Interest Rate Risk - • make loan interest rates variable...

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Interest Rate Risk Interest rate risk is the riskiness of earnings and returns that is associated with changes in interest rates. rate-sensitive interest rates change at least once a year fixed-rate interest rates remain unchanged for over a year Suppose interest rates rise by 10%. Income on assets rises by $2m while payments on liabilities go up by $5m. Therefore, bank profits decline by $3m. If a bank has more rate-sensitive liabilities than assets, a rise in interest rates causes profits to fall while if interest rates decline, profits rise. measuring the sensitivity of profits to changes in interest rates gap analysis (rate-sensitive assets - rate-sensitive liabilities)(change in the interest rate) duration analysis % change in the market value of a security = - (% point change in interest rate)(duration in years) Managing Interest Rate Risk altering composition of portfolio to alter durations
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Unformatted text preview: • make loan interest rates variable • interest rate swaps - a bank with more risk-sensitive assets trades payment streams with a bank with more risk-sensitive liabilities Suppose the 1st NB wants to convert $30m of fixed-rate assets into $30m of rate-sensitive assets while the 2nd NB has $30m of rate-sensitive assets it wants to make fixed-rate. The 1st NB could pay the 2nd NB the interest earned on the $30m of fixed-rate assets while the 2nd NB could pay the 1st NB the interest earned on the $30m of rate-sensitive assets. Off-balance sheet Activities Off-balance sheet activities consist of trading financial instruments and generating income from fees and loan sales, all of which affect bank profits but are not visible on balance sheets. These activities expose banks to additional risk....
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