Mishkin8-Ch9-Lecture2

Mishkin8-Ch9-Lecture2 - Managing Interest-Rate Risk...

Info iconThis preview shows pages 1–7. Sign up to view the full content.

View Full Document Right Arrow Icon
Interest Rate Risk Interest rate risk is the potential impact of interest rate movements on an institution’s net interest income and capital level. It focuses on the repricing speed of the institution’s assets relative to liabilities Credit Risk Credit risk is the oldest of all financial risks. It is the danger that a borrower will simply fail to meet interest payments or repay a debt Liquidity Risk Liquidity risk is concerned with maintaining an adequate availability of funds for loan demand, deposit outflows, and expense payments in changing interest rate environments Managing Interest-Rate Risk
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Loan originations per year Inflow/Production Amortization / sales Prepayments Chargeoffs per year Loan balance Valve/Control: 1. Interest rates 2. Loan underwriting standards Equilibrium Condition Inflow = Outflow Valve/Control: 1. Contract term 2. Interest rates 3. Economy
Background image of page 2
Interest Rate Risk (IRR) 3 Types 1. Repricing risk (timing or repricing mismatch) Timing differences in the maturity (for fixed rate) and repricing (for floating rate) characteristics of assets and liabilities. Example: funding long-term, fixed rate loans with short-term or variable deposits. 1. Basis risk : The risk that poor correlation between changes in rates on assets and liabilities will adversely impact earnings/capital. Typical “price setting” rates: Treasury, Fed Funds, Libor, Prime, COFI, Competition 1. Embedded Option risk (embedded/off-balance sheet) The risk that cash flow uncertainty associated with embedded options in financial instruments can adversely impact earnings/capital. Financial instruments with embedded options: mortgage loans and MBS, callable bonds or CDs, floating rate loans/notes/bonds with interest rates caps and floors, liabilities with characteristics similar to any of the above.
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Yield Curve & the 3 Components of NIM 6 4 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 1 year 2 3 4 5 year 6 Years to Maturity Percent Funding Spread Interest Rate Risk Spread Credit Spread 1-year CD @ 3.0% 5-year loan @ 7.5% “Carry Trade” -Borrow short-term -Lend long-term $1 Million example (retail market) Issue 1-yr CD at 3% ($30,000) Originate 5-yr loan at 7.5% ($75,000) Earn $45,000 NIM = Funding Spread + IRR Spread + Credit Spread
Background image of page 4
Basis Risk Correlation Between Prime and 3-M Libor 0 1 2 3 4 5 6 7 8 9 10 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Percen 2 2.2 2.4 2.6 2.8 3 3.2 3.4 Prime - Libor Prime 3-M Libor 2006 Prime 7.25 => 8.25,… = 1.0% 3-M Libor 4.60 => 5.35,… = 0.75% Assume Fed Reserve increases fed funds rate 1% in 2006.
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Risk Measurement Systems 3 Types 1. Gap Analysis: Measures the dollar volume of maturity and repricing differences between assets and liabilities. Gap is only appropriate for CUs whose IRR exposure consists primarily of repricing risk . 1.
Background image of page 6
Image of page 7
This is the end of the preview. Sign up to access the rest of the document.

Page1 / 22

Mishkin8-Ch9-Lecture2 - Managing Interest-Rate Risk...

This preview shows document pages 1 - 7. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online