Class 15&16 Interest Rate Risk

Interest rate risk:

Risk that a firm will lose money if interest rate changes

Interest rate risk is incurred by FIs because

the maturities of their assets and liabilities do NOT match

Two main components of interest rate risk:

Price risk & refinancing risk

Price risk:

Variation in market prices caused by unexpected changes in interest rates

Refinancing risk:

Variation in the rate at which intermediate funds are borrowed

Accounting approach to Interest Rate Risk:

Repricing (funding gap) model

Repricing (funding gap) model focuses on

evaluating the impact of changes in interest rates on net interest income

Repricing interval:

Amount of time that the FI needs to wait until the interest rate on the asset or liability can be changed to reflect market conditions

Repricing gap:

Rate sensitive assets (RSA) - Rate sensitive liabilities (RSL)

Suppose rates increase 1% for BOTH RSA and RSL, the expected annual change in net interest income (NII) is:

NII= CGAP x ∆IR —> IR is positive if increased

Suppose rates decrease 1% for BOTH RSA and RSL, the expected annual change in net interest income (NII) is:

NII= CGAP x ∆-IR —> IR is negative if decreased

If changes in rates on RSA and RSL are NOT equal:

NII= (RSA x ∆R_RSA) - (RSL x ∆_RSL)

Disadvantages of Repricing model:

Maturity based therefore it is a simple but not reliable tool and IGNORES the market value effect

Bond prices move ____ with bond yields

inversly

Price of the longer maturity bond falls more than the price of a shorter maturity loan because

the payment is discounted a greater number of times

The effect of change in interest rate _____ diminishes as interest rate increases (convexity)

diminishes

Sensitivity of a bonds market price to interest rate changes depend on

the maturity of the loan

Duration:

Weighted average time to maturity using the relative present values of the cash flows as weights

Duration is a better

measure of interest rate sensitivity than maturity

Features of duration, as market yield increases,

duration decrease

Features of duration, as coupon rate decrease,

duration increases

Duration increases with

the maturity of the asset

Economic meaning of duration:

Duration is elasticity (sensitivity) of the securitys price to small interest rate changes

Limitation of duration:

Does not accurately capture large interest rate change effects

Convexity:

Degree of curvature of the price-yield curve around some interest rate level

Positive convexity is a

desirable feature

High convexity means

that for equally large changes of r up and down, the capital gain effect of a rate decrease more than offsets the capital loss effect of a rate increase

Duration is the ____ of the price yield curve

slope