FIN 4620
Chapter 8 - Interest Rate Risk I
In-Class Exercises
Row
C
GAP
in Rates
in NII
in Int Rev
in Int Exp
1
Positive
>
2
Positive
>
3
Negative
<
4
Negative
<
1.
If interest rates decrease 50 basis points (.5%, or .005) for an FI that has a gap
of $
Duration for the FI Balance Sheet
Consider a simplified FI balance sheet
Assets
Liabilities & Equity
(Assets
millions):
$100 Liabilities
Equity
Total Assets
$90
$10
$100 Total Liabilities & Equity
1
$100
Duration for the FI Balance Sheet
Given that:
E = A
Chapter 09 - Interest Rate Risk II
Chapter Nine
Interest Rate Risk II
Solutions for End-of-Chapter Questions and Problems
1. What is the difference between book value accounting and market value accounting? How do
interest rate changes affect the value of
PERSONAL FINANCE
Earliest types of trade
Bartering
Economics of all cultures are based on
Trade
Historians believe that the Chinese developed the first
Metal currency
Gross Income
Total income before any deductions are taken
Net Income
Take-home pay
Volun
Duration Insurance Co. Example
Well use insurance companies to illustrate
interest rate risk.
Policy calls for the payment of a lump sum at
the policyholders retirement.
The value of the account must be sufficient the
make the payment.
Suppose it is 2010;
Duration Model
Advantages of Duration Modeling:
Unlike the Maturity Model, the Duration Model
considers the following conditions:
Degree of leverage.
Maturity distributions (short, intermediate, long).
Timing of cash flows and TVM.
Like the Maturity Model
FIN 4620 - Case Study
Spring 2012
You may submit the case on an interim basis on the dates indicated on the syllabus. It will
be graded as you proceed. The grade will not be adjusted for any previously graded work,
but will assist with work not yet submit
FIN 4620
Exam 1 Handout
CGAP = RSA RSL
NIIi = (RSAi - RSLi)(ri) = (GAPi)(ri)
NII = (RSA RRSA ) - (RSL RRSL )
NII = (CGAPplanning period)(R)
CGAP/Assets
Row
C
GAP
in Rates
in NII
in Int Rev
in Int Exp
1
Positive
>
2
Positive
>
3
Negative
<
4
Negative
Disintermediation
Disintermediation exists in all industries and cuts out
the middleman:
Internet Retailers
Amazon Bookstores
Netflix Video Stores
Wikipedia Encyclopedias
Craigslist The Classified Ads
In banks, the disintermediation of bank deposits was
m
DIs Balance Sheet
Banks offer products on both sides of the balance
sheet.
Loans are assets.
Deposits are liabilities.
Assets
Liabilities and Equity
Loans
Other
Deposits
Other
This unique combination creates risk.
1
DIs Balance Sheet
In the simplest form,
Comparison - Coupon Rate
Duration is impacted by the coupon rate.
Bonds with high coupon rates have lower
durations.
Below, holding the yield constant, duration
increases from 1.883 years to 1.909 years
with a 2% decrease in the coupon rate.
Yield:
12.0%
What is Duration?
Duration is the weighted-average time to maturity
on the loan using the relative present values of
the cash flows as weights.
It is the point at which the present value of the
cash flows is evenly distributed.
Cash flow received before t
Commercial Banks
The largest category of DIs is commercial banks.
1
FDIC Graph Book
Commercial Banks
Commercial banks have the most diversified balance
sheet, with the asset mix dependent on bank size.
2
Types of Commercial Banks
Community
Regional / Supe
1
Chapter 9
Interest Rate Risk
II
Prepared by Patty Robertson
May not be used without permission
Interest Rate Risk Part II
2
In the second chapter on interest rate risk, we
look at:
The difference between book value and market
value.
The principles of bo
Valuing A Bond
In order to value (price) a bond today, we need the
following information:
Face Value
Coupon Rate
Number of periods remaining until maturity
The % of face paid out annually.
Not necessarily years!
Market Rate
For bonds with similar risk and
FIN 4620
Duration Illustrative
You are considering buying one of two bonds. You are choosing between a 7% coupon bond and a 14%
coupon bond. Both pay annual coupons, have seven year maturities, offer 8% yields, and have a face
value of $100,000. Which bon
Financial Services Industry
Intermediary Role of FIs
When corporations raise capital, they sell securities.
In the absence of FIs, households (net savers) could
hold cash or invest in securities of corporations (net
borrowers).
Households
(netsavers)
Equi
Wall Street Journal
FRONT PAGE
AUGUST 5, 2011
New Fee to Bank Cash by Liz Rappaport
Bank of New York Mellon Corp. on Thursday took the extraordinary step of telling large clients it will charge them to hold
cash.
Bank of New York Mellon is preparing to ch
Market Risk
FIs are large holders
of financial assets.
Market risk is related
to the uncertainty of
earnings from
changes in market
conditions (asset
prices, interest rate
risk, and foreign
exchange risk).
This risk applies to
the FIs trading
portfolio, r
Wall Street Journal
MUTUAL FUNDS
AUGUST 19, 2011
Low Rates Hit Money-Market Funds by Mary Pilon and Randall Smith
Money-market mutual funds, those havens of safety for investors during tumultuous times, are facing their own pressures
as interest rates con
Wall Street Journal
2011
HEARD ON THE STREET
OCTOBER 1,
Lost Decade Looms Over Insurers by Hester Plumridge
The latest fear for insurers? Turning Japanese.
Roughly a decade ago, a number of Japan's life insurers failed, weakened by persistently low intere
Wall Street Journal
MONEY AND INVESTING
AUGUST 22, 2011
Living In A Low-Rate World by Matt Phillips
Borrowers Benefit, Savers Suffer as Interest Rates Fall; Mixed Blessing For
Firms
Federal Reserve Chairman Ben Bernanke has put the financial world on noti
Interest Rate Sensitivity
Taking the derivative of the bonds price with
respect to the YTM (a complex manipulation
of the bond valuation formula):
[P/P]
% change in price
change in yield Measure of=
[R/(1+R)]
interest-D
%
elasticity to a small
change in
Interest Rate Risk
r = RR + IP + DP + MP + LP + EP + TP
Even risk-free bonds (Treasuries) have risk.
Bondholders are subject to interest rate risk since the value of
their investment changes as interest rates change.
All things being equal, the interest r
Wall Street Journal
OPTIONS FOR SAVERS
JUNE 3, 2011
In Stashing Cash, Look Ahead by Karen Damato
When interest rates eventually rise, today's low-risk alternatives won't all fare the same
The returns on low-risk savings these days range from just about zi