AC959 Bank Strategy and Risk

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AC959 Bank Strategy and Risk

• Lecture 8
• Interest Rate Risk management

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Aims of lecture

• Understand the importance of Asset-Liability
  Management (ALM) in Interest Rate Risk management
• Examine the key techniques for monitoring and
  managing interest rate risk
• Introduce the use of derivatives in managing
  interest rate risk

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What is interest rate risk

• The risk of a decline in earnings due to the
  movements of interest rates.
• Bessis, 2002
• Risk arising from the mismatching of the
  maturity and the volume of banks assets and
  liabilities as part of their asset transformation
  function. Casu, Giradone and Molyneux,
  2006

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Interest rate risk management techniques

• Gap analysis
• Basic gap analysis
• Maturity bucket gap
• Maturity gap
• Duration analysis
• Simulation approaches
• Static simulations
• Dynamic simulations, e.g. dynamic gap analysis

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Gap analysis

• Gap RSA-RSL
• Rate-sensitive assets, RSA
• Rate-sensitive Liabilities, RSL

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Gap analysis
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Gap analysis

• RSAgtRSL Interest margin rises if interest rates
  rise and fall if interest rates fall
• RSAltRSL interest margin will move in the
  opposite direction to the change of interest
  rates
• Good examples, see http//stlouisfed.org/col/direc
  tor/alco/reviewreports_gapanalysis.htm

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Maturity Bucket Gap
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Liabilities reprice sooner
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Gap or Interest-sensitivity ratio

• Gap ratio RSA/RSL
• Good example, see http//stlouisfed.org/col/direct
  or/alco/reviewreports_gapanalysis.htm

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Maturity Gap

• Maturity Gap WaRSA - WaRSL
• WaRSA is the Weighted average of maturity of
  rate-sensitive assets
• WaRSL is the weighted average maturity of
  rate-sensitive liabilities

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Criticisms of Gap approaches

• Naïve - oversimplifies the complexity of a banks
  ALM
• Over aggregation intra-bucket effects ignored
• Fails to account for changes in the timing of
  payments due to changes in the interest rate
  environment, e.g. pre-payment risk (risk that
  loans will be repaid early when interest rates
  rise)
• Ignores differences in spreads between interest
  rates that could arise as market interest rates
  change (basis risk)

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Duration

• Average life of an assets (or liabilities) cash
  flows

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Macaulay duration example
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Duration Gap

• Measures the mismatch in duration between assets
  and liabilities
• Can also calculate the impact of the change in
  interest rates on the value of banks equity

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Duration Gap example
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Problems with duration measure

• Convexity
• Data requirements
• Focuses on one type of interest rate risk

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Interest rate swap example