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FINS3630 Bank Financial Management Formulas

Interest Rate Risk



Duration of consol bond
D
c
= 1 + 1/R
Firm duration
E = (D
A
D
L
k) A


o Where k = L/A (a firm's leverage measured in market values)
o Note: all variables are market values
Duration and convexity

()



Funding gap
NII
i
= (GAP
i
)R
i

o NII
i
= change in net interest income in the ith bucket
o GAP
i
= the dollar size of the gap between the book value of assets and liabilities
o R
i
= change in the level of interest rates impacting assets and liabilities in the ith bucket
Funding gap unequal change in rates
NII = (RSA R
RSA
) (RSL R
RSL
)
Market Risk

DEAR
(FX) DEAR = FX position spot exchange rate 1.65
(EQ) DEAR = P 1.65


(FI) DEAR = Market value of position -MD 1.65
o MD =


VaR
Market value at risk (VaR) = DEAR
Credit Risk

*Gross return on loan (k) or ROA per dollar lent:
()
()

o Loan interest rate = base lending rate/prime rate (BR) + credit risk premium (m)
o Direct fees, for example, loan origination fee (f)
o Indirect fees, for example, compensating balance requirements (b), reserve requirement (RR)
Expected return: E(r) = p(1+k)
o p = probability of loan repayment (if p < 1 then there is default risk)
o There is a negative relationship between p and k
The relation between cumulative return and single period return:
o Return for two periods (1+k) = (1+k
2
)
2
= (1+k
1
)(1+k
1-2
)
Where k
1
and k
2
are 1-year and 2-year spot rates (the annual interest rate on a zero-
coupon bond)
Approach 1: infer from the equality of expected cumulative (total) returns
o *( )( ) ( )
1-p = cumulative default probability (default risk)
k = cumulative return for debt
i = cumulative risk-free return
= proportion of the loan's principal and interest that is collectible on default
(collateral backing)
RAROC = risk-adjusted return on capital =

()

Measuring net income
o One year net income on a loan = (Spread + Fees) Dollar value of the loan outstanding
Measuring loan risk
o Using duration


= dollar capital risk exposure or loss amount
D = duration of the loan
L = risk amount or size of the loan
= the increase in risk premium under adverse credit scenarios

= expected maximum change in the loan rate due to a change in the


credit risk premium (m) or risk factor on the loan
o Using loan default rates
RAROC =

( )

Unexpected default rate is the default rate under adverse credit scenarios from
historical distributions
KMV Model
Expected return on a loan to borrower i: R
i
= AIS
i
[EDF
i
LGD
i
]
o AIS is the all-in-spread, calculated as the difference between contractually promised return
minus the funding cost
o LGD is the loss if the client defaults, calculated as the contractually promised return
multiplying by the (1 recovery rate)
o EDF is the probability of default, termed as expected default frequency by KMV
Risk of a loan to borrower i:


Concentration limit
Concentration limit = Maximum loss as a percentage of capital



Loan volume based models

= standard deviation of bank's jth asset allocation proportions from the national
benchmark
o

= asset allocation proportions of the jth bank


o

= national asset allocations


o = number of observations or loan categories

Loan loss ratio based models



(


)
o = loan loss rate for a sector with no sensitivity to losses on the aggregate portfolio (i.e. its
= 0)
o

= systematic loss sensitivity of the ith sector loans to total loans