BUS307 Topic 2-2 - Topic 2 Interest Rate Risk Measurement Repricing Model BUS307 Commercial Banking 1.0 Introduction This topic will consider the risk

# BUS307 Topic 2-2 - Topic 2 Interest Rate Risk Measurement...

• 48

This preview shows page 1 - 11 out of 48 pages.

Topic 2 Interest Rate Risk Measurement Repricing Model BUS307 Commercial Banking Subscribe to view the full document.

1.0 Introduction This topic will consider the risk faced by banks as a result of changes in market interest rates. Interest rate changes impact a bank’s net interest revenue (NIR) as its interest income and interest expenses change. This will be the focus of this week’s lectures. 1.0 Introduction (Continued) Interest rate changes also impact the (market) value of a bank’s assets and its liabilities, and therefore its equity, which will be the focus of next Topic’s lectures. To understand the impact of interest rate changes, it is first necessary to understand the relationship between interest rates of different maturities, forward rates, and expected future interest rates. Hence, the yield curve and associated calculations will be considered first. Subscribe to view the full document.

2.0 The Yield Curve Yield Curve Plot of yields against maturity Relation is the term structure of interest rates All rates must reflect similar default risk Usually default-free government securities Example : 2.0 The Yield Curve (Continued) Normal yield curve Upward sloping Long term rates generally higher than short- term rates Inverted yield curve Downward sloping Subscribe to view the full document.

2.0 The Yield Curve (Continued) In BUS244 Treasury Management, it was shown that the yield to maturity i 0,n of an n-period instrument was the geometric average of the expected short-term rates as follows: This however only applies for ‘pure discount’ (zero coupon) securities, or to coupon bonds only in the special case where the yield curve is flat. 1 i 0, n n 1 i t 1, t t 1 n or i 0, n 1 i t 1, t t 1 n n 1 2.0 The Yield Curve (Continued) The yield to maturity of a bond was calculated as follows: where: C t = Expected NCF to debt security holders (interest) in period t n = Maturity term (periods) FV = Face value paid on maturity k d = Required rate of return per period on the particular type of security MarketValue C t 1 k d t t 1 n FV 1 k d n Subscribe to view the full document.

2.0 The Yield Curve (Continued) That is, the yield to maturity was the internal rate of return of the bond - that rate which would discount the coupon and face value cash-flows to equal the market value of the bond. Implicitly, coupons are assumed to be re-invested at the IRR. The yield to maturity (k d ) on the coupon bond is therefore not the same as the yield to maturity (i 0,n ) determined from the geometric average of short term rates because the implicit assumption of the IRR method that the coupons can be re-invested at k d is violated . It will only be the same in the special case where the yield curve is flat. 2.0 The Yield Curve (Continued) That is where : Hence But since i 0,1 i 1,2 i 2,3 .... i n 1, n k d 1 i t 1, t t 1 n 1 k d n 1 i 0, n n 1 i t 1, t t 1 n Subscribe to view the full document.

2.0 The Yield Curve (Continued) It follows that Or  • Summer '19

### What students are saying

• As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

Kiran Temple University Fox School of Business ‘17, Course Hero Intern

• I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

Dana University of Pennsylvania ‘17, Course Hero Intern

• The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

Jill Tulane University ‘16, Course Hero Intern

Ask Expert Tutors You can ask 0 bonus questions You can ask 0 questions (0 expire soon) You can ask 0 questions (will expire )
Answers in as fast as 15 minutes