Chapter Twenty-
Three
Managing Interest
Rate Risk
Repricing Gap: RSA, RSL, NII
Duration Gap: Duration A/L, Net Worth
Copyright © 2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill.
Interest Rate Risk
l Asset-transformation function performed by financial
institutions (FIs) often exposes them to interest rate risk via
the mismatching of asset and liability maturities
l FIs use two main methods to measure interest rate
exposure: RSA - RSL
It tell us the cash flow
1. Repricing gap (i.e., funding gap) model examines the impact
of interest rate changes on an FI’s net interest income (NII)
focus on the market value of the balance sheet
Estimate the equity change, market value change
2. Duration gap model incorporates the impact of interest rate
changes on the overall market value of an FI’s balance sheet
and ultimately on its owners’ equity or net worth Da - kDL
k is leverage factor
l Insolvency risk is the result, a consequence, or an outcome
of excessive amounts of one or more of the risks taken by
an FI (e.g., liquidity risk, credit risk, and interest rate risk)
© 2022 McGraw-Hill Education. 23-2
Interest Rate Risk Measurement
and Management
l Federal Reserve’s monetary policy strategy is the most
direct influence on the level and movement of interest rates
l If the Fed wants to slow down the economy, it will tighten
monetary policy by taking actions that raise interest rates
l Results in a decrease in business and household spending
l If the Fed wants to stimulate the economy (i.e., expansionary
monetary policy), it allows interest rates to fall
l Promotes borrowing and spending
l Until recently, bank regulators based evaluations of bank
interest rate risk on the repricing gap model alone
l While the repricing gap model is still used to measure interest
rate risk in most FIs, it is increasingly being used in
conjunction with the duration gap model
© 2022 McGraw-Hill Education. 23-3
Repricing Model
l Repricing or funding gap is the difference between
those assets whose interest rates will be repriced or
changed over some future period (RSAs) and liabilities
whose interest rates will be repriced or changed over
some future period (RSLs)
l Simple model used by small FIs in the U.S.
l Model is essentially a book value accounting cash flow
analysis of the interest income earned on an FI’s assets
and the interest expense paid on its liabilities (or its net
interest income) over some particular period
l Using this approach, DIs report quarterly on their Call
Reports, interest-rate sensitivity reports which show the
repricing gaps for assets and liabilities with various
maturities
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Repricing Gaps for an FI
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Repricing Model (Continued)
l Gap in each maturity bucket (or bin) is calculated by
estimated the difference between the rate-sensitive assets
(RSAs) and the rate-sensitive liabilities (RSLs)
l Rate sensitivity is the time to repricing of an asset or liability
l Repricing model measures the change in an FI’s net
interest income exposure (or profit exposure) to interest
rate changes in each different maturity bucket
l Negative gap (where RSA < RSL) exposes the FI to
refinancing risk, the risk that the cost of rolling over or
reborrowing funds will rise above the returns being earned on
asset investments
l A positive gap (where RSA > RSL) exposes the FI to
reinvestment risk, the risk that the returns on funds to be
reinvested will fall below the cost of the funds
© 2022 McGraw-Hill Education. 23-6
Change in Net Interest Income
If RSA < RSL, when interest rate increase, NII decrease
If RSA > RSL, when interest rate increase, NII increase
l Change in net interest income in the ith maturity bucked
is calculated as follows:
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Cumulative Gaps (CGAP)
l FI manager can also estimate cumulative gaps (CGAP)
over various repricing categories or buckets
l Common CGAP of interest is the one-year repricing gap
l Cumulative effect on a bank’s net interest income may be
estimated using:
l CGAP effect is the relation between changes in interest
rates and changes in net interest income
© 2022 McGraw-Hill Education. 23-8
Impact of Rate Changes on Net
Interest Income When CGAP is
Positive
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Spread Effect
spread effect increase NII increase
l Spread effect is the effect that a change in the spread
between rates on RSAs and RSLs has on net interest
income (NII) as interest rates change
When the interest rate change, the change in asset and liabilities is different
l In general, the spread effect is such that, regardless of the
direction of the change in interest rates, a positive relation
exists between changes in the spread (between rates on
RSAs and RSLs) and changes in NII
l When the spread increases (decreases), NII increases
(decreases)
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Impact of Spread Effect on Net
Interest Income
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Check Point 每年都有⼈repay 晒mortgage, 亦都有新mortgage
所以 fix mortgage 都有機會有影響 sensitive
所有 floating rate asset 都會受interest rate 影響
What is the CGAP? NII with +1%
interest rate change?
What products are rate sensitive?
McGraw-Hill/Irwin 22-12
Weaknesses of the Repricing
Model
l Repricing model has five major weaknesses
1. It ignores market value effects of interest rate changes
l Repricing gap is only a partial and short-term measure of overall interest
rate exposure
2. It ignores cash flow patterns within a maturity bucket
l On average, liabilities may be repriced toward the end of the bucket’s
range and assets may be repriced toward the beginning
3. It fails to deal with the problem of rate-insensitive asset and liability cash
flow runoffs and prepayments
l FI receives runoff from its rate-insensitive portfolio that can be reinvested
at current market rates
4. It ignores cash flows from off-balance-sheet (OBS) activities
l Changes in interest rates will affect the cash flows on many OBS
instruments, as well as those listed on the balance sheet
5. Rate-sensitivity calculations depend on managers’ experience and
estimations
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The Duration Model
l Duration measures the interest rate sensitivity of an asset
or liability’s value to small changes in interest rates
l measured in term of years
l The duration gap is a measure of overall interest rate risk
exposure for an FI between assets and liabilities
𝐿
DA – kDL, when 𝑘 =
𝐴
l reflects the duration mismatch on an FI’s balance sheet
l the larger the gap, the more exposed the FI to interest rate
risk
l It affects equity value of FI
McGraw-Hill/Irwin 22-14
The Duration Model
l It is important to find the duration of the total portfolio
of assets (DA) (or liabilities (DL)) for an FI
l First determine the duration of each asset (or liability)
in the portfolio
l Then, calculate the market value weighted average of
the duration of the assets (or liabilities) in the portfolio
Assets $ Amount Weight Duration Weight x Duration
T-bills 90 2.96% 0.500 0.015
T-notes 55 1.81% 0.900 0.016
T-bonds 176 5.78% 4.393 0.254
Loans 2,724 89.46% 3.000 2.684
3,045 100.00% DurA 2.969
McGraw-Hill/Irwin 22-15
Duration Gap Model
l Duration measures the interest rate sensitivity of an asset
or liability’s value to small changes in interest rates
l Duration gap is a measure of overall interest rate risk
exposure for an FI
l To estimate the overall duration gap of an FI:
l Determine the duration of an FI’s asset portfolio (A) and the
duration of its liability portfolio (L)
l Calculate the market value weighted average of the duration
of the assets (or liabilities) in the portfolio
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Duration Gap Model (Continued)
l The dollar change in the market value of the asset portfolio for a
change in interest rates is:
l Similarly, the dollar change in the market value of the liability
portfolio for a change in interest rates is:
l Rearranging and combining these equations results in a measure
of the change in the market value of equity:
A = L + E ÞDA = DL + DE
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Duration Gap Model (Concluded)
l Effect of interest rate changes on the market value of an
FI’s equity or net worth (∆E) breaks down into three effects:
1. Leverage-adjusted duration gap = DA – kDL
l Measured in years and reflects degree of duration mismatch in an
FI’s balance sheet
l The larger this gap in absolute terms, the more exposed the FI is
to interest rate risk
2. Size of the FI
l A measures the size of the FI’s assets; the larger the asset size,
the larger the dollar size of the potential net worth exposure from
any given interest rate shock
3. Size of the interest rate shock = ∆R/(1 + R)
l The larger the shock, the greater the FI’s exposure
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Difficulties in Applying the
Duration Model to Real-World FI
Balance Sheets
l Duration matching can be costly
l Critics claim that restructuring the balance sheet can be time-
consuming and costly
l Note that this argument isn’t as true today as is has been in the
past, given the growth of purchased funds, asset securitization,
and loan sales markets have eased the speed and lowered the
transaction costs of major balance sheet restructurings
duration change every day
l Immunization is a dynamic problem
l The duration of assets and liabilities changes as they approach
maturity, and the rate at which their durations change through
time may not be the same on the asset and liability sides of the
balance sheet
l Large interest rate changes and convexity only good for small interest rate movement
l Convexity is the degree of curvature of the price-yield curve
around some interest rate level
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