Managing Interest Rate Risk Module -5 Session No.

13 to 20

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Interest rate risk management

.and bank profitability .and measure of risk the behavior of interest rates

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Bank profitability

Net interest income

Net interest margin

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.and Measures of risk

Assets liability sensibility Sensitivity mismatch The sensitivity gap

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.behavior of interest rates

Interest rate risk is the risk that banks earnings will be aversely influenced by unanticipated changes in interest rates. Interest rate risk depends on

The degree to which bank assets and liabilities are interest rate sensitive

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ALM approach for Interest Rate Risk Management

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ALM approach

Bank create assets and liabilities of different maturities and sizes Priced differently NII Re-pricing concept- Assets and liabilities falls due for re-pricing on different dates Banks assets and liabilities are seldom matched by size and maturity- mismatch or gap Cause interest rate risk - explain with example

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Concept of RSA and RSL

Any investment, loan, deposit, liability, assets that matures during the bucket period ( any principal payment expected during the bucket period) Floating rate deposit or advances- if the change is expected in the base rate during the bucket period since change in base rate will lead to re-pricing

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Measure Interest rate risk Three approaches

GAP analysis Earning at risk approach Risk adjusted GAP approach Duration GAP analysis

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Measure Interest rate risk GAP approach

Identify RSA and RSL Under stand positive gap or negative gap Gap can be expressed in three ways

Negative or positive (absolute figures) Ratio of gap to RSA Ratio of RSA and RSL

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Case study ALM

Assets /Liabilities 1- 28 days 29 days to 3 months > 3 months to 6 months > 6 months to 1 year More than one year Nonsensitive Total

Cash

20

20

Balance with RBI (CRL)

100

100

Inter bank deposit

20

20

Investments

180

100

80

100

500

960

Loan and advances

1200

300

320

400

600

2820

Premises, stationery etc. TOTAL 1400 400 400 500 1100

600 720

600 4520

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Case study ALM

Current deposit 20 30 50

Saving deposit

180

370

550

Term deposit

100

100

150

50

500

900

Certificate of deposit

100

50

50

200

Borrowings

920

250

450

200

200

2020

Other liabilities

100

100

Net worth TOTAL Gap Cumulative gap 1320 80 80 400 0 80 650 -250 -170 250 250 80 1100 0 80

700 800 -80 0

700 4520 0 0

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ALM approach- Gap analysis

Gap Positive Positive Negative Negative
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Interest rate change Increase Decrease Increase Decrease

Impact on NII Positive Negative Negative Positive

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Measure Interest rate risk GAP Ratio

Bank A Total assets RSA RSL 1000 40 20 Bank B 1000 400 200

GAP
GAP Ratio (RSA/RSL) NII Decrease in interest rate Change in NII ( GAP X Change in interest rate)
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20
2 200 2% -0.4

200
2 400 2% -4

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Gap analysis- Merit

Commonly

used Easy to understand Risk sensitive assets and liabilities can be identified and GAP easily calculated
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Gap analysis- Weakness

Assumption that all position matures or re priced simultaneously Ignore basis risk serious measurement error Ignore time value of money cash flow arise at the beginning of the bucket or at the end of the bucket period Rate sensitive liability that bear no interest are ignored but in practice when interest move up customer may move no interest deposit to interest earning deposits

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Gap analysis- Weakness

Option embedded assets and liabilities premature discounting of deposits and prepaying of loans- They alter the GAP and also the NII Do not capture non interest revenue and interest due to interest rate fluctuations

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Basis risk- Case study

Liabilities Amount Interest change (%) Assets Amount Interest change (%) 30 120 .10 .25

Inter bank deposit Borrowings

50 100 50

.01 Investments .50 Loans .10 Gap (-)

50

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Measuring interest rate risk Earning at Risk Approach

Project interest rate movement assuming various interest rate environments Assess the likelihood that assets and liabilities would be re-priced under each of identified environment Calculate NII in each environment and allow management to set limit for NIM in each environment Test earning at risk (EAR)

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Measuring interest rate risk Rate adjusted GAP

Used when assets and liabilities are not dramatically change in the short term Assess the GAP for all item of balance sheet Calculate EVF (Earning volatility factor) Calculate Income statement GAP Calculate impact on NII

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Measuring interest rate risk Rate adjusted GAP

Base rate fall by 100bps Balance sheet Demand liabilities Time liabilities Total RSL 400 400 800 EVF (assumed) 75% 85% Income statement GAP 300 340 640

Loans
Investments Other assets Total RSA

400
200 100 700

100%
75% 95%

400
150 95 645

GAP
Total assets GAP as % of total assets
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-100
1000 10

5
1000 0.5
21 -0.05

Duration GAP analysis

Measure of long term interest rate risk Focus on entire life of assets and liabilities Duration is average life of an asset or liability and is measured as weighted average time to maturity using present value of cash flow relative to total present value of assets or liability as weight

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Duration GAP analysis

Calculate duration of various RSA and RSL Calculate weighted average duration of liabilities Calculate weighted average duration of assets Calculate duration GAP(DGAP) Calculate expected NII Forecast changes in banks MVE under various interest rate environments

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Duration GAP analysis

Interest rate risk can be understood from mismatch between duration of assets and liabilities and also by duration GAP Change in interest rate would impact market value of assets and liabilities with different amount. This would impact NII and MVE

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Revisit the concepts for ALM Interest rate risk

Mismatch or Gap risk Basis risk Embedded option risk Reinvestment risk Price risk- Investments Non paying liabilities

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Interest Rate Risk Management Key take away

Bank need to forecast interest rate movement Aggressive strategy is to keep the gap position open where it is profitable or To keep the gap ZERO ( with some tolerance level) so that NII is protected DO behavioral analysis of customers to safeguard against embedded option risk Know impact on MVE through duration gap analysis for long term perspective
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Alternate approach to Interest Rate Risk Management

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Financial derivatives

Contingent contracts Underlying assets like currency, stock indices, interest rate instruments, commodities etc. Pricing and trading is complex and prone to high risk Shift the risk from seller to buyer Improve the liquidity of underlying instruments Hedger use derivatives to protect their assets from erosion in value due to market volatility
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Interest rate derivatives (IRD)

Used to hedge the position that expose them to risk
Negative or positive gap

Tool to actively manage interest rate risk

Complement existing strategies to immunizing the volatility of earnings and MVE to changes in interest rates

Used to lower credit risk and add liquidity also Will discuss some widely used concepts

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Interest rate swaps (IRS)

Instrument to manage interest rate risk An OTC contract An agreement to exchange fixed interest to floating or floating to fix for a period ( start date and end date) May also have BASIS swaps pay MIBOR and receive LIBOR pricing of swap is dependent on forecasting interest rates Credit risk in swap management is limited to interest payment
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Swap deals
Firm A Fixed rate 12% Floating Rate PLR+2%

10%

PLR+0.5%

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Swap deals
A Firm Pay to PLR + 2% lender Receive PLR from B from other Pay to other 9.75% from A Net effect
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B Firm 10%

9.75% to A
PLR from A PLR+ 0.25% floating
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11.75% fixed

Advantage of swap to B
Asset liability is matched Cost is reduced in floating market Eliminate interest rate risk It constituted a off balance sheet transaction

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Advantage of swap to A
Asset liability is matched Lower cost from fixed rate market Capacity to borrow from fixed rate market remain intact It constituted a off balance sheet transaction

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Interest rate swaps

In practice it is not possible to find two parties with opposite need hence intermediaries are engaged Intermediary share the profits also Major swap market players are banks, intermediaries and corporate Swap tenor are normally independent to loan tenor

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Interest rate swaps (IRS)

Bank can use IRS for Adjusting rate sensitivity of assets and liability Creating synthetic transaction and securities Adjusting GAP or duration GAP Liability sensitive bank can enter into swap where it pays fixed rate and receive floating rate Asset sensitive bank can enter into swap agreement where it pay floating rate and received fixed rate
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Interest rate future

Legal agreement to buy or sell something at predetermined price on predetermined time

Future price Future settlement or delivery date

Future contracts are traded in recognized exchanges which assumes responsibility of settlement When underlying security is interest bearing security it is known as interest rate future say 90 days treasury bills Transfer interest rate risk from hedger to speculator

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Interest rate future

Asset Sensitive
Buy interest rate future if it expects interest rates to fall Sell interest rate future if it expects interest rates to rise

Gap

Interest rate change Increase Decrease Increase Decrease

Impact on NII Positive Negative Negative Positive

Positive Positive Negative Negative

Liability sensitive
Sell interest rate future if it expects interest rates to fall Buy interest rate future if it expects interest rates to rise

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Interest rate future- issues

Contract size and maturities are standardized hence it may be difficult to find matching hedge Monitoring of position on daily basis is essential as settlement takes place every day by mark to market method

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Forward rate agreement (FRA)

An OTC contract Resemble a swap agreement but difference is that it is single settlement vs series of settlement Agreement to settle interest rate differentials Typical forward contract Notional principal amount and no commitment to borrow or lend by parties Buyer to pay fixed and receive floating Seller to pay floating and receive fixed Cash settlement is done if actual rate of interest differ to forecasted rates Bank use FRA to lock in fixed interest rate expenses ( deposits) to floating rate deposits or fixed interest rate advances to floating rate advances

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Fixed Income securities

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Fixed income securities

Equity and Bonds are two major capital market instruments Bonds fall under fixed income securities Example 9.25% GOI securities 2015 Generate fixed coupon income till maturity Not changed despite change in interest rates

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Bond price-Sensitivity
Inflation GDP growth Liquidity in market Interest rates Fiscal policies Unemployment Money supply

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Bond Valuation

Interest rate for residual term of maturity keep changing Value of bonds rests on movement of interest rates When market rate and coupon rate are same, bonds trade at par When market rate rises over coupon rate, bonds trade at discount and When market rate falls over coupon rate bonds trade at premium
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Bond theorems
Price of bond is inversely relates to the yield Increase in price of bond when interest rate goes down by certain % is greater than decrease in its price when interest rates goes up by the same %- This is called convexity

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Bonds theorems
Longer the term to maturity of a bond higher will be its price sensitivity Between two bonds of same maturity but different coupons, the bond will lower coupon will experience more price sensitivity than with higher coupon

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Duration
Reinvestment of coupons also generate income Two opposite effects: Fall in price of bonds due to rise in interest rates and extra income generated due to reinvestments of coupon may get neutralize during life of security Measured through weighted average life of a fixed income security It is also a measure of price sensitivity measure of a bond to changes in interest rates

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Modified duration
Duration does not accurately changes in price of bonds arising from larger changes in interest rates Hence modified duration = Duration/ 1+ yield

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Banks investments portfolio

Classified into three category

Held till maturity ( up to 25% of banks total investments) Held for trading ( acquired with intention to sale) Available for sale ( which do not fall under above category) HFT security are to be sold within 90 days

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Banks investments portfolio Valuation method

Held till maturity

Need not be marked to market but banks investment in subsidiary or joint ventures when diminished has to be provided for

Held for trading

Marked to market with monthly or more frequent intervals

Available for sale

Marked to market with quarterly or more frequent intervals

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Investment reserves
Provision for depreciation in AFS and HFT in excess of required amount in any year should be credit to P & L account and same amount transferred to Reserve & Surplus Included in Tier 2 capital of the bank Investment fluctuations reserves @ minimum 5% of investment portfolio ( only HFT and AFS)

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Mark to market procedure

Quoted securities as per latest quotes in stock exchange, prices declared by FIMMDA or RBI Unquoted

Price or YTM published by FIMMDA Sate government securities based on YTM and marked 25 bps above the yield of central government securities

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