Interest Rate Risk Asset Liability Management The potential significant changes in a bank s profitability and market value of equity due to unexpected changes in interest rates Reinvestment rate risk Interest rate changes affect the bank s cost of funds and return on invested assets (differing magnitudes possible) Price Risk Interest rate changes impact the market values of the bank s assets and liabilities (and therefore, its value of equity) 4 Asset Liability Management Manage a bank s sensitivity to changes in market interest rates (interest rate risk) Plan, organize, and control asset and liability volume, mix, maturity, and rates Achieve an acceptable risk of change in net interest margin or economic value of equity Interest Rate Risk Repricing risk: assets and liabilities reprice at different times Basis risk: rates change by different amounts for various assets and liabilities Yield curve risk: rates change by different amounts across maturities Option risk: changes in rates result in option exercise (for example, prepayments or early withdrawals) 2 5 ALM Policy and Procedures Provide authority and responsibility for establishing and maintaining an effective interest rate risk management program to identify, measure, monitor and control risk Types of instruments and activities that may be used to manage risk Appropriate risk measurement system Limits relative to earnings and value that directly relate to the measurement system Responsibility for authorizing exceptions Risk-Return Tradeoff Generally, the greater the risk assumed, the greater the expected profit Risk and associated return are primary determinants of value Bank management in conjunction with the board of directors is responsible for determining the appropriate balance between acceptable risk assumed and profit or value 3 6 1
Managing Interest Rate Risk Banks typically focus on IRR s effects on: Net interest income GAP Earnings Sensitivity Analysis The market value of stockholders equity Duration GAP Economic Value of Equity Measuring Interest Rate Risk with GAP GAP Analysis: GAP = RSA RSL RSA: Rate Sensitive Assets Assets that will reprice in a given time period RSL: Rate Sensitive Liabilities Liabilities that will reprice in a given time period Focuses on managing net interest income in short-run Implicitly assumes that all rates change at the same time, in the same direction and by the same amount 7 10 ALM: Earnings Focus Net Interest Income (NII) = Interest Income minus Interest Expense Net Interest Margin (NIM) = Net Interest Income divided by Earning Assets NII and NIM can and will fluctuate due to changes in the general level of rates GAP and Earnings Sensitivity Analysis are measures of the amount of Interest Rate Risk (IRR) in relation to earnings Rate Sensitivity An asset or liability is rate sensitive if during the time interval it: Matures Is an interim or partial principal payment Will likely be repriced: The interest rate applied to principal changes contractually during the interval The outstanding principal can be repriced when an index changes and the index is expected to change during the interval Is principal associated with the exercise of an embedded option 8 11 ALM: Earnings Focus GAP a static measure of risk that is commonly associated with net interest income (margin) If interest rates change, the bank will have to reinvest the cash flows from assets and refinance rolled-over liabilities at different interest rates Which is impacted the most? Rate Sensitivity Classification Easy Cases Fixed maturities and high costs for prepayment or withdrawal Variable rate instruments Credit risk free instruments Hard cases High prepayment prospects High credit risk assets No specified maturity Basic Rule: Classify as to likelihood of repricing, not capacity to reprice 9 12 2
Steps in GAP Analysis Select a series of time buckets or intervals for determining when assets and liabilities will reprice Group assets and liabilities into these buckets Calculate the GAP for each bucket Estimate the change in net interest income given an assumed change in interest rates Rates Down 1% From Base Case NII increases by $1 million (GAP X rate change) 13 16 Sample Bank Balance Sheet Sample Bank Revised GAP is negative. If rates change, more liabilities than assets will reprice. Suppose the bank moves $50 assets to ratesensitive and $50 liabilities to non-sensitive. 14 17 Rates Up 1% From Base Case NII falls by $1 million (GAP X rate change) GAP Equals Zero If interest rates go up (down): $550 assets reprice at higher (lower) rate $550 liabilities reprice at higher (lower) rate Net Interest Income is unaffected What is initial cost of balance sheet composition change? NIM falls from 4.41% to 4.18% Gain: bank faces less interest rate risk 15 18 3
GAP If GAP is negative: Rate increases result in lower NII Rate decreases result in higher NII If GAP is Positive: Rate increases result in higher NII Rate decreases result in lower NII GAP=0 immunizes bank s net interest income to effects of interest rate changes Optimal GAP There is no general optimal GAP for all banks GAP=0 immunizes bank s net interest income to effects of interest rate changes If rate movements could be predicted, a GAP of zero is not preferred since a positive or negative GAP would yield higher income Active Gap Management Sign of the bank s gap indicates the direction of beliefs Size of relative gap measures magnitude of risk ALM policy must evaluate overall risk and return profile and objectives to determine optimal GAP for bank 19 22 Interest Rate-Sensitivity Reports GAP values are reported a periodic and cumulative basis for each time interval Periodic GAP: GAP for each time bucket: insight into timing of repricings Cumulative GAP: Sum of periodic GAP's Cumulative GAP directly measures a bank s net interest sensitivity throughout the time interval under consideration Interest Rate Risk Policy Guidelines GAP Policies: often stated using relative to assets or as a ratio 1-year cumulative GAP to earning assets of between -15% and +15% 1-year cumulative GAP to total assets of between -10% and +10% GAP ratio (RSAs to RSLs) of 0.90 to 1.10 20 23 Static GAP Analysis Advantages Easy to understand Works well with small changes in interest rates Determinants of NII and NIM Level of interest rates Composition of assets and liabilities Disadvantages Ex-post measurement errors Ignores the time value of money Ignores the cumulative impact of interest rate changes Assumes repricing assets and liabilities are equally sensitive to rate changes (Beta GAP) Ignores embedded options 21 Volume of earning assets (EA) and interestbearing liabilities (IBL) Relative rates on EA and IBL How do these change with economy? 24 4
ALM: Earnings Based Earnings Sensitivity Analysis Earnings sensitivity analysis extends GAP analysis by focusing on changes in bank earnings due to changes in interest rates and balance sheet composition Allows management to incorporate the impact of different spreads between asset yields and liability interest costs when rates change by different amounts Embedded Option Considerations Who determines when the option is exercised (bank or customer)? What is compensation for selling the option, or how much does it cost to buy the option? Under what conditions (economic and interest rate environment) will the option be exercised? Static GAP analysis ignores these embedded options 25 28 Earnings Sensitivity Analysis Incorporates the impact when asset yields and liability interest costs change by different amounts Allows consideration of embedded options that can potentially alter the bank s cash flows Adjusts for changes in composition in different rate environments 26 Steps in ESE Determine interest rates changes of concern Identify composition changes in assets and liabilities in different rate environments Forecast exercise of embedded options Base repricing assumptions for assets and liabilities on forecasted rate environments Estimate net interest income and net income Repeat and compare forecasts of net interest income and net income across different interest rate environments 29 Embedded Options Many bank assets and liabilities contain explicit and/or implicit options: Option to repay a loan early Call option on bonds Option to withdraw funds prior to maturity Cap (maximum) rate on a floating-rate loan 27 Interest Rates Interest rate forecasts are often used to determine a base case The base case is the most likely interest rate Earnings estimated at the expected level of rates Rates are then varied above and below the base case Earnings are reestimated based on expectations of exercise of embedded options, asset/liability composition, etc. under new rate environment Computer simulation models often used 30 5
Adjust Rate Sensitivity Reduce asset sensitivity Buy longer-term securities; Lengthen the maturities of loans; Move from floating-rate loans to term loans Increase asset sensitivity Buy short-term securities; Shorten loan maturities; Make more loans on a floating-rate basis Reduce liability sensitivity Pay premiums to attract longer-term deposit instruments; Issue long-term subordinated debt Increase liability sensitivity Pay premiums to attract short-term deposit instruments; Borrow more via non-core purchased liabilities 31 34 Earnings-at-Risk The possible variation in net interest income across different interest rate environments Based on assumptions about: balance sheet composition exercise of embedded options timing of repricings Demonstrates the potential volatility in earnings across these environments The greater is the earnings at risk, the greater is the amount of risk assumed, or The greater is the maximum loss, the greater is risk ALM: Value Focus As interest move up and down the value of the bank s assets and liabilities change, thus impacting the value of equity (A = L + E) Simple rule: Interest rates go up --- present value goes down Interest rates go down --- present value goes up The question is whether the value of assets or the value of liabilities is impacted most by rate changes. 32 35 Managing GAP or Earnings Sensitivity Risk Steps to reduce risk Calculate periodic GAPs over short time intervals. Fund repriceable assets with matching repriceable liabilities so that periodic GAPs approach zero. Fund long-term assets with matching noninterest-bearing liabilities. Use off-balance sheet transactions to hedge. Duration GAP Duration GAP Analysis Compares the price sensitivity of a bank s assets and liabilities to assess the impact of changes in interest rates on the value of stockholders equity Economic Value of Equity Sensitivity Analysis Focuses on changes in stockholders equity across different rate environments Allows for duration changes across the rate environments 33 36 6
Duration Duration measures the effective maturity of a security Duration Examples What is the duration of a bond with a $1,000 face value, 10% annual coupon payments, 4 years to maturity and a 5% YTM? Incorporates timing and size of cash flows Measures price sensitivity to changes in interest rates The larger the duration, the larger the price sensitivity The smaller the duration, the smaller the price sensitivity 37 40 Duration Duration Examples What is the duration of a zero-coupon bond with a $1,000 face value, 4 year maturity, and 12% YTM? 38 41 Measuring Duration Duration is a time-weighted average of the expected cash flows from a security relative to the security s price Duration and Modified Duration Modified Duration gives an estimate of how much price will change in percentage terms for a given change in rates Macaulay s Duration 39 42 7
Duration GAP Model Duration GAP Focus on managing market value of stockholders equity Compares duration of assets with the duration of liabilities The larger the duration GAP, the larger the change in the economic value of stockholders equity when interest rates change A duration GAP of zero implies that changes in rates would not affect the value of equity 43 Economic Value of Equity Sensitivity Analysis Involves basically the same steps as earnings sensitivity analysis However, in EVE analysis the focus is on: The relative durations of assets and liabilities How much the durations change in different interest rate environments What happens to the economic value of equity across different rate environments 46 Steps in Duration GAP Analysis Estimate market values of assets, liabilities and stockholders equity Estimate weighted average duration of assets and liabilities (incorporate the effects of both on- and off-balance sheet items) Forecast changes in market value of stockholders equity across different interest rate environments Embedded Options Embedded options heavily influence the estimated volatility in EVE Prepayments that exceed (fall short of) that expected will shorten (lengthen) duration. A bond being called will shorten duration. A deposit that is withdrawn early will shorten duration. A deposit that is not withdrawn as expected will lengthen duration. 44 47 Duration GAP (DGAP) MVA and MVL equal the market values of assets and liabilities, respectively. Earnings Sensitivity Analysis Economic Value of Equity 45 48 8
Asset/Liability Sensitivity and DGAP Funding GAP and Duration GAP are not directly comparable Funding GAP examines various time buckets while Duration GAP represents the entire balance sheet If a bank is liability (asset) sensitive in the sense that net interest income falls (rises) when rates rise and vice versa, it will often have a positive (negative) DGAP suggesting that assets are more price sensitive than liabilities, on average. Speculating on Duration GAP It is difficult to actively vary GAP or DGAP and consistently win Interest rate forecasts are frequently wrong Even if rates change as predicted, banks have limited flexibility in varying GAP and DGAP and must often sacrifice yield to do so 49 52 Strengths and Weaknesses: DGAP and EVE Strengths Duration analysis provides a comprehensive measure of interest rate risk (it considers all cash flows and their timing) Duration measures are additive This allows for the matching of total assets with total liabilities rather than the matching of individual accounts Duration analysis takes a longer term view than static gap analysis Derivatives Any security or contract that derives its value from another underlying asset Derivatives Used to Manage Interest Rate Risk Financial Futures Contracts Forward Rate Agreements Interest Rate Swaps Options on Interest Rates Interest Rate Caps Interest Rate Floors 50 53 Strengths and Weaknesses: DGAP and EVE Weaknesses It is difficult to compute duration accurately Correct duration analysis requires that each future cash flow be discounted by a distinct discount rate A bank must continuously monitor and adjust the duration of its portfolio It is difficult to estimate the duration on assets and liabilities that do not earn or pay interest Duration measures are highly subjective Characteristics of Financial Futures Cash or Spot Market Market for any asset where the buyer tenders payment and takes possession of the asset when the price is set Futures Markets The organized exchanges where futures contracts are traded Prices set for future delivery of an underlying good 51 54 9
Characteristics of Financial Futures Financial Futures Contracts A contract between a buyer and seller on the quantity and price for the future delivery of a standardized financial asset or index Interest Rate Futures: Underlying asset is an interest-bearing security Forward Contract Contract for any asset where the buyer and seller agree on the asset s price but defer the actual exchange until a specified future date 55 Characteristics of Financial Futures Buyer (long position) Agrees to pay the futures price and/or take delivery of the underlying asset Buyers gain when futures prices rise and lose when futures prices fall Seller (short position) Agrees to receive the futures price and/or deliver the underlying asset Sellers gain when futures prices fall and lose when futures prices rise 58 Characteristics of Financial Futures Forward versus Futures Contracts Futures Contracts Traded on formal exchanges Examples: Chicago Board of Trade and the Chicago Mercantile Exchange Standardized contracts Daily marking to market Require margins: initial margin, variation margin, maintenance margin Basic Interest Rate Swaps Basic or Plain Vanilla Interest Rate Swap An agreement between two parties to exchange a series of cash flows based on a specified notional principal amount One party makes payments based on a fixed interest rate and receives floating rate payments The other party exchanges floating rate payments for fixed-rate payments When interest rates change, the party that benefits from a swap receives a net cash payment while the party that loses makes a net cash payment 56 59 Characteristics of Financial Futures Forward versus Futures Contracts Forward contracts Parties negotiate terms Quantities and types of underlying assets are not necessarily standardized Generally no margins or cash exchange required until expiration Do not mark-to-market Basic Interest Rate Swaps Basic interest rate swaps are used to: Adjust the rate sensitivity of an asset or liability For example, effectively converting a fixedrate loan into a floating-rate loan Create a synthetic security For example, enter into a swap instead of investing in a security Macrohedge Use swaps to hedge the bank s aggregate interest rate risk 57 60 10
Swap Example The bank makes a 3-year $10 million loan at a 7.5% fixed rate. It finances the loan with a Eurodollar deposit priced at 3-month LIBOR. Swap Example Risk: The bank is liability sensitive If rates rise, the bank s cost of funds increases while its interest income remains the same. 61 64 Swap to Hedge Bank enters a 3-year $10,000,000 notional value swap to pay a fixed rate of 3.5% and receive 3-month LIBOR. Result: Interest Income: 7.5% (loan) + LIBOR (swap) Interest Expense: 3.5% (swap) + LIBOR (dep) Net Interest Income: 4% Interest Rate Caps and Floors Interest Rate Cap An agreement between two counterparties that limits the buyer s interest rate exposure to a maximum limit Buying a interest rate cap is the same as purchasing a call option on an interest rate Interest Rate Floor An agreement between two counterparties that limits the buyer s interest rate exposure to a minimum rate Buying an interest rate floor is the same as purchasing a put option on an interest rate 62 65 Swap Example Features/Benefits of Interest Rate Caps Provides a cap on interest costs Provides protection against rising rates without fixing rates Buyer retains benefits if rates decline Allows user to take advantage of short term rates Requires an upfront payment by the buyer Risk profile is similar to options 63 66 11
Features/Benefits of Interest Rate Floors Provides a floor under an interest stream Provides protection against falling rates without fixing rates The buyer retains the benefits of rate increases Requires an upfront payment by the buyer Risk profile is similar to options Asset Liability Management 67 Interest Rate Caps and Floors 68 Interest Rate Collar Interest Rate Collar The simultaneous purchase of an interest rate cap and sale of an interest rate floor on the same index for the same maturity and notional principal amount A collar creates a band within which the buyer s effective interest rate fluctuates It protects a bank from rising interest rates 69 12