Interest Rate Risk-2

Objective
In this session ,we will comprehend the following two
variants of interest rate risk.

Basis Risk

Yield curve Risk
Basis Risk
We assume that changes in interest rates equally affect both the assets and
liabilities.
But in reality, the extent of change in interest rate on re-pricing will depend
upon the specific asset/liability subject to re-pricing.
The risk of different groups of banks assets and liabilities being based on
different interest rate basis (like MIBOR, treasury bill rates etc.)which change by
varying degrees (in response to a given change in the key interest rates in the
market )is called Basis Risk.
Changes in deposit interest typically lag behind loan rates.
The complex linkages between interest rates in different segments of the market
(Call,Repos,CDs,Interbank term money etc.) contribute to basis risk.
Whatever be the underlying reasons, bank's net interest income will be
impacted by basis risk.
Typically, in a falling interest rate scenario, it is possible that interest rates on
assets may be lowered generally while the deposits may continue at the
contacted higher interest rates.
Basis Risk
The following illustration will make the concept of
Basis risk clear.
The Bharat Bank Limited
(Interest Sensitivity Gap Position 1-30 days Bucket)

Liabilities Assets
Call Money 50 Treasury Bills 30

Repo 50 Advances 120
Deposits 100
Total 200 Total 150
Basis Risk
If interest rate rises by 1%,bank will lose 0.5crore per
year assuming that the rise in interest will be uniformly
applicable to all the items of assets and liabilities.
But in reality, interest rates on assets and liabilities do
not change in the same proportions. Let us assume the
following changes in interest rates.
1. Call money rate may go ,up by 1%
2. Repo by 0.5%
3. Deposits by 0.25%
4. Treasury bills by 1.0%
5. Advances by 0.75%

Basis Risk

The impact of changes will be as follows:
Interest on liability/Asset
Call 50 0.01 % high 0.5
Repo 50 0.005 % high 0.25
Deposits 100 0.0025 0.25
Treasury Bills 30 0.01 0.3
Advances 120 0.0075 0.9
Net impact
on NII
0.20
YIELD CURVE RISK
On account of volatility in interest rates, the yield
curve unpredictability and often substantially
changes in shape.
If the interest rates on assets and liabilities are
pegged to the bench mark rates (like treasury bills
cut-off rates ),there is the risk that the interest
spread may decrease as term spread narrows
down.
YIELD CURVE RISK
Illustration
Assume that the bank has raised a floating rate deposit which will be repriced
1% above the 91 day Treasury Bills cut-off and invested the amount in a
floating rate loan of the same re-pricing interval but at a spread of 2% above
364 Day Treasury Bills cut-off .The following table shows the Yield curve Risk
involved, as the spread between the two maturities of treasury bills
narrowed.


Period 91 Day TB 364 Day TB Term
Spread
Interest spread
between deposit
& loan.
April1999 8.75% 10.07% 1.32% 2.32%
June1999 9.24% 10.32% 1.08% 2.08%
August 1999 9.46% 10.28% 0.82% 1.82%
March2000 9.16% 9.93% 0.77% 1.77%
Feb.20002 6.25% 6.42% 0.17% 1.17%