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28 просмотров79 страницInterest rate risk

Sep 13, 2019

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Interest rate risk

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28 просмотров79 страницInterest rate risk

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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

9/13/2019 TAPMI:TSMT:RSV 14

Term Structure of Interest Rate

9/13/2019 TAPMI:TSMT:RSV 15

Types of Interest rate risks- General

• Maturity mismatch or gaps

• Reinvestment risk

• Basis risk

• Price risk

Some statistical measurements

Dimensions of risk

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

correlated

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

skewed.

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

skewed

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.

94.10.

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

• 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

9/13/2019 TAPMI:TSMT:RSV 35

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)

GAP RISK

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

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

40

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

41

Yield Curve Risk

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

42

Embedded Options Risk:

This risk is on account of risk arising out of pre-payment of assets or

premature closure of liabilities

clients exercise the embedded option

9/13/2019 TAPMI:TSMT:RSV 43

EVE perspective

EVE MVA-MVL

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

in MVE ΔE/Equity*100

Risk Measurement

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

Maturity

GAP Analysis

Duration

GAP Analysis

Maturity Gap Analysis

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

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

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.

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)

Term to maturity (Time)

Current interest rate (Yield-PV factor)

Coupon (Cash Flows)

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

13 September 2019 TAPMI:TSMT:RSV 54

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

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

tangency

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%

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

PV PVn

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

2.846472

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

• 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) +( 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

liabilities

• 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)

………9

• 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

= Liabilities / Assets

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%