7Lecture8interestrateriskIV

7Lecture8interestrateriskIV - Financial Institutions...

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1 Financial Institution’s Interest Rate Risk Macro-Interest Rate Risk Funding Gap Duration Gap Hedging Strategies
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2 1.Causes of Interest Rate Risk Maturity mismatch between Assets & Liabilities Repricing mismatch between Assets &Liabilities Increasing Volatility in interest rate Resetting interest rates Ex 2-year fixed rate Loan Reset in 2 years Ex 2-year variable rate Loan Can be reset every 3-month
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3 Refinance Position Bank Loans 1-year at 6% 50 2-year at 7% 50 Deposits 1-year at 4% 100 Repriced in 1-year Repriced in 1 year ST Financing LT Investment Refinance Position Repriced in 2 years Borrow Short Term and Lend Long Term
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4 1 year later Bank Loans 2-year at 7% 50 Deposits 1-year at r? 50 Interest Rate Risk? If rates remain the same Same Margin If rates fall Margin increases If rates rise Margin falls
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5 Re-investment Position Bank Loans 1-year at 6% 50 2-year at 7% 50 Deposits 2-year at 5% 100 LT Financing ST Investment Re-investment Position
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6 1 year Later Bank Loans 1-year at r ? 50 2-year at 7% 50 Deposits 2-year at 5% 100 Interest Rate Risk? If rates remain the same Same Margin If rates fall Margin falls If rates increase Margin Increases
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7 Which position? Take Refinance Position Riding the Yield Curve borrow Lend Max Profit But Interest rate risk Increases especially lose if rates go up
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8 2.Funding Gap /Repricing Gap/ Gap Method or Interest rate Gap Group assets/liabilities into different time intervals based on repricing dates ~ Repricing buckets (or bins) Define Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) as a security that will be repriced in one year or less Define Fixed Rate Assets (FRA) and Fixed Rate Liabilities (FRL) as a security that will be repriced more than one year Which one you need to evaluate the interest rate risk?
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9 Example B/S 1-year Loan $50 DD $40 2-year Loan 25 Savings 30 3-mo T-bills 65 3-mo CD 40 3-yr T-bonds 70 6-mo CP 80 10-yrFx-r Mtg 20 1-yr TDep 20 30-yr V-r Mtg 40 2-yr TD 40 Equity 20 Repriced every 6-month
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10 RSA = RSL =
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11 Period Gap i = RSA i -RSL i i =1-day, 3-day…. = dollar size of gap between book value of assets and liabilities in maturity bucket i Cumulative Gap = i Period Gap i
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12 Value rate sensitivity on Net Interest Income (Rate sensitivity means time to repricing) Δ NII i = Gap i x Δ r i i =1-day,3-day …. If Gap>0 Asset Sensitive Position ( RSA>RSL ) If rates increase ► NII If rates decrease ► NII If Gap<0 Liability Sensitive Position ( RSA<RSL ) If rates increase ► NII If rates descrease ► NII Higher gap ► Higher the insterest rate risk
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13 Applying the Repricing Model NII i = (GAP i ) R i = (RSA i - RSL i ) r i Example: In the 3-month bucket, gap is…… If rates rise by 1%, NII i =
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14 If we consider the cumulative 1-year gap, CGAP= $15 mln NII i = (CGAP i ) r i = T ≤ 3-month 3-month < T ≤ 6-month 6-month< T≤1-year
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15 CGAP Ratio May be useful to express CGAP in ratio form as, CGAP/Assets.
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