interest rate risk - vfccu.orgwhat is interest rate risk? threat that a change in market interest...
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Interest Rate Risk Lisa Boylen
VP ALM Services
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Session Objectives • Understand the risk associated with
changes in interest rates • Gain a basic understanding of the various
sources of interest rate risk
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What is INTEREST RATE RISK?
Threat that a change in market interest rates may:
• Reduce net interest income • Adversely affect the economic values of
financial assets and liabilities • Impair capital, elevating the risk of
insolvency • Impair liquidity
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IRR – Why is it Important? The majority of our assets and liabilities
are financial instruments We buy and sell money Income - We sell loans and receive interest. Expense - We buy shares and pay a dividend
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The income we earn is therefore affected by future economic
circumstances and future interest rates.
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SOURCES OF INTEREST RATE RISK • Repricing Risk • Basis Risk • Yield Curve Risk • Option Risk
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REPRICING RISK Repricing risk is the risk resulting when
assets and liabilities have different average maturities or repricing dates.
Earnings change when there is a change in the level of rates.
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WHAT CAUSES REPRICING RISK? Borrowing short term to fund long-term assets
• Problematic when rates rise Borrowing long term to fund short-term assets
• Problematic when rates fall
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Repricing Risk Example
Balance Sheet
Year 1 Year 2 – Fed Raises
Rates 1%
Rate Income/ Expense
Rate
Income/ Expense
$5,000,000 15 year Mortgage 5.25% $262,500 5.25% $262,500
$5,000,000 1 Year Certificate 2.00% $100,000
3.00% $150,000
Net Interest Income 3.25% $162,500 2.25% $112,500
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BASIS RISK
• This is the risk from unequal movements in interest rates on a credit union’s assets and liabilities with the same maturity or repricing.
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Basis Risk Example ASSET Home Equity Line of Credit
• Loan Rate = Prime + 1 • Resets Annually • Initial Rate
Ø Prime 3.25% Ø Spread 1.00% Ø Rate 4.25%
LIABILITY Member Certificate
• 1 Year Maturity • Renewable Annually at
Prevailing Rate • Initial Rate
Ø 1.50%
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Basis Risk Example
Balance Sheet
Year 1 Year 2 – Prime Increases 1%
Year 3 – Prime Decreases 1.5%
Rate Income/ Expense
Rate
Income/ Expense
Rate Income/ Expense
$5M HELOC 4.25% $212,500 5.25% $262,500 3.75% $187,500
$5M 1 Year Certificate
1.50% $75,000
2.00% $100,000 1.25% $62,500
Net Interest Income
2.75% $137,500 3.25% $162,500 2.50% $125,000
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Yield Curve Risk
• Risk of short-term rates changing by more or less than the change in long-term rates.
• Rule of Thumb • Short term rates are often more volatile than
intermediate and long-term rates.
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YIELD CURVE RISK
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Yield Curve Risk Example
Balance Sheet
Year 1 Year 2 – Fed Raises
Fed Funds 3%
Rate Income/ Expense
Rate
Income/ Expense
$5,000,000 15 year Mortgage Matures in Year 2
5.25% $262,500 6.00% $300,000
$5,000,000 1 Year Certificate 2.00% $100,000
4.00% $200,000
Net Interest Income 3.25% $162,500 2.00% $100,000
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OPTION RISK
Option risk is the risk of adverse
consequences from customer decisions to exercise options in products, such as
prepay loans
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CAUSES OF OPTION RISK
Option risk arises whenever credit union
products give customer the right, but not the obligation, to alter the quantity or
the timing of cash flows
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EXAMPLES OF OPTION RISK • Contractual Options
§ Call/Put options in securities § Interest rate caps, floors
• Ambiguous Options § Loan prepayments/payoffs § Revolving balance accounts, credit cards, lines of
credit § Withdrawal of shares § “Implicit” rate caps and floors
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Review Questions Interest rate risk refers to the risk that the
credit union’s earnings and capital may be affected by changes in market interest rates
q True q False
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Review Questions Which of the following are sources of
interest rate risk (Select all that apply) q Yield Curve Risk q Option Risk q Credit Risk q Repricing Risk q Reputation Risk q Basis Risk
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