1. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 1 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter 14 Interest Rate Risk Measurement

2. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 2 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Learning Objectives Describe interest rate risk and its forms Identify the components of an interest rate risk exposure management system Explain the interest rate risk management principle of asset repricing before liabilities Describe the interest rate risk measurement models repricing gap analysis, duration (and convexity) Outline internal and external interest rate risk management techniques

3. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 3 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 14.1 Introduction 14.2 Interest Rate Risk 14.3 Exposure Management Systems 14.4 Assets Repriced Before Liabilities Principle (ARBL) 14.5 Pricing Financial Securities

4. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 4 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 14.6 Repricing Gap Analysis 14.7 Duration 14.8 Convexity 14.9 Interest Rate Risk Management Techniques 14.10 Summary

5. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 5 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.1 Introduction Chapter 13 considered the – Macro-economic context of interest rates – Loanable funds approach to interest rate determination – A number of theories that explain the shape of the yield curve Unknown is the timing and extent of interest rate changes Interest rate risk needs to be managed

6. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 6 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 14.1 Introduction 14.2 Interest Rate Risk 14.3 Exposure Management Systems 14.4 Assets Repriced Before Liabilities Principle (ARBL) 14.5 Pricing Financial Securities

7. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 7 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.2 Interest Rate Risk Interest rate risk takes two forms – Reinvestment risk  Impact of a change in interest rates on a firm’s future cash flows – Price risk  Impact of a change in interest rates on the value of a firm’s assets and liabilities  An inverse relationship exists between interest rates and security prices i.e. a rise in interest rates results in a fall in the value of an asset or liability, or vice versa

8. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 8 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.2 Interest Rate Risk (cont.) Interest rate risk exposures may also be described as – Direct  Reinvestment and price risk – Indirect  Relate to the future actions of market participants e.g. a rise in interest rates causes borrowers to seek new loans elsewhere and/or repay existing loans

9. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 9 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.2 Interest Rate Risk (cont.) Interest rate risk exposures may also be described as (cont.) – Basis  Occurs when pricing differentials exist between markets e.g. futures market and the underlying physical market

10. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 10 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 14.1 Introduction 14.2 Interest Rate Risk 14.3 Exposure Management Systems 14.4 Assets Repriced Before Liabilities Principle (ARBL) 14.5 Pricing Financial Securities

11. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 11 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.3 Exposure Management Systems An exposure management system involves structured procedures that enable a firm to effectively measure and manage risk, including – Forecasting – Strategies and techniques – Management and reporting systems

12. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 12 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.3 Exposure Management Systems (cont.) Forecasting – A firm needs to understand factors that will impact upon risk exposures and its environment  A firm must know the current structure of its balance sheet and forecast future changes in its assets, liabilities and equities with regard to Future business activity growth Future interest rates Future financing needs, and use of debt financing

13. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 13 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.3 Exposure Management Systems (cont.) Strategies and techniques – The strategies and techniques used relate to the types of interest cash flows associated with a firm’s assets and liabilities, and include  Monitoring and adjusting the maturity structure of assets and liabilities, taking into account the term structure of interest rates Maturity structure is the relative proportion of assets and liabilities maturing at different time intervals

14. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 14 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.3 Exposure Management Systems (cont.) Strategies and techniques (cont.) – The strategies and techniques used relate to the types of interest cash flows associated with a firm’s assets and liabilities, and include (cont.)  Specified proportions of fixed-interest versus floating- interest debt

15. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 15 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.3 Exposure Management Systems (cont.) Strategies and techniques (cont.) – The strategies and techniques used relate to the types of interest cash flows associated with a firm’s assets and liabilities, and include (cont.)  Liability diversification—where a firm raises funds from a range of different sources, thereby reducing its exposure to potential interest changes in a particular market

16. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 16 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.3 Exposure Management Systems (cont.) Strategies and techniques (cont.) – Two broad interest rate risk management techniques, internal and external methods, are discussed later

17. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 17 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.3 Exposure Management Systems (cont.) Management reporting – Policies and procedures need to provide clear instructions on  The type of information to be reported  Frequency of reports  Report hierarchy  Delegation and staff responsible to act on the reports  The need for audit and review of policies and procedures

18. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 18 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 14.1 Introduction 14.2 Interest Rate Risk 14.3 Exposure Management Systems 14.4 Assets Repriced Before Liabilities Principle (ARBL) 14.5 Pricing Financial Securities

19. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 19 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.4 Assets Repriced Before Liabilities Principle (ARBL) Repricing of assets and liabilities is essential in interest rate risk measurement and management – Positive ARBL gap exists when assets are repriced before liabilities  For e.g., if interest rates are forecast to rise A bank increases the interest rate on loans (assets) before increasing the rate on deposits (liabilities) A firm increases the price of its goods before or at the same time as interest rates rise on its loan

20. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 20 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.4 Assets Repriced Before Liabilities Principle (ARBL) (cont.) Repricing of assets and liabilities is essential in interest rate risk measurement and management (cont.) – Negative ARBL gap exists when liabilities are repriced before assets  For e.g., if interest rates are forecast to fall A bank lowers the interest rate on deposits (liabilities) before lowering the rate on loans (assets)

21. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 21 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.4 Assets Repriced Before Liabilities Principle (ARBL) (cont.) A firm should measure its ARBL interest rate sensitivity of its balance sheet assets and liabilities over a range of planning periods

22. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 22 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 14.1 Introduction 14.2 Interest Rate Risk 14.3 Exposure Management Systems 14.4 Assets Repriced Before Liabilities Principle (ARBL) 14.5 Pricing Financial Securities

23. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 23 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.5 Pricing Financial Securities The effect of interest rate risk on the price of discount securities and fixed-interest corporate/government bonds can be demonstrated using calculations discussed in Chapters 9, 10 and 12 (14.1)

24. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 24 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.5 Pricing Financial Securities (cont.) – Example 1: A company is to issue a ninety-day bank bill, with a face value of $500,000 yielding 9.5 per cent per annum. What amount will the company raise on the issue?

25. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 25 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.5 Pricing Financial Securities (cont.) – Example 1 (cont.): If the company has a rollover facility in place for this bill, it is exposed to interest-rate risk at the next repricing date, the rollover date, in ninety-days time. If the yield at the next rollover date is 9.25 per cent per annum the company will xxx. – In this example the cost of borrowing has fallen by $294.45.

26. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 26 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 14.6 Repricing Gap Analysis 14.7 Duration 14.8 Convexity 14.9 Interest Rate Risk Management Techniques 14.10 Summary

27. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 27 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.6 Repricing Gap Analysis Repricing gap analysis is the monitoring of the interest rate sensitivities of assets and liabilities over specified planning periods – Interest rate sensitivity relates to the repricing of an asset or liability within the planning period  The longer the planning period, the more likely a security is to be rate sensitive

28. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 28 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.6 Repricing Gap Analysis (cont.) The repricing gap is rate sensitive assets minus rate sensitive liabilities – Three groupings of assets and liabilities assist in determining the repricing gap  Interest-sensitive assets financed by interest-sensitive liabilities  Fixed-interest assets financed by fixed-interest liabilities and equities  Interest-sensitive assets financed by fixed-interest liabilities

29. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 29 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.6 Repricing Gap Analysis (cont.)

30. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 30 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.6 Repricing Gap Analysis (cont.)

31. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 31 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.6 Repricing Gap Analysis (cont.) Change in profitability = Gap x change in rates x period (14.3) = $15 billion x 0.005 x 1 = $75 million

32. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 32 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 14.6 Repricing Gap Analysis 14.7 Duration 14.8 Convexity 14.9 Interest Rate Risk Management Techniques 14.10 Summary

33. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 33 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.7 Duration Duration is another tool for the measurement and management of interest rate risk exposures – It is a measure in years, that considers the timing and present values of cash flows associated with a financial asset or liability – Duration is calculated as the weighted average time over which cash flows occur, where weights are the relative present values of the cash flows

34. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 34 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.7 Duration (cont.)

35. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 35 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.7 Duration (cont.)

36. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 36 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.7 Duration (cont.) Duration can also be used to determine the dollar impact of a change in interest rates on the price of a security using equation 14.5 (14.5)

37. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 37 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.7 Duration (cont.) Duration can also be used to determine the dollar impact of a change in interest rates on the price of a security using equation 14.5 (14.5 [cont.])

38. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 38 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.7 Duration (cont.) The duration of a portfolio of securities is the weighted duration of each asset or liability in the portfolio – Given a forecasted change in interest rates, the dollar change in the equity position of a firm can be calculated from equation 14.6 (14.6)

39. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 39 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.7 Duration (cont.)

40. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 40 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 14.6 Repricing Gap Analysis 14.7 Duration 14.8 Convexity 14.9 Interest Rate Risk Management Techniques 14.10 Summary

41. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 41 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.8 Convexity Convexity is curvature in the price/yield curve – This overcomes the limitation of the duration method which reflects a linear relationship between yield and price – Convexity is illustrated in the following example  A 2% interest rate change on one-year, two-year and three- year bonds that have a face value of $1000 and pay a fixed annual coupon of 8% p.a.  Figure 14.1 illustrates that the percentage change in price relationships for the one, two and year bonds is not linear, but convex

42. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 42 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.8 Convexity (cont.)

43. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 43 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.8 Convexity (cont.) Figure 14.2 indicates the difference in the price of the following bond using the duration and convexity approaches, assuming a forecast interest rate rise of 2% – $1000 bond paying 5% coupon pa, maturing in four years, currently yielding 5% p.a. The problem with duration can be compensated for by adjusting for convexity %  price = - duration [  r%] + 0.5(convexity)(  r 2 )(14.8) (1+r)

44. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 44 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.8 Convexity (cont.)

45. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 45 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 14.6 Repricing Gap Analysis 14.7 Duration 14.8 Convexity 14.9 Interest Rate Risk Management Techniques 14.10 Summary

46. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 46 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.9 Interest Rate Risk Management Techniques Interest rate risk management techniques also include internal and external methods – Internal methods involve the restructuring of a firm’s balance sheet and associated cash flows  Asset and liability portfolio restructuring E.g. a funds manager sells part of its bond portfolio and invests the funds in shares or property

47. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 47 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.9 Interest Rate Risk Management Techniques (cont.) Interest rate risk management techniques also include internal and external methods (cont.) – Internal methods (cont.)  Asset and liability repricing E.g. seek fixed-rate funds in periods when interest rates are rising

48. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 48 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.9 Interest Rate Risk Management Techniques (cont.) Interest rate risk management techniques also include internal and external methods (cont.) – Internal methods (cont.)  Cash flow timing Change the timing of cash flows to minimise the effect of interest rate changes or to take advantage of forecast rate movements by E.g. switching from one security to another with different frequency of interest payments

49. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 49 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.9 Interest Rate Risk Management Techniques (cont.) Interest rate risk management techniques also include internal and external methods (cont.) – Internal methods (cont.)  Reduced reliance on interest rates E.g. introduction of other fees on loans by a bank

50. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 50 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.9 Interest Rate Risk Management Techniques (cont.) Interest rate risk management techniques also include internal and external methods (cont.) – Internal methods (cont.)  Prepayment and pre-redemption conditions E.g. early payment penalties to discourage borrowers repaying floating-rate loans early in periods of rising interest rates

51. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 51 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.9 Interest Rate Risk Management Techniques (cont.) Interest rate risk management techniques also include internal and external methods (cont.) – External methods  External methods involve strategies outside the balance sheet Primarily involve the use of derivative products allowing a party to lock in a price today that will apply at a specified future date i.e. futures contracts, forward rate agreements, interest options and swaps

52. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 52 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 14.6 Repricing Gap Analysis 14.7 Duration 14.8 Convexity 14.9 Interest Rate Risk Management Techniques 14.10 Summary

53. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 53 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.10 Summary Interest rate risk is the sensitivity of the value of balance sheet assets and liabilities and cash flow to movements in interest rates Interest rate risk exists in the form of reinvestment risk and price risk A firm must establish an effective interest rate exposure management system

54. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 54 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 14.10 Summary (cont.) ARBL is a basic principle of interest rate risk management Models for measuring interest rate risk include repricing gap analysis, duration (and convexity) A range of internal and external interest rate risk management techniques exist