Interest Rate Risk Management

on Whole Balance sheet of FI

Refer: Chapter 1,2,3,4- Risk Management and Shareholder Value in
Banking by Resti/Sirohi
Chapter 22-Financial Institutions Management by Saunders/Cornett
Interest Rate Risk
• Inherent in basic model of banking:
• Maturity transformation: Usually shorter maturity liabilities(ex. Customer
deposits/short term borrowing) to finance long term assets(ie; loans of higher
maturity)
• Upward slopping yield curve justifies using the above funding strategy by
creating positive Net Interest Income(NII) which is Interest Income(II) minus
Interest Expenses(IE)
• If Maturity Asset > Maturity Liability the Banks is exposed to Refinancing Risks
• If Maturity Asset < Maturity Liability the bank is exposed to Reinvestment Risks
Interest Rate Risk
• Direct Impact of Interest Rate Risk: Changes in market interest rate
impact the earnings(via Net Interest Income:NII) as well as economic
value of the bank
• Indirect effect: Rate change can impact volumes of transaction of the
bank
• This does not depend on mismatch of maturities between asset and liability
of the bank
• This is driven by elasticity of demand for deposits and loans to rate changes
• Example: A rise in interest rate may cause customer deposits to move out of the bank in
search of even higher returns, in case the bank’s rates are not increased immediately.
Additionally, bank’s borrowers tend to reduce their usage of credit lines.
Measuring Interest Rate Risk
• Reprising GAP
• Duration GAP
• Cashflow-Flow Mapping
• Internal Transfer Rates
Measuring Interest Rate Risk: Reprising GAP
• Reprising GAP: Focusses on calculating the impact of change in
interest rates on Net Interest Rates (NII)->Interest Income(II)-Interest
Expense(IE) i.e. Interest Earned on Assets minus Interest Paid of
liability
• Process:
• A period is considered( called the Gapping Period-> t). Over the period t, the
difference(in monetary terms) is calculated between rate sensitive assets(SAt )
and rate sensitive liabilities(SAl ).
• Rate sensitive is defined as only those assets(SA) or liabilities(SL) which are
either maturing during ‘t’ or they will get repriced /reset during ‘t’.
 Reprising GAP
• IF SAis > SL for the Gapping period t, then the GAP(SA - SL L)
considered positive. Under such a scenario an increase in
SLt interest rate increases the NII
SAt • Alternately, if the GAP is negative, an increase in interest rate
reduces the NII.

GAPt • ΔNII= Δr*(SA-SL); where Δr is change in interest rate and is

positive for a rise in interest rate.( Assumes change in interest
NSLt is same in both asset and liability side)
NSAt

NII=II-IE = [Link] - [Link]= rA.(SA+NSA)- rL.(SL+NSL) ; Change in NII ie; ΔNII = Δ [Link]- Δ [Link]
 Reprising GAP-Maturity Adjusted GAP
Assets (€ m) saj pj 1-min(1,pj) saj x Liabilities (€ m) slj pj 1-min(1,pj) slj x
[1-min(1,pj)] [1-min(1,pj)]
1-month interest-earning interbank 200 1/12 11/12 183.3 1-month interest-bearing interbank 60 1/12 11/12 55.0
deposits deposits
3m gov’t securities 30 1/4 3/4 22.5 Variable-rate CDs (next repricing in 3 200 1/4 3/4 150.0
months)
5yr variable-rate securities (next 120 1/2 1/2 60.0 Variable-rate bonds (next repricing in 80 1/2 1/2 40.0
repricing in 6 months) 6 months)
5m consumer credit 80 5/12 7/12 46.7 1yr fixed-rate CDs 160 1 0 0.0

20yr variable-rate mortgages (next 70 1 0 0.0 5yr fixed-rate bonds 180 5 0 0.0
repricing in 1year)
5yr treasury bonds 170 5 0 0.0 10yr fixed-rate bonds 120 10 0 0.0

10yr fixed-rate mortgages 200 10 0 0.0 20yr subordinated securities 80 20 0 0.0

30yr treasury bonds 130 30 0 0.0 Equity (not a sensitive liability) 120      

Total 1000     312.5 Total 1000     245.0

Assets repricing in one year or less 500       Liabilities repricing in one year or less 500      

Simple Reprising GAP is over-simplistic; Maturity Adjusted GAP considers the fact that in case of a change in interest
rate the impact, even for sensitive asset/liability are felt from the date of maturity or reprising to the residual period
of ‘t’.
Measuring Interest Rate Risk: Duration GAP
• Measure of overall interest rate exposure of a bank or FI is measured
in terms of duration gap;
• Duration GAP= Weighted Average Duration of Assets(A) – Weighted
Average Duration of liabilities(L);
• DA= X1ADA1 + X2ADA2 +…..+ XnADAn ;
• DL= X1LDL1 + X2LDL2 +…..+ XnLDLn ;

• X are the market value proportions of each asset or liability held in the respective asset and liability portfolio; Duration of
a portfolio of assets and liabilities is a market value weighted average of individual durations of the assets or liabilities on

the balance sheet ;

Measuring Interest Rate Risk: Cash-flow Mapping
• Duration GAP Model assumes parallel shift in yield curve
• Changes in Short-term interest rates are usually greater and more frequent than changes in long-term rates
• Volatility in interest rates decreases as maturity increases
• In Cashflow Mapping; Each Cashflow even from the same asset/liability are assumed/modelled as zero-coupon
bonds for that specific maturity.
• Ex: Half yearly Payable , % year Bond would be broken up into 10 Zero coupon bond maturing with an interval of six
months. All cash flows, even from different instruments but occurring in the identical time-period are clubbed
together and considered as one-zero coupon bond- to be discounted by the interest rate from the yield curve which
is applicable to that period.
• Choosing Specific Points(Vertices) in Term Structure: Given the large number of assets/liabilities in a bank’s books a
large number of zero-coupon ‘clusters’ gets formed but they may be of limited use:
• Interest rate at all points of the term-structure may be theoretical with no corresponding market validation
• Hedging instruments for all time periods are not available so even in the interest rate risk is measured with great granularity it will
not help
• Limited number of ‘nodes’ are chosen due to above considerations; For the entire time period typically 7(Barra) to
13(Basel)/15(RiskMetrics ), with higher number of nodes at the shorter end and nodes for medium term to longer
time period clustered around 5 Year/ 10 Year and Max Value at 30 Year/ Specific choices driven by liquidity levels of
local market
Modified Duration
Cash-flow Mapping: Duration Interval Method

Modified Duration
10.00 Low Coupon Rate 10.00 High Coupon Rate

8.00 8.00

6.00 6.00

4.00 4.00

2.00 2.00

0.00 0.00
0 2 4 6 8 10 0 2 4 6 8 10
Time to maturity Time to maturity
M o d ifie d d uratio n

10.00

7.50

5.00

2.50 Coupon =0%

Coupon =2%
Coupon =5%
0.00
0 2.5 5 7.5 10
Time to maturity
Cash-flow Mapping: Clumping

• In Clumping, Actual CF of an asset or liability is decomposed into a

stream of two virtual cashflow corresponding to two specific nodes in
the term structure; Such that:
• The sum of the Market Value(MV) of the two virtual CF has to be equal to the
MV of the original/real cashflow;
• The weighted average risk(modified duration) of the two virtual CF has to be
equal to the risk of the real CF.
MVt= FVt/(1+rt)^t= MVn + MVn+1 = FVn/(1+rn)^n + FVn+1/(1+rn+1)^(n +1)…. (1)
MDt= MDn*(MVN/(MVN + MVn+1) + MDn+1*(MVN+1/(MVN + MVn+1) …..(2)
ri=Zero coupon rate of maturity I;
FV i=Face Value of cash flow that matures at i;
Impact of Interest Rate on Capital
• A=L + E; thus ΔA= ΔL + ΔE;……..1
• Interest rate change affects the assets as well as the liabilities;
• The impact on the capital/networth is the difference between the
change in value of asset and the change in value of liability;
• ΔE= ΔA- ΔL;………..2
• ΔA/A=- DA. ΔR/(1+R);………3
• ΔL/L=- DL. ΔR/(1+R);…….4
• Substituting the Value of ΔA& ΔL in 2 by using 3 & 4;
• ΔE =-[DA – DL. L/A]*A*ΔR/(1+R);
Impact of Interest Rate on Capital
• ΔE =-[DA – DL. L/A]*A*ΔR/(1+R);
• ΔE = -[Leveraged adjusted duration gap]*[Asset Size]*Interest rate
shock;
• Leveraged adjusted duration gap:Expressed in years; Measures the
degree of duration mismatch in an FI’s Balance sheet; Higher the gap
in absolute terms, the more exposed is the FI to interest rate shock;
• Example
Hedging Interest Rate Risk
• MicroHedging:Using Derivatives contract to hedge a transaction specific
exposure;
• Macro Hedging: Hedging the entire duration gap at a portfolio/overall balance
sheet level;
• To hedge the balance sheet exposure the risk manager would enter into a
futures position such that in the interest rates rise by 1%, the FI will make a gain
on the futures position which will offset the loss at the balance sheet level;
• When interest rate rise, the price of futures contract falls since it reflects the
alue of the underlying bond whose prise will also fall;
• ΔF/F=- DF. ΔR/(1+R) where F=NF*PF refers to product of number of contracts
times the price of each contract
Hedging Interest Rate Risk
• For ideal hedging ΔF + ΔE=0;
• - DF. NF*PF *ΔR/(1+R) -[DA – DL. L/A]*A*ΔR/(1+R)=0;
• Thus the number of futures that need to be sold are given by
• NF*P=-{(DA – DL. L/A)*A)}/(DF *PF );
• When interest rate rise, the price of futures contract falls since it
reflects the alue of the underlying bond whose prise will also fall;
• ΔF/F=- DF. ΔR/(1+R) where F=NF*PF refers to product of number of
contracts times the price of each contract