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Interest rate gap :

Gap model, NII and interest rate gaps, Gap Management and hedging,
Economic value of the banking book, Convexity Risk
Interest rate risk : In mismatching the maturities of assets and liabilities as
part of their asset transformation function, Fis expose themselves to interest
rate risk

Market risk : this adds another dimension to interest rate risk. It results from
the trading activity. It is an incremental risk. It is the risk of volatility in
earnings/ value of asset due to variation in the market factors such as
interest rate, investment rates and currency rates.
• It is the risk of volatility in earnings/ value of asset due to variation in
the market factors such as interest rate, investment rates and
currency rates.
• Relevant only after 1991-92 : The impact of this risk in the financial
system was not felt when there were regulatory restrictions on banks.
Banks became conscious of this risk only after the introduction of the
financial sector reforms and deregulation of interest rates
• 1956 many bank failure period of consolidation 1964 RBI
regulating the spread
• Banks are now free to fix the rate of interest on their assets and
liabilities. Hence it is necessary for them to know the behaviour of the
interest rates. There are four theories2 that explain the behaviour of
interest rates.
• Pure expectations theory advocates that forward rates (the market
may be a spot market where currencies are bought and sold for
immediate delivery at rates referred to as spot rates and forward
markets where currencies are bought and sold now for future delivery
at forward rates) are the unbiased estimators of expected spot rates.
The present market yield curve can provide information, about the
expectations of the market on future interest rates.
• As the economy moves through a business / economic cycle, the yield
curve changes rather frequently. At the beginning of an economic
expansion, the yield curve is upward sloping (short term interest rates
lower than long term rates). As the expansion proceeds, short-term
rates tend to rise faster than long-term rates, so the yield curve shifts
upwards and flattens out. Near the business cycle peak, the yield
curve can become downward sloping (inverted) and short-term yield
rates can become higher than long-term yields.
• The Liquidity Theory argues that the rates for the long term will be
higher than the rates for the short term and hence an upward sloping
curve. Interest represents the cost of funds and reward to the lender
who could have utilised the money for consumption. The lender is
willing to forgo the liquidity for which he must be rewarded. The
longer the period of giving up this liquidity, the higher the returns.
• The Preferred Habitat Theory agrees with the concept of liquidity
premium, but argues that it cannot be extended across all the
maturities. While the maturity pattern of borrowing and lending
depends on the constraints of the individuals, which will vary from
person to person, the payment of premium to induce them to change
their preferred maturity will be effective only upto a certain extent,
beyond which even enhanced premium will not induce them to
change their maturity.
• Market Segmentation Theory is a replica of the preferred habitat
theory without the flexibility, which it assumes. This theory states
that players in different markets are there due to their asset liability
maturity patterns and the interest rates are governed by the supply
and demand factors in each of the segments The players are not
induced by premium to shift their maturity.
• While all the above theories do provide insights into the factors that
influence interest rates, no single theory can explain reality. Again
what is long term for some, may be short term for others. There
cannot be strict guidelines for forecasting of interest rates. It is
necessary to have a view about the future. An estimate of the change
in interest rates in terms of its direction can only be attempted.
Determinants of interest rate
• Free market determination: The demand for any instrument is
influenced not only by its own rate but also rates of competing
instruments and the level of wealth of the investor. The own rate
positively and competing rates negatively influence the demand. The
supply side of the instrument is linked negatively to its own rate but
positively to interest rates on the issuers other liabilities. The total
debt and its change also influence the supply side of the instrument.
Then there are the systemic factors such as statutory preemption and
the liquidity position of the banking industry.
• Managed rate determination: In case the rates are fixed by one party
to the contract, the amount to be borrowed / lent will be determined
by the other party to the contract. If banks fix the PLR, the quantity of
the loan to be borrowed will be determined by the borrower,
depending on the PLR and interest rates on other types of
borrowings. Similarly if banks have to invest in assets on which
interest rates are determined purely by market forces, then the
deposit rate of banks will also be affected by the rates on instruments
competing for funds of the depositors.
Perspective of interest rate risk
• Impact on the NII ( the earnings perspective ) and the impact on the
balance sheet ( The economic value perspective)
• The risk from the former is measured as a change in the NII and the
later as a change in the value of assets and liabilities
Yield Curve
The yield curve is an analysis of the relationship between the
yields (interest rate) and different periods to maturity
Graphical relationship between yield and maturity
Yield is measured on the vertical axis and term to maturity is on
the horizontal
Yield curve Shape
Upward-sloping: long-term rates are above short-term rates
Flat: short and long-term rates are the same
Inverted: long-term rates are below short-term rates

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Term Structure of Interest Rate

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Types of Interest rate risks- General

( Identify the following with the help of examples)

• Maturity mismatch or gaps
• Reinvestment risk
• Basis risk
• Price risk
Some statistical measurements
Dimensions of risk

Symmetrical ( movement of asset prices in either direction leads to a

corresponding impact on the position value) and Asymmetrical or
unsymmetrical (unequal impact)
Absolute (measured with reference to the initial investment) and
relative ( measured relative to a benchmark index)
Directional ( exposure to the direction or movement of a major
financial variable , measured by linear approximations such as Beta,
Duration or delta) and non directional (non linear exposures or
exposures to hedged positions or volatilities, measures include
convexity or gamma
Systematic ( undiversifiable risk inherent to business) and
unsystematic risk (risk that can be minimized by diversification)
• Mean is a measure of central tendency
( along with median and mode)
• Standard Deviation ( measure of
dispersion from the mean)
Mean/ SD/Variance /
• Variance ( square of the standard
Covariance deviation)
• Covariance (tells us whether two
variables tend to rise or fall together or
how large those movements tend to be)
Correlation ( tendency of two
variables to move together-
Correlation positive, negative or nuetral)
Also written as cov (X,Y)/SDx*SDy
• Correlation coefficient always lies between -1 and 1
When it is close to 1, then variables are highly positively correlated
When it is close to -1, then the variables are highly negatively
When it is close to 0, then the variables are not correlated or neutral
While correlation coefficient
measures the extent of linear
relationship between two
Regression variables, it does not establish the
direction of the relationship.
Measures of regression help in
this regard
Y= a+bX
Here a, b are the parameters of
the equation, a is the intercept
Regression and b is the slope , also called as
regression coefficient
Also written as :
Cov(X.Y)/ standard deviation x ^2
measures how the observations
are dispersed horizontally about
the mean- whether symmetric or
Skewness If the value is equal to 0, the
observations are not skewed, if
greater than 0, then right skewed
and if less than 0, then left
measures how the observations
are dispersed vertically about the
mean- whether flat (platykurtic),
steep peaks in the middle that
flatten rapidly towards the tail (
leptokurtic) or smoother peaks in
Kurtosis the middle that flatten gradually
towards the tail ( mesokurtic)
If the value is equal to 3, the
observations are mesokurtic, if
greater than 3, then leptokurtic,
and if less than 3, then platykurtic
Sensitivity is the degree of change in a
dependent variable in response to a
Sensitivity change in the independent variable on
which it is dependent
Duration is a measure of a bond's
sensitivity to interest rate changes. The
higher the bond's duration, the greater its
Duration sensitivity to the change (also know as
volatility) and vice versa.
Example :The market rate of a bond of
face value of Rs. 100 and coupon rate
12.5% is redeemable after 5 years at a
Maturity vs Duration premium of 5 percent. With current
market interest at 15 percent, the present
value of the cash flows works out to Rs.
Size and frequency of rapid
changes in the price of a security.
(percentage change in the variable
from the original value of the
Volatility variable or delta p/p). If the
present price is 98.25 and it falls
to 97.95, the price volatility is
{(98.25-97.95)/98.25}* 100 = 0.3%
Volatility (Delta P/P) is equal to
Modified Duration -(D /(1+i))*(Delta i) where
(D /(1+i)) = modified duration
Percentage change in bond price /
Elasticity Percentage change in interest rate
• It is the tendency (sensitivity) of the
changes in the price of interest bearing
Convexity bonds to accelerate as the price
appreciates. Captures how bond
duration changes as bond yield changes
Types of Interest rate risks- Bank specific

( Identifying the following with the help of examples)

• Maturity mismatch or gap risk
• Re investment risk
• Basis Risk
• Price Risk
• Option Risk
• Yield curve risk
• Run off risk
Mismatch Risk: It is the risk of pricing changes of the assets and liabilities
when they fall due for re-pricing. Also called as Gap Risk arising from
holding of assets and liabilities with different principal amounts,
maturity and re-pricing dates.
• timing differences in the maturity (for fixed-rate) and repricing (for
floating rate) of bank assets, liabilities, and OBS positions
• Interest mismatch between amount of assets and liabilities on which
interest rates are re-set or re-priced during a given period
• The mismatch may lead to gain or loss depending upon the direction
of movement of market interest rate

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Rate Sensitive
Assets /
Liabilities (in
INR Mn) 1M 1-3M 3-6M 6M-1Y
Rate sensitive
Assets 1000 800 500 700
Rate sensitive
Liabilities 800 1200 600 300
Calculate the impact on account of a 0.5% increase in the interest rates. You may
take the average maturity in every gap
Interest Rate Risk (IRR)

Rate Sensitive Assets /
Liabilities (in INR Mn) 1M 1-3M 3-6M 6M-1Y
Rate sensitive Assets 1000 800 500 700
Rate sensitive Liabilities 800 1200 600 300
Gap 200 -400 -100 400
Impact of 0.5% Increase in
Interest Rate 0.92 -1.67 -0.31 0.5
Cumulative Impact 0.92 -0.75 -1.06 -0.56
Basis Risk

• Basis risk describes the impact of relative changes in interest rates for
the assets and liabilities that have similar tenors but are priced using
different interest rate indices (bases) [e.g. an asset priced off Libor
funded by a liability priced off MIBOR)
• Basis risk, also described as spread risk, arises when assets and
liabilities are priced off different yield curves and the spread between
these curves shifts
• When interest rates change, these differences can give rise to
unexpected changes in the cash flows and earnings spread between
assets, liabilities of similar maturities or repricing frequencies
Rate Sensitive Assets &
Liabilities (amount
in INRMn) Exposure Δ Interest Rate
Re-Pricing Assets
Call Money 40 0.20%
Loan/Advances 60 1%
Total Re-pricing Assets 100
Re-Pricing Liabilities
Certificate of Deposit 10 0.50%
Term Deposit 90 0.75%
Total Re-pricing Liabilities 100
Basis Risk

Rate Sensitive Assets & Δ Interest

Liabilities Δ Interest Income/
(amount in INRMn) Exposure Rate Expenses
Re-Pricing Assets
Call Money 40 0.20% 0.08
Loan/Advances 60 1% 0.6
Total Re-pricing Assets 100 0.68
Re-Pricing Liabilities
Certificate of Deposit 10 0.50% 0.05
Term Deposit 90 0.75% 0.68
Total Re-pricing Liabilities 100 0.73
Net Position/NII 0 -0.05

Yield Curve Risk
• Arises due to the changes in the slope and shape of the yield curve
resulting in unanticipated shifts of the Yield Curve causing adverse effects
on a bank's income or underlying economic value
• Change of slope of the yield curve result in change in interest rates in
varying magnitude across different maturity periods

Yield Curve Risk

It is the risk that the changes to the term structure

of interest rates occur consistently across the yield
curve (parallel risk), or differentially by period
(non-parallel risk) as against consistently across
the yield curve (parallel risk)
This type of risk arises due to the changes in the
slope and shape of the yield curve resulting in
unanticipated shifts of the Yield Curve causing
adverse effects on a bank's income or underlying
economic value
The extent of gap risk depends also on whether
changes to the term structure of interest rates
occur as parallel risk or as non-parallel risk

Embedded Options Risk:
This risk is on account of risk arising out of pre-payment of assets or
premature closure of liabilities

As interest rate increases or decreases, banks are exposed to risk when

clients exercise the embedded option

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EVE perspective


MDuration Gap MDA -(RSL/RSA)MDL

Change in value of Equity for a

given change in interest rate ΔE =(‐[MDG]*RSA* Δ I)

For every given rise in ROI,% fall

in MVE ΔE/Equity*100
Risk Measurement

( to determine the capital required + limit the amount of risk

based on availability of capital)
• Notional amount based on risk weights
• Scenario based methods
• Loss Distribution approach
• Scoring and rating models
• Gap models
• Static Ratios
Gap Models

GAP Analysis

GAP Analysis
Maturity Gap Analysis

GAP = Rate sensitive assets (RSA)-Rate sensitive Liabilities (RSL)

Positive gap
Negative gap
Zero or balanced gap
GAP Summary
Gap position Change in Change in interest Change in Change in net
interest rate income interest interest
expense income

Positive Increase Increase > Increase Increase

Positive Decrease Decrease > Decrease Decrease

Negative Increase Increase < Increase Decrease

Negative Decrease Decrease < Decrease Increase

Zero Increase Increase = Increase Neutral

Zero Decrease Decrease = Decrease Neutral

Position of gaps during business cycle
Assets Liabilities Aim at
Recovery Increase RSA, Avoid fixed Encourage fixed cost Positive gap
rate loans sources of funds

Boom Encourage fixed rate Encourage short term Negative gap

loans to lock in high yield sources of funds

Recession Encourage fixed rate loans Raise short term sources Negative gap
of funds
Depression Sell fixed rate loans and Borrow long term fixed Positive gap
investments to rates
supplement income
Increase RSA in
anticipation of higher
interest rates when
recovery occurs
Assessing the target gap for a Bank.

• The objective of interest rate risk management is to target a gap in

order to maintain the spread within certain limits

• The bank should first assess the percentage change in spread that is
acceptable to the bank, depending on the burden (non interest
income-non interest expenditure) and the targeted profit
• Targeted gap = (Delta C* RSA*NII)/ delta r
• where Delta c = tolerable percentage variation in spread
• Delta r= change in interest rate envisaged
• RSA = risk sensitive assets
Duration Gap Analysis
Matching the duration of assets and liabilities instead of matching the
time until pricing is another way to approach gap management.
It is a more sophisticated cash flow analytical tool used to primarily
measure the sensitivity of the market value of the net worth to
changes in interest rate
Duration analysis is based on Macaulay’s concept of duration, which
measures the average life time of a security’s stream of payments
Bond Duration
Duration (also known as Macaulay Duration) of a bond is a
measure of the time taken to recover the initial investment
in present value terms. In simplest form, duration refers to
the time taken for a bond to recoup its own purchase price
under time value concept of money
Duration is expressed in number of years
It measures the weighted average time taken to receive all
the cash flows of a bond (Wt. is the PV of cash flows)

Duration is function of:

 Term to maturity (Time)
 Current interest rate (Yield-PV factor)
 Coupon (Cash Flows)

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Properties of duration
Properties of duration
Duration and term to maturity: directly related
Duration and current interest rate (YTM) –inversely related
Duration and coupon rate –inversely related
Price volatility of a bond from MD = ΔP/P = -D x (Δy/ (1+y)
= - D/(1+y) x Δy
Modified Duration (MD) is the measure of price volatility of a bond
MD= D/(1+y)
MD gives the number by which percentage bond price will change with
one percent change in interest rate
Computation of MD from price volatility
Conversely, Price volatility is measured using MD Appr.MD
Percentage change in bond price = - MD x percentage change in yield
Bond Price Change = - MD x percentage change in yield × Bond Price
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Factors affecting duration

• Higher the Yield to maturity, shorter the duration (term of the bond
remaining constant) and vice versa
• The higher the coupon rate of a bond, the shorter the duration (term
of the bond remaining constant) and vice versa
• Duration is always less than or equal to the overall life (to maturity) of
the bond
• Only a zero coupon bond (a bond with no coupons) will have duration
equal to its maturity

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Duration and Price determination
• Duration is only an approximation of the change in
bond price
• For small changes in yield, it is very accurate, but for
larger changes in yield, it always underestimates the
resulting bond prices
• This is because duration is a tangent line to the price-
yield curve
• The difference between the duration tangent line and
the price-yield curve increases as the yield moves
farther away in either direction from the point of

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Exercise 1
Calculation of Duration
FV of Bond 1000
Coupon 8%
Term to maturity in years 5
1 Present Market Interest Rate 9%
2 Present Market Interest Rate 7%
3 Present Market Interest Rate 11%

what is the duration and price when coupon increases

4 10%
• Calculate the duration of a two year corporate bond paying 6 percent
interest annually

• 1.9434
• Calculate the duration of a two year corporate loan paying 6 percent
interest annually, selling at par. The $30000000 loan is 100 percent
amortising with annual payments

• First ascertain the annual coupon. For that use PMT option in excel
• 16363107
• 1.4854
• An FI purchases a $9.982 million pool of commercial loans at par. The
loans have an interest rate of 8%, a maturity of 5 years, and annual
payments of principal and interest that will exactly amortise the loan
at maturity. What is the duration of the asset
1 2500056 0.925926 2314867 2314867
2 2500056 0.857339 2143395 4286790
3 2500056 0.793832 1984625 5953875
4 2500056 0.73503 1837616 7350463
5 2500056 0.680583 1701496 8507481
12500280 3.99271 9981999 28413476
Duration and interest risk management
• An insurer has to make a guaranteed payment of 1469 on a lumpsum
investment of 1000 at an annual compounded rate of 8%
• Two options
Buy a zero coupon bond of 5 years. Maturity and duration is equal in
the case of a zero coupon bond
• Given a face value of 1000 and 8% yield, the current price =
1000/(1.08)^5 = 680.58.
• He needs to buy 1.469 of these bonds to get a sale proceed of 1469
• (680.58*1.469)
• If 5 year Duration bonds are not available, then he has to invest in
appropriate duration bonds to hedge interest rate risk
• When yield = coupon, price is equal to face value irrespective of
maturity or duration
• So the insurer can buy any maturity bond which has a coupon equal
to yield (which is 8%) and sell this bond at end of 5 years
• The concept of duration helps in immunising the interest rate risk by
holding an investment till the end of duration instead of maturity. Thus
matching the duration of assets and liabilities instead of matching the time
until re-pricing is another way to approach gap management.

• Additional data required to calculate the duration gap are the market
yields/ costs for different categories of assets and liabilities. The duration of
each assets and liability can then be pooled together for assets and
liabilities. The duration of non rate sensitive assets and liabilities is zero.
The floating assets and liabilities can be treated as zero coupon
instruments (non-interest bearing) maturing at the time of next repricing.
• The analysis starts by discounting the balance sheet’s future cash
flows to their present value. The present value calculations are then
used to determine the duration of the cash flows. The duration of
assets and liabilities are calculated using weighted average method.
Once this is done, the duration gap can be worked out with the help
of the following formula.10

• Assets (A) = Liability (L) + Equity (E)

• The duration of the bank’s assets may be defined as the weighted duration of the
bank’s liability and equity

• E= A-L …….5
• DE * E = (DA*A- DL* L) ……………..6

• DA is the summation of each of the duration of assets weighted by its share in the
total assets. DL is same measure for liabilities and DE is the measure for equity. If
DE is positive, then the value of equity is exposed to increase in interest rate (if
rates increase, then the value declines and vice versa). If DE is negative, then the
value of equity is exposed to decrease in interest rate (if rates decrease then the
value increases and vice versa). If DE is zero, then the interest rate risk is
completely eliminated.
• Interest rate risk index is the duration of equity multiplied by ratio of
equity to asset. (DE * E/A). It is intended to indicate the response of the
bank’s equity to asset ratio to a change in interest rates.
Substituting L=A-E in equation (6)

• DE * E= (DA*A)- (DL* (A-E))

• DE * E = (DA *A) –( DL*A) +( DL*E)…………….7.
Dividing equation 7 by E
• DE = (DA *A)/E –( DL*A)/E +( DL*E)/E
• DE = A/E (DA – DL)+ DL
• Thus Duration of equity (gap) is the composite duration of liabilities
and the multiple of the difference between composite duration of
assets and the composite duration of the liabilities and the asset-
equity ratio.
• DE = DL+ A/E (DA – DL)
• If the duration of assets is perfectly matched with the duration of
• DE = DA = DL
• DE = DA or DL
• Indicates that the duration of equity is not eliminated by matching the
duration of assets and liabilities
• Since matching the duration does not eliminate the risk the next option is to
mismatch the duration of assets and liabilities ideally
• DE = DL+ A/E (DA – DL)
• If DE has to be 0,
• DL+ A/E (DA – DL)=0
• -DL = A/E(DA -DL)
• - DL /(A/E) = DA – DL
(immunization through mismatch , what should be the ratio of DA/DL)
• Taking it further,
• DA - DL = - DL *( E )/A
• DA - DL = - DL(A-L)/A
• DA =- DL ((A-L)/A) + DL
• DA =- DL *A/A + DL *L/ A + DL
• DA =- DL + DL *L/A + DL
• DA = DL *L/A
(immunizing through asset duration)
• If a zero gap is targeted then Duration of assets must be equal to
(Duration of liabilities multiplied by ( Liabilities /Assets)
• The more unbalanced the banks assets and liabilities with respect to
duration, the greater the duration of equity and the more vulnerable
the bank is to interest rate changes.
• Once the duration of equity is ascertained, the effect of the rate
fluctuation on the market value of assets and liabilities is calculated.
• Change in market value = -(D (^r) * current market value) / (1+r)
• Where D= Duration of equity
• ^r = change in interest rates
• r = current rate
Duration measure is advantageous because the bank can match total
assets and liabilities rather than match individual accounts. But no
banks are using duration gap analysis because of the non availability of
data required to calculate the duration gap, such as the market yields
or costs for the individual category of assets and the historical data on
the interest rate movements,
Measuring IRR using gap analysis and duration gap analysis has
limitations if interest rate volatility is high. Focussing on the impact of
interest rate shocks on NPV of cash flows on the asset and liability side
gives a more accurate measure of the impact on equity when
examining parallel shifts of the yield curve
Leveraged Adjusted Gap

• -(DA- DLk ) where DA= Duration of assets = Duration of liabilities and k

= Liabilities / Assets

• Change in market value of equity = -(DA- DLk)*A* (Change in r/1+r)

where k = Liabilities / Assets
• A FI has financial assets of $800 and equity of $50. If the duration of
the assets is 1.21 years and duration of all liabilities is 0.25 years,
what is the leverage – adjusted duration gap
-(1.21-(0.25*((800-50)/800))) = -0.9756
• Use the duration model to approximate the change in the market
value (per $100 face value) of two year loans if interest rates increase
by 100 basis points from 9%