Assignment on Interest Rate Risk

Submitted by: -
TUSHAR DIWAKAR
04214901815
BBA(B&I) 6th Semester

Submitted to: -
Dr. Jasbir Singh

Subject: -
Management of Commercial Banks
 Concept of interest rate risk (IRR)
The interest rate risk is 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 (such as through an interest rate swap).

HOW IT WORKS (EXAMPLE):

Let's assume you purchase a bond from Company XYZ. Because bond prices typically fall
when interest rates rise, an unexpected increase in interest rates means that your investment
could suddenly lose value. If you expect to sell the bond before it matures, this could mean you
end up selling the bond for less than you paid for it (a capital loss). Of course, the magnitude
of change in the bond price is also affected by the maturity, coupon rate, its ability to be called,
and other characteristics of the bond.

Interest Rate Risk can be measured by gap analysis, duration analysis and simulation analysis.

Sources of Interest Rate Risk

1. Repricing risk: As financial intermediaries, banks encounter interest rate risk in several
ways. The primary and most often discussed form of interest rate risk arises from timing
differences in the maturity (for fixed rate) and repricing (for floating rate) of bank assets,
liabilities and off-balance-sheet (OBS) positions. While such repricing mismatches are
fundamental to the business of banking, they can expose a bank's income and underlying
economic value to unanticipated fluctuations as interest rates vary. For instance, a bank that
funded a long-term fixed rate loan with a short-term deposit could face a decline in both the
future income arising from the position and its underlying value if interest rates increase.
These declines arise because the cash flows on the loan are fixed over its lifetime, while the
interest paid on the funding is variable, and increases after the short-term deposit matures.
2. Yield curve risk: Repricing mismatches can also expose a bank to changes in the slope
and shape of the yield curve. Yield curve risk arises when unanticipated shifts of the yield
curve have adverse effects on a bank's income or underlying economic value. For instance,
the underlying economic value of a long position in 10-year government bonds hedged by a
short position in 5-year government notes could decline sharply if the yield curve steepens,
even if the position is hedged against parallel movements in the yield curve.

3. Basis risk: Another important source of interest rate risk (commonly referred to as basis
risk) arises from imperfect correlation in the adjustment of the rates earned and paid on
different instruments with otherwise similar repricing characteristics. When interest rates
change, these differences can give rise to unexpected changes in the cash flows and earnings
spread between assets, liabilities and OBS instruments of similar maturities or repricing
frequencies. For example, a strategy of funding a one year loan that reprices monthly based
on the one month U.S. Treasury Bill rate, with a one-year deposit that reprices monthly based
on one month Libor, exposes the institution to the risk that the spread between the two index
rates may change unexpectedly.

4. Optionality: An additional and increasingly important source of interest rate risk arises
from the options embedded in many bank assets, liabilities and OBS portfolios. Formally, an
option provides the holder the right, but not the obligation, to buy, sell, or in some manner
alter the cash flow of an instrument or financial contract. Options may be stand alone
instruments such as exchange-traded options and over-the-counter (OTC) contracts, or they
may be embedded within otherwise standard instruments. While banks use exchange-traded
and OTC-options in both trading and non-trading accounts, instruments with embedded
options are generally most important in non-trading activities. They include various types of
bonds and notes with call or put provisions, loans which give borrowers the right to prepay
balances, and various types of non-maturity deposit instruments which give depositors the
right to withdraw funds at any time, often without any penalties. If not adequately managed,
the asymmetrical payoff characteristics of instruments with optionality features can pose
significant risk particularly to those who sell them, since the options held, both explicit and
embedded, are generally exercised to the advantage of the holder and the disadvantage of the
seller. Moreover, an increasing array of options can involve significant leverage which can
magnify the influences (both negative and positive) of option positions on the financial
condition of the firm.
 Effects of Interest Rate Risk
As the discussion above suggests, changes in interest rates can have adverse effects both on a
bank's earnings and its economic value. This has given rise to two separate, but
complementary, perspectives for assessing a bank's interest rate risk exposure.

1. Earnings perspective: In the earnings perspective, the focus of analysis is the impact of
changes in interest rates on accrual or reported earnings. This is the traditional approach to
interest rate risk assessment taken by many banks. Variation in earnings is an important focal
point for interest rate risk analysis because reduced earnings or outright losses can threaten
the financial stability of an institution by undermining its capital adequacy and by reducing
market confidence.

In this regard, the component of earnings that has traditionally received the most attention is
net interest income (i.e. the difference between total interest income and total interest
expense). This focus reflects both the importance of net interest income in banks' overall
earnings and its direct and easily understood link to changes in interest rates. However, as
banks have expanded increasingly into activities that generate fee-based and other non-
interest income, a broader focus on overall net income - incorporating both interest and non-
interest income and expenses - has become more common. The non-interest income arising
from many activities, such as loan servicing and various asset securitisation programs, can be
highly sensitive to market interest rates. For example, some banks provide the servicing and
loan administration function for mortgage loan pools in return for a fee based on the volume
of assets it administers. When interest rates fall, the servicing bank may experience a decline
in its fee income as the underlying mortgages prepay. In addition, even traditional sources of
non-interest income such as transaction processing fees are becoming more interest rate
sensitive. This increased sensitivity has led both bank management and supervisors to take a
broader view of the potential effects of changes in market interest rates on bank earnings and
to factor these broader effects into their estimated earnings under different interest rate
environments.

2. Economic value perspective: Variation in market interest rates can also affect the
economic value of a bank's assets, liabilities and OBS positions. Thus, the sensitivity of a
bank's economic value to fluctuations in interest rates is a particularly important
consideration of shareholders, management and supervisors alike. The economic value of an
instrument represents an assessment of the present value of its expected net cash flows,
discounted to reflect market rates. By extension, the economic value of a bank can be viewed
as the present value of bank's expected net cash flows, defined as the expected cash flows on
assets minus the expected cash flows on liabilities plus the expected net cash flows on OBS
positions. In this sense, the economic value perspective reflects one view of the sensitivity of
the net worth of the bank to fluctuations in interest rates.

Since the economic value perspective considers the potential impact of interest rate changes
on the present value of all future cash flows, it provides a more comprehensive view of the
potential long-term effects of changes in interest rates than is offered by the earnings
perspective. This comprehensive view is important since changes in near-term earnings - the
typical focus of the earnings perspective - may not provide an accurate indication of the
impact of interest rate movements on the bank's overall positions.

3. Embedded losses: The earnings and economic value perspectives discussed thus far focus
on how future changes in interest rates may affect a bank's financial performance. When
evaluating the level of interest rate risk it is willing and able to assume, a bank should also
consider the impact that past interest rates may have on future performance. In particular,
instruments that are not marked to market may already contain embedded gains or losses due
to past rate movements. These gains or losses may be reflected over time in the bank's
earnings. For example, a long term fixed rate loan entered into when interest rates were low
and refunded more recently with liabilities bearing a higher rate of interest will, over its
remaining life, represent a drain on the bank's resources.

Management of interest rate risk

In general, IRR is the potential for changes in interest rates to reduce a bank's earnings and
lower its net worth. IRR manifests in several different ways but we will provide a simplified
example to illustrate the general issue. The most common manifestation of IRR occurs because
the assets of the banks, such as the loans it holds, come due or mature at a different time than
the liabilities of the bank, such as deposits.

Take, for example, a bank that funds itself only with certificates of deposit that have a maturity
of two years. This bank also only makes mortgage loans with a maturity of 15 years. Should
interest rates rise in the future, the bank would face a decline in its expected income. Why? The
monthly inflow of cash to the bank from the mortgages is fixed for 15 years. When the
certificates of deposit come due before the mortgages, the bank will have to pay more to receive
funding so cash flows out of the bank will increase.

Clearly IRR holds the potential to have a negative impact on earnings and net worth of a bank.
So why don't banks try to eliminate it by ensuring that all of its assets and liabilities have
exactly the same maturities? Banks would earn less money without taking on this risk. By
earning the difference between long-term and short-term rates, for example, banks are getting
paid to assume IRR and meet the demands of customers for deposits and loans. The challenge
for banks is to measure IRR and manage it such that the compensation they receive is adequate
for the risks they incur.

Impacts of interest rate risk

1) The immediate impact of changes in interest rates is on the Net Interest
Income(NII). A long-term impact of changing interest rates is on the bank’s net
worth since the economic value of a bank’s assets, liabilities and off-balance sheet
positions get affected due to variation in market interest rates.

2) The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent
on the movements of interest rates. Any mismatches in the cash flows (fixed assets
or liabilities) or reprising dates (floating assets or liabilities), expose bank’s NII or
NIM to variations. The earning of assets and the cost of liabilities are closely related
to market interest rate volatility.

3) The interest rate risk when viewed from these viewed from these two perspectives
is knows as earnings perspective and economic value perspective, respectively.
Management of interest rate risk aims at capturing the risks arising from the
maturity and reprising mismatches and is measured both from the earnings and
economic value perspective.
 Principles for the management for interest rate risk

Board and Senior Management Oversight of Interest Rate Risk:

Principle 1: In order to carry out its responsibilities, the board of directors in a bank should
approve strategies and policies with respect to interest rate risk management and ensure that
senior management takes the steps necessary to monitor and control these risks consistent with
the approved strategies and policies. The board of directors should be informed regularly of
the interest rate risk exposure of the bank in order to assess the monitoring and controlling of
such risk against the board’s guidance on the levels of risk that are acceptable to the bank.

Principle 2: Senior management must ensure that the structure of the bank's business and the
level of interest rate risk it assumes are effectively managed, that appropriate policies and
procedures are established to control and limit these risks, and that resources are available for
evaluating and controlling interest rate risk.

Principle 3: Banks should clearly define the individuals and/or committees responsible for
managing interest rate risk and should ensure that there is adequate separation of duties in key
elements of the risk management process to avoid potential conflicts of interest. Banks should
have risk measurement, monitoring, and control functions with clearly defined duties that are
sufficiently independent from position-taking functions of the bank and which report risk
exposures directly to senior management and the board of directors. Larger or more complex
banks should have a designated independent unit responsible for the design and administration
of the bank's interest rate risk measurement, monitoring, and control functions.

Adequate Risk Management Policies and Procedures

Principle 4: It is essential that banks' interest rate risk policies and procedures are clearly
defined and consistent with the nature and complexity of their activities. These policies should
be applied on a consolidated basis and, as appropriate, at the level of individual affiliates,
especially when recognising legal distinctions and possible obstacles to cash movements
among affiliates.
Principle 5: It is important that banks identify the risks inherent in new products and activities
and ensure these are subject to adequate procedures and controls before being introduced or
undertaken. Major hedging or risk management initiatives should be approved in advance by
the board or its appropriate delegated committee.

Risk Measurement, Monitoring, and Control Functions

Principle 6: It is essential that banks have interest rate risk measurement systems that capture
all material sources of interest rate risk and that assess the effect of interest rate changes in
ways that are consistent with the scope of their activities. The assumptions underlying the
system should be clearly understood by risk managers and bank management.

Principle 7: Banks must establish and enforce operating limits and other practices that maintain
exposures within levels consistent with their internal policies.

Principle 8: Banks should measure their vulnerability to loss under stressful market conditions
- including the breakdown of key assumptions - and consider those results when establishing
and reviewing their policies and limits for interest rate risk.

Principle 9: Banks must have adequate information systems for measuring, monitoring,
controlling, and reporting interest rate exposures. Reports must be provided on a timely basis
to the bank's board of directors, senior management and, where appropriate, individual business
line managers.

Internal Controls

Principle 10: Banks must have an adequate system of internal controls over their interest rate
risk management process. A fundamental component of the internal control system involves
regular independent reviews and evaluations of the effectiveness of the system and, where
necessary, ensuring that appropriate revisions or enhancements to internal controls are made.
The results of such reviews should be available to the relevant supervisory authorities.
Information for Supervisory Authorities

Principle 11: Supervisory authorities should obtain from banks sufficient and timely
information with which to evaluate their level of interest rate risk. This information should take
appropriate account of the range of maturities and currencies in each bank's portfolio, including
off-balance sheet items, as well as other relevant factors, such as the distinction between trading
and non-trading activities.

Principle 12: Banks must hold capital commensurate with the level of interest rate risk they
undertake.

Disclosure of Interest Rate Risk

Principle 13: Banks should release to the public information on the level of interest rate risk
and their policies for its management.

Supervisory Treatment of Interest Rate Risk in the Banking Book

Principle 14: Supervisory authorities must assess whether the internal measurement systems
of banks adequately capture the interest rate risk in their banking book. If a bank’s internal
measurement system does not adequately capture the interest rate risk, the bank must bring the
system to the required standard. To facilitate supervisors’ monitoring of interest rate risk
exposures across institutions, banks must provide the results of their internal measurement
systems, expressed in terms of the threat to economic value, using a standardised interest rate
shock.

Principle 15: If supervisors determine that a bank is not holding capital commensurate with
the level of interest rate risk in the banking book, they should consider remedial action,
requiring the bank either to reduce its risk or hold a specific additional amount of capital, or a
combination of both.
 Interest Rate Risk Measurement Techniques

Gap Analysis
Gap analysis measures the difference between the amount of interest-earning assets and
interest-bearing liabilities (both on-and off-balance sheet) that reprice in a particular time
period.
A negative or liability-sensitive gap occurs when interest-bearing liabilities exceed interest-
earning assets for a specific or cumulative maturity period, that is, more liabilities are re-priced
than assets. In this situation, a decrease in interest rates should improve the net interest rate
spread in the short-term, as deposits are rolled over at lower rates before the corresponding
assets. On the other hand, an increase in interest rates lowers earnings by narrowing or
eliminating the interest spread.
A positive or asset-sensitive gap occurs when interest-earning assets exceed interest-bearing
liabilities for a specific or cumulative maturity period, that is, more assets are re-priced than
liabilities. In this situation, a decline in interest rates should lower or eliminate the net interest
rate spread in the short term, as assets are rolled over at lower rates before the corresponding
liabilities. An increase in interest rates should increase the net interest spread.
More sophisticated gap reports measure mismatches of an institution’s principal and interest
cash inflows and outflows (including final maturities), both on- and off-balance sheet, that
reprice in a given period.

limitations of GAP Analysis:

 Gap analysis does not capture basis risk or investment risk.
 It is generally based on parallel shifts in the yield curve.
 It does not incorporate future growth or changes in the mix of business.
 It does not account for time value of money
Moreover, Simple Gap analysis (based on contractual term to maturity) assumes the timing and
amount of assets and liabilities maturing within a specific gap period are fixed and determined,
therefore ignoring the effects of principal and interest cash flows arising from honouring
customer draw-downs on credit commitments, deposit redemptions, and prepayments, either
on mortgages or term loans, as well as the timing of maturities within the gap period. Regulators
and banks employ a wide variety of techniques to measure and manage interest rate risk
(Feldman & Schmidt, 2000). A traditional measure of interest rate risk is the maturity gap
between assets and liabilities, which is based on the reprising interval of each component of
the balance sheet. To compute the maturity gap, the assets and liabilities must be grouped
according to their reprising intervals. Within each category, the gap is then expressed as the
rand amount of assets minus those of liabilities. Although the maturity gap suggests how a
bank’s condition will respond to a given change in interest rates (Schaffer, 1991), and thus
permits the analyst to get a quick and simple overview of the profile of exposure (Hudson,
1992), the downside of this approach is that it doesn’t offer a single summary statistic that
expresses the bank’s interest rate risk. It also omits some important factors, for example, cash
flows, unequal interest rates on assets and liabilities, and initial net worth (Schaffer, 1991).

Duration Analysis
Duration is the time weighted average maturity of the present value of the cash flows from
assets, liabilities, and off-balance sheet items. It measures the relative sensitivity of the value
of these instruments to changing interest rates (the average term to re-pricing), and therefore
reflects how changes in interest rates will affect the institution’s economic value, i.e.-the
present value of equity. In this context, the maturity of an investment is used to provide an
indication of interest rate risk. The longer the term to maturity of an investment, the greater the
chance of interest rates by using a single number to index the bank’s interest rate risks. This
index represents the average term to maturity of the cash flows.
Duration can also be used and is usually presented as an account’s weighted average time to
reprising, where the weights are discounted components of cash flow. A bank will be perfectly
hedged when the duration of its assets, weighted by rands of assets, equals to the duration of
its liabilities, weighted by rands of liabilities. The difference between these two durations is
called the duration gap, and the larger the bank’s duration gap is, the more sensitive a bank’s
net worth will be to a given change in interest rates (Schaffer, 1991).

Advantages of duration analysis are:

 it provides a simple and accurate basis for hedging portfolios,
 it can be used as a standard of comparison for business development and funding
strategies,
 and it provides the essential elements for the calculation of interest rate elasticity and
price elasticity (Cade, 1997).
Several technical factors however, make it difficult to apply duration analysis correctly. First,
the detailed information on cash flows required for duration analysis presents a computational
and accounting burden. Moreover, traditional duration analysis assumes that the cash flows of
assets and liabilities are known, which may not always be the case. Second, the true cash flow
patterns are not well known for certain types of accounts, such as demand deposits, and they
are likely to vary with the size or timing of a change in market interest rates, making it harder
to quantify the associated interest rate risk. Other than this, a more complex version of duration
is needed to reflect the fact that, long-term interest rates are not always equal to short-term
interest rates and may move independently from each other (Schaffer, 1991). Additionally,
duration reflects a linear approximation to the price changes that constitute interest rate risk.
However, changes in price and yields do not change linearly.

Simulation Analysis
Stimulation models are a valuable complement to gap and duration analysis. Simulation models
analyse interest rate risk in a dynamic context. They evaluate interest rate risk arising from
both current and future business and provide a way to evaluate the effects of strategies to
increase earnings or reduce interest rate risk. Simulation models are also useful tools for
strategic planning; they enable a bank to effectively integrate risk management and control into
the planning process.

Their forecasts are based on a number of assumptions including:

 Future levels and directional changes of interest rates;
 The slope of the yield curve and the relationship between the various indices
that the institution uses to price credits and deposit;
 Pricing strategies for assets and liabilities as they mature; and
 The growth, volume and mix of future business.
Simulation is usually used to measure interest rate risk by estimating the effect of changes in
interest rates, business strategies, and other factors on net interest income, net income, and
interest rate risk positions. Simulation models can also be used to calculate the present value
and duration of assets and liabilities.
Some banks simulate the impact of various risk scenarios on their portfolios (Schaffer, 1991).
In other words, simulation analysis involves the modelling of changes in the bank’s
profitability and value under alternative interest rate scenarios (Payne et al., 1999). The
advantages of this technique are that it permits an easy examination of a bank’s interest rate
sensitivities and 62 Investment Management and Financial Innovations, 2/2004 strategies
(Cade, 1997), and it replicates the same bottom line as duration theory while bypassing the
more sophisticated mathematical deviations. The drawback of this approach is that the need for
detailed cash flow data for assets and liabilities are not satisfied and computers alone cannot
solve the problem of forecasting cash-flow patterns for some assets and liabilities (Shaffer,
1991).

OFF BALANCE SHEET RISK: In the context of a bank OBS items are the obligations that
are contingent liabilities of the bank and they do not appear in the balance sheet. In this situation
a bank substitutes its own credit for a third party in including stand by letter of credit,
irrevocable letter of credit which guarantees re-payment of commercial paper, risk participation
in bankers’ acceptance, sale and repurchase agreements, interest rate swaps, interest rate
options and currency options, etc. In the OBS exposure, a bank runs a risk in the event of
default by a customer on whose behalf commitment was undertaken by the bank.