Table of Content
1. Executive summary
3. Repricing Model
I) Refunding or funding gap
4. Maturity Model
5. Weakness of maturity model
6. Duration Model
7. Limitation of Duration model
8. Case Study –Brac Bank Ltd
Interest Rate Risk - In the process of FIs performing their asset-transformation function, FIs are exposed to Interest Rate Risk, from Mismatched Maturity/Duration: Borrowing Short, Lending Long. The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (e.g. through an interest rate swap).
Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.
Repricing Model is a CF analysis of interest income (+cfs) from loans; and interest expense (-CF) on deposits, looking at Rate-Sensitive Assets (RSAs) vs. Rate-Sensitive Liabilities (RSLs). Rate sensitivity results from either:
a) variable rate loans or deposits that adjust to market rates, or
b) maturing loans or deposits that will adjust, and roll over to current market rates. Until recently, Fed required quarterly reporting of repricing gaps.
Refunding or Funding Gap:
The difference between assets whose interest rates will be re-priced or charged over some future period (rate-sensitive assets) and liabilities whose interest rates will be re-priced or charged over some future period (rate-sensitive liabilities). i.e. Refunding or Funding Gap = RSAs - RSLs, over some period from 1 day to 5+ years. Maturity mismatch exposes an FI to a possible Refunding/Funding Gap.
If RSA < RSL and interest rates increase, the FI's net income will decrease, because the interest expense on deposits will rise faster than interest income on loans. Formula:
Δ NII = GAP * (ΔR), where:
Δ NII = Change in Net Interest Income ($) GAP = (RSA - RSL)
ΔR = Change in Interest Rates
For the first time period (1 day), for every 1% increase in R:
Δ NII = (-$10m) x .01 = -$100,000
For the third time period (3-6 months), for every 1% increase in R:
Δ NII = (-$15m) x .01 = -$150,000
We can also calculate cumulative gaps (CGAP) over a certain period, e.g. 1 YR:
CGAP (one-year): -$10m + -$10m + -$15m + $20m = -$15m
Δ NII (one-year) = (-$15m) x .01 = -$150,000
Changes in interest rates also affect the market value (PV) of the loans and deposits, and these balance sheet changes are not accounted for in the Funding Gap Model, which assumes historic or book values of assets and liabilities (loans and deposits).
1. When RSA > RSL, then CGAP > 0.
2. When RSA < RSL, then CGAP < 0.
3. If CGAP > 0, if interest rates rise (fall), NII will rise (fall). 4. If CGAP < 0, when interest rate rise (fall), NII will fall (rise).
Equal Rate Changes on RSAs, RSLs :
◆ ( NIIi = (GAPi) (Ri = (RSAi - RSLi) ( Ri
◆ Example: Suppose rates rise 1% for both...
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