Lecture 2 Interest Rate Risk I.pdf - Lecture 2 Interest Rate Risk(Part I Overview of Lecture Topics • The relationship between security prices and

Lecture 2 Interest Rate Risk I.pdf - Lecture 2 Interest...

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Lecture 2 Interest Rate Risk (Part I)
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Overview of Lecture Topics The relationship between security prices and interest rates, and various sources of interest rate movement. A particular interest rate risk measurement and management model: repricing model. How to measure an FI’s exposure to interest rate risk based on the effect on net interest income The weaknesses of the model The basics of duration Definition of duration and the formulae for bond duration calculation. The relationship between the duration of a security and various securities features 2 Introduction
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About Interest Rates Why does interest rate risk matters? 3
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The Level and Movement of Interest Rates Interest rate can be considered as the price of money. It is the price to exchange money today for money in the future. Like other prices, they are set in equilibrium by the demand and supply of money at a given time. At any point of time, interest rates on debt instruments of different maturities (terms) are different. The relation between terms of the debt instruments (of identical default risk) and their market rates of interest is known as the term structure of interest rates . To display the term structure of interest rates, economists use a diagram called yield curve . 4 Interest Rate Movement
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Example of yield curve - Visualization.aspx Interest Rate Movement 5
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6 0.00 0.50 1.00 1.50 2.00 2.50 3.00 1 Mo 2 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr Yield Curve
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The Level and Movement of Interest Rates Central bank’s monetary policy strategy most directly underlies the level and movement of interest rates. Central banks typically target at short-term rates, the changes of which usually feed through to the whole term structure of interest rates. The increased financial market integration increases the speed with which interest rate changes and associated volatility are transmitted among countries. Assumptions we make in most of our discussions: a flat yield curve - constant interest rate for all maturities at a given point of time. a parallel shift in yield curves – the same change in interest rates for all maturities across time. 7 Interest Rate Movement
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US Federal Funds Rate 8 , -1 -0.75 -0.5 -0.25 0 0.25 0.5 0.75 0 1 2 3 4 5 6 7 2/1/2000 8/1/2000 2/1/2001 8/1/2001 2/1/2002 8/1/2002 2/1/2003 8/1/2003 2/1/2004 8/1/2004 2/1/2005 8/1/2005 2/1/2006 8/1/2006 2/1/2007 8/1/2007 2/1/2008 8/1/2008 2/1/2009 8/1/2009 2/1/2010 8/1/2010 2/1/2011 8/1/2011 2/1/2012 8/1/2012 2/1/2013 8/1/2013 2/1/2014 8/1/2014 2/1/2015 8/1/2015 2/1/2016 8/1/2016 in % Fed Funds Rates and Changes Level Change
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Australian Cash Rate -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 0 3 6 9 12 15 1 -Jan-1990 1 -Jan-1991 1 -Jan-1992 1 -Jan-1993 1 -Jan-1994 1 -Jan-1995 1 -Jan-1996 1 -Jan-1997 1 -Jan-1998 1 -Jan-1999 1 -Jan-2000 1 -Jan-2001 1 -Jan-2002 1 -Jan-2003 1-Jan-2004 1-Jan-2005 1-Jan-2006 1-Jan-2007 1-Jan-2008 1-Jan-2009 1 -Jan-2010 1 -Jan-2011 1 -Jan-2012 1 -Jan-2013 1 -Jan-2014 1 -Jan-2015 1 -Jan-2016 Level Change
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Why interest rate risk matters?
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