![Page 1: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/1.jpg)
Interest Rate Risk
II. Types of Interest Rate Risk
![Page 2: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/2.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
Types of Interest Rate Risk
INTEREST RATE RISK
Yield Curve Risk
Option RiskBasis Risk
RepricingRisk
![Page 3: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/3.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
The risk from timing differences between rate changes or cash flows
from assets, liabilities, and off-balance sheet instruments
Definition of Repricing Risk
=RepricingRisk
![Page 4: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/4.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
Assume a 2% increase in time deposit rates in the second year
Example of Repricing Risk
15‐Year Mortgage
1‐Year Time Deposit
Net Interest Spread
Period 1
4.00
1.00
3.00
Period 2
4.00
3.00
1.00
![Page 5: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/5.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
The risk from non-parallel changes in the yield curve
Definition of Yield Curve Risk
=Yield Curve Risk
![Page 6: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/6.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
0
1
2
3
4
5
6
3M 1Y 5Y 10Y 30Y
Yield Curve – 2004 to 2006Rate, %
1Q 2006
1Q 2005
1Q 2004
Source: Federal Reserve Board/Haver Analytics
Strategy: Borrow short and lend long
Risk: Yield curve flattens
1Q 2004: Short-term interest rates began to rise sharply
2006 or 2007: Flat or inverted yield curve
Yield Curve Shifts: A Recent Example of Flattening
![Page 7: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/7.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
15‐Year Mortgage
1‐Year Time Deposit
Net Interest Spread
Period 1
6.00
1.00
5.00
Period 2
6.50
4.00
2.50
Example of Yield Curve Risk
Flattening Yield Curve: short-term rates rise faster than long-term rates and reduce net interest income
![Page 8: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/8.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
the risk that cash flows change due to embedded options
(e.g., prepayment / extension, call options, deposit runoff)
Definition of Option Risk
=OptionRisk
![Page 9: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/9.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
Option Risk
• Residential mortgages • Mortgage-backed securities• Callable bonds
Assets
• Non-maturity deposits • Time deposit redemptions • Certain FHLB borrowings
Liabilities
![Page 10: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/10.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
15‐Year Mortgage
3‐Year Time Deposit
Net Interest Spread
Period 1
7.00
4.00
3.00
Period 2
5.00
4.00
1.00
Assume a 2% Decrease in Mortgage Interest Rates. Customer refinances in Period 2.
Example of Option Risk
![Page 11: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/11.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
0
250
500
750
1,000
0 30 60 90 120 150 180 210 240 270 300 330 360Months
Increase in Average Life of Mortgage Pool
11 years6.5 years
4.5 years
$, In Thous.Rate scenarios
+100 bpsStable +300 bps
Example of Option Risk
![Page 12: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/12.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
Mortgage Backed Securities are More Price Sensitive as Rates Rise
$50
$75
$100
$125
$150
3 4 5 6 7 8 9 10
Price Change for MBS vs. Treasury
Treasury‐10yr (positive convexity)
MBS (negative convexity)
Hypothetical Rate
Negative Convexity: As interest rates rise, MBS portfolios stand to lose more value than non-callable bonds
Yield (%)
Price ($)
![Page 13: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/13.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
The risk that different indices with the same repricing frequency do not move
in unison
Definition of Basis Risk
=Basis Risk
![Page 14: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/14.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
Short-term rates increase unevenly: 3-month Treasury increases 1% and LIBOR increases 2%
Example of Basis Risk
3‐Month Treasury‐based Loan
3‐Month LIBOR‐based Borrowing
Net Interest Spread
Period 1
3.25
1.00
2.25
Period 2
4.25
3.00
1.25
![Page 15: Interest Rate Risk · 2017-02-04 · FEDERAL DEPOSIT INSURANCE CORPORATION Assume a 2% increase in time deposit rates in the second year Example of Repricing Risk 15‐Year Mortgage](https://reader033.vdocuments.us/reader033/viewer/2022042019/5e7719c73d77971cf863736d/html5/thumbnails/15.jpg)
FEDERAL DEPOSIT INSURANCE CORPORATION
Summary
Interest Rate Risk has several components including:• Repricing Risk• Yield Curve Risk• Option Risk
o Prepayment / Extension Risk• Basis Risk
How financial institutions identify, measure, monitor, and control these risks is critical to an effective IRR Management program