UNSW Business School

FINS3630
Lecture 04

Interest Rate Risk I & II

(Chapter 8 & Chapter 9)
 Topics for discussion
We will discuss
Factors that affect the level and movement in interest rate
The Repricing model
Equal change in interest rates.
Unequal change in interest rates
And Introduce the Duration model

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The Level and Movement of Interest Rates
While many factors influence the level and movement of interest rates, it is the central banks
monetary policy strategy that most directly underlies the level and movement of interest rates.

The central bank through daily open market operations, such as buying and selling treasury
bonds and treasury bills, seeks to influence the money supply, inflation and the level of interest
rates.

Central banks actions are targeted mostly at short-term rates

Changes in short-term rates usually feed through to the whole term structure of interest rates.

The increased financial market integration over the last decade has also affected interest rates.

Financial market integration increases the speed with which interest rate changes and associated
volatility are transmitted among countries, making the control of interest rates by the central
bank more difficult and less certain than before.

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U.S. 91-Day T-Bill rate
The level and volatility of interest rates and increase in worldwide financial
market integration make the measurement and management of interest rate
risk one of the key issues facing FI managers.

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Australian 2-year Government Bond Yields

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Interest Rate Risk of FIs
Asset transformation naturally results in mismatch in asset & liability maturities.
If interest rate is constant over time and deposits can be rolled over at the same rate,
this is no risk to the bank.
The interest spread is locked in
However, when interest rate changes over time, the bank is exposed to interest rate
risk.
Net interest income (NII) is affected
-Measured by the Repricing Model
Net worth (market value of equity) is affected.
-Measured by the Duration Model

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Repricing Model
Repricing gap is the difference between
assets whose interest rates will be repriced or changed over some future period (Rate-Sensitive
Assets) and
liabilities whose interest rates will be repriced or changed over some future period (Rate Sensitive
Liabilities).
Any discussion of RSA and RSL is relative to the planning horizon
Rate-Sensitive Assets -Examples
Short-term loans, T-Notes (of various maturities), Floating-rate long-term loans.
The question to ask is: Will or can this asset have its interest rate changed within the planning horizon?
Yes? Rate-sensitive.
No? Not rate-sensitive.
For assets with maturity shorter than the planning horizon, what matters is the reinvestment rate
which should change with the market interest rate when reinvesting.

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Repricing Model (Cont.)
Rate-Sensitive Liabilities-Examples
Term deposits (of various maturities), All roll-over credits, such as
Bankers acceptances, certificates of deposits (CDs), commercial
papers
The question to ask is: Will or can this liability have its interest rate changed
within the planning horizon?
-Yes? Rate-sensitive.
-No? Not rate-sensitive.
For liabilities with maturity shorter than the planning horizon, what matters is the
refinance rate which should change with the market interest rate when
refinancing.

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Repricing Model (Cont.)
Repricing gap provides a measure of an FIs net interest income exposure to
interest rate changes in different maturity buckets.
Repricing can be the result of

A rollover of an asset or liability, e.g. a loan is paid off at or prior to maturity and
the funds are used to issue a new loan at current market rates or
It can occur because the asset or liability is a variable-rate instrument, e.g. a
variable rate mortgage whose interest rate is reset every quarter based on
movements in a prime rate.

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Repricing Model (Cont.)
Repricing model assumes:
equal changes in interest rates on RSAs and RSLs:

=( ) =
is the change in net interest income in maturity bucket
is the change in the level of interest rates impacting assets and liabilities in the
bucket
is called the repricing gap in maturity bucket .
A negative repricing gap ( < ) exposes the bank to refinancing risk in that a
rise in interest rates would lower the FIs NII.
Refinancing risk the risk that the cost of rolling over or reborrowing funds will rise above the returns
being earned on asset investments

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Repricing Model (Cont.)
A positive repricing gap ( > ) exposes the bank to reinvestment risk
in that a drop in interest rates would lower the FIs NII
reinvestment risk is the risk that the returns on funds to be reinvested will fall
below the cost of the funds.
FI can restructure assets and liabilities, on- or off- the balance sheet, to
benefit from projected interest rate changes
When projecting an increase in interest rates, maintaining a positive repricing
gap will increase net interest income.
When projecting a decrease in interest rates, maintaining a negative repricing
gap will increase net interest income

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Identify RSAs and RSLs over an One-Year Interval

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Identify RSAs and RSLs over an One-Year Interval (cont.)
Rate Sensitive Assets:
Short-term consumer loans ($50).
If repriced at year-end, would just make one-year cutoff.
Three-month T-bills repriced on maturity every 3 months ($30)
Six-month T-notes repriced on maturity every 6 months ($30)
-30-year floating-rate mortgages repriced (rate reset) every 9 months ($40)
Rate Sensitive Liabilities
Three-month CDs ($40)
Three-month bankers acceptances ($20)
Six-month commercial papers ($60)
One-year time deposits ($20)

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Identify RSAs and RSLs over an One-Year Interval (cont.)
Demand deposits and passbook savings accounts are generally
considered to be rate-insensitive (act as core deposits).
The explicit interest rate on demand deposits is zero by regulation.
Further, although explicit interest is paid on transaction accounts such as NOW
accounts, the rates paid by FI do not fluctuate directly with changes in the
general level of interest rates.

However, there are arguments for their inclusion as rate-sensitive

liabilities.
When interest rates rise, individuals may draw down their demand deposits or
savings account and move the money to alternative instruments paying a higher
interests, forcing the bank to replace them with more expensive fund
substitutions.

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Cumulative Gap
If a bank keeps track of repricing gaps for several consecutive repricing
intervals, the repricing gap over a broader repricing interval can be calculated
by summing over the repricing gaps over the narrower intervals contained by
the broader interval.
The sum of the repricing gaps is called the cumulative gap.

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Using the Repricing Model
Identify assets and liabilities that will be repriced over a certain time horizon (or
maturity bucket).
Suppose interest rate is expected to rise by 1% over the next 3 months, what is
the expected annualized change in the banks net interest income over the
next 3 months?
=$20
=$20 1%=$200,000

The repricing model calculates the annualized change in an FIs net interest
income with interest rate quoted on per annum basis
The formula assumes that both RSA and RSL are repriced at the beginning of the
repricing interval

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Repricing Gap (cont.) !
Often FIs express interest rate sensitivity as a percentage of assets,
""#$"
Expressing the repricing gap this way is useful since it tells us
(1) the direction of the interest rate exposure (Positive or negative CGAP)
(2) the scale of that exposure.

Alternatively, FIs calculate a gap ratio defined as rate-sensitive assets divided by rate-
%&
sensitive liabilities,
%&'
A gap ratio below 1 indicates that the FI is exposed to a refinancing risk. FI is set to
see increase in net interest income when interest rates decrease.
A gap ratio greater than 1 indicates that the FI is exposed to a reinvestment risk. FI is
set to see increase in net interest income when interest rates increase.

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Equal Changes in Rates on RSAs and RSLs
= =)
The larger the absolute value of CGAP, the larger the expected change in NII.
In general, when CGAP is positive, the change in NII is positively related to the change
in interest rates.
FI would want its CGAP to be positive when interest rates are expected to rise
FI would want its CGAP to be negative when interest rates are expected to fall

This relationship is known as CGAP effects.

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Unequal Changes in Rates on RSAs and RSLs
If changes in rates on RSAs and RSLs are not equal, the NII effect should be calculated as

=
There is a spread effect in addition to the GAP effect.
If the spread between the rate on RSAs and RSLs increases, when interest rates rise
(fall), interest revenue increases (decreases) by more (less) than interest expense.
The result is an increase in NII.
Conversely, if the spread between the rates on RSAs and RSLs decreases, when
interest rates rise (fall), interest revenue increases (decreases) less (more) than
interest expense, and NII decreases.
In general, the spread effect is such that, regardless of the direction of the change in
interest rates, a positive relation occurs between changes in the spread (between
rates on RSAs and RSLs) and changes in NII.
Whenever the spread increases (decreases), NII increases (decreases).

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Various combinations of CGAP and spread changes
This table shows various combinations of CGAP and spread changes and their effect on NII

Can we accurately predict what happens to NII if CGAP is negative and interest rates increase with a
decrease in spread between RSAs and RSLs?
Can we accurately predict what happens to NII if CGAP is negative and interest rates increase with a
increase in spread between RSAs and RSLs?
When the CGAP effect and the Spread effect work in opposite directions, the change in net
interest income cannot be predicted without knowing the size of CGAP and the Change in
Spread.

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Weaknesses of the Repricing Model
It ignores market value effects of interest rate changes.
The present values of cash flows on assets and liabilities change in addition to
the immediate interest received and paid on them, as interest rates change.
The repricing model ignores the market value effect implicitly assuming a book
value accounting approach.
As such, the repricing gap is only a partial measure of the true interest rate risk
exposure of an FI.
It ignores information regarding the distribution of assets and liabilities
within each maturity bucket.
Assets and liabilities may be repriced at different time within the bucket.
The shorter the range over which bucket gaps are calculated, the smaller this
problem is.

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The Overaggregation Problem
Although regulators require the reporting of repricing gaps over only
relatively wide maturity bucket ranges, FI managers could set in place
internal information systems to report the daily future patterns of such
gaps.

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Weaknesses of the Repricing Model
It ignores runoff cash flows.
Periodic cash flow of interest and principal amortization payments on long-term assets,
such as conventional mortgages, that can be reinvested at market rates
In the simple repricing model weve discussed so far, rate sensitive assets and
liabilities are defined by the original maturities of these instruments.
In reality, FIs continuously originates and retires assets as it creates new liabilities.
For example, today, some 30-year original maturity mortgages may have only 1
year left before they mature.
In addition, even if an asset or liability is rate insensitive, virtually all assets and
liabilities pay some principals and/or interest back to the FI in any given year.
As a result, the FI receives a runoff cash flow from its rate-insensitive portfolio that
can be reinvested at current market rates.
That is runoff cash flow component of a rate-insensitive asset or liability is itself
rate sensitive.

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Weaknesses of the Repricing Model
The FI manager can deal easily with this runoff cash flows in the repricing
model by identifying for each asset or liability item the estimated dollar
cash flow that will run off within the next repricing interval and adding
these amounts to the value of rate sensitive assets and liabilities.

It ignores cash flows from Off-Balance-Sheet Activities

The RSAs and RSLs used in repricing model generally include only the
assets and liabilities listed on the balance sheet.
Changes in interest rates will affect the cash flows on many off-balance-
sheet instruments as well.
For example, an FI might have hedged its interest rate risk with an interest
futures contract.
The mark-to-market process could produce a daily cash flow for the FI that
may offset any on-balance-sheet gap exposure.

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Duration Model
Change in interest rate leads to changes in market value of assets and
liabilities and thus the net worth of a FI.
Net worth is the difference between the market value of assets and
liabilities.
This is different from book values of assets and liabilities used in accounting.
The appropriate measure of the market value effect of interest rate
changes is duration
Essential ideas
Change in security values due to change in interest rates
Any sensible risk measurement should measure the sensitivity of
market value to the change in interest rate

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Duration Formulae
Duration formulae (annual interest payments):
Where:

N = the last period in which the cash flow is received (i.e., time to maturity)
CFt = cash flow received on the security at the end of period t
DFt = the discount factor = 1/(1+R)t
PV(CFt) = CFt * DFt = the present value of CFt

Duration formulae (semi-annual interest payments):

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Duration Interpretation
Economic meaning: the sensitivity of market value to small changes in interest rate
(Interest elasticity)
The interpretation of duration based on its formulae
the average life (or economic life) of securities (or assets / liabilities): modified time to
maturity concept
the weighted-average time to maturity of all cash flows for a security
weighting rules: using the relative (present) values of each cash flow
Hence duration takes into account of the following factors
An asset or liabilitys maturity
The amount of all cash flows
The timing of all cash flows

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Calculating Duration: Typical Bonds
Consider a bond with a principal value of $1000 and 3 years to
maturity. The bond pays coupons annually and the coupon rate is
10% p.a.. The current interest rate is 8% p.a.
What is the securitys duration?

t CFt DFt CFtDFt CFtDFtt

1 $100 0.9259 $92.59 $92.59
2 $100 0.8573 $85.73 $171.46
3 $1100 0.7938 $873.18 $2619.54
= $1051.5 = $2883.59

D = 2883.59 / 1051.5= 2.74 years

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Calculating Duration: Annuity I
Consider a security with annual cash flows of $1000 and a time to
maturity of three years. The current interest rate is 8% p.a.
What is the securitys duration?

t CFt DFt CFtDFt CFtDFtt

1 $1000 0.9259 $925.9 $925.9
2 $1000 0.8573 $857.3 $1714.6
3 $1000 0.7938 $793.8 $2381.4
= $2577 = $5021.9

D = 5021.9 / 2577 = 1.95 years

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Calculating Duration: Annuity II
Consider again the security in the previous case. But now assume that
instead of paying $1000 annually, the security pays semi-annual cash
flows of $500 for three years.
Quoting tradition for semi-annual coupon payment bonds:
if the discount rate is 8% p.a., the correct discount rate to be used is
4% per half-year.
Similarly for the coupon rate quotation, if the coupon rate is X% p.a., it
means paying a semi-annual coupon rate of X%/2
How about the case of quarterly or monthly coupon payment bonds?
Would you expect the duration to be shorter or longer than that of the
Annuity I? Why?

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Calculating Duration: Annuity II (Cont.)
What is the duration in this case?
t CFt DFt CFtDFt CFtDFtt
1 $500 0.9615 $480.8 $480.4
2 $500 0.9246 $462.3 $924.6
3 $500 0.8890 $444.5 $1333.6
4 $500 0.8548 $427.4 $1709.6
5 $500 0.8219 $411 $2055
6 $500 0.7903 $395.2 $2371.2
= $2621.2 = $8874.4
R = 4% for half-year
D = 8874.4 / 2621.2 = 3.38 > 1.95 (duration of Annuity I) ???
What are units of time measurement in both cases?
3.38 half years versus 1.95 years.

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Calculating Duration: Comparing Two Annuities

For Annuity II, D = 3.38 half-years = 1.69 years < 1.95 years for Annuity I,
despite that:
Both securities have the same maturity (3 years)
Both securities have the same total cash flow ($3000)
The discount rate is 8% p.a. for both securities (in quotation
tradition). Which one actually has a higher effective interest rate
p.a.?
Can you explain why?
Please do a similar exercise for the previous typical bond case by making it a
semi-annual coupon payment bond, while all parameters are the same.
And if you are interested, try quarterly coupon payment bond also.

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