Interest Rate Risk. Balkrishna Parab
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1 Interest Rate Risk Balkrishna Parab
2 Interest Rate Risk Interest rate risk is the exposure of a bank s financial condition to adverse movements in interest rates.
3 Income Risk Interest Rate Risk Liquidity Risk Value Risk
4 Interest Rate Risk Earnings Perspective Economic Value Perspective Primary Secondary
5 Repricing Sources of IRR Options Basis
6 Rupee Gap Assets Liabilities Rate Sensitive Assets (RSA) Not Rate Sensitive Rate Sensitive Liabilities (RSL) Not Rate Sensitive
7 GAP = RSA - RSL When RSA > RSL Positive GAP When RSA < RSL Negative GAP NII = GAP r
8 Example #1 From the following information calculate the potential impact of change in interest rate on the net interest income (NII): Rate sensitive assets: Rs. 150 mn Rate sensitive liabilities: Rs. 250 mn Increase in interest rate by 50 basis points
9 NII = GAP r NII = ( ) NII = -500,000
10 Example #2 From the following information calculate the potential impact of change in interest rate: Rate sensitive assets: Rs. 350 mn Rate sensitive liabilities: Rs. 250 mn Increase in interest rate by 50 basis points
11 NII = GAP r NII = ( ) NII = 500,000
12 Example #3 From the following information calculate the potential impact of change in interest rate: Rate sensitive assets: Rs. 250 mn Rate sensitive liabilities: Rs. 250 mn Increase in interest rate by 100 basis points
13 NII = GAP r NII = ( ) 0.01 NII = 0
14 Example #4 From the following information calculate the potential impact of change in interest rate: Rate sensitive assets: Rs. 150 mn Rate sensitive liabilities: Rs. 250 mn Decreace in interest rate by 50 basis points
15 NII = GAP r NII = ( ) NII = 500,000
16 Example #5 From the following information calculate the potential impact of change in interest rate: Rate sensitive assets: Rs. 350 mn Rate sensitive liabilities: Rs. 250 mn Decrease in interest rate by 50 basis points
17 NII = GAP r NII = ( ) NII = -500,000
18 Example #6 From the following information calculate the potential impact of change in interest rate: Rate sensitive assets: Rs. 250 mn Rate sensitive liabilities: Rs. 250 mn Decrease in interest rate by 100 basis points
19 NII = GAP r NII = ( ) NII = 0
20 GAP and r Sr# GAP (RSA-RSL) Direction of r Impact on NII 1 Positive Positive Increase 2 Positive Negation Decrease 3 Negative Positive Decrease 4 Negative Negation Increase
21 Duration Gap Analysis The duration gap compares the effects of changes in interest rates on the duration of a bank s assets and liabilities to determine the economic value of stockholders equity.
22 Macaulay Duration Macaulay duration is the effective maturity of a bond. It is the weighted average term to maturity of the cash flows from a bond. The weight of each cash flow is determined by dividing the present value of the cash flow by the price. balkrishnaparab@jbims.edu
23 Macaulay Duration MacaulayDuration = T t=1 t CF t (1 + r) t P CF i is the cash flow on the bond per period r is the expected or market interest rate T is the maturity of bond in years t is time P is the fair value of the bond balkrishnaparab@jbims.edu
24 Exercise 7 Callaghan Motors bonds have 10 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is five per cent. The bonds have a yield to maturity of six per cent. a) What is the current market price? b) What is the Macaulay Duration? balkrishnaparab@jbims.edu
25 Solution 7 (a) Year (t) Cash Flows (C) PV Factor 1/(1+r) balkrishnaparab@jbims.edu PV of cash Flows C/(1+r) Fair Value = Sum of Present Value of Cash Flows:
26 Solution 7 (b) Year (t) Cash Flow (C) Weighted Cash Flow (tc) balkrishnaparab@jbims.edu PV Factor 1/(1+r) PV of Weighted Cash Flow tc/(1+r) Sum of Present Value of Weighted Cash Flows: Fair Value = Sum of Present Value of Cash Flows: Macaulay Duration = /926.39=8.02
27 Modified Duration Modified duration is an approximate measure of bond price volatility with respect to interest rates. Modified Duration = Macaulay Duration ; or (1 + r) Modified Duration = 1 P T t=1 t CF t (1 + r) t 1 (1 + r) balkrishnaparab@jbims.edu
28 Exercise 8 Jackson Corporation s bonds have 6 years remaining to maturity. Interest is paid annually, the par value of the bond is Rs.1000 and the coupon interest rate is 8%. The bonds have a yield to maturity of 9%. Calculate: (a) Fair value of the bond (b) Macaulay duration (c) Modified duration balkrishnaparab@jbims.edu
29 Solution 8 (a) Year (t) Cash Flows (C) PV Factor 1/(1+r) PV of cash Flows C/(1+r) balkrishnaparab@jbims.edu
30 Solution 8 (b) and (c) Year (t) Cash Flow (C) Weighted Cash Flow (tc) PV Factor 1/(1+r) PV of Weighted Cash Flow tc/(1+r) Sum of Present Value of Weighted Cash Flows: Fair Value = Sum of Present Value of Cash Flows: Macaulay Duration = 4.97 Modified balkrishnaparab@jbims.edu Duration = (Macaulay Duration/ (1+r)) = 4.56
31 Duration Gap DGAP is the duration Gap DA is the duration of Assets DL is the duration of liabilities DGAP = (DA) (W) (DL) NW = DGAP i 1 + i A W is the ratio of liabilities to assets NW is the change in the net worth of the bank A is Assets i is the interest rate i is the change in interest rate
32 Exercise 9 Suppose that: the duration of a bank s assets is 4 years; the duration of its liabilities is 2 years; the ratio of liabilities to assets is 0.9; the current rate of interest is 7 per cent and it is expected to increase by 100 basis points; and the bank has total assets of $100 million. Required Determine the dollar amount of the change in net worth.
33 Solution 9 DGAP = (DA) (W) (DL) NW = DGAP i 1 + i A DGAP = (4) (0.90) (2) = 2.2 NW = =
34 Present Value of a Rupee Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% balkrishnaparab@jbims.edu
35 Present Value of an Annuity Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% balkrishnaparab@jbims.edu
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