Chapter 8: Interest Rate Risk I Flashcards
How do monetary policy actions made by the Bank of Canada impact interest rates?
The Bank of Canada’s mandate is to keep inflation under control and within an established band. It does this through the Target Overnight Rate. When the Bank of Canada finds it necessary to prevent an increase in inflation, it raises the Target Overnight Rate. The normal result is a decrease in business and household spending
Conversely, if business and household spending decline to the extent that the Bank of Canada becomes worried about deflation and finds it necessary to stimulate the economy it lowers the Target Overnight Rate. The drop in rates promotes borrowing and spending.
How has the increased level of financial market integration affected interest rates?
Increased financial market integration, or globalization, increases the speed with which interest rate changes and volatility are transmitted among countries. The result of this quickening of global economic adjustment is to increase the difficulty and uncertainty faced by the Bank of Canada and other central banks as they attempt to respond to changes in economic conditions. Further, because FIs have become increasingly more global in their activities, any change in interest rate levels or volatility caused by Bank of Canada or other central bank’s actions creates additional interest rate risk issues for these companies.
What is the repricing gap?
The repricing gap is a measure of the difference between the dollar value of assets that will reprice and the dollar value of liabilities that will reprice within a specific time period, where repricing can be the result of a roll over of an asset or liability or because the asset or liability is a variable rate instrument.
What is meant by rate sensitivity?
Rate sensitivity represents the time interval where repricing can occur. The model focuses on the potential changes in the net interest income variable. In effect, if interest rates change, interest income and interest expense will change as the various assets and liabilities are repriced, that is, receive new interest rates.
What is a maturity bucket in the repricing model?
The maturity bucket is the time window over which the dollar amounts of assets and liabilities are measured.
Why is the length of time selected for repricing assets and liabilities important when using the repricing model?
The length of the repricing period determines which of the securities in a portfolio are rate-sensitive. The longer the repricing period, the more securities either mature or need to be repriced, and, therefore, the more the interest rate exposure. An excessively short repricing period overstates the rate sensitivity of the balance sheet.
What is the CGAP effect?
The CGAP effect describes the relations between changes in interest rates and changes in net interest income.
According to the CGAP effect, what is the relationship between changes in interest rates and changes in NII when CGAP is positive? When CGAP is negative?
According to the CGAP effect, when CGAP is positive the change in NII is positively related to the change in interest rates. Thus, an FI would want its CGAP to be positive when interest rates are expected to rise. According to the CGAP effect, when CGAP is negative the change in NII is negatively related to the change in interest rates. Thus, an FI would want its CGAP to be negative when interest rates are expected to fall.
What is the gap to total assets ratio? What is the value of this ratio to interest rate risk managers and regulators?
The gap ratio to total assets ratio is the ratio of the cumulative gap position to the total assets of the FI. The cumulative gap position is the sum of the individual gaps over several time buckets. The value of this ratio is that it tells the direction of the interest rate exposure and the scale of that exposure relative to the size of the FI.
What is the spread effect?
The spread effect is the effect that a change in the spread between rates on RSAs and RSLs has on net interest income as interest rates change. The spread effect is such that, regardless of the direction of the change in interest rates, a positive relationship occurs between changes in the spread and changes in NII. Whenever the spread increases (decreases), NII increases (decreases).
What is the spread effect?
The spread effect is the effect that a change in the spread between rates on RSAs and RSLs has on net interest income as interest rates change. The spread effect is such that, regardless of the direction of the change in interest rates, a positive relationship occurs between changes in the spread and changes in NII. Whenever the spread increases (decreases), NII increases (decreases).
What are the weakness of the repricing model?
- It ignores market value effects.
- It does not take into account the fact that the dollar value of rate sensitive assets and liabilities within a bucket are not similar. Thus, if assets, on average, are repriced earlier in the bucket than liabilities, and if interest rates fall, FIs are subject to reinvestment risks.
- It ignores the problem of runoffs, that is, that some assets are prepaid and some liabilities are withdrawn before the maturity date.
- It ignores income generated from off-balance-sheet activities.
How have large banks solved the problem of choosing the optimal time period for repricing?
Large banks are able to reprice securities every day using their own internal models so reinvestment and repricing risks can be estimated for each day of the year.
What is runoff cash flow?
Runoff cash flow reflects the assets that are repaid before maturity and the liabilities that are withdrawn unsuspected. To the extent that either of these amounts is significantly greater than expected, the estimated interest rate sensitivity of the bank will be in error.
What is runoff cash flow?
Runoff cash flow reflects the assets that are repaid before maturity and the liabilities that are withdrawn unsuspected. To the extent that either of these amounts is significantly greater than expected, the estimated interest rate sensitivity of the bank will be in error.
