1 Managing Interest Rate Risk Interest Rate Risk The potential loss from unexpected changes in interest rates which can significantly alter a banks profitability and market value of equity 2 Managing Interest Rate Risk ID: 669913
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Slide1
Managing Interest Rate Risk: GAP and Earnings Sensitivity
1Slide2
Managing Interest Rate Risk
Interest Rate Risk
The potential loss from unexpected changes in interest rates which can significantly alter a bank’s profitability and market value of equity
2Slide3
Managing Interest Rate Risk
Interest Rate Risk
When a bank’s assets and liabilities do not
reprice at the same time, the result is a change in net interest income
The change in the value of assets and the change in the value of liabilities will also differ, causing a change in the value of stockholder’s equity
3Slide4
Managing Interest Rate Risk
Interest Rate Risk
Banks typically focus on either:
Net interest income or
The market value of stockholders' equity
GAP Analysis
A static measure of risk that is commonly associated with net interest income (margin) targeting
Earnings Sensitivity Analysis
Earnings sensitivity analysis extends GAP analysis by focusing on changes in bank earnings due to changes in interest rates and balance sheet composition
4Slide5
Managing Interest Rate Risk
Interest Rate Risk
Asset and Liability Management Committee (ALCO)
The bank’s ALCO primary responsibility is interest rate risk management.
The ALCO coordinates the bank’s strategies to achieve the optimal risk/reward trade-off
5Slide6
Measuring Interest Rate Risk with GAP
Three general factors potentially cause a bank’s net interest income to change.
Rate Effects
Unexpected changes in interest rates
Composition (Mix) Effects
Changes in the mix, or composition, of assets and/or liabilities
Volume Effects
Changes in the volume of earning assets and interest-bearing liabilities
6Slide7
Measuring Interest Rate Risk with GAP
Consider a bank that makes a $25,000 five-year car loan to a customer at fixed rate of 8.5%. The bank initially funds the car loan with a one-year $25,000 CD at a cost of 4.5%. The bank’s initial spread is 4%.
What is the bank’s risk?
7Slide8
Measuring Interest Rate Risk with GAP
Traditional Static Gap Analysis
Static GAP Analysis
GAP
t
=
RSAt
-
RSLtRSA
t
Rate Sensitive Assets
Those assets that will mature or
reprice
in a given time period (t)
RSL
t
Rate Sensitive Liabilities
Those liabilities that will mature or
reprice
in a given time period (t)
8Slide9
Measuring Interest Rate Risk with GAP
Traditional Static Gap Analysis
Steps in GAP Analysis
Develop an interest rate forecast
Select a series of “time buckets” or time intervals for determining when assets and liabilities will
reprice
Group assets and liabilities into these “buckets”
Calculate the GAP for each “bucket ”
Forecast the change in net interest income given an assumed change in interest rates
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Measuring Interest Rate Risk with GAP
What Determines Rate Sensitivity
The initial issue is to determine what features make an asset or liability rate sensitive
10Slide11
Measuring Interest Rate Risk with GAP
Expected
Repricing
versus Actual
Repricing
In general, an asset or liability is normally classified as rate sensitive within a time interval if:
It matures
It represents an interim or partial principal payment
The interest rate applied to the outstanding principal balance changes contractually during the interval
The interest rate applied to the outstanding principal balance changes when some base rate or index changes and management expects the base rate/index to change during the time interval
11Slide12
Measuring Interest Rate Risk with GAP
What Determines Rate Sensitivity
Maturity
If any asset or liability matures within a time interval, the principal amount will be repriced
The question is what principal amount is expected to reprice
Interim or Partial Principal Payment
Any principal payment on a loan is rate sensitive if management expects to receive it within the time interval
Any interest received or paid is
not
included in the GAP calculation
12Slide13
Measuring Interest Rate Risk with GAP
What Determines Rate Sensitivity
Contractual Change in Rate
Some assets and deposit liabilities earn or pay rates that vary contractually with some index
These instruments are repriced whenever the index changes
If management knows that the index will contractually change within 90 days, the underlying asset or liability is rate sensitive within 0–90 days.
13Slide14
Measuring Interest Rate Risk with GAP
What Determines Rate Sensitivity
Change in Base Rate or Index
Some loans and deposits carry interest rates tied to indexes where the bank has no control or definite knowledge of when the index will change.
For example, prime rate loans typically state that the bank can contractually change prime daily
The loan is rate sensitive in the sense that its yield can change at any time
However, the loan’s effective rate sensitivity depends on how frequently the prime rate actually changes
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Rate, Composition (Mix) and Volume Effects
All affect net interest income
15Slide16
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Changes in the Level of Interest Rates
The sign of GAP (positive or negative) indicates the nature of the bank’s interest rate risk
A negative (positive) GAP, indicates that the bank has more (less) RSLs than RSAs. When interest rates rise (fall) during the time interval, the bank pays higher (lower) rates on all
repriceable
liabilities and earns higher (lower) yields on all
repriceable
assets
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Changes in the Level of Interest Rates
The sign of GAP (positive or negative) indicates the nature of the bank’s interest rate risk
If all rates rise (fall) by equal amounts at the same time, both interest income and interest expense rise (fall), but interest expense rises (falls) more because more liabilities are
repriced
Net interest income thus declines (increases), as does the bank’s net interest margin
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Changes in the Level of Interest Rates
If a bank has a zero GAP, RSAs equal RSLs and equal interest rate changes do not alter net interest income because changes in interest income equal changes in interest expense
It is virtually impossible for a bank to have a zero GAP given the complexity and size of bank balance sheets
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Changes in the Level of Interest Rates
GAP analysis assumes a parallel shift in the yield curve
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Changes in the Level of Interest Rates
If there is a parallel shift in the yield curve then changes in Net Interest Income are directly proportional to the size of the GAP:
∆NII
EXP
= GAP x ∆i
EXP
It is rare, however, when the yield curve shifts parallel. If rates do not change by the same amount and at the same time, then net interest income may change by more or less
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Changes in the Level of Interest Rates
Example 1
Recall the bank that makes a $25,000 five-year car loan to a customer at fixed rate of 8.5%. The bank initially funds the car loan with a one-year $25,000 CD at a cost of 4.5%. What is the bank’s 1-year GAP?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Changes in the Level of Interest Rates
Example 1
RSA
1 YR
= $0
RSL
1 YR
= $10,000GAP1 YR = $0 - $25,000 = -$25,000
The bank’s one year funding GAP is -$25,000
If interest rates rise (fall) by 1% in 1 year, the bank’s net interest margin and net interest income will fall (rise)
∆NII
EXP
= GAP x ∆
i
EXP
= -$10,000 x 1% = -$100
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Changes in the Level of Interest Rates
Example 2
Assume a bank accepts an 18-month $30,000 CD deposit at a cost of 3.75% and invests the funds in a $30,000 6-month T-Bill at rate of 4.80%. The bank’s initial spread is 1.05%. What is the bank’s 6-month GAP?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Changes in the Level of Interest Rates
Example 2
RSA
6 MO
= $30,000
RSL
6 MO
= $0GAP6 MO = $30,000 – $0 = $30,000
The bank’s 6-month funding GAP is $30,000
If interest rates rise (fall) by 1% in 6 months, the bank’s net interest margin and net interest income will rise (fall)
∆NII
EXP
= GAP x ∆
i
EXP
= $30,000 x 1% = $300
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Changes in the Relationship Between Asset Yields and Liability Costs
Net interest income may differ from that expected if the spread between earning asset yields and the interest cost of interest-bearing liabilities changes
The spread may change because of a nonparallel shift in the yield curve or because of a change in the difference between different interest rates (basis risk)
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Changes in Volume
Net interest income varies directly with changes in the volume of earning assets and interest-bearing liabilities, regardless of the level of interest rates
For example, if a bank doubles in size but the portfolio composition and interest rates remain unchanged, net interest income will double because the bank earns the same interest spread on twice the volume of earning assets such that NIM is unchanged
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Changes in Portfolio Composition
Any variation in portfolio mix potentially alters net interest income
There is no fixed relationship between changes in portfolio mix and net interest income
The impact varies with the relationships between interest rates on rate-sensitive and fixed-rate instruments and with the magnitude of funds shifts
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.0
30Slide31
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.0
Interest Income
($500 x 8%) + ($350 x 11%) = $78.50
Interest Expense
($600 x 4%) + ($220 x 6%) = $37.20
Net Interest Income
$78.50 - $37.20 = $41.30
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.0
Earning Assets
$500 + $350 = $850
Net Interest Margin
$41.3/$850 = 4.86%Funding GAP
$500 - $600 = -$100
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.1
What if all rates increase by 1%?
33Slide34
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.1
What if all rates increase by 1%?
With a negative GAP, interest income increases by less than the increase in interest expense. Thus, both NII and NIM fall.
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.2
What if all rates fall by 1%?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.2
What if all rates fall by 1%?
With a negative GAP, interest income decreases by less than the decrease in interest expense. Thus, both NII and NIM increase.
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.3
What if rates rise but the spread falls by 1%?
37Slide38
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.3
What if rates rise but the spread falls by 1%?
Both NII and NIM fall with a decrease in the spread.
Why the larger change?
Note:
∆NII
EXP
≠ GAP x ∆
i
EXP
Why?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.4
What if rates fall but the spread falls by 1%?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.4
What if rates fall and the spread falls by 1%?
Both NII and NIM fall with a decrease in the spread.
Note:
∆NII
EXP
≠ GAP x ∆
i
EXP
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.5
What if rates rise and the spread rises by 1%?
41Slide42
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.5
What if rates rise and the spread rises by 1%?
Both NII and NIM increase with an increase in the spread.
Note:
∆NII
EXP
≠ GAP x ∆
i
EXP
42Slide43
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.6
What if rates fall and the spread rises by 1%?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.6
What if rates fall and the spread rises by 1%?
Both NII and NIM increase with an increase in the spread.
Note:
∆NII
EXP
≠ GAP x ∆
i
EXP
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.7
What if the bank proportionately doubles in size?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 3.7
What if the bank proportionately doubles in size?
Both NII doubles but NIM stays the same. Why? What has happened to the bank’s risk?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.0
47Slide48
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.0
Bank has a positive GAP
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.1
What if rates increase by 1%?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.1
What if rates increase by 1%?
With a positive GAP, interest income increases by more than the increase in interest expense. Thus, both NII and NIM rise.
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.2
What if rates decrease by 1%?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.2
What if rates decrease by 1%?
With a positive GAP, interest income decreases by more than the decrease in interest expense. Thus, both NII and NIM fall.
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.3
What if rates rise but the spread falls by 1%?
53Slide54
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.3
What if rates rise but the spread falls by 1%?
Both NII and NIM fall with a decrease in the spread.
Why the larger change?
Note:
∆NII
EXP
≠ GAP x ∆
i
EXP
Why?
54Slide55
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.4
What if rates fall and the spread falls by 1%?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.4
What if rates fall and the spread falls by 1%?
Both NII and NIM fall with a decrease in the spread.
Note: ∆NII
EXP
≠ GAP x ∆
i
EXP
56Slide57
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.5
What if rates rise and the spread rises by 1%?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.5
What if rates rise and the spread rises by 1%?
Both NII and NIM increase with an increase in the spread.
Note:
∆NII
EXP
≠ GAP x ∆
i
EXP
58Slide59
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.6
What if rates fall and the spread rises by 1%?
59Slide60
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.6
What if rates fall and the spread rises by 1%?
Both NII and NIM increase with an increase in the spread.
Note:
∆NII
EXP
≠ GAP x ∆
i
EXP
60Slide61
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.7
What if the bank proportionately doubles in size?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 4.7
What if the bank proportionately doubles in size?
Both NII doubles but NIM stays the same. Why? What has happened to the bank’s risk?
62Slide63
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 5.0
63Slide64
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 5.0
Bank has zero GAP
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 5.1
What if rates increase by 1%?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 5.1
What if rates increase by 1%?
With a zero GAP, interest income increases by the amount as the increase in interest expense. Thus, there is no change in NII or NIM!
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 5.2
What if rates fall and the spread falls by 1%?
67Slide68
Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 5.2
What if rates fall and the spread falls by 1%?
Even with a zero GAP, interest income falls by more than the decrease in interest expense. Thus, both NII and NIM fall with a decrease in the spread. Note: ∆NII
EXP
≠ GAP x ∆
i
EXP
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 5.3
What if rates rise and the spread rises by 1%?
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Example 5.3
What if rates rise and the spread rises by 1%?
Even with a zero GAP, interest income rises by more than the increase in interest expense. Thus, both NII and NIM increase with an increase in the spread. Note: ∆NII
EXP
≠ GAP x ∆
i
EXP
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Measuring Interest Rate Risk with GAP
Factors Affecting Net Interest Income
Summary of Base Cases
If a Negative GAP gives the largest NII and NIM, why not plan for a Negative GAP?
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Measuring Interest Rate Risk with GAP
Rate, Volume, and Mix Analysis
Many financial institutions publish a summary in their annual report of how net interest income has changed over time
They separate changes attributable to shifts in asset and liability composition and volume from changes associated with movements in interest rates
72Slide73
73Slide74
Measuring Interest Rate Risk with GAP
Rate Sensitivity Reports
Many managers monitor their bank’s risk position and potential changes in net interest income using rate sensitivity reports
These report classify a bank’s assets and liabilities as rate sensitive in selected time buckets through one year
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Measuring Interest Rate Risk with GAP
Rate Sensitivity Reports
Periodic GAP
The Gap for each time bucket and measures the timing of potential income effects from interest rate changes
75Slide76
Measuring Interest Rate Risk with GAP
Rate Sensitivity Reports
Cumulative GAP
The sum of periodic GAP's and measures aggregate interest rate risk over the entire period
Cumulative GAP is important since it directly measures a bank’s net interest sensitivity throughout the time interval
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77Slide78
Measuring Interest Rate Risk with GAP
Strengths and Weaknesses of Static GAP Analysis
Strengths
Easy to understand
Works well with small changes in interest rates
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Measuring Interest Rate Risk with GAP
Strengths and Weaknesses of Static GAP Analysis
Weaknesses
Ex-post measurement errors
Ignores the time value of money
Ignores the cumulative impact of interest rate changes
Typically considers demand deposits to be non-rate sensitive
Ignores embedded options in the bank’s assets and liabilities
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Measuring Interest Rate Risk with GAP
GAP Ratio
GAP Ratio = RSAs/RSLs
A GAP ratio greater than 1 indicates a positive GAP
A GAP ratio less than 1 indicates a negative GAP
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Measuring Interest Rate Risk with GAP
GAP Divided by Earning Assets as a Measure of Risk
An alternative risk measure that relates the absolute value of a bank’s GAP to earning assets
The greater this ratio, the greater the interest rate risk
Banks may specify a target GAP-to-earning-asset ratio in their ALCO policy statements
A target allows management to position the bank to be either asset sensitive or liability sensitive, depending on the outlook for interest rates
81Slide82
Earnings Sensitivity Analysis
Allows management to incorporate the impact of different spreads between asset yields and liability interest costs when rates change by different amounts
82Slide83
Earnings Sensitivity Analysis
Steps to Earnings Sensitivity Analysis
Forecast interest rates.
Forecast balance sheet size and composition given the assumed interest rate environment
Forecast when embedded options in assets and liabilities will be exercised such that prepayments change, securities are called or put, deposits are withdrawn early, or rate caps and rate floors are exceeded under the assumed interest rate environment
83Slide84
Earnings Sensitivity Analysis
Steps to Earnings Sensitivity Analysis
Identify when specific assets and liabilities will
reprice
given the rate environment
Estimate net interest income and net income under the assumed rate environment
Repeat the process to compare forecasts of net interest income and net income across different interest rate environments versus the base case
The choice of base case is important because all estimated changes in earnings are compared with the base case estimate
84Slide85
Earnings Sensitivity Analysis
The key benefits of conducting earnings sensitivity analysis are that managers can estimate the impact of rate changes on earnings while allowing for the following:
Interest rates to follow any future path
Different rates to change by different amounts at different times
Expected changes in balance sheet mix and volume
Embedded options to be exercised at different times and in different interest rate environments
Effective GAPs to change when interest rates change
Thus, a bank does not have a single static GAP, but instead will experience amounts of RSAs and RSLs that change when interest rates change
85Slide86
Earnings Sensitivity Analysis
Exercise of Embedded Options in Assets and Liabilities
The most common embedded options at banks include the following:
Refinancing of loans
Prepayment (even partial) of principal on loans
Bonds being called
Early withdrawal of deposits
Caps on loan or deposit rates
Floors on loan or deposit rates
Call or put options on FHLB advances
Exercise of loan commitments by borrowers
86Slide87
Earnings Sensitivity Analysis
Exercise of Embedded Options in Assets and Liabilities
The implications of embedded options
Does the bank or the customer determine when the option is exercised?
How and by what amount is the bank being compensated for selling the option, or how much must it pay to buy the option?
When will the option be exercised?
This is often determined by the economic and interest rate environment
Static GAP analysis ignores these embedded options
87Slide88
Earnings Sensitivity Analysis
Different Interest Rates Change by Different Amounts at Different Times
It is well recognized that banks are quick to increase base loan rates but are slow to lower base loan rates when rates fall
88Slide89
Earnings Sensitivity Analysis
Earnings Sensitivity: An Example
Consider the rate sensitivity report for First Savings Bank (FSB) as of year-end 2008 that is presented on the next slide
The report is based on the most likely interest rate scenario
FSB is a $1 billion bank that bases its analysis on forecasts of the federal funds rate and ties other rates to this overnight rate
As such, the federal funds rate serves as the bank’s benchmark interest rate
89Slide90
90Slide91
91Slide92
92Slide93
Earnings Sensitivity Analysis
Explanation of Sensitivity Results
This example demonstrates the importance of understanding the impact of exercising embedded options and the lags between the pricing of assets and liabilities.
The framework uses the federal funds rate as the benchmark rate such that rate shocks indicate how much the funds rate changes
Summary results are known as Earnings-at-Risk Simulation or Net Interest Income Simulation
93Slide94
Earnings Sensitivity Analysis
Explanation of Sensitivity Results
Earnings-at-Risk
The potential variation in net interest income across different interest rate environments, given different assumptions about balance sheet composition, when embedded options will be exercised, and the timing of repricings.
94Slide95
Earnings Sensitivity Analysis
Explanation of Sensitivity Results
FSB’s earnings sensitivity results reflect the impacts of rate changes on a bank with this profile
There are two basic causes or drivers behind the estimated earnings changes
First, other market rates change by different amounts and at different times relative to the federal funds rate
Second, embedded options potentially alter cash flows when the options go in the money
95Slide96
Income Statement GAP
Income Statement GAP
An interest rate risk model which modifies the standard GAP model to incorporate the different speeds and amounts of repricing of specific assets and liabilities given an interest rate change
96Slide97
Income Statement GAP
Beta GAP
The adjusted GAP figure in a basic earnings sensitivity analysis derived from multiplying the amount of rate-sensitive assets by the associated beta factors and summing across all rate-sensitive assets, and subtracting the amount of rate-sensitive liabilities multiplied by the associated beta factors summed across all rate-sensitive liabilities
97Slide98
Income Statement GAP
Balance Sheet GAP
The effective amount of assets that
reprice
by the full assumed rate change minus the effective amount of liabilities that
reprice
by the full assumed rate change.Earnings Change Ratio (ECR)
A ratio calculated for each asset or liability that estimates how the yield on assets or rate paid on liabilities is assumed to change relative to a 1 percent change in the base rate
98Slide99
99Slide100
Managing the GAP and Earnings Sensitivity Risk
Steps to reduce risk
Calculate periodic GAPs over short time intervals
Match fund repriceable assets with similar repriceable liabilities so that periodic GAPs approach zero
Match fund long-term assets with non-interest-bearing liabilities
Use off-balance sheet transactions to hedge
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Managing the GAP and Earnings Sensitivity Risk
How to Adjust the Effective GAP or Earnings Sensitivity Profile
101Slide102
Managing Interest Rate Risk: Economic Value of Equity
102Slide103
Managing Interest Rate Risk:Economic Value of Equity
Economic Value of Equity (EVE) Analysis
Focuses on changes in stockholders’ equity given potential changes in interest rates
103Slide104
Managing Interest Rate Risk:Economic Value of Equity
Duration GAP Analysis
Compares the price sensitivity of a bank’s total assets with the price sensitivity of its total liabilities to assess the impact of potential changes in interest rates on stockholders’ equity
104Slide105
Managing Interest Rate Risk:Economic Value of Equity
GAP and Earnings Sensitivity versus Duration GAP and EVE Sensitivity
105Slide106
Managing Interest Rate Risk:
Economic Value of Equity
Recall from Chapter 6
Duration is a measure of the effective maturity of a security
Duration incorporates the timing and size of a security’s cash flows
Duration measures how price sensitive a security is to changes in interest rates
The greater (shorter) the duration, the greater (lesser) the price sensitivity
106Slide107
Managing Interest Rate Risk:
Economic Value of Equity
Market Value Accounting Issues
EVE sensitivity analysis is linked with the debate concerning whether market value accounting is appropriate for financial institutions
Recently many large commercial and investment banks reported large write-downs of mortgage-related assets, which depleted their capital
Some managers argued that the write-downs far exceeded the true decline in value of the assets and because banks did not need to sell the assets they should not be forced to recognize the “paper” losses
107Slide108
108Slide109
Measuring Interest Rate Risk with Duration GAP
Duration GAP Analysis
Compares the price sensitivity of a bank’s total assets with the price sensitivity of its total liabilities to assess whether the market value of assets or liabilities changes more when rates change
109Slide110
Measuring Interest Rate Risk with Duration GAP
Duration, Modified Duration, and Effective Duration
Macaulay’s Duration (D)
where P* is the initial price,
i
is the market interest rate, and t is equal to the time until the cash payment is made
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Measuring Interest Rate Risk with Duration GAP
Duration, Modified Duration, and Effective Duration
Macaulay’s Duration (D)
Macaulay’s duration is a measure of price sensitivity where P refers to the price of the underlying security:
111Slide112
Measuring Interest Rate Risk with Duration GAP
Duration, Modified Duration, and Effective Duration
Modified Duration
Indicates how much the price of a security will change in percentage terms for a given change in interest rates
Modified Duration = D/(1+i)
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Measuring Interest Rate Risk with Duration GAP
Duration, Modified Duration, and Effective Duration
Example
Assume that a ten-year zero coupon bond has a par value of $10,000, current price of $7,835.26, and a market rate of interest of 5%. What is the expected change in the bond’s price if interest rates fall by 25 basis points?
113Slide114
Measuring Interest Rate Risk with Duration GAP
Duration, Modified Duration, and Effective Duration
Example
Since the bond is a zero-coupon bond, Macaulay’s Duration equals the time to maturity, 10 years. With a market rate of interest, the Modified Duration is 10/(1.05) = 9.524 years. If rates change by 0.25% (.0025), the bond’s price will change by approximately 9.524 × .0025 × $7,835.26 = $186.56
114Slide115
Measuring Interest Rate Risk with Duration GAP
Duration, Modified Duration, and Effective Duration
Effective Duration
Used to estimate a security’s price sensitivity when the security contains embedded options
Compares a security’s estimated price in a falling and rising rate environment
115Slide116
Measuring Interest Rate Risk with Duration GAP
Duration, Modified Duration, and Effective Duration
Effective Duration
where: P
i-
= Price if rates fall
P
i+
= Price if rates rise
P
0
= Initial (current) price
i
+
= Initial market rate plus the increase in the rate
i
-
= Initial market rate minus the decrease in the rate
116Slide117
Measuring Interest Rate Risk with Duration GAP
Duration, Modified Duration, and Effective Duration
Effective Duration
Example
Consider a 3-year, 9.4 percent semi-annual coupon bond selling for $10,000 par to yield 9.4 percent to maturity
Macaulay’s Duration for the option-free version of this bond is 5.36 semiannual periods, or 2.68 years
The Modified Duration of this bond is 5.12 semiannual periods or 2.56 years
117Slide118
Measuring Interest Rate Risk with Duration GAP
Duration, Modified Duration, and Effective Duration
Effective Duration
Example
Assume that the bond is callable at par in the near-term .
If rates fall, the price will not rise much above the par value since it will likely be called
If rates rise, the bond is unlikely to be called and the price will fall
118Slide119
Measuring Interest Rate Risk with Duration GAP
Duration, Modified Duration, and Effective Duration
Effective Duration
Example
If rates rise 30 basis points to 5% semiannually, the price will fall to $9,847.72.
If rates fall 30 basis points to 4.4% semiannually, the price will remain at par
119Slide120
Measuring Interest Rate Risk with Duration GAP
Duration, Modified Duration, and Effective Duration
Effective Duration
Example
120Slide121
Measuring Interest Rate Risk with Duration GAP
Duration GAP Model
Focuses on managing the market value of stockholders’ equity
The bank can protect EITHER the market value of equity or net interest income, but not both
Duration GAP analysis emphasizes the impact on equity and focuses on price sensitivity
121Slide122
Measuring Interest Rate Risk with Duration GAP
Duration GAP Model
Steps in Duration GAP Analysis
Forecast interest rates
Estimate the market values of bank assets, liabilities and stockholders’ equity
Estimate the weighted average duration of assets and the weighted average duration of liabilities
Incorporate the effects of both on- and off-balance sheet items. These estimates are used to calculate duration gap
Forecasts changes in the market value of stockholders’ equity across different interest rate environments
122Slide123
Measuring Interest Rate Risk with Duration GAP
Duration GAP Model
Weighted Average Duration of Bank Assets (DA):
where
w
i
= Market value of asset
i
divided by the market value of all bank assets
Dai = Macaulay’s duration of asset
i
n = number of different bank assets
123Slide124
Measuring Interest Rate Risk with Duration GAP
Duration GAP Model
Weighted Average Duration of Bank Liabilities (DL):
where
z
j
= Market value of liability j divided by the market value of all bank liabilities
Dl
j
= Macaulay’s duration of liability jm = number of different bank liabilities
124Slide125
Measuring Interest Rate Risk with Duration GAP
Duration GAP Model
Let MVA and MVL equal the market values of assets and liabilities, respectively
If
Δ
EVE =
Δ
MVA –
Δ
MVLand Duration GAP = DGAP = DA – (MVL/MVA)DLthen
Δ
EVE = -DGAP[
Δ
y/(1+y)]MVA
where y is the interest rate
125Slide126
Measuring Interest Rate Risk with Duration GAP
Duration GAP Model
To protect the economic value of equity against any change when rates change , the bank could set the duration gap to zero:
126Slide127
Measuring Interest Rate Risk with Duration GAP
Duration GAP Model
DGAP as a Measure of Risk
The sign and size of DGAP provide information about whether rising or falling rates are beneficial or harmful and how much risk the bank is taking
If DGAP is positive, an increase in rates will lower EVE, while a decrease in rates will increase EVE
If DGAP is negative, an increase in rates will increase EVE, while a decrease in rates will lower EVE
The closer DGAP is to zero, the smaller is the potential change in EVE for any change in rates
127Slide128
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
128Slide129
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
Implications of DGAP
The value of DGAP at 1.42 years indicates that the bank has a substantial mismatch in average durations of assets and liabilities
Since the DGAP is positive, the market value of assets will change more than the market value of liabilities if all rates change by comparable amounts
In this example, an increase in rates will cause a decrease in EVE, while a decrease in rates will cause an increase in EVE
129Slide130
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
Implications of DGAP > 0
A positive DGAP indicates that assets are more price sensitive than liabilities
When interest rates rise (fall), assets will fall proportionately
more
(less) in value than liabilities and EVE will
fall
(rise) accordingly.
Implications of DGAP < 0A negative DGAP indicates that liabilities are more price sensitive than assets
When interest rates rise (fall), assets will fall proportionately
less
(more) in value that liabilities and the EVE will
rise
(fall)
130Slide131
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
131Slide132
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
Duration GAP Summary
132Slide133
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
DGAP As a Measure of Risk
DGAP measures can be used to approximate the expected change in economic value of equity for a given change in interest rates
133Slide134
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
DGAP As a Measure of Risk
In this case:
The actual decrease, as shown in Exhibit 8.3, was $12
134Slide135
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
An Immunized Portfolio
To immunize the EVE from rate changes in the example, the bank would need to:
decrease the asset duration by 1.42 years
or
increase the duration of liabilities by 1.54 years
DA/( MVA/MVL)
= 1.42/($920/$1,000)
= 1.54 years
or
a combination of both
135Slide136
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
136Slide137
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
An Immunized Portfolio
With a 1% increase in rates, the EVE did not change with the immunized portfolio versus $12.0 when the portfolio was not immunized
137Slide138
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
An Immunized Portfolio
If DGAP > 0, reduce interest rate risk by:
shortening asset durations
Buy short-term securities and sell long-term securities
Make floating-rate loans and sell fixed-rate loans
lengthening liability durations
Issue longer-term CDs
Borrow via longer-term FHLB advances
Obtain more core transactions accounts from stable sources
138Slide139
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
An Immunized Portfolio
If DGAP < 0, reduce interest rate risk by:
lengthening asset durations
Sell short-term securities and buy long-term securities
Sell floating-rate loans and make fixed-rate loans
Buy securities without call options
shortening liability durations
Issue shorter-term CDs
Borrow via shorter-term FHLB advances
Use short-term purchased liability funding from federal funds and repurchase agreements
139Slide140
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
Banks may choose to target variables other than the market value of equity in managing interest rate risk
Many banks are interested in stabilizing the book value of net interest income
This can be done for a one-year time horizon, with the appropriate duration gap measure
140Slide141
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
DGAP* = MVRSA(1 − DRSA) − MVRSL(1 − DRSL)
where
MVRSA = cumulative market value of rate-sensitive assets (RSAs)
MVRSL = cumulative market value of rate-sensitive liabilities (RSLs)
DRSA = composite duration of RSAs for the given time horizon
DRSL = composite duration of RSLs for the given time horizon
141Slide142
Measuring Interest Rate Risk with Duration GAP
A Duration Application for Banks
DGAP* > 0
Net interest income will decrease (increase) when interest rates decrease (increase)
DGAP* < 0
Net interest income will decrease (increase) when interest rates increase (decrease)
DGAP* = 0
Interest rate risk eliminated
A major point is that duration analysis can be used to stabilize a number of different variables reflecting bank performance
142Slide143
Economic Value of Equity Sensitivity Analysis
Involves the comparison of changes in the Economic Value of Equity (EVE) across different interest rate environments
An important component of EVE sensitivity analysis is allowing different rates to change by different amounts and incorporating projections of when embedded customer options will be exercised and what their values will be
143Slide144
Economic Value of Equity Sensitivity Analysis
Estimating the timing of cash flows and subsequent durations of assets and liabilities is complicated by:
Prepayments that exceed (fall short of) those expected
A bond being
A deposit that is withdrawn early or a deposit that is not withdrawn as expected
144Slide145
Economic Value of Equity Sensitivity Analysis
EVE Sensitivity Analysis: An Example
First Savings Bank
Average duration of assets equals 2.6 years
Market value of assets equals $1,001,963,000
Average duration of liabilities equals 2 years
Market value of liabilities equals $919,400,000
145Slide146
146Slide147
Economic Value of Equity Sensitivity Analysis
EVE Sensitivity Analysis: An Example
First Savings Bank
Duration Gap
2.6 – ($919,400,000/$1,001,963,000) × 2.0 = 0.765 years
Example:
A 1% increase in rates would reduce EVE by $7.2 million
ΔMVE = -DGAP[
Δy
/(1+y)]MVA
ΔMVE = -0.765 (0.01/1.0693) × $1,001,963,000
= -$7,168,257
Recall that the average rate on assets is 6.93%
The estimate of -$7,168,257 ignores the impact of interest rates on embedded options and the effective duration of assets and liabilities
147Slide148
Economic Value of Equity Sensitivity Analysis
EVE Sensitivity Analysis: An Example
148Slide149
Economic Value of Equity Sensitivity Analysis
EVE Sensitivity Analysis: An Example
First Savings Bank
The previous slide shows that FSB’s EVE will fall by $8.2 million if rates are rise by 1%
This differs from the estimate of -$7,168,257 because this sensitivity analysis takes into account the embedded options on loans and deposits
For example, with an increase in interest rates, depositors may withdraw a CD before maturity to reinvest the funds at a higher interest rate
149Slide150
Economic Value of Equity Sensitivity Analysis
EVE Sensitivity Analysis: An Example
First Savings Bank
Effective “Duration” of Equity
Recall, duration measures the percentage change in market value for a given change in interest rates
A bank’s duration of equity measures the percentage change in EVE that will occur with a 1 percent change in rates:
Effective duration of equity = $8,200 / $82,563 = 9.9 years
150Slide151
Earnings Sensitivity Analysis versus EVE Sensitivity Analysis
Strengths and Weaknesses: DGAP and EVE-Sensitivity Analysis
Strengths
Duration analysis provides a comprehensive measure of interest rate risk
Duration measures are additive
This allows for the matching of total assets with total liabilities rather than the matching of individual accounts
Duration analysis takes a longer term view than static gap analysis
151Slide152
Earnings Sensitivity Analysis versus EVE Sensitivity Analysis
Strengths and Weaknesses: DGAP and EVE-Sensitivity Analysis
Weaknesses
It is difficult to compute duration accurately
“Correct” duration analysis requires that each future cash flow be discounted by a distinct discount rate
A bank must continuously monitor and adjust the duration of its portfolio
It is difficult to estimate the duration on assets and liabilities that do not earn or pay interest
Duration measures are highly subjective
152Slide153
A Critique of Strategies for Managing Earnings and EVE Sensitivity
GAP and DGAP Management Strategies
It is difficult to actively vary GAP or DGAP and consistently win
Interest rates forecasts are frequently wrong
Even if rates change as predicted, banks have limited flexibility in changing GAP and DGAP
153Slide154
A Critique of Strategies for Managing Earnings and EVE Sensitivity
Interest Rate Risk: An Example
Consider the case where a bank has two alternatives for funding $1,000 for two years
A 2-year security yielding 6 percent
Two consecutive 1-year securities, with the current 1-year yield equal to 5.5 percent
It is not known today what a 1-year security will yield in one year
154Slide155
A Critique of Strategies for Managing Earnings and EVE Sensitivity
Interest Rate Risk: An Example
Consider the case where a bank has two alternative for funding $1,000 for two years
155Slide156
A Critique of Strategies for Managing Earnings and EVE Sensitivity
Interest Rate Risk: An Example
Consider the case where a bank has two alternative for funding $1,000 for two years
For the two consecutive 1-year securities to generate the same $120 in interest, ignoring compounding, the 1-year security must yield 6.5% one year from the present
This break-even rate is a 1-year forward rate of :
6% + 6% = 5.5% + x so x must = 6.5%
156Slide157
A Critique of Strategies for Managing Earnings and EVE Sensitivity
Interest Rate Risk: An Example
Consider the case where a bank has two alternative for investing $1,000 for two years
By
investing
in the 1-year security, a depositor is betting that the 1-year interest rate in one year will be greater than 6.5%
By
issuing
the 2-year security, the bank is betting that the 1-year interest rate in one year will be greater than 6.5%
By choosing one or the other, the depositor and the bank “place a bet” that the actual rate in one year will differ from the forward rate of 6.5 percent
157Slide158
Yield Curve Strategies
When the U.S. economy hits its peak, the yield curve typically inverts, with short-term rates exceeding long-term rates.
Only twice since WWII has a recession not followed an inverted yield curve
As the economy contracts, the Federal Reserve typically increases the money supply, which causes rates to fall and the yield curve to return to its “normal” shape.
158Slide159
Yield Curve Strategies
To take advantage of this trend, when the yield curve inverts, banks could:
Buy long-term non-callable securities
Prices will rise as rates fall
Make fixed-rate non-callable loans
Borrowers are locked into higher rates
Price deposits on a floating-rate basis
Follow strategies to become more liability sensitive and/or lengthen the duration of assets versus the duration of liabilities
159Slide160
160Slide161
Using Derivatives to Manage Interest Rate Risk
161Slide162
Using Derivatives to Manage Interest Rate Risk
Derivative
Any instrument or contract that derives its value from another underlying asset, instrument, or contract
162Slide163
Using Derivatives to Manage Interest Rate Risk
Derivatives Used to Manage Interest Rate Risk
Financial Futures Contracts
Forward Rate Agreements
Interest Rate Swaps
Options on Interest Rates
Interest Rate CapsInterest Rate Floors
163Slide164
Characteristics of Financial Futures
Financial Futures Contracts
A commitment, between a buyer and a seller, on the quantity of a standardized financial asset or index
Futures Markets
The organized exchanges where futures contracts are traded
Interest Rate Futures
When the underlying asset is an interest-bearing security
164Slide165
Characteristics of Financial Futures
Buyers
A buyer of a futures contract is said to be
long futures
Agrees to pay the underlying futures price or take delivery of the underlying asset
Buyers gain when futures prices rise and lose when futures prices fall
165Slide166
Characteristics of Financial Futures
Sellers
A seller of a futures contract is said to be
short futures
Agrees to receive the underlying futures price or to deliver the underlying asset
Sellers gain when futures prices fall and lose when futures prices rise
166Slide167
Characteristics of Financial Futures
Cash or Spot Market
Market for any asset where the buyer tenders payment and takes possession of the asset when the price is set
Forward Contract
Contract for any asset where the buyer and seller agree on the asset’s price but defer the actual exchange until a specified future date
167Slide168
Characteristics of Financial Futures
Forward versus Futures Contracts
Futures Contracts
Traded on formal exchanges
Examples: Chicago Board of Trade and the Chicago Mercantile Exchange
Involve standardized instruments
Positions require a daily marking to market
Positions require a deposit equivalent to a performance bond
168Slide169
Characteristics of Financial Futures
Forward versus Futures Contracts
Forward contracts
Terms are negotiated between parties
Do not necessarily involve standardized assets
Require no cash exchange until expiration
No marking to market
169Slide170
Characteristics of Financial Futures
A Brief Example
Assume you want to invest $1 million in 10-year T-bonds in six months and believe that rates will fall
You would like to “lock in” the 4.5% 10-year yield prevailing today
If such a contract existed, you would buy a futures contract on 10-year T-bonds with an expiration date just after the six-month period
Assume that such a contract is priced at a 4.45% rate
170Slide171
Characteristics of Financial Futures
A Brief Example
If 10-year Treasury rates actually fall sharply during the six months, the futures rate will similarly fall such that the futures price rises
An increase in the futures price generates a profit on the futures trade
You will eventually sell the futures contract to exit the trade
171Slide172
Characteristics of Financial Futures
A Brief Example
You will eventually sell the futures contract to exit the trade
Your effective yield will be determined by the prevailing 10-year Treasury rate and the gain (or loss) on the futures trade
In this example, the decline in 10-year rates will be offset by profits on the long futures position
172Slide173
Characteristics of Financial Futures
A Brief Example
The 10-year Treasury rate falls by 0.80%, which represents an opportunity loss
However, buying a futures contract generates a 0.77% profit
The effective yield on the investment equals the prevailing 3.70% rate at the time of investment plus the 0.77% futures profit, or 4.47%
173Slide174
Characteristics of Financial Futures
A Brief Example
174Slide175
Characteristics of Financial Futures
Types of Future Traders
Commission Brokers
Execute trades for other parties
Locals
Trade for their own account
Locals are speculators
175Slide176
Characteristics of Financial Futures
Types of Future Traders
Speculator
Takes a position with the objective of making a profit
Tries to guess the direction that prices will move and time trades to sell (buy) at higher (lower) prices than the purchase price
176Slide177
Characteristics of Financial Futures
Types of Future Traders
Scalper
A speculator who tries to time price movements over very short time intervals and takes positions that remain outstanding for only minutes
177Slide178
Characteristics of Financial Futures
Types of Future Traders
Day Trader
Similar to a scalper but tries to profit from short-term price movements during the trading day; normally offsets the initial position before the market closes such that no position remains outstanding overnight
178Slide179
Characteristics of Financial Futures
Types of Future Traders
Position Trader
A speculator who holds a position for a longer period in anticipation of a more significant, longer-term market moves
179Slide180
Characteristics of Financial Futures
Types of Future Traders
Hedger
Has an existing or anticipated position in the cash market and trades futures contracts to reduce the risk associated with uncertain changes in the value of the cash position
Takes a position in the futures market whose value varies in the opposite direction as the value of the cash position when rates change
Risk is reduced because gains or losses on the futures position at least partially offset gains or losses on the cash position
180Slide181
Characteristics of Financial Futures
Types of Future Traders
Hedger versus Speculator
The essential difference between a speculator and hedger is the objective of the trader
A speculator wants to profit on trades
A hedger wants to reduce risk associated with a known or anticipated cash position
181Slide182
Characteristics of Financial Futures
Types of Future Traders
Spreader versus Arbitrageur
Both are speculators that take relatively low-risk positions
Futures Spreader
May simultaneously buy a futures contract and sell a related futures contract trying to profit on anticipated movements in the price difference
The position is generally low risk because the prices of both contracts typically move in the same direction
182Slide183
Characteristics of Financial Futures
Types of Future Traders
Arbitrageur
Tries to profit by identifying the same asset that is being traded at two different prices in different markets at the same time
Buys the asset at the lower price and simultaneously sells it at the higher price
Arbitrage transactions are thus low risk and serve to bring prices back in line in the sense that the same asset should trade at the same price in all markets
183Slide184
Characteristics of Financial Futures
The Mechanics of Futures Trading
Initial Margin
A cash deposit (or U.S. government securities) with the exchange simply for initiating a transaction
Initial margins are relatively low, often involving less than 5% of the underlying asset’s value
184Slide185
Characteristics of Financial Futures
The Mechanics of Futures Trading
Maintenance Margin
The minimum deposit required at the end of each day
Unlike margin accounts for stocks, futures margin deposits represent a guarantee that a trader will be able to make any mandatory payment obligations
185Slide186
Characteristics of Financial Futures
The Mechanics of Futures Trading
Marking-to-Market
The daily settlement process where at the end of every trading day, a trader’s margin account is:
Credited with any gains
Debited with any losses
Variation Margin
The daily change in the value of margin account due to marking-to-market
186Slide187
Characteristics of Financial Futures
The Mechanics of Futures Trading
Expiration Date
Every futures contract has a formal expiration date
On the expiration date, trading stops and participants settle their final positions
Less than 1% of financial futures contracts experience physical delivery at expiration because most traders offset their futures positions in advance
187Slide188
Characteristics of Financial Futures
An Example: 90-Day Eurodollar Time Deposit Futures
The underlying asset is a Eurodollar time deposit with a 3-month maturity
Eurodollar rates are quoted on an interest-bearing basis, assuming a 360-day year
Each Eurodollar futures contract represents $1 million of initial face value of Eurodollar deposits maturing three months after contract expiration
188Slide189
Characteristics of Financial Futures
An Example: 90-Day Eurodollar Time Deposit Futures
Contracts trade according to an index:
100 – Futures Price = Futures Rate
An index of 94.50 indicates a futures rate of 5.5%
Each basis point change in the futures rate equals a $25 change in value of the contract (0.001 x $1 million x 90/360)
189Slide190
Characteristics of Financial Futures
An Example: 90-Day Eurodollar Time Deposit Futures
Over forty separate contracts are traded at any point in time, as contracts expire in March, June, September and December each year
Buyers make a profit when futures rates fall (prices rise)
Sellers make a profit when futures rates rise (prices fall)
190Slide191
191Slide192
Characteristics of Financial Futures
An Example: 90-Day Eurodollar Time Deposit Futures
OPEN
The index price at the open of trading
HIGH
The high price during the day
LOW
The low price during the day
LAST
The last price quoted during the dayPT CHGE
The basis-point change between the last price quoted and the closing price the previous day
192Slide193
Characteristics of Financial Futures
An Example: 90-Day Eurodollar Time Deposit Futures
SETTLEMENT
The previous day’s closing price
VOLUME
The previous day’s volume of contracts traded during the day
OPEN INTEREST
The total number of futures contracts outstanding at the end of the day.
193Slide194
Characteristics of Financial Futures
Expectations Embedded in Future Rates
According to the unbiased expectations theory, an upward sloping yield curve indicates a consensus forecast that short-term interest rates are expected to rise
A flat yield curve suggests that rates will remain relatively constant
194Slide195
Characteristics of Financial Futures
Expectations Embedded in Future Rates
195Slide196
Characteristics of Financial Futures
Expectations Embedded in Future Rates
The previous slide presents two yield curves at the close of business on June 5, 2008
There was a sharp decrease in rates from one year prior.
The yield curve in June 2008 was relatively steep
The difference between the one-month and 30-year Treasury rates was 289 basis points
The yield curve in June 2007 was relatively flat
196Slide197
Characteristics of Financial Futures
Expectations Embedded in Future Rates
One interpretation of futures rates is that they provide information about consensus expectations of future cash rates
When futures rates continually rise as the expiration dates of the futures contracts extend into the future, it signals an expected increase in subsequent cash market rates
197Slide198
Characteristics of Financial Futures
Daily Marking-To-Market
Consider a trader trading on June 6, 2008 who buys one December 2008 three-month Eurodollar futures contract at $96.98 posting $1,100 in cash as initial margin
Maintenance margin is set at $700 per contract
The futures contract expires approximately six months after the initial purchase, during which time the futures price and rate fluctuate daily
198Slide199
Characteristics of Financial Futures
Daily Marking-To-Market
Suppose that on June 13 the futures rate falls fro 3.02% to 2.92%
The trader could withdraw $250 (10 basis points × $25) from the margin account, representing the increase in value of the position
199Slide200
Characteristics of Financial Futures
Daily Marking-To-Market
If the futures rate increases to 3.08% the next day, the trader’s long position decreases in value
The 16 basis-point increase represents a $400 drop in margin such that the ending account balance would equal $950
200Slide201
Characteristics of Financial Futures
Daily Marking-To-Market
If the futures rate increases further to 3.23%, the trader must make a variation margin payment sufficient to bring the account up to $700
In this case, the account balance would have fallen to $575 and the margin contribution would equal $125
The exchange member may close the account if the trader does not meet the variation margin requirement
201Slide202
Characteristics of Financial Futures
Daily Marking-To-Market
The Basis
Basis = Cash Price – Futures Price
or
Basis = Futures Rate – Cash Rate
It may be positive or negative, depending on whether futures rates are above or below spot rates
May swing widely in value far in advance of contract expiration
202Slide203
Characteristics of Financial Futures
203Slide204
Speculation versus Hedging
Speculators Take On Risk To Earn Speculative Profits
Speculation is extremely risky
Example
You believe interest rates will fall, so you buy Eurodollar futures
If rates fall, the price of the underlying Eurodollar rises, and thus the futures contract value rises earning you a profit
If rates rise, the price of the Eurodollar futures contract falls in value, resulting in a loss
204Slide205
Speculation versus Hedging
Hedgers Take Positions to Avoid or Reduce Risk
A hedger already has a position in the cash market and uses futures to adjust the risk of being in the cash market
The focus is on reducing or avoiding risk
205Slide206
Speculation versus Hedging
Hedgers Take Positions to Avoid or Reduce Risk
Example
A bank anticipates needing to borrow $1,000,000 in 60 days. The bank is concerned that rates will rise in the next 60 days
A possible strategy would be to short Eurodollar futures.
If interest rates rise (fall), the short futures position will increase (decrease) in value. This will (partially) offset the increase (decrease) in borrowing costs
206Slide207
207Slide208
Speculation versus Hedging
Steps in Hedging
Identify the cash market risk exposure to reduce
Given the cash market risk, determine whether a long or short futures position is needed
Select the best futures contract
Determine the appropriate number of futures contracts to trade
208Slide209
Speculation versus Hedging
Steps in Hedging
Buy or sell the appropriate futures contracts
Determine when to get out of the hedge position, either by reversing the trades, letting contracts expire, or making or taking delivery
Verify that futures trading meets regulatory requirements and the banks internal risk policies
209Slide210
Speculation versus Hedging
A Long Hedge: Reduce Risk Associated With A Decrease In Interest Rates
A long hedge (buy futures) is appropriate for a participant who wants to reduce spot market risk associated with a decline in interest rates
If spot rates decline, futures rates will typically also decline so that the value of the futures position will likely increase.
Any loss in the cash market is at least partially offset by a gain in futures
210Slide211
Speculation versus Hedging
A Long Hedge: Reduce Risk Associated With A Decrease In Interest Rates
On June 6, 2008, your bank expects to receive a $1 million payment on November 28, 2008, and anticipates investing the funds in three-month Eurodollar time deposits
The cash market risk exposure is that the bank would like to invest the funds at today’s rates, but will not have access to the funds for over five months
In June 2008, the market expected Eurodollar rates to increase as evidenced by rising futures rates.
211Slide212
Speculation versus Hedging
A Long Hedge: Reduce Risk Associated With A Decrease In Interest Rates
In order to hedge, the bank should buy futures contracts
The best futures contract will generally be the first contract that expires after the known cash transaction date.
This contract is best because its futures price will generally show the highest correlation with the cash price
In this example, the December 2008 Eurodollar futures contract is the first to expire after November 2008
212Slide213
Speculation versus Hedging
A Long Hedge: Reduce Risk Associated With A Decrease In Interest Rates
The time line of the bank’s hedging activities:
213Slide214
Speculation versus Hedging
214Slide215
Speculation versus Hedging
A Short Hedge: Reduce Risk Associated With A Increase In Interest Rates
A short hedge (sell futures) is appropriate for a participant who wants to reduce spot market risk associated with an increase in interest rates
If spot rates increase, futures rates will typically also increase so that the value of the futures position will likely decrease.
Any loss in the cash market is at least partially offset by a gain in the futures market
215Slide216
Speculation versus Hedging
A Short Hedge: Reduce Risk Associated With A Increase In Interest Rates
On June 6, 2008, your bank expects to sell a six-month $1 million Eurodollar deposit on August 17, 2008
The cash market risk exposure is that interest rates may rise and the value of the Eurodollar deposit will fall by August 2008
In order to hedge, the bank should sell futures contracts
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Speculation versus Hedging
A Long Hedge: Reduce Risk Associated With A Decrease In Interest Rates
In order to hedge, the bank should sell futures contracts
In this example, the September 2008 Eurodollar futures contract is the first to expire after September 17, 2008
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Speculation versus Hedging
A Long Hedge: Reduce Risk Associated With A Decrease In Interest Rates
The time line of the bank’s hedging activities:
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Speculation versus Hedging
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Speculation versus Hedging
Change in the Basis
Long and short hedges work well if the futures rate moves in line with the spot rate
The actual risk assumed by a trader in both hedges is that the basis might change between the time the hedge is initiated and closed
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Speculation versus Hedging
Change in the Basis
Effective Return
= Initial Cash Rate – Change in Basis
= Initial Cash Rate – (B
2
– B
1
)
where :B1 is the basis when the hedge is opened
B
2
is the basis when the hedge is closed
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Speculation versus Hedging
Change in the Basis
Effective Return: Long Hedge
= Initial Cash Rate – (B
2
– B
1)
= 2.68% - (0.10% - 0.34%) = 2.92%
Effective Return: Short Hedge
= Initial Cash Rate – (B2
– B
1
)
= 3.00% - (0.14% - -0.17%) = 2.69%
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Speculation versus Hedging
Basis Risk and Cross Hedging
Cross Hedge
Where a trader uses a futures contract based on one security that differs from the security being hedged in the cash market
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Speculation versus Hedging
Basis Risk and Cross Hedging
Cross Hedge
Example
Using Eurodollar futures to hedge changes in the commercial paper rate
Basis risk increases with a cross hedge because the futures and spot interest rates may not move closely together
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Microhedging Applications
Microhedge
The hedging of a transaction associated with a specific asset, liability or commitment
Macrohedge
Taking futures positions to reduce aggregate portfolio interest rate risk
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Microhedging Applications
Banks are generally restricted in their use of financial futures for hedging purposes
Banks must recognize futures on a micro basis by linking each futures transaction with a specific cash instrument or commitment
Some feel that such micro linkages force
microhedges
that may potentially increase a firm’s total risk because these hedges ignore all other portfolio components
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Microhedging Applications
Creating a Synthetic Liability with a Short Hedge
Example
Assume that on June 6, 2008, a bank agreed to finance a $1 million six-month loan
Management wanted to match fund the loan by issuing a $1 million, six-month Eurodollar time deposit
The six-month cash Eurodollar rate was 3%
The three-month Eurodollar rate was 2.68%
The three-month Eurodollar futures rate for September 2008 expiration equaled 2.83%
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Microhedging Applications
Creating a Synthetic Liability with a Short Hedge
Rather than issue a direct six-month Eurodollar liability at 3%, the bank created a synthetic six-month liability by shorting futures
The objective was to use the futures market to borrow at a lower rate than the six-month cash Eurodollar rate
A short futures position would reduce the risk of rising interest rates for the second cash Eurodollar borrowing
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Microhedging Applications
Creating a Synthetic Liability with a Short Hedge
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Microhedging Applications
The Mechanics of Applying a
Microhedge
Determine the bank’s interest rate position
Forecast the dollar flows or value expected in cash market transactions
Choose the appropriate futures contract
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Microhedging Applications
The Mechanics of Applying a
Microhedge
Determine the correct number of futures contracts
Where
NF = number of futures contracts
A = Dollar value of cash flow to be hedged
F = Face value of futures contract
Mc = Maturity or duration of anticipated cash asset or liability
Mf = Maturity or duration of futures contract
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Microhedging Applications
The Mechanics of Applying a
Microhedge
Determine the Appropriate Time Frame for the Hedge
Monitor Hedge Performance
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Macrohedging Applications
Macrohedging
Focuses on reducing interest rate risk associated with a bank’s entire portfolio rather than with individual transactions
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Macrohedging Applications
Hedging: GAP or Earnings Sensitivity
If a bank loses when interest rates fall (the bank has a positive GAP), it should use a long hedge
If rates rise, the bank’s higher net interest income will be offset by losses on the futures position
If rates fall, the bank’s lower net interest income will be offset by gains on the futures position
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Macrohedging Applications
Hedging: GAP or Earnings Sensitivity
If a bank loses when interest rates rise (the bank has a negative GAP), it should use a short hedge
If rates rise, the bank’s lower net interest income will be offset by gains on the futures position
If rates fall, the bank’s higher net interest income will be offset by losses on the futures position
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Macrohedging Applications
Hedging: Duration GAP and EVE Sensitivity
To eliminate interest rate risk, a bank could structure its portfolio so that its duration gap equals zero
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Macrohedging Applications
Hedging: Duration GAP and EVE Sensitivity
Futures can be used to adjust the bank’s duration gap
The appropriate size of a futures position can be determined by solving the following equation for the market value of futures contracts (MVF), where DF is the duration of the futures contract
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Macrohedging Applications
Hedging: Duration GAP and EVE Sensitivity
Example:
With a positive duration gap, the EVE will decline if interest rates rise
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Macrohedging Applications
Hedging: Duration GAP and EVE Sensitivity
Example:
The bank needs to sell interest rate futures contracts in order to hedge its risk position
The short position indicates that the bank will make a profit if futures rates increase
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Macrohedging Applications
Hedging: Duration GAP and EVE Sensitivity
Example:
If the bank uses a Eurodollar futures contract currently trading at 4.9% with a duration of 0.25 years, the target market value of futures contracts (MVF) is:
MVF = $4,096.82, so the bank should sell four Eurodollar futures contracts
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Macrohedging Applications
Accounting Requirements and Tax Implications
Regulators generally limit a bank’s use of futures for hedging purposes
If a bank has a dealer operation, it can use futures as part of its trading activities
In such accounts, gains and losses on these futures must be marked-to-market, thereby affecting current income
Microhedging
To qualify as a hedge, a bank must show that a cash transaction exposes it to interest rate risk, a futures contract must lower the bank’s risk exposure, and the bank must designate the contract as a hedge
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Using Forward Rate Agreements to Manage Rate Risk
Forward Rate Agreements
A forward contract based on interest rates based on a notional principal amount at a specified future date
Similar to futures but differ in that they:
Are negotiated between parties
Do not necessarily involve standardized assets
Require no cash exchange until expiration (i.e. there is no marking-to-market)
No exchange guarantees performance
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Using Forward Rate Agreements to Manage Rate Risk
Notional Principal
Serves as a reference figure in determining cash flows for the two counterparties to a forward rate agreement agree
“Notional” refers to the condition that the principal does not change hands, but is only used to calculate the value of interest payments
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Using Forward Rate Agreements to Manage Rate Risk
Buyer
Agrees to pay a fixed-rate coupon payment and receive a floating-rate payment against the notional principal at some specified future date
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Using Forward Rate Agreements to Manage Rate Risk
Seller
Agrees to pay a floating-rate payment and receive the fixed-rate payment against the same notional principal
The buyer and seller will receive or pay cash when the actual interest rate at settlement is different than the exercise rate
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Using Forward Rate Agreements to Manage Rate Risk
Forward Rate Agreements: An Example
Suppose that Metro Bank (as the seller) enters into a receive fixed-rate/pay floating-rating forward rate agreement with County Bank (as the buyer) with a six-month maturity based on a $1 million notional principal amount
The floating rate is the 3-month LIBOR and the fixed (exercise) rate is 5%
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Using Forward Rate Agreements to Manage Rate Risk
Forward Rate Agreements: An Example
Metro Bank would refer to this as a “3 vs. 6” FRA at 5% on a $1 million notional amount from County Bank
The only cash flow will be determined in six months at contract maturity by comparing the prevailing 3-month LIBOR with 5%
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Using Forward Rate Agreements to Manage Rate Risk
Forward Rate Agreements: An Example
Assume that in three months 3-month LIBOR equals 6%
In this case, Metro Bank would receive from County Bank $2,463
The interest settlement amount is $2,500:
Interest = (.06 - .05)(90/360) $1,000,000 = $2,500
Because this represents interest that would be paid three months later at maturity of the instrument, the actual payment is discounted at the prevailing 3-month LIBOR
Actual interest = $2,500/[1+(90/360).06]=$2,463
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Using Forward Rate Agreements to Manage Rate Risk
Forward Rate Agreements: An Example
If instead, LIBOR equals 3% in three months, Metro Bank would pay County Bank:
The interest settlement amount is $5,000
Interest = (.05 -.03)(90/360) $1,000,000 = $5,000
Actual interest = $5,000 /[1 + (90/360).03] = $4,963
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Using Forward Rate Agreements to Manage Rate Risk
Forward Rate Agreements: An Example
County Bank would pay fixed-rate/receive floating-rate as a hedge if it was exposed to loss in a rising rate environment
This is analogous to a short futures position
Metro Bank would sell fixed-rate/receive floating-rate as a hedge if it was exposed to loss in a falling rate environment.
This is analogous to a long futures position
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Using Forward Rate Agreements to Manage Rate Risk
Potential Problems with FRAs
There is no clearinghouse to guarantee, so you might not be paid when the counterparty owes you cash
It is sometimes difficult to find a specific counterparty that wants to take exactly the opposite position
FRAs are not as liquid as many alternatives
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Basic (Plain Vanilla) Interest Rate Swap
An agreement between two parties to exchange a series of cash flows based on a specified notional principal amount
Two parties facing different types of interest rate risk can exchange interest payments
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Basic (Plain Vanilla) Interest Rate Swap
One party makes payments based on a fixed interest rate and receives floating rate payments
The other party exchanges floating rate payments for fixed-rate payments
When interest rates change, the party that benefits from a swap receives a net cash payment while the party that loses makes a net cash payment
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Basic (Plain Vanilla) Interest Rate Swap
Conceptually, a basic interest rate swap is a package of FRAs
As with FRAs, swap payments are netted and the notional principal never changes hands
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Plain Vanilla Example
Using data for a 2-year swap based on 3-month LIBOR as the floating rate
This swap involves eight quarterly payments.
Party FIX agrees to pay a fixed rate
Party FLT agrees to receive a fixed rate with cash flows calculated against a $10 million notional principal amount
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Plan Vanilla Example
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Plain Vanilla Example
If the three-month LIBOR for the first pricing interval equals 3%
The fixed payment for Party FIX is $83,770 and the floating rate receipt is $67,744
Party FIX will have to pay the difference of $16,026
The floating-rate payment for Party FLT is $67,744 and the fixed-rate receipt is$83,520
Party FLT will receive the difference of $15,776
The dealer will net $250 from the spread ($16,026 -$15,776)
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Plain Vanilla Example
At the second and subsequent pricing intervals, only the applicable LIBOR is unknown
As LIBOR changes, the amount that both Party FIX and Party FLT either pay or receive will change
Party FIX will only receive cash at any pricing interval if three-month LIBOR exceeds 3.36%
Party FLT will similarly receive cash as long as three-month LIBOR is less than 3.35%
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Convert a Floating-Rate Liability to a Fixed Rate Liability
Consider a bank that makes a $1 million, three-year fixed-rate loan with quarterly interest at 8%
It finances the loan by issuing a three-month Eurodollar deposit priced at three-month LIBOR
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Convert a Floating-Rate Liability to a Fixed Rate Liability
By itself, this transaction exhibits considerable interest rate
The bank is liability sensitive and loses (gains) if LIBOR rises (falls)
The bank can use a basic swap to
microhedge
this transaction
Using the data from Exhibit 9.8, the bank could agree to pay 3.72% and receive three-month LIBOR against $1 million for the three years
By doing this, the bank locks in a borrowing cost of 3.72% because it will both receive and pay LIBOR every quarter
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Convert a Floating-Rate Liability to a Fixed Rate Liability
The use of the swap enables the bank to reduce risk and lock in a spread of 4.28 percent (8.00 percent − 3.72 percent) on this transaction while effectively fixing the borrowing cost at 3.72 percent for three years
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Convert a Fixed-Rate Asset to a Floating-Rate Asset
Consider a bank that has a customer who demands a fixed-rate loan
The bank has a policy of making only floating-rate loans because it is liability sensitive and will lose if interest rates rise
Ideally, the bank wants to price the loan based on prime
Now assume that the bank makes the same $1 million, three-year fixed-rate loan as in the “Convert a Floating-Rate Liability to a Fixed Rate Liability” example
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Convert a Fixed-Rate Asset to a Floating-Rate Asset
The bank could enter into a swap, agreeing to pay a 3.7% fixed rate and receive prime minus 2.40% with quarterly payments
This effectively converts the fixed-rate loan into a variable rate loan that floats with the prime rate
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Create a Synthetic Hedge
Some view basic interest rate swaps as synthetic securities
As such, they enter into a swap contract that essentially replicates the net cash flows from a balance sheet transaction
Suppose a bank buys a three-year Treasury yielding 2.73%, which it finances by issuing a three-month deposit
As an alternative, the bank could enter into a three-month swap agreeing to pay three-month LIBOR and receive a fixed rate
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Macrohedge
Banks can also use interest rate swaps to hedge their aggregate risk exposure measured by earnings and EVE sensitivity
A bank that is liability sensitive or has a positive duration gap will take a basic swap position that potentially produces profits when rates increase
With a basic swap, this means paying a fixed rate and receiving a floating rate
Any profits can be used to offset losses from lost net interest income or declining
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Basic Interest Rate Swaps as a Risk Management Tool
Characteristics
Macrohedge
In terms of GAP analysis, a liability-sensitive bank has more rate-sensitive liabilities than rate-sensitive assets
To hedge, the bank needs the equivalent of more RSAs
A swap that pays fixed and receives floating is comparable to increasing RSAs relative to RSLs because the receipt reprices with rate changes
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Basic Interest Rate Swaps as a Risk Management Tool
Pricing Basic Swaps
The floating rate is based on some predetermined money market rate or index
The payment frequency is coincidentally set at every six months, three months, or one month, and is generally matched with the money market rate
The fixed rate is set at a spread above the comparable maturity fixed rate security
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Basic Interest Rate Swaps as a Risk Management Tool
Comparing Financial Futures, FRAs and Basic Swaps
Similarities
Each enables a party to enter an agreement, which provides for cash receipts or cash payments depending on how interest rates move
Each allows managers to alter a bank’s interest rate risk exposure
None requires much of an initial cash commitment to take a position
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Basic Interest Rate Swaps as a Risk Management Tool
Comparing Financial Futures, FRAs and Basic Swaps
Differences
Financial futures are standardized contracts based on fixed principal amounts while with FRAs and interest rate swaps, parties negotiate the notional principal amount
Financial futures require daily marking-to-market, which is not required with FRAs and swaps
Many futures contracts cannot be traded out more than three to four years, while interest rate swaps often extend 10 to 30 years
The market for FRAs is not that liquid and most contracts are short term
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Basic Interest Rate Swaps as a Risk Management Tool
The Risk with Swaps
Counterparty risk is extremely important to swap participants
Credit risk exists because the counterparty to a swap contract may default
This is not as great for a single contract since the swap parties exchange only net interest payments
The notional principal amount never changes hands, such that a party will not lose that amount
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Interest Rate Caps and Floors
Buying an Interest Rate Cap
Interest Rate Cap
An agreement between two counterparties that limits the buyer’s interest rate exposure to a maximum rate
Buying a cap is the same as purchasing a call option on an interest rate
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Interest Rate Caps and Floors
Buying an Interest Rate Floor
Interest Rate Floor
An agreement between two counterparties that limits the buyer’s interest rate exposure to a minimum rate
Buying a floor is the same as purchasing a put option on an interest rate
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Interest Rate Caps and Floors
Interest Rate Collar and Reverse Collar
Interest Rate Collar
The simultaneous purchase of an interest rate cap and sale of an interest rate floor on the same index for the same maturity and notional principal amount
A collar creates a band within which the buyer’s effective interest rate fluctuates
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Interest Rate Caps and Floors
Interest Rate Collar and Reverse Collar
Zero Cost Collar
A collar where the buyer pays no net premium
The premium paid for the cap equals the premium received for the floor
Reverse Collar
Buying an interest rate floor and simultaneously selling an interest rate cap
Used to protect a bank against falling interest rates
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Interest Rate Caps and Floors
Interest Rate Collar and Reverse Collar
The size of the premiums for caps and floors is determined by:
The relationship between the strike rate an the current index
This indicates how much the index must move before the cap or floor is in-the-money
The shape of yield curve and the volatility of interest rates
With an upward sloping yield curve, caps will be more expensive than floors
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Interest Rate Caps and Floors
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Interest Rate Caps and Floors
Protecting Against Falling Interest Rates
Assume that a bank is asset sensitive
The bank holds loans priced at prime plus 1% and funds the loans with a three-year fixed-rate deposit at 3.75% percent
Management believes that interest rates will fall over the next three years
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Interest Rate Caps and Floors
Protecting Against Falling Interest Rates
It is considering three alternative approaches to reduce risk associated with falling rates:
Entering into a basic interest rate swap to pay three-month LIBOR and receive a fixed rate
Buying an interest rate floor
Buying a reverse collar
Note that, initially, the bank holds assets priced based on prime and deposits priced based on a fixed rate of 3.75%
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Interest Rate Caps and Floors
Protecting Against Falling Interest Rates
Strategy: Use a Basic Interest Rate Swap: Pay Floating and Receive Fixed
As shown on the next slide, the use of the swap effectively fixes the spread near the current level, except for basis risk
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Interest Rate Caps and Floors
Protecting Against Falling Interest Rates
Strategy: Buy a Floor on the Floating Rate
As shown on the next slide, the use of the floor protects against loss from falling rates while retaining the benefits from rising rates
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Interest Rate Caps and Floors
Protecting Against Falling Interest Rates
Strategy: Buy a Reverse Collar: Sell a Cap and Buy a Floor on the Floating Rate
As shown on the next slide, the use of the reverse collar differs from a pure floor by eliminating some of the potential benefits in a rising-rate environment
The bank actually receives a net premium up front and while this is attractive up front, if rates increase sufficiently, the bank does not benefit
The net result is that the bank’s spread will vary within a band
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Interest Rate Caps and Floors
Protecting Against Rising Interest Rates
Assume that a bank is liability sensitive
That bank has made three-year fixed-rate term loans at 7% funded with three-month Eurodollar deposits for which it pays the prevailing LIBOR minus 0.25%
Management believes is concerned that interest rates will rise over the next three years
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Interest Rate Caps and Floors
Protecting Against Rising Interest Rates
It is considering three alternative approaches to reduce risk associated with rising rates:
Entering into a basic interest rate swap to pay a fixed rate and receive the three-month LIBOR
Buying an interest rate cap
Buying a collar
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Interest Rate Caps and Floors
Protecting Against Rising Interest Rates
Strategy: Use a Basic Interest Rate Swap: Pay Fixed and Receive Floating
As shown on the next slide, the use of the swap effectively fixes the spread near the current level, except for basis risk
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Interest Rate Caps and Floors
Protecting Against Rising Interest Rates
Strategy: Buy a Cap on the Floating Rate
As shown on the next slide, the use of the cap protects against loss from rising rates while retaining the benefits from falling rates
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Interest Rate Caps and Floors
Protecting Against Rising Interest Rates
Strategy: Buy a Collar: Buy a Cap and Sell a Floor on the Floating Rate
As shown on the next slide, the use of the collar differs from a pure cap by eliminating some of the potential benefits in a falling-rate environment
The net result is that the collar effectively creates a band within which the bank’s margin will fluctuate
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Using Derivatives to Manage Interest Rate Risk
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