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. (3
rd
ed).
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 defaultfree government securities
* Example:
* Normal yield curve
 Upward sloping
 Long term rates generally higher than shortterm
rates
* Inverted yield curve
 Downward sloping
Living yield curve:

yieldcurve7923/
3
* In BUS244 Treasury Management, it was shown that
the yield to maturity i
0,n
of an nperiod instrument was
the geometric average of the expected shortterm
rates as follows:
1
)
1
(
)
1
(
)
1
(
,
1
1
,
0
,
1
1
,
0
n
t
t
n
t
n
t
t
n
t
n
n
i
i
or
i
i
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.
* The yield to maturity of a bond was calculated as
follows:
n
d
n
t
t
d
t
k
FV
k
C
Value
Market
)
1
(
)
1
(
1
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
4
5