Interest rate risk Management

Why is interest rate risk a concern for banks and regulators?

Because increased interest rate volatility can impact bank profits and stability.

What is interest rate risk?

The risk that unexpected changes in interest rates will affect both a bank’s borrowing and lending sides.

How do banks make money in relation to interest rates?

By profiting from the difference (spread) between borrowing rates and rates of return on loans and investments.

What is the typical mismatch between bank deposits and loans?

Short-term deposits fund longer-term or fixed-rate loans.

Why does this mismatch create risk?

Because deposits reprice faster than loans when interest rates rise, reducing profits.

what are the three ways of measuring interest rate risk?

Maturity gap analysis, Duration gap analysis, Value of Risk (VaR)

What is maturity gap analysis?

A method to ensure banks match the maturity of assets and liabilities.

What is the formula for maturity gap?

Maturity Gap = rate sensitive assets (RSA) – rate sensitive liabilities (RSL)

How is the maturity gap usually expressed?

As a dollar amount or as a percentage of total earning assets.

What effect does a large maturity gap have?

It increases the volatility of a bank’s earnings.

What financial tool do banks use to hedge interest rate risk?

Futures contracts.

In duration gap analysis, what does a positive duration gap indicate?

Assets have a longer duration than liabilities, so liabilities reprice before assets.

What is the impact of a positive duration gap when interest rates rise?

Bank earnings decline because liabilities become more expensive before asset returns adjust.

How do duration gaps compare to maturity gaps for the same risk exposure?

Duration gaps are opposite in sign from maturity gaps for the same risk exposure.

What does a positive maturity gap mean?

Assets mature later than liabilities, exposing the bank to rising interest rates.

Why are duration gaps opposite in sign from maturity gaps for the same risk exposure?

Because they measure different aspects of risk: timing vs. value sensitivity, so the same situation affects them in opposite ways.

What is Value at Risk (VaR)?

a statistical probability model that attempts to estimate the maximum potential gains and losses that may be incurred by a portfolio within a given time period

What formula is used to calculate VaR using Duration?

VaR = Duration × (1 / (1 + y)) × Portfolio Value × Worst Yield Increase

Formula to calculate VaR using past data:

VaR=Portfolio Value×Worst Loss Percentage (best out of 3 worst daily value changes)

What are some critiques on VaR?

The future might be different from the past, might give a false sense of security, two different investment portfolios could have the same VaR, but have entirely different expected levels of loss VaR with statistics calculation assumes normal distribution.

Why might VaR give a false sense of security?

Because VaR does not report the maximum potential loss.

What is one critique of VaR regarding past data?

The future might be different from the past.

Can two portfolios have the same VaR but different expected losses?

Yes, one portfolio might have a potential extreme loss while the other might not.

what does VaR with statistics assume?

normal distribution

What are the two types of hedging used to control interest rate risk?

Micro hedging and macro hedging.

What is micro hedging?

Hedging a specific transaction or matched funding (fixed rate loans are funded by deposits or borrowed funds of same maturity)

What is macro hedging?

Using financial futures, options on futures, and interest rate swaps to manage risk.