Interest Rate risk Flashcards
definition of interest rate risk
the sensitivity of bank earnings (price effect) or market value (value effect) to unexpected interest rate changes.
why are banks exposed to interest rate risk
as maturity transformers, banks are intrinsically exposed to interest rate risk
what is refinancing risk
liabilities have shorter maturity than assets
what is reinvestment risk
assets have shorter maturity than liabilities
what are valuation effects
refers to the relationship between i/r’s and market value of assets and liabilities
when are value effects most negative
1) when value of liabilities rises more rapidly than assets when interest rate decreases. 2) When value of liabilities falls more slowly than market value of assets when interest rates increase
Methods of measuring exposure to interest rate risk
Repricing gap model and duration gap model
what is repricing gap model
focus on earning effects, based on rate sensitivty of assets and liabilities within maturity bucket. Book value accounting cash flow analysis on repricing gap between interest revenue (assets) and expenses (liabilities)
what is duration gap model
focus on market value, based on duration of assets and liabilities
How to measure repricing gaps and what it allows us to do
Gaps measured in each maturity bucket by calculating rate sensitivity of eash asset (RSA) and liability (RSL) on BS. Allows us to quantify impact on next interest income margin from changes in interest rates.
what is cumulative gap (CGAP)
sum of gaps computed in different maturity buckets, usually 1 year. Allows bank to understand impact of i/r change on NII within 1 year.
GAP ratio and what it shows
GAP Ratio= CGAP/A. Provides direction and scale of exposure.
Weaknesses of Repricing Model
1) Ignores market value effects of i/r changes. 2) Overaggregation: fails to consider intra-bucket effects. Values of RSA and RSL can be same within bucket but time of repricing can be different. 3) Non-BS items not included when considering Cash Flows, hedging effects of derivatives not captured. 4) GAP model is linear, sensitivty to i/r shocks is constant. 5) Sensitivity can be different for upward and downward movements in i/r’s, downside usually slower. 6) Embedded option like fixed rate mortgages can be renegotiated when interest rates decline. 7) Gaps cannot be considered constant when i/r’s change, required adjustment
What is Duration gap model
Takes account of ‘marking to market’ or fair value. Reflects market value of all assets and liabilities if liquidated at current price. Duration analysis examines sensitivity of market values of A&L’s to changes in i/r’s.
What is duration?
Duration is a measurement of the life on a present value basis. Longer duration implies higher sensitivity. Represents security’s weighted average maturity.
Duration and maturity relationship
Duration increases with maturity of a fixed income asset/liability, but at a decreasing rate.
Duration and yield relationship
Duration falls as yield increases. Higher yield discounts later cash flows more heavily, later cash flows decline in weight.
Duration and coupon interest relationship
higher coupon, lower duration
Duration and elasticity relationship
Duration provides info on charge in market value as a result of i/r changes.
Criticism of duration
1) Assumes no default risk. 2) Difficult to apply as restructuring entire BS costly and time consuming. 3) Linear, doesn’t account for convexity
Recent bank failure due to interest rate risk
SVB 2023, mismatch as held long term, low interest bonds and interest rates increased. Significant losses selling these bonds
