part b covers pages 201-205

Interest Rate Risk IInterest Rate Risk I

Chapter 8

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin

Part BCovers pages 201-205

8-2

Repricing Gap Example

Assets Liabilities Gap Cum. Gap

1-day $ 20 $ 30 $-10 $-10

>1day-3mos. 30 40 -10 -20

>3mos.-6mos. 70 85 -15 -35

>6mos.-12mos. 90 70 +20 -15

>1yr.-5yrs. 40 30 +10 -5

>5 years 10 5 +5 0

8-3

Applying the Repricing Model

Example II:

If we consider the cumulative 1-year gap,

NII = (CGAPone year) R = (-$15 million)(.01)

= -$150,000.

8-4

Equal Rate Changes on RSAs, RSLs

Example: Suppose rates rise 1% for RSAs and RSLs. Expected annual change in NII,

NII = CGAP × R

= -$15 million × .01

= -$150,000 With positive CGAP, rates and NII move in

the same direction. Change proportional to CGAP

8-5

Unequal Changes in Rates

If changes in rates on RSAs and RSLs are not equal, the spread changes. In this case,

NII = (RSA × RRSA ) - (RSL × RRSL )

8-6

Repricing Gap Example

Assets Liabilities Gap Cum. Gap

1-day $ 20 $ 30 $-10 $-10

>1day-3mos. 30 40 -10 -20

>3mos.-6mos. 70 85 -15 -35

>6mos.-12mos. 90 70 +20 -15

210 225

>1yr.-5yrs. 40 30 +10 -5

>5 years 10 5 +5 0

8-7

Unequal Rate Change Example

Spread effect example: RSA rate rises by 1.0% and RSL rate rises by 1.0%

NII = interest revenue - interest expense

= ($210 million × 1.0%) - ($225 million × 1.0%)

= $2,100,000 -$2,250,000 = -$150,000

8-8




= ($210 million × 1.2%) - ($225 million × 1.0%)

= $2,520,000 -$2,250,000 = $270,000

8-9




= ($210 million × 1.0%) - ($225 million × 1.2%)

= $2,100,000 -$2,700,000 = -$600,000

8-10

Simple Bank Repricing

Maturity Balance 0 to 1 >1

Securities 0.75 9,000 9,000

Consumer Loans 0.5 10,000 10,000


Consumer Loans 3 16,000 16,000

Prime-Based Loans 3 50,000 50,000

Total Assets 100,000 69,000

Demand Deposits - Fixed 5 15,000 15,000

Demand Deposits - Variable 0.01 35,000 35,000

CDs 0.5 30,000 30,000

CDs 0.75 5,000 5,000

CDs 2 5,000 5,000

Equity NA 10,000

Total Liabilities & NW 100,000 70,000

1 year Cum Gap -1,000

Change In Mkt Rates 1%

Change in NII -10

Chang in NII/ Assets -.01%

Repricing Model – 1 Year Cum Gap Analysis

8-11



Securities 0.75 9,000 9,000




Mortgage Loans 3 50,000 50,000




CDs 0.5 30,000 30,000

CDs 0.75 5,000 5,000

CDs 2 5,000 5,000

Equity NA 10,000




Change in NII -510



8-12

Difficult Balance Sheet Items

Equity/Common Stock O/S Ignore for repricing model, duration/maturity = 0

Demand Deposits Treat as 30% repricing over 5 years/duration = 5 years

70% repricing immediately/duration = 0 Passbook Accounts

Treat as 20% repricing over 5 years/duration = 5 years 80% repricing immediately/duration = 0

Amortizing Loans We will bucket at final maturity, but really should be

spread out in buckets as principal is repaid. Not a problem for duration/market value methods

8-13

Difficult Balance Sheet Items

Prime-based loans Adjustable rate mortgages

Put in based on adjustment date Repricing/maturity/duration models cannot cope with

life-time cap

Assets with options Repricing model cannot cope Duration model does not account for option Only market value approaches have the capability to

deal with options Mortgages are most important class Callable corporate bonds also

8-14

Prime Rate Vs Fed Funds 1955-2009

0

5

10

15

20

25

Fed Funds Rate

Prime Rate

8-15


0

1

2

3

4

5

6

7

8

9

10

Fed Funds

Prime Rate

8-16


0

1

2

3

4

5

6

7

8

9

Fed Funds

Prime Rate

8-17



Securities 0.75 9,000 9,000








CDs 0.5 30,000 30,000

CDs 0.75 5,000 5,000

CDs 2 5,000 5,000

Equity NA 10,000




Change in NII -20



8-18



Securities 0.75 9,000 9,000








CDs 0.5 30,000 30,000

CDs 0.75 5,000 5,000

CDs 2 5,000 5,000

Equity NA 10,000




Change in NII -60



8-19


Simple S&L Repricing


Securities 0.75 12,000 12,000




Fixed Rate Mortgages 30 82,000 82,000


Demand Deposits - Fixed 5 0 0

NOW Accounts 0.01 20,000 20,000

CDs 0.5 61,000 61,000

CDs 0.75 10,000 10,000

CDs 2 5,000 5,000

Equity NA 4,000




Change in NII -770


8-20




Securities 0.75 12,000 12,000







NOW Accounts 0.01 20,000 20,000

CDs 0.5 61,000 61,000

CDs 0.75 10,000 10,000

CDs 2 5,000 5,000

Equity NA 4,000




Change in NII -1,540

Chang in NII/ Assets -01.54%

8-21




Securities 0.75 12,000 12,000







NOW Accounts 0.01 20,000 20,000

CDs 0.5 61,000 61,000

CDs 0.75 10,000 10,000

CDs 2 5,000 5,000

Equity NA 4,000




Change in NII -4,620

Chang in NII/ Assets -4.62%

8-22

Comparison of 1980 Bank vs S&L

No Change in Rates No Change in Rates

Simple Bank Yield Balance Interest Simple S&L Yield Balance Interest

Assets 6.5% 100,000 6,500 Assets 7.0% 100,000 7,000

Liabilities 2.5% 90,000 -2,250 Liabilities 4.9% 96,000 -4,704

Equity 0 10,000 Equity 0 4,000

NII 4,250 NII 2,296

Operating Expenses -2,000 Operating Expenses -1,400

Pre-tax income 2,250 Pre-tax income 896

Taxes at 35% -788 Taxes at 35% -314

Net income 1,463 Net income 582

ROA 1.46% ROA 0.58%

ROE 14.6% ROE 14.6%

8-23

Comparison of 1980 Bank vs S&L

Rates Up 6% Rates Up 6%

Simple Bank Yield Balance Interest Simple S&L Yield Balance Interest

Assets 10.6% 100,000 10,640 Assets 7.8% 100,000 7,840

Liabilities 7.3% 90,000 -6,570 Liabilities 10.6% 96,000 -10,176

Equity 0 10,000 Equity 0 4,000

NII 4,070 NII -2,336

Operating Expenses -2,000 Operating Expenses -1,400

Pre-tax income 2,070 Pre-tax income -3,736

Taxes at 35% -725 Taxes at 35% 1,308

Net income 1,346 Net income -2,428

ROA 1.35% ROA -2.43%

ROE 13.5% ROE -60.7%

8-24

Restructuring Assets & Liabilities

The FI can restructure its assets and liabilities, on or off the balance sheet, to benefit from projected interest rate changes. Positive gap: increase in rates increases NII Negative gap: decrease in rates increases NII

The “simple bank” we looked at does not appear to be subject to much interest rate risk.

Let’s try restructuring for the “Simple S&L”

8-25

Weaknesses of Repricing Model

Weaknesses: Ignores market value effects and off-balance

sheet (OBS) cash flows Overaggregative

Distribution of assets & liabilities within individual buckets is not considered. Mismatches within buckets can be substantial.

Ignores effects of runoffs Bank continuously originates and retires consumer

and mortgage loans and demand deposits/passbook account balances can vary. Runoffs may be rate-sensitive.

8-26

A Word About Spreads

Text example: Prime-based loans versus CD rates

What about libor-based loans versus CD rates?

What about CMT-based loans versus CD rates

What about each loan type above versus wholesale funding costs?

This is why the industry spreads all items to Treasury or LIBOR

8-27

*The Maturity Model

Explicitly incorporates market value effects. For fixed-income assets and liabilities:

Rise (fall) in interest rates leads to fall (rise) in market price.

The longer the maturity, the greater the effect of interest rate changes on market price.

Fall in value of longer-term securities increases at diminishing rate for given increase in interest rates.

8-28

Maturity of Portfolio*

Maturity of portfolio of assets (liabilities) equals weighted average of maturities of individual components of the portfolio.

Principles stated on previous slide apply to portfolio as well as to individual assets or liabilities.

Typically, maturity gap, MA - ML > 0 for most banks and thrifts.

8-29

*Effects of Interest Rate Changes

Size of the gap determines the size of interest rate change that would drive net worth to zero.

Immunization and effect of setting

MA - ML = 0.

8-30

*Maturities and Interest Rate Exposure

If MA - ML = 0, is the FI immunized? Extreme example: Suppose liabilities consist of

1-year zero coupon bond with face value $100. Assets consist of 1-year loan, which pays back $99.99 shortly after origination, and 1¢ at the end of the year. Both have maturities of 1 year.

Not immunized, although maturity gap equals zero.

Reason: Differences in duration**

**(See Chapter 9)

8-31

*Maturity Model

Leverage also affects ability to eliminate interest rate risk using maturity model Example:

Assets: $100 million in one-year 10-percent bonds, funded with $90 million in one-year 10-percent deposits (and equity)

Maturity gap is zero but exposure to interest rate risk is not zero.

8-32

Modified Maturity Model

Correct for leverage

to immunize, change:

MA - ML = 0 to

MA – ML& E = 0 with ME = 0

(not in text)

part b covers pages 201-205

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