13 to 20 interest rate risk management

5/12/2018 13 to 20 Interest Rate Risk Management - slidepdf.com

http://slidepdf.com/reader/full/13-to-20-interest-rate-risk-management 1/52

1/8/20121/8/2012 11

Managing Interest Rate RiskManaging Interest Rate RiskModuleModule --55Session No. 13 to 20Session No. 13 to 20



1/8/20121/8/2012 22

Interest rate risk management Interest rate risk management

.and bank profitability.and bank profitability

.and measure of risk.and measure of risk

the behavior of interest ratesthe behavior of interest rates



1/8/20121/8/2012 33

Bank profitabilityBank profitability

Net interest incomeNet interest income

Net interest marginNet interest margin



1/8/20121/8/2012 44

.and Measures of risk.and Measures of risk

Assets liability sensibility Assets liability sensibility

Sensitivity mismatchSensitivity mismatch

The sensitivity gapThe sensitivity gap



1/8/20121/8/2012 55

.behavior of interest rates.behavior of interest rates

Interest rate risk is the risk that banksInterest rate risk is the risk that banksearnings will be aversely influenced byearnings will be aversely influenced by

unanticipated changes in interest rates.unanticipated changes in interest rates. Interest rate risk depends onInterest rate risk depends on

The degree to which bank assets andThe degree to which bank assets andliabilities are interest rate sensitiveliabilities are interest rate sensitive



1/8/20121/8/2012 66

ALM approach ALM approachforfor

Interest Rate Risk Management Interest Rate Risk Management



1/8/20121/8/2012 77

ALM approach ALM approach

Bank create assets and liabilities of different Bank create assets and liabilities of different maturities and sizesmaturities and sizes

Priced differentlyPriced differently NIINII

ReRe--pricing concept pricing concept-- Assets and liabilities falls Assets and liabilities fallsdue for redue for re--pricing on different datespricing on different dates

Banks assets and liabilities are seldom matchedBanks assets and liabilities are seldom matched

by size and maturityby size and maturity-- mismatch or gapmismatch or gap Cause interest rate riskCause interest rate risk -- explain with exampleexplain with example



1/8/20121/8/2012 88

Concept of RSA and RSLConcept of RSA and RSL

Any investment, loan, deposit, liability, Any investment, loan, deposit, liability,assets that matures during the bucket assets that matures during the bucket

period ( any principal payment expectedperiod ( any principal payment expectedduring the bucket period)during the bucket period)

Floating rate deposit or advancesFloating rate deposit or advances-- if theif thechange is expected in the base rate duringchange is expected in the base rate during

the bucket period since change in basethe bucket period since change in baserate will lead to rerate will lead to re--pricingpricing



1/8/20121/8/2012 99

Measure Interest rate riskMeasure Interest rate risk

Three approachesThree approaches GAP analysisGAP analysis

Earning at risk approachEarning at risk approach

Risk adjusted GAP approachRisk adjusted GAP approach Duration GAP analysisDuration GAP analysis



1/8/20121/8/2012 1010


GAP approachGAP approach Identify RSA and RSLIdentify RSA and RSL

Under stand positive gap or negative gapUnder stand positive gap or negative gap

Gap can be expressed in three waysGap can be expressed in three ways Negative or positive (absolute figures)Negative or positive (absolute figures)

Ratio of gap to RSARatio of gap to RSA

Ratio of RSA and RSLRatio of RSA and RSL



1/8/20121/8/2012 1111

Assets /Liabilities 1- 28 days29 days to 3

months

> 3 months to

6 months

> 6 months

to 1 year

More than one

year

Non-

sensitive 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. 600 600

TOTAL 1400 400 400 500 1100 720 4520

Case study ALM



1/8/20121/8/2012 1212

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 700 700

TOTAL 1320 400 650 250 1100 800 4520

Gap 80 0 -250 250 0 -80 0

Cumulative gap 80 80 -170 80 80 0 0

Case study ALM



1/8/20121/8/2012 1313

ALM approach ALM approach-- Gap analysisGap analysis

GapGap Interest rateInterest ratechangechange

Impact on NIIImpact on NII

PositivePositive IncreaseIncrease PositivePositive

PositivePositive DecreaseDecrease NegativeNegative

NegativeNegative IncreaseIncrease NegativeNegative

NegativeNegative DecreaseDecrease PositivePositive



1/8/20121/8/2012 1414


GAP RatioGAP Ratio Bank ABank A Bank BBank B

Total assetsTotal assets 10001000 10001000

RSARSA 4040 400400

RSLRSL 2020 200200

GAPGAP 2020 200200

GAP Ratio (RSA/RSL)GAP Ratio (RSA/RSL) 22 22

NIINII 200200 400400Decrease in interest rateDecrease in interest rate 2%2% 2%2%

Change in NII ( GAP X Change inChange in NII ( GAP X Change ininterest rate)interest rate)

--0.40.4 --44



1/8/20121/8/2012 1515

Gap analysisGap analysis-- Merit Merit

Commonly usedCommonly used

Easy to understandEasy to understandRisk sensitive assets andRisk sensitive assets and

liabilities can be identifiedliabilities can be identifiedand GAP easily calculatedand GAP easily calculated



1/8/20121/8/2012 1616

Gap analysisGap analysis-- WeaknessWeakness

Assumption that all position matures or re priced Assumption that all position matures or re pricedsimultaneouslysimultaneously

Ignore basis riskIgnore basis risk serious measurement errorserious measurement error

Ignore time value of moneyIgnore time value of money cash flow arise at cash flow arise at the beginning of the bucket or at the end of thethe beginning of the bucket or at the end of thebucket periodbucket period

Rate sensitive liability that bearRate sensitive liability that bear no interestno interest areare

ignored but in practice when interest move upignored but in practice when interest move upcustomer may move no interest deposit tocustomer may move no interest deposit tointerest earning depositsinterest earning deposits



1/8/20121/8/2012 1717

Gap analysisGap analysis-- WeaknessWeakness

Option embedded assets and liabilitiesOption embedded assets and liabilities --premature discounting of deposits andpremature discounting of deposits andprepaying of loansprepaying of loans-- They alter the GAPThey alter the GAPand also the NIIand also the NII

Do not capture non interest revenue andDo not capture non interest revenue andinterest due to interest rate fluctuationsinterest due to interest rate fluctuations



1/8/20121/8/2012 1818

Basis riskBasis risk-- Case studyCase study

LiabilitiesLiabilities Amount Amount Interest Interest changechange(%)(%)

Assets Assets Amount Amount Interest Interest changechange(%)(%)

Inter bankInter bank 5050 .01.01 InvestmentsInvestments 3030 .10.10

deposit deposit 100100 .50.50 LoansLoans 120120 .25.25

BorrowingsBorrowings 5050 .10.10

Gap (Gap (--)) 5050



1/8/20121/8/2012 1919

Measuring interest rate riskMeasuring interest rate risk

Earning at Risk ApproachEarning at Risk Approach Project interest rate movement assumingProject interest rate movement assuming

various interest rate environmentsvarious interest rate environments

Assess the likelihood that assets and liabilities Assess the likelihood that assets and liabilities

would be rewould be re--priced under each of identifiedpriced under each of identifiedenvironment environment

Calculate NII in each environment and allowCalculate NII in each environment and allowmanagement to set limit for NIM in eachmanagement to set limit for NIM in each

environment environment Test earning at risk (EAR)Test earning at risk (EAR)



1/8/20121/8/2012 2020

Measuring interest rate riskMeasuring interest rate risk

Rate adjusted GAPRate adjusted GAP Used when assets and liabilities are not Used when assets and liabilities are not

dramatically change in the short termdramatically change in the short term

Assess the GAP for all item of balance Assess the GAP for all item of balancesheet sheet

Calculate EVF (Earning volatility factor)Calculate EVF (Earning volatility factor)

Calculate Income statement GAPCalculate Income statement GAP Calculate impact on NIICalculate impact on NII



1/8/20121/8/2012 2121

Measuring interest rate riskMeasuring interest rate riskRate adjusted GAPRate adjusted GAP

Base rate fall by 100bpsBase rate fall by 100bps

Balance sheet Balance sheet EVFEVF

(assumed)(assumed)

Income statement Income statement GAPGAP

Demand liabilitiesDemand liabilities 400400 75%75% 300300

Time liabilitiesTime liabilities 400400 85%85% 340340

Total RSLTotal RSL 800800 640640

LoansLoans 400400 100%100% 400400

InvestmentsInvestments 200200 75%75% 150150

Other assetsOther assets 100100 95%95% 9595

Total RSATotal RSA 700700 645645GAPGAP --100100 55

Total assetsTotal assets 10001000 10001000

GAP as % of totalGAP as % of totalassetsassets

1010 0.50.5

Change in NII (GAPChange in NII (GAP**

11 --0.050.05



1/8/20121/8/2012 2222

Duration GAP analysisDuration GAP analysis

Measure of long term interest rate riskMeasure of long term interest rate risk

Focus on entire life of assets and liabilitiesFocus on entire life of assets and liabilities

Duration is average life of an asset orDuration is average life of an asset orliability and is measured as weightedliability and is measured as weightedaverage time to maturity using present average time to maturity using present value of cash flow relative to total present value of cash flow relative to total present value of assets or liability as weight value of assets or liability as weight



1/8/20121/8/2012 2323


Calculate duration of various RSA and RSLCalculate duration of various RSA and RSL

Calculate weighted average duration of liabilitiesCalculate weighted average duration of liabilities

Calculate weighted average duration of assetsCalculate weighted average duration of assets

Calculate duration GAP(DGAP)Calculate duration GAP(DGAP)

Calculate expected NIICalculate expected NII

Forecast changes in banks MVE under variousForecast changes in banks MVE under various

interest rate environmentsinterest rate environments



1/8/20121/8/2012 2424


Interest rate risk can be understood fromInterest rate risk can be understood frommismatch between duration of assets andmismatch between duration of assets andliabilities and also by duration GAPliabilities and also by duration GAP

Change in interest rate would impact Change in interest rate would impact market value of assets and liabilities withmarket value of assets and liabilities withdifferent amount. This would impact NIIdifferent amount. This would impact NII

and MVEand MVE



1/8/20121/8/2012 2525

Revisit the concepts for ALMRevisit the concepts for ALMInterest rate riskInterest rate risk

Mismatch or Gap riskMismatch or Gap risk

Basis riskBasis risk

Embedded option riskEmbedded option risk

Reinvestment riskReinvestment risk

Price riskPrice risk-- InvestmentsInvestments

Non paying liabilitiesNon paying liabilities



1/8/20121/8/2012 2626

Interest Rate Risk Management Interest Rate Risk Management Key take awayKey take away

Bank need to forecast interest rate movement Bank need to forecast interest rate movement

Aggressive strategy is to keep the gap position Aggressive strategy is to keep the gap positionopen where it is profitable oropen where it is profitable or

To keep the gap ZERO ( with some toleranceTo keep the gap ZERO ( with some tolerancelevel) so that NII is protectedlevel) so that NII is protected

DO behavioral analysis of customers toDO behavioral analysis of customers to

safeguard against embedded option risksafeguard against embedded option risk Know impact on MVE through duration gapKnow impact on MVE through duration gap

analysis for long term perspectiveanalysis for long term perspective



1/8/20121/8/2012 2727

Alternate approach Alternate approachtoto

Interest Rate RiskInterest Rate Risk

Management Management



1/8/20121/8/2012 2828

Financial derivativesFinancial derivatives

Contingent contractsContingent contracts

Underlying assets like currency, stock indices,Underlying assets like currency, stock indices,interest rate instruments, commodities etc.interest rate instruments, commodities etc.

Pricing and trading is complex and prone to highPricing and trading is complex and prone to highriskrisk

Shift the risk from seller to buyerShift the risk from seller to buyer

Improve the liquidity of underlying instrumentsImprove the liquidity of underlying instruments Hedger use derivatives to protect their assetsHedger use derivatives to protect their assets

from erosion in value due to market volatilityfrom erosion in value due to market volatility



1/8/20121/8/2012 2929

Interest rate derivatives (IRD)Interest rate derivatives (IRD)

Used to hedge the position that expose them to riskUsed to hedge the position that expose them to risk

Negative or positive gapNegative or positive gap

Tool to actively manage interest rate riskTool to actively manage interest rate risk Complement existing strategies to immunizing the volatilityComplement existing strategies to immunizing the volatility

of earnings and MVE to changes in interest ratesof earnings and MVE to changes in interest rates

Used to lower credit risk and add liquidity alsoUsed to lower credit risk and add liquidity also

Will discuss some widely used conceptsWill discuss some widely used concepts



1/8/20121/8/2012 3030

Interest rate swaps (IRS)Interest rate swaps (IRS) Instrument to manage interest rate riskInstrument to manage interest rate risk

An OTC contract An OTC contract

An agreement to exchange fixed interest to floating An agreement to exchange fixed interest to floating

or floating to fix for a period ( start date and endor floating to fix for a period ( start date and enddate)date)

May also have BASIS swaps pay MIBOR and receiveMay also have BASIS swaps pay MIBOR and receiveLIBORLIBOR

pricing of swap is dependent on forecasting interest pricing of swap is dependent on forecasting interest ratesrates

Credit risk in swap management is limited to interest Credit risk in swap management is limited to interest payment payment



1/8/20121/8/2012 3131

Swap dealsSwap deals

FirmFirm Fixed rateFixed rate Floating RateFloating Rate

A A 12%12% PLR+2%PLR+2%

BB 10%10% PLR+0.5%PLR+0.5%



1/8/20121/8/2012 3232

Swap dealsSwap deals

A Firm A Firm B FirmB Firm

Pay toPay to

lenderlender

PLR + 2%PLR + 2% 10%10%

ReceiveReceivefrom otherfrom other

PLR from BPLR from B 9.75% to A9.75% to A

Pay toPay tootherother 9.75% from A9.75% from A PLR from APLR from A

Net effect Net effect 11.75% fixed11.75% fixed PLR+ 0.25%PLR+ 0.25%floatingfloating



1/8/20121/8/2012 3333

Advantage of swap to B Advantage of swap to B

Asset liability is matched Asset liability is matched

Cost is reduced in floating market Cost is reduced in floating market

Eliminate interest rate riskEliminate interest rate risk It constituted a off balance sheet It constituted a off balance sheet

transactiontransaction



1/8/20121/8/2012 3434

Advantage of swap to A Advantage of swap to A

Asset liability is matched Asset liability is matched

Lower cost from fixed rate market Lower cost from fixed rate market

Capacity to borrow from fixed rate market Capacity to borrow from fixed rate market remain intact remain intact

It constituted a off balance sheet It constituted a off balance sheet

transactiontransaction



1/8/20121/8/2012 3535

Interest rate swapsInterest rate swaps

In practice it is not possible to find twoIn practice it is not possible to find twoparties with opposite needparties with opposite need hencehenceintermediaries are engagedintermediaries are engaged

Intermediary share the profits alsoIntermediary share the profits also

Major swap market players are banks,Major swap market players are banks,intermediaries and corporateintermediaries and corporate

Swap tenor are normally independent toSwap tenor are normally independent toloan tenorloan tenor



1/8/20121/8/2012 3636

Interest rate swaps (IRS)Interest rate swaps (IRS) Bank can use IRS forBank can use IRS for

Adjusting rate sensitivity of assets and liability Adjusting rate sensitivity of assets and liability

Creating synthetic transaction and securitiesCreating synthetic transaction and securities

Adjusting GAP or duration GAP Adjusting GAP or duration GAP Liability sensitive bankLiability sensitive bank can enter intocan enter into

swap where it pays fixed rate and receiveswap where it pays fixed rate and receivefloating ratefloating rate

Asset sensitive bank Asset sensitive bank can enter into swapcan enter into swapagreement where it pay floating rate andagreement where it pay floating rate andreceived fixed ratereceived fixed rate



1/8/20121/8/2012 3737

Interest rate futureInterest rate future

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

Future priceFuture price Future settlement or delivery dateFuture settlement or delivery date

Future contracts are traded in recognizedFuture contracts are traded in recognizedexchanges which assumes responsibility of exchanges which assumes responsibility of settlement settlement

When underlying security is interest bearingWhen underlying security is interest bearingsecurity it is known as interest rate future say 90security it is known as interest rate future say 90days treasury billsdays treasury bills

Transfer interest rate riskTransfer interest rate risk from hedger tofrom hedger tospeculatorspeculator



1/8/20121/8/2012 3838

Interest rate futureInterest rate future

Asset Sensitive Asset Sensitive Buy interest rate futureBuy interest rate future

if it expects interest if it expects interest rates to fallrates to fall

Sell interest rate futureSell interest rate futureif it expects interest if it expects interest rates to riserates to rise

Liability sensitiveLiability sensitive Sell interest rate futureSell interest rate future

if it expects interest if it expects interest rates to fallrates to fall

Buy interest rate futureBuy interest rate futureif it expects interest if it expects interest rates to riserates to rise

GapGap Interest Interest rateratechangechange

Impact onImpact onNIINII

PositivePositive IncreaseIncrease PositivePositive

PositivePositive DecreaseDecrease NegativeNegative

NegativeNegative IncreaseIncrease NegativeNegative

NegativeNegative DecreaseDecrease PositivePositive



1/8/20121/8/2012 3939

Interest rate futureInterest rate future-- issuesissues

Contract size and maturities areContract size and maturities arestandardized hence it may be difficult tostandardized hence it may be difficult tofind matching hedgefind matching hedge

Monitoring of position on daily basis isMonitoring of position on daily basis isessential as settlement takes place everyessential as settlement takes place everyday by mark to market methodday by mark to market method



1/8/20121/8/2012 4040

Forward rate agreement (FRA)Forward rate agreement (FRA)

An OTC contract An OTC contract Resemble a swap agreement but difference is that it is singleResemble a swap agreement but difference is that it is single

settlement vs series of settlement settlement vs series of settlement Agreement to settle interest rate differentials Agreement to settle interest rate differentials Typical forward contract Typical forward contract

Notional principal amount and no commitment to borrow or lend byNotional principal amount and no commitment to borrow or lend bypartiesparties

Buyer to pay fixed and receive floatingBuyer to pay fixed and receive floating Seller to pay floating and receive fixedSeller to pay floating and receive fixed Cash settlement is done if actual rate of interest differ to forecastedCash settlement is done if actual rate of interest differ to forecasted

ratesrates Bank use FRA to lock in fixed interest rate expenses ( deposits)Bank use FRA to lock in fixed interest rate expenses ( deposits)

to floating rate deposits or fixed interest rate advances to floatingto floating rate deposits or fixed interest rate advances to floatingrate advancesrate advances



1/8/20121/8/2012 4141

Fixed Income securitiesFixed Income securities



1/8/20121/8/2012 4242

Fixed income securitiesFixed income securities

Equity and Bonds are two major capitalEquity and Bonds are two major capitalmarket instrumentsmarket instruments

Bonds fall under fixed income securitiesBonds fall under fixed income securities Example 9.25% GOI securities 2015Example 9.25% GOI securities 2015

Generate fixed coupon income tillGenerate fixed coupon income till

maturitymaturity Not changed despite change in interest Not changed despite change in interest

ratesrates



1/8/20121/8/2012 4343

Bond priceBond price--SensitivitySensitivity

InflationInflation

GDP growthGDP growth

Liquidity in market Liquidity in market Interest ratesInterest rates

Fiscal policiesFiscal policies

Unemployment Unemployment Money supplyMoney supply



1/8/20121/8/2012 4444

Bond ValuationBond Valuation

Interest rate for residual term of maturity keepInterest rate for residual term of maturity keepchangingchanging

Value of bonds rests on movement of interest Value of bonds rests on movement of interest

ratesrates When market rate and coupon rate are same,When market rate and coupon rate are same,

bonds trade at parbonds trade at par

When market rate rises over coupon rate, bondsWhen market rate rises over coupon rate, bonds

trade at discount andtrade at discount and When market rate falls over coupon rate bondsWhen market rate falls over coupon rate bonds

trade at premiumtrade at premium



1/8/20121/8/2012 4545

Bond theoremsBond theorems

Price of bond is inversely relates to thePrice of bond is inversely relates to theyieldyield

Increase in price of bond when interest Increase in price of bond when interest rate goes down by certain % is greaterrate goes down by certain % is greaterthan decrease in its price when interest than decrease in its price when interest rates goes up by the same %rates goes up by the same %-- This isThis is

called convexitycalled convexity



1/8/20121/8/2012 4646

Bonds theoremsBonds theorems

Longer the term to maturity of a bondLonger the term to maturity of a bondhigher will be its price sensitivityhigher will be its price sensitivity

Between two bonds of same maturity but Between two bonds of same maturity but different coupons, the bond will lowerdifferent coupons, the bond will lowercoupon will experience more pricecoupon will experience more pricesensitivity than with higher couponsensitivity than with higher coupon



1/8/20121/8/2012 4747

DurationDuration

Reinvestment of coupons also generate incomeReinvestment of coupons also generate income

Two opposite effects: Fall in price of bonds dueTwo opposite effects: Fall in price of bonds dueto rise in interest rates and extra incometo rise in interest rates and extra income

generated due to reinvestments of coupon maygenerated due to reinvestments of coupon mayget neutralize during life of securityget neutralize during life of security

Measured through weighted average life of aMeasured through weighted average life of afixed income securityfixed income security

It is also a measure of price sensitivity measureIt is also a measure of price sensitivity measureof a bond to changes in interest ratesof a bond to changes in interest rates



1/8/20121/8/2012 4848

Modified durationModified duration

Duration does not accurately changes inDuration does not accurately changes inprice of bonds arising from larger changesprice of bonds arising from larger changesin interest ratesin interest rates

Hence modified durationHence modified duration

= Duration/ 1+ yield= Duration/ 1+ yield



1/8/20121/8/2012 4949

Banks investments portfolioBanks investments portfolio

Classified into three categoryClassified into three category

Held till maturity ( up to 25% of banks totalHeld till maturity ( up to 25% of banks totalinvestments)investments)

Held for trading ( acquired with intention toHeld for trading ( acquired with intention tosale)sale)

Available for sale ( which do not fall under Available for sale ( which do not fall under

above category)above category) HFT security are to be sold within 90 daysHFT security are to be sold within 90 days



1/8/20121/8/2012 5050

Banks investments portfolioBanks investments portfolio Valuation method Valuation method

Held till maturityHeld till maturity

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

to be provided forto be provided for Held for tradingHeld for trading

Marked to market with monthly or more frequent Marked to market with monthly or more frequent intervalsintervals

Available for sale Available for sale Marked to market with quarterly or more frequent Marked to market with quarterly or more frequent

intervalsintervals



1/8/20121/8/2012 5151

Investment reservesInvestment reserves

Provision for depreciation in AFS and HFTProvision for depreciation in AFS and HFTin excess of required amount in any yearin excess of required amount in any yearshould be credit to P & L account andshould be credit to P & L account and

same amount transferred to Reserve &same amount transferred to Reserve &SurplusSurplus

Included in Tier 2 capital of the bankIncluded in Tier 2 capital of the bank

Investment fluctuations reserves @Investment fluctuations reserves @minimum 5% of investment portfoliominimum 5% of investment portfolio( only HFT and AFS)( only HFT and AFS)



1/8/20121/8/2012 5252

Mark to market procedureMark to market procedure

Quoted securities as per latest quotes inQuoted securities as per latest quotes instock exchange, prices declared bystock exchange, prices declared byFIMMDA or RBIFIMMDA or RBI

UnquotedUnquoted

Price or YTM published by FIMMDAPrice or YTM published by FIMMDA

Sate government securities based on YTM andSate government securities based on YTM and

marked 25 bps above the yield of centralmarked 25 bps above the yield of centralgovernment securitiesgovernment securities

13 to 20 interest rate risk management

Documents