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 Interest rate risk models *Term structure of interest rate risk *Theories of the term structure of interest rates

8-3 Interest Rate Risk Models Repricing model Maturity model Duration model In-house models  Proprietary  Commercial

8-4 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

8-5 Determination of Equilibrium Interest Rates

8-6 Note that y-axis is bond PRICE

8-7 Increase in Demand for Bonds

8-8 Factors that impact bond demand

8-9 Bond Supply Shift – Increase in Supply

8-10 Factors that impact bond supply

8-11 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 August 2006  inflation concerns take prominence  17 consecutive increases in interest rates 2008/2009 Short rates lowered to virtually zero

8-12 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.

8-13 Short-Term Rates

8-14 Short-Term Rates

8-15 Short-Term Rates

8-16 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

8-17 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)

8-18 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

8-19 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

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

8-21 Repricing Gap Example AssetsLiabilities GapCum. Gap 1-day $ 20 $ 30 $-10 $-10 >1day-3mos >3mos.-6mos >6mos.-12mos >1yr.-5yrs >5 years  Note this example is not realistic because asset = liabilities  Usually assets > liabilities, final CGAP will be +

8-22 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.

8-23 Applying the Repricing Model  Example II: If we consider the cumulative 1-year gap,   NII = (CGAP one year )  R = (-$15 million)(.01) = -$150,000.

8-24 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.

8-25 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

8-26 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.

8-27 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