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Managing Interest Rate Risk: GAP and Earnings Sensitivity Managing Interest Rate Risk: GAP and Earnings Sensitivity

Managing Interest Rate Risk: GAP and Earnings Sensitivity - PowerPoint Presentation

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Managing Interest Rate Risk: GAP and Earnings Sensitivity - PPT Presentation

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

9Slide10

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

14Slide15

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

16Slide17

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

17Slide18

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

18Slide19

Measuring Interest Rate Risk with GAP

Factors Affecting Net Interest Income

19Slide20

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

20Slide21

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

21Slide22

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?

22Slide23

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

23Slide24

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?

24Slide25

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

25Slide26

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)

26Slide27

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

27Slide28

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

28Slide29

29Slide30

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

31Slide32

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

32Slide33

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.

34Slide35

Measuring Interest Rate Risk with GAP

Factors Affecting Net Interest Income

Example 3.2

What if all rates fall by 1%?

35Slide36

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.

36Slide37

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?

38Slide39

Measuring Interest Rate Risk with GAP

Factors Affecting Net Interest Income

Example 3.4

What if rates fall but the spread falls by 1%?

39Slide40

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

40Slide41

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%?

43Slide44

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

44Slide45

Measuring Interest Rate Risk with GAP

Factors Affecting Net Interest Income

Example 3.7

What if the bank proportionately doubles in size?

45Slide46

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?

46Slide47

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

48Slide49

Measuring Interest Rate Risk with GAP

Factors Affecting Net Interest Income

Example 4.1

What if rates increase by 1%?

49Slide50

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.

50Slide51

Measuring Interest Rate Risk with GAP

Factors Affecting Net Interest Income

Example 4.2

What if rates decrease by 1%?

51Slide52

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.

52Slide53

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%?

55Slide56

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%?

57Slide58

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?

61Slide62

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

64Slide65

Measuring Interest Rate Risk with GAP

Factors Affecting Net Interest Income

Example 5.1

What if rates increase by 1%?

65Slide66

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!

66Slide67

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

68Slide69

Measuring Interest Rate Risk with GAP

Factors Affecting Net Interest Income

Example 5.3

What if rates rise and the spread rises by 1%?

69Slide70

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

70Slide71

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?

71Slide72

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

74Slide75

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

76Slide77

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

78Slide79

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

79Slide80

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

80Slide81

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

100Slide101

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

110Slide111

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)

112Slide113

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

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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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