Saunders FIM 11e PPT CH08 Accessible LM Alpha

CHAPTER 8
Interest Rate Risk 1
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Overview
This chapter discusses the interest rate risk
associated with FIs:
• Federal Reserve monetary policy.
• Repricing, or funding gap, model.
Appendix 8A:
• The Maturity Model.
• www.mhhe.com/saunders11e.
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Level and Movement of Interest
Rates
Federal Reserve: U.S. central bank.
• Open market operations influence money supply,
inflation, and interest rates.
• Actions of Fed (December 2008) in response to
economic crisis.
• Target rate between 0.0 and 0.25 percent.
• Fed eventually raised interest rates (for the first
time in 10 years) in December 2015.
• Increased rates six more times by June 2018.
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U.S. T-Bill Rate, 1965 to 2021
FIGURE 8-1 Interest Rate on U.S. Three-month Treasury Bills, 19 65 to 2021.
Source: Federal Reserve Board website, various dates. www.federalreserve.gov or Federal Reserve
Bank of St. Louis website research.stlouisfed.org/fred2/graph/?id-TB3Ms.
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Central Bank and Interest Rates
Actions mostly target short term rates.
• Focus on federal funds rate, in particular.
Interest rate changes and volatility

increasingly transmitted from country to
country due to increased globalization of
financial markets.
• Statements by Jerome Powell can have dramatic
effects on world interest rates.
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Repricing Model 1
Repricing, or funding gap, model is a simple

model used by small FIs in the U.S.
• Essentially a book value accounting cash flow
analysis of the repricing gap between the
interest income earned on an F I’s assets and the
interest expense paid on its liabilities over a
particular period of time.
Contrasts with market value-based maturity

and duration models in appendix.
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Repricing Model 2
• Rate sensitivity means repricing at (or

near) current market interest rates within a
specified time horizon.
• Repricing gap is the difference between
rate-sensitive assets (RSAs) and rate-
sensitive liabilities (RSLs).
• Refinancing risk.
• Reinvestment risk.
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Maturity Buckets
Commercial banks report quarterly repricing
gaps for assets and liabilities with maturities
of:
• One day.
• More than one day to three months.
• More than three months to six months.
• More than six months to twelve months.
• More than one year to five years.
• More than five years.
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Repricing Gap: Example
(4)
(1) (2) (3) Cumulative
Assets Liabilities Gap Gap
1. One day. $ 20 $ 30 −$10 −$10
2. More than 1 day to 3 months. 30 40 −10 −20
3. More than 3 months to 6 months. 70 85 −15 −35
4. More than 6 months to 12 months. 90 70 +20 −15
5. More than 1 year to 5 years. 40 30 +10 −5
6. Over 5 years. 10 5 +5 0
260 260
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Applying the Repricing Model 1
ΔNlli   GAPi  ΔR i   RSA i  RSLi  ΔR i
• Example 1:
In the one-day bucket, gap is −$10 million.
If rates rise by 1%,
ΔNlli   $10 million   .01  $100,000
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Applying the Repricing Model 2
• Example 2:
If we consider the cumulative 1-year gap,
ΔNlli =  CGAP  ΔR i   $15 million .01

 $150,000
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Rate-Sensitive Assets
Examples from hypothetical balance sheet:
• Short-term consumer loans: 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.
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Rate-Sensitive Liabilities 1
RSLs bucketed in same manner as RSAs.

Demand deposits warrant special attention.
• Generally considered rate-insensitive (act as
core deposits).
• Not included as RSLs, but arguments can be
made for their inclusion as R SLs.
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Rate-Sensitive Liabilities 2
Liability items that fit the one-year rate or

repricing sensitivity test.
• Three-month CDs.
• Three-month bankers acceptances.
• Six-month commercial paper.
• One-year time deposits.
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Demand Deposits as RSLs
Against Inclusion. For Inclusion.
• Explicit interest rate on • Pay implicit interest
demand deposits is zero because FIs do not
by regulation. charge fees that fully
• Rates paid by FIs do not cover their costs for
fluctuate directly with checking services.
changes in the general • Risk of runoff.
level of interest rates.
• Act as core deposits.
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GAP Ratio
May be useful to express interest rate
sensitivity in ratio form as CGAP/Assets,
referred to as “gap ratio.”
• Provides direction and scale of exposure.
Example:
• Gap ratio = CGAP/A = $15 million / $270 million
= 0.056, or 5.6 percent.
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Equal Rate Changes on RSAs,
RSLs
• Example 8-1: Suppose rates rise 1% for R SAs
and RSLs. Expected annual change in N II,
Nll  CGAP   R
 $15 million  .01
 $150,000
• CGAP is positive, change in NII is positively
related to change in interest rates.
• CGAP is negative, change in NII is negatively
related to change in interest rates.
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Unequal Changes in Rates
• If changes in rates on RSAs and RSLs are
not equal, the spread changes.
• In this case,
Nll   RSA  R RSA    RSL  R RSL 
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Unequal Rate Change Example
• Example 8-2:
RSA rate rises by 1.2% and RSL rate rises
by 1.0%.
Nll   interest revenue   interest expense

 $155 million  1.2%   $155 million  1.0% 
 $310,000
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Weaknesses of Repricing Model 1
Ignores market value effects of interest rate

changes.
Overaggregation.
• Distribution of assets and liabilities within
individual buckets is not considered.
• Mismatches within buckets can be substantial.
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Weaknesses of Repricing Model 2
Ignores effects of rate-insensitive runoffs.

• Bank continuously originates and retires consumer and
mortgage loans.
• Runoff of rate-insensitive asset/liability is rate-sensitive.
Off-balance-sheet items are not included

when considering cash flows.
• Hedging effects of off-balance-sheet items not
captured.
• Example: Futures contracts.
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End of Main Content
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CHAPTER 8

Interest Rate Risk 1

Interest rate changes and volatility

Repricing, or funding gap, model is a simple

Contrasts with market value-based maturity

• Rate sensitivity means repricing at (or

1. One day. $ 20 $ 30 −$10 −$10

2. More than 1 day to 3 months. 30 40 −10 −20

3. More than 3 months to 6 months. 70 85 −15 −35

4. More than 6 months to 12 months. 90 70 +20 −15

5. More than 1 year to 5 years. 40 30 +10 −5

ΔNlli   GAPi  ΔR i   RSA i  RSLi  ΔR i

ΔNlli   $10 million   .01  $100,000

ΔNlli =  CGAP  ΔR i   $15 million .01

RSLs bucketed in same manner as RSAs.

Liability items that fit the one-year rate or

Nll   interest revenue   interest expense

Ignores market value effects of interest rate

Ignores effects of rate-insensitive runoffs.

Off-balance-sheet items are not included

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