and RSLs are not

equal, the spread changes. In this case,
NII = (RSA ×  RRSA ) - (RSL ×  RRSL )
 Spread effect example:
• RSA=RSL=$155m
• RSA rate rises by 1.2% and RSL rate rises by
1.0%
NII =  interest revenue -  interest expense
= ($155 million × 1.2%) - ($155 million × 1.0%)
= $310,000

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 8-12

Restructuring Assets & Liabilities

 The FI can restructure its assets and
liabilities, on or off the balance sheet, to
benefit from projected interest rate changes.
 Positive gap: increase in rates increases NII
 Negative gap: decrease in rates increases NII
 Example: State Street Boston
 Good luck?
 Or Good Management?

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 8-13
Repricing Model

 Problems with model:

 measures only short-term profit changes not
shareholder wealth changes
 maturity buckets are arbitrarily chosen
 assets and liabilities within a bucket are
considered equally rate sensitive
 ignores runoffs
 ignores prepayments
 ignores CFs gnerated from off balance sheet
activities

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 8-14

The Maturity Model

 Explicitly incorporates market value effects.

 For fixed-income assets and liabilities:
 Rise (fall) in interest rates leads to fall (rise) in
market price.
 The longer the maturity, the greater the effect of
interest rate changes on market price.
 Fall in value of longer-term securities increases
at diminishing rate for given increase in interest
rates.

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 8-15
Maturity Model Example
 FI issues a one-year CD to a depositor that has a
face value of $100 and an interest rate promised
to depositors of 15%. (On maturity at year end,
the FI has to repay $115.) Suppose FI lends $100
for one year to a corporate borrower at 15%
annual interest (so $A=$L). However, the FI
contractually requires half of the loan ($50) to be
repaid after 6 months and the last half to be repaid
at the end of the year. Note that although the
maturity of the loan equals the maturity of the
deposit and the loan is fully funded by the deposit
liabilities, the CFs on the loan may be greater or
less than the $115 required to pay off depositors,
depending on what happens to interest rates over
the one year period.

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 8-16

Maturities and Interest Rate Exposure

 If MA - ML = 0, is the FI immunized?
 Extreme example: Suppose liabilities consist of
1-year zero coupon bond with face value $100.
Assets consist of 1-year loan, which pays back
$99.99 shortly after origination, and 1¢ at the
end of the year. Both have maturities of 1 year.
 Not immunized, although maturity gap equals
zero.
 Reason: Differences in duration*

*(See Chapter 9)
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 8-17

Maturity Model
 Leverage also affects ability to eliminate
interest rate risk using maturity model
Example:
Assets: $100 million in one-year 10-percent
bonds, funded with $90 million in one-year 10-
percent deposits (and equity)
Maturity gap is zero but exposure to interest rate
risk is not zero.

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