Interest Rate Risk I Chapter 8 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Part A Covers pages

8-2 Overview  This chapter discusses the interest rate risk associated with financial intermediation: Federal Reserve monetary policy Repricing model Maturity model Duration model *Term structure of interest rate risk *Theories of the term structure of interest rates

8-3 Loanable Funds Theory  Interest rates reflect supply and demand for loanable funds  Shifts in supply or demand generate interest rate movements as market forces establish a new equilibrium

8-4 Determination of Equilibrium Interest Rates

8-5 Note that y-axis is bond PRICE

8-6 Increase in Demand for Bonds

8-7 Bond Supply Shift – Increase in Supply

8-8

8-9

8-10

8-11

8-12 Level & Movement of Interest Rates  Federal Reserve Bank: U.S. central bank Open market operations influence money supply, inflation, and interest rates Actions of Fed in response to 2001 attacks on World Trade Center  Lowered interest rates 11 times during the year June August 2006  inflation concerns take prominence  17 consecutive increases in interest rates

8-13 Central Bank and Interest Rates  Target is primarily short term rates Focus on Fed Funds Rate in particular  Interest rate changes and volatility increasingly transmitted from country to country Statements by Ben Bernanke can have dramatic effects on world interest rates.

8-14 Repricing Model  Repricing or funding gap model based on book value.  Contrasts with market value-based maturity and duration models recommended by the Bank for International Settlements (BIS).  Rate sensitivity means time to repricing.  Repricing gap is the difference between the rate sensitivity of each asset and the rate sensitivity of each liability: RSA - RSL.  Refinancing risk

8-15 Maturity Buckets  Commercial banks must report repricing gaps for assets and liabilities with maturities of: One day. More than one day to three months. More than 3 three months to six months. More than six months to twelve months. More than one year to five years. Over five years.

8-16 Repricing Gap Example AssetsLiabilities GapCum. Gap 1-day $ 20 $ 30 $-10 $-10 >1day-3mos >3mos.-6mos >6mos.-12mos >1yr.-5yrs >5 years

8-17 Applying the Repricing Model   NII i = (GAP i )  R i = (RSA i - RSL i )  R i Example: In the one day bucket, gap is -$10 million. If rates rise by 1%,  NII (1) = (-$10 million) ×.01 = -$100,000.

8-18 Applying the Repricing Model  Example II: If we consider the cumulative 1-year gap,   NII = (CGAP one year )  R = (-$15 million)(.01) = -$150,000.

8-19 Rate-Sensitive Assets  Examples from hypothetical balance sheet: Short-term consumer loans. If repriced at year- end, would just make one-year cutoff. Three-month T-bills repriced on maturity every 3 months. Six-month T-notes repriced on maturity every 6 months. 30-year floating-rate mortgages repriced (rate reset) every 9 months.

8-20 Rate-Sensitive Liabilities  RSLs bucketed in same manner as RSAs.  Demand deposits and passbook savings accounts warrant special mention. Generally considered rate-insensitive (act as core deposits), but there are arguments for their inclusion as rate-sensitive liabilities.

8-21 CGAP Ratio  May be useful to express CGAP in ratio form as, CGAP/Assets. Provides direction of exposure and Scale of the exposure.  Example: CGAP/A = $15 million / $270 million = 0.56, or 5.6 percent.

8-22 Equal Rate Changes on RSAs, RSLs  Example: Suppose rates rise 2% for RSAs and RSLs. Expected annual change in NII,  NII = CGAP ×  R = $15 million ×.01 = $150,000  With positive CGAP, rates and NII move in the same direction.  Change proportional to CGAP

8-23 Unequal Changes in Rates  If changes in rates on RSAs and RSLs are not equal, the spread changes. In this case,  NII = (RSA ×  R RSA ) - (RSL ×  R RSL )

8-24 Unequal Rate Change Example  Spread effect example: RSA rate rises by 1.2% and RSL rate rises by 1.0%  NII =  interest revenue -  interest expense = ($155 million × 1.2%) - ($155 million × 1.0%) = $310,000

8-25 Restructuring Assets & Liabilities  The FI can restructure its assets and liabilities, on or off the balance sheet, to benefit from projected interest rate changes. Positive gap: increase in rates increases NII Negative gap: decrease in rates increases NII Example: Macatawa Bank’s one-year repricing gap ratio of percent.  Effect of rising interest rates in 2006:  Bad luck?  Or Bad Management?

8-26 Weaknesses of Repricing Model  Weaknesses: Ignores market value effects and off-balance sheet (OBS) cash flows Overaggregative  Distribution of assets & liabilities within individual buckets is not considered. Mismatches within buckets can be substantial. Ignores effects of runoffs  Bank continuously originates and retires consumer and mortgage loans and demand deposits/passbook account balances can vary. Runoffs may be rate- sensitive.

8-27 Prime Rate Versus CD Rates

8-28 A Word About Spreads  Text example: Prime-based loans versus CD rates  What about libor-based loans versus CD rates?  What about CMT-based loans versus CD rates  What about each loan type above versus wholesale funding costs?  This is why the industry spreads all items to Treasury or LIBOR

8-29 *The Maturity Model  Explicitly incorporates market value effects.  For fixed-income assets and liabilities: Rise (fall) in interest rates leads to fall (rise) in market price. The longer the maturity, the greater the effect of interest rate changes on market price. Fall in value of longer-term securities increases at diminishing rate for given increase in interest rates.

8-30 Maturity of Portfolio*  Maturity of portfolio of assets (liabilities) equals weighted average of maturities of individual components of the portfolio.  Principles stated on previous slide apply to portfolio as well as to individual assets or liabilities.  Typically, maturity gap, M A - M L > 0 for most banks and thrifts.

8-31 *Effects of Interest Rate Changes  Size of the gap determines the size of interest rate change that would drive net worth to zero.  Immunization and effect of setting M A - M L = 0.

8-32 *Maturities and Interest Rate Exposure  If M A - M L = 0, is the FI immunized? Extreme example: Suppose liabilities consist of 1-year zero coupon bond with face value $100. Assets consist of 1-year loan, which pays back $99.99 shortly after origination, and 1¢ at the end of the year. Both have maturities of 1 year. Not immunized, although maturity gap equals zero. Reason: Differences in duration** **(See Chapter 9)

8-33 *Maturity Model  Leverage also affects ability to eliminate interest rate risk using maturity model Example: Assets: $100 million in one-year 10-percent bonds, funded with $90 million in one-year 10- percent deposits (and equity) Maturity gap is zero but exposure to interest rate risk is not zero.

8-34 *Duration  The average life of an asset or liability  The weighted-average time to maturity using present value of the cash flows, relative to the total present value of the asset or liability as weights.

8-35 *Term Structure of Interest Rates Time to Maturity YTM

8-36 *Unbiased Expectations Theory  Yield curve reflects market’s expectations of future short-term rates.  Long-term rates are geometric average of current and expected short-term rates. _ _ ~ ~ R N = [(1+R 1 )(1+E(r 2 ))…(1+E(r N ))] 1/N – 1 2 f 1 = ((1+ 1 R 2 ) 2 / (1+ 1 R 1 ))) - 1

8-37 *Liquidity Premium Theory  Allows for future uncertainty.  Premium required to hold long-term.

8-38

8-39 *Market Segmentation Theory  Investors have specific needs in terms of maturity.  Yield curve reflects intersection of demand and supply of individual maturities.

8-40 Pertinent Websites  For information related to central bank policy, visit: Bank for International Settlements: Federal Reserve Bank: