Recap 03B -- Interest-Rate and Liquidity Risk

Recap 03B -- Interest-Rate and Liquidity Risk - FINS 5550...

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FINS 5550 / FINS 3650 — International Banking Topic 3B Recap Maturity Transformation and Interest-Rate Risk Banks make money through maturity, liquidity, and credit transformation. To make money by engaging in maturity transformation, a bank necessarily takes on interest-rate risk. Interest-Rate Essentials Using concepts explored last week, we start by looking at the dynamics of interest- rate risk, and how a bank could minimise interest-rate risk. But even as we explore how a bank COULD hedge its interest-rate risk, we appreciate that the typical bank DOESN’T hedge its interest-rate risk. Yield-Curve Risk The yield curve — a snapshot of equilibrium in the risk-free interest rate across all maturities — is positively sloped yield most of the time. According to Oldrich Vasicek’s term structure of interest rates hypothesis, a positively sloped yield curve indicates that the market believes that rates will rise. In fact, though, even when investors believe that rates are likely to remain the same, the yield curve tends to stay positively sloped, which is why positively sloped is commonly referred to as “normal”. Instead, higher rates on longer-dated bonds is a function of higher volatility and the possibility of mark-to-market losses or losses due to forced sales. Long-term investors stand to benefit from both the higher yield payable on longer-dated bonds, and the gains from “rolling down the yield curve”. The higher implied forward rate of Vasicek’s hypothesis is really a measure of how much this benefit is worth, and arises from the non-arbitrage condition rather than any expectations as to future rates. A bank can minimise its yield-curve risk by match-funding, which means that the bank raises debt with the exact maturity profile as its assets. However, match-funding not only eliminates interest-rate risk, it also eliminates the benefit of maturity transformation. Which is why banks DON’T match-fund. Alternatively, banks can offset their interest-rate risk by hedging in the derivatives markets. In general, banks are most likely to do so using interest-rate futures. Some textbooks suggest that banks hedge by purchasing forward-rate agreements , or FRAs . [What’s a FRA? S earch for “bionicturtledotcom FRA site:www.youtube.com” for a useful explanation of how FRAs are settled.] However, purchasing FRAs is like being on the wrong side of the yield-curve trade. Which is why banks would rather SELL FRAs than buy FRAs. Fixed vs. Floating In theory, a bank could eliminate its interest-rate risk by originating its entire balance sheet as floating-rate assets and liabilities. Alternatively, to the extent the bank originates fixed-rate assets or liabilities, it could swap them back to floating using interest- rate swaps. [Once again, check out bionicturtledotcom’s explanation of how interest-rate
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Topic 3B Recap FINS XX50 — International Banking 2 risk swaps are settled.] But if a bank earns only the credit spread, it leaves money on the table, in the form of the interest-rate risk reflected in the swap curve.
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