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Part A Covers pages 190-200

Part A Covers pages 190-200. Overview. This chapter discusses the interest rate risk associated with financial intermediation: Federal Reserve monetary policy Interest rate risk models *Term structure of interest rate risk *Theories of the term structure of interest rates.

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Part A Covers pages 190-200

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  1. Part A Covers pages 190-200

  2. Overview • This chapter discusses the interest rate risk associated with financial intermediation: • Federal Reserve monetary policy • Interest rate risk models • *Term structure of interest rate risk • *Theories of the term structure of interest rates

  3. Interest Rate Risk Models Repricing model Maturity model Duration model In-house models Proprietary Commercial

  4. 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

  5. Determination of Equilibrium Interest Rates

  6. Note that y-axis is bond PRICE

  7. Increase in Demand for Bonds

  8. Factors that impact bond demand

  9. Bond Supply Shift – Increase in Supply

  10. Factors that impact bond supply

  11. 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 2004- August 2006 • inflation concerns take prominence • 17 consecutive increases in interest rates • 2008/2009 Short rates lowered to virtually zero

  12. 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.

  13. Short-Term Rates 1954-2009

  14. Short-Term Rates 1997-2009

  15. Short-Term Rates 2007-2009

  16. Rate Changes Can Vary by Market • Note that there have been significant differences in recent years • If your asset versus liability rates change by different amounts, that is called “basis risk” • May not be accounted for in your interest rate risk model

  17. 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 • However, theoretically could be reinvestment risk (positive gap)

  18. Repricing Model We are interested in the Repricing Model as an introduction to the importance of Net Interest Income Variability of NII is really what we are trying to protect NII is the lifeblood of banks/thrifts

  19. 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. • Note the cut-off levels

  20. Repricing Gap Example AssetsLiabilitiesGapCum. Gap 1-day $ 20 $ 30 $-10 $-10 >1day-3mos. 30 40 -10 -20 >3mos.-6mos. 70 85 -15 -35 >6mos.-12mos. 90 70 +20 -15 >1yr.-5yrs. 40 30 +10 -5 >5 years 10 5 +5 0

  21. Repricing Gap Example AssetsLiabilitiesGapCum. Gap 1-day $ 20 $ 30 $-10 $-10 >1day-3mos. 30 40 -10 -20 >3mos.-6mos. 70 85 -15 -35 >6mos.-12mos. 90 70 +20 -15 >1yr.-5yrs. 40 30 +10 -5 >5 years 10 5 +5 0 Note this example is not realistic because asset = liabilities Usually assets > liabilities, final CGAP will be +

  22. Applying the Repricing Model • DNIIi = (GAPi) DRi = (RSAi - RSLi) DRi Example: In the one day bucket, gap is -$10 million. If rates rise by 1%, DNII(1) = (-$10 million) × .01 = -$100,000.

  23. Applying the Repricing Model • Example II: If we consider the cumulative 1-year gap, DNII = (CGAPone year) DR = (-$15 million)(.01) = -$150,000.

  24. 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.

  25. 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. • FOR NOW, we will treat these as though they reprice overnight • Text assumes that they do not reprice at all

  26. CGAP Ratio • May be useful to express CGAP in ratio form as, CGAP/Assets. • Provides direction of exposure and • Scale of the exposure. • Example- 12 month CGAP: • CGAP/A = $15 million / $270 million = 0.056, or 5.6 percent.

  27. 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 × .02 = $300,000 • With positive CGAP, rates and NII move in the same direction. • Change proportional to CGAP

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