Interest Rate Risk Measurement –Repricing Model REFERENCES Hogan, W., et al., 2004. Management of Financial Institutions. Brisbane Wiley, Chapter 4. Lange, H. et al., 2013. Financial Institutions Management. (3rded). Sydney: McGraw Hill, Chapter 5. 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.* 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 week’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.
2 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: * Normal yield curve - Upward sloping - Long term rates generally higher than short-term rates * Inverted yield curve - Downward sloping Living yield curve: -yield-curve-7923/
3 * In BUS244 Treasury Management, it was shown that the yield to maturity i0,nof an n-period instrument was the geometric average of the expected short-term rates as follows: 1)1()1()1(,11,0,11,0nttntnttntnniioriiThis however only applies for ‘pure discount’ (zero coupon) securities, or to coupon bonds only in the special case where the yield curve is flat. * The yield to maturity of a bond was calculated as follows: ndnttdtkFVkCValueMarket)1()1(1where: Ct= Expected NCF to debt security holders (interest) in period t n = Maturity term (periods) FV = Face value paid on maturity kd= Required rate of return per period on the particular type of security