FMI- Interest rate risk

What is an interest rate?

The price of money accounted for time value.

What is borrowing

The price paid to get money NOW

What is lending

The price received for waiting to get money in the future

What are fixed rate assets and liabilities

Have a predetermined Interest rate that does not change for a specific period.

What are rate sensitive assets and liabilities

Whose interest rates or values are directly affected by changes in prevailing market interest rates.

What decisions do interest rates affect

Consumption or saving, Allocation of capital and Duration

Why are IR important for Corporate fiance

Cost of debt, valuation of bonds, portfolio theory

What is Interest rate risk

Incurred by the FIs when the maturities of its assets and liabilities are mismatched

What is refinancing risk

The risk that the returns on funds to be reinvested will fall below the cost of funds

How to measure IR risk

Gap analysis and Duration Analysis

What is Gap analysis

The gap refers to the difference between interest rate sensetive assets and interest rate sensitive liabilities over specific time horizon

GAP EQUATION

GAP= RSA-RSL

Main aim of Gap analysis

Evaluate the impact of a change in interest rates on the banks net interest income and net interest margin

Net Interest Margin equation

NIM= NII/ Total assets

Calculate Net interest income

Interest received on assets-Interest paud on liabilities

RSA and RSL charactaristics

‘repriced periodically’ and cash flows received or paid are adjusted if IR change

What is Maturity Gap analysis

A better reflection of economic reality if the FI’s portfolio was liquidated at todays prices.

Maturity gap equation

Maturity gap= Maturity of assets- Maturity of Liabilities

Criticism of gap analysis

Ignores market value effect, ignores run offs, overall very simplified.

What is duration analysis?

Measure of the average life of an assets cash flow

What does duration analysis take into account

Average life rather than maturity

Advantages of Duration model

More accurate measure of interest rate risk and more useful for hedging purposes

Limitations of Duration model

Linear relationship issue, static measure, based on historical data