FINS 5550 / FINS 3650 — International Banking
Topic 3B Recap
Maturity Transformation and Interest-Rate Risk
Banks make money through maturity, liquidity, and credit transformation.
money by engaging in maturity transformation, a bank necessarily takes on interest-rate
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.
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
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
In general, banks are most likely to do so using interest-rate futures.
textbooks suggest that banks hedge by purchasing
[What’s a FRA?
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
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-
[Once again, check out bionicturtledotcom’s explanation of how interest-rate