copyright 2007 mcgraw-hill australia pty ltd ppts t/a mcgraths financial institutions, instruments...
TRANSCRIPT
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-1
Chapter 14
Interest Rate
Risk Measurement
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-2
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• Revisit financial securities repricing and interest
rate risk• Describe the interest rate risk measurement
models, particularly repricing gap analysis, duration and convexity
• Outline internal and external interest rate risk management techniques
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-3
Chapter Organisation
14.1 Interest Rate Risk
14.2 Exposure Management Systems
14.3 Assets Repriced Before Liabilities Principle
(ARBL)
14.4 Pricing Financial Securities
14.5 Repricing Gap Analysis
14.6 Duration
14.7 Convexity
14.8 Interest Rate Risk Management Techniques
14.9 Summary
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-4
14.1 Interest Rate Risk
• Chapter 13 considered the– Macro-economic context of interest rates– Loanable funds approach to interest rate determination– Theories that explain the shape of the yield curve
• The timing and extent of interest rate changes is unknown
• Interest rate risk needs to be managed
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-5
14.1 Interest Rate Risk (cont.)
• 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
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-6
14.1 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
– Basis Occurs when pricing differentials exist between markets,
e.g. futures market and the underlying physical market
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-7
Chapter Organisation
14.1 Interest Rate Risk
14.2 Exposure Management Systems
14.3 Assets Repriced Before Liabilities Principle
(ARBL)
14.4 Pricing Financial Securities
14.5 Repricing Gap Analysis
14.6 Duration
14.7 Convexity
14.8 Interest Rate Risk Management Techniques
14.9 Summary
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-8
14.2 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 reporting systems
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-9
14.2 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
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-10
14.2 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
Specified proportions of fixed-interest versus floating-interest debt, with remaining portion available to take advantage of forecast changes
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-11
14.2 Exposure Management Systems (cont.)
• Strategies and techniques (cont.) 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
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
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-12
14.2 Exposure Management Systems (cont.)
• Strategies and techniques (cont.)
Two broad interest rate risk management techniques are discussed later
• Internal methods• External methods
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-13
14.2 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
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-14
Chapter Organisation
14.1 Interest Rate Risk
14.2 Exposure Management Systems
14.3 Assets Repriced Before Liabilities Principle
(ARBL)
14.4 Pricing Financial Securities
14.5 Repricing Gap Analysis
14.6 Duration
14.7 Convexity
14.8 Interest Rate Risk Management Techniques
14.9 Summary
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-15
14.3 Assets Repriced Before Liabilities Principle
– Interest rate risk is the sensitivity of assets, liabilities and cash flows to changes in interest rates
– Assets repriced before liabilities (ARBL) is a risk management technique that ensures net margins and profitability are protected
– A firm should measure its ARBL interest rate sensitivity of its balance sheet assets and liabilities over a range of planning periods
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-16
14.3 Assets Repriced Before Liabilities Principle
– Positive ARBL gap exists when assets are repriced before liabilities and an organisation is able to benefit, e.g.
Interest rates are forecast to rise• A bank increases the interest rate received on loans (assets)
before increasing the rate paid on deposits (liabilities)• A company increases the price of its goods (assets) before or
at the same time as interest rates rise on its floating-rate loan (liability)
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-17
14.3 Assets Repriced Before Liabilities Principle (cont.)
– Negative ARBL gap exists when liabilities are repriced before assets, e.g.
Interest rates are forecast to fall• A bank lowers the interest rate paid on deposits (liabilities)
before lowering the rate received on loans (assets)
Interest rates are forecast to rise• A bank may implement strategies to reduce the negative ARBL
gap to a smaller level
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-18
Chapter Organisation
14.1 Interest Rate Risk
14.2 Exposure Management Systems
14.3 Assets Repriced Before Liabilities Principle
(ARBL)
14.4 Pricing Financial Securities
14.5 Repricing Gap Analysis
14.6 Duration
14.7 Convexity
14.8 Interest Rate Risk Management Techniques
14.9 Summary
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-19
14.4 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
maturity to days
100yield 365
365value facePrice
(14.1)
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-20
14.4 Pricing Financial Securities (cont.)
– Example 1: A company is to issue a 90-day bank bill with a face value of $500 000 yielding 9.5% per annum. What amount will the company raise on the issue?
555.75 $488373.55
000 500 18290)(0.0950 365
365000 $500Price
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-21
14.4 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, i.e. the rollover date in 90 days’ time. If the yield at the next rollover date is 9.25% per annum the company will raise:
– In this example the cost of borrowing has fallen by $294.45.
850.20 $488373.325
000 500 18290)(0.0925 365
365000 $500Price
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-22
Chapter Organisation
14.1 Interest Rate Risk
14.2 Exposure Management Systems
14.3 Assets Repriced Before Liabilities Principle
(ARBL)
14.4 Pricing Financial Securities
14.5 Repricing Gap Analysis
14.6 Duration
14.7 Convexity
14.8 Interest Rate Risk Management Techniques
14.9 Summary
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-23
14.5 Repricing Gap Analysis
– This is the monitoring of the interest rate sensitivities of assets and liabilities over specified planning periods
Interest rate sensitivity (or repricing gap) relates to the repricing of an asset or liability during a planning period
• Defined as rate-sensitive assets minus rate-sensitive liabilities
The longer the planning period, the more likely a security is to be rate sensitive
• e.g. a 90-day discount security is not interest rate sensitive over a 1-month planning period, but is over a 6-month planning period
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-24
14.5 Repricing Gap Analysis (cont.)
– Three groupings of assets and liabilities assist in determining the repricing gap
Interest-sensitive assets financed by interest-sensitive liabilities
• Are both sides of the balance sheet affected at the same time and to the same extent?
Fixed-rate assets financed by fixed-rate liabilities and equity• Are not exposed to interest rate risk during a planning period
as the cost of funds and return on funds is fixed
Rate-sensitive assets financed by fixed-rate liabilities or vice versa
• One side of the balance sheet is exposed to interest rate risk while the other is not
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-25
14.5 Repricing Gap Analysis (cont.)
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-26
14.5 Repricing Gap Analysis (cont.)
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-27
14.5 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
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-28
Chapter Organisation
14.1 Interest Rate Risk
14.2 Exposure Management Systems
14.3 Assets Repriced Before Liabilities Principle
(ARBL)
14.4 Pricing Financial Securities
14.5 Repricing Gap Analysis
14.6 Duration
14.7 Convexity
14.8 Interest Rate Risk Management Techniques
14.9 Summary
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-29
14.6 Duration
• Duration is another tool for the measurement and management of interest rate risk exposures– It is a measure in years and 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
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-30
14.6 Duration (cont.)
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-31
14.6 Duration (cont.)
– The duration calculations in Table 14.4 can also be achieved using Equation 14.5
N
t titC
N
t ti
ttC
D
1 )(1
1 )(1
)(
(14.5)
flows cash of number
decimal a as expressed yieldmaket current
due isflow cash the until periods of number the
time at flows cash of value dollar
:where
N
i
t
ttC
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-32
14.6 Duration (cont.)
• Duration can also be used to ascertain the dollar impact of a change in interest rates on the value of a financial asset or security– The change in value will be proportional to the duration,
but in the opposite direction
change to forecast is or changes, rate interest the before
decimal, a as expressed yield,current the is
where
)(1
Δduration - price %Δ
r
r
r
(14.6)
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-33
14.6 Duration (cont.)
– Example: Assume the funds manager has forecast that interest rates will continue to rise by another 50 basis points. The approximate change in the value of the corporate bond in Table 14.4 is:
$962.90 to$975.12 from $12.22by fall willbond thei.e.
$12.22-
0.012527- x $975.12 price
:therefore
centper 1.2527
0.012527-
)10.01(
0.00502.7559 - price %
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-34
14.6 Duration (cont.)
• Duration can also be applied to a portfolio of assets and a portfolio of liabilities– Duration of a portfolio is the weighted duration of each
asset and liability in a portfolio
portfolio asset of value dollar change rate interest an before decimal, a as expressed yield,current
sliabilitieby funded assets of % being leverage, portfolioliability of duration
portfolio asset of duration :where
)(1 Δ] - [- equity in %Δ
ArkDD
rrAkDD
L
A
LA(14.7)
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-35
14.6 Duration (cont.)
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-36
14.6 Duration (cont.)
– Change in the value of equity = change in the value of asset portfolio + change in the value of the liability portfolio
– Limitations of duration as a measure of interest-rate risk Unrealistically assumes changes in interest rates occur
along the entire maturity spectrum, i.e. parallel shift in yield curve
Assumes yield curve is flat, i.e. yields do not vary over time Duration is a static measure at a point in time, requiring
regular recalculation to incorporate changes in cash flow, yield and maturity characteristics of assets and liabilities
Assumes linear relationship between interest rate changes and price, whereas pricing of fixed-interest securities exhibits convexity
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-37
Chapter Organisation
14.1 Interest Rate Risk
14.2 Exposure Management Systems
14.3 Assets Repriced Before Liabilities Principle
(ARBL)
14.4 Pricing Financial Securities
14.5 Repricing Gap Analysis
14.6 Duration
14.7 Convexity
14.8 Interest Rate Risk Management Techniques
14.9 Summary
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-38
14.7 Convexity
• Convexity is curvature in the price/yield curve of a security– This overcomes the limitation of the duration method,
which reflects a linear relationship between yield and price
– Example: A bond with a face value of $1000, coupon 5% per annum, maturing in 4 years, current yield 5% per annum, and interest rates forecast to rise by 200 basis points
The duration price approximation calculation indicates the bond price would drop from $1000 to $929.08
The bond pricing formula indicates the bond price would drop from $1000 to $932.26
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-39
14.7 Convexity (cont.)
• Convexity is curvature in the price/yield curve of a security (cont.)– The error of the duration approximation can be generalised: if
interest rates Rise, duration overestimates the change in price Fall, duration underestimates the change in price
– The problem with duration can be compensated for by adjusting for convexity, which is given by
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-40
14.7 Convexity (cont.)
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-41
14.7 Convexity (cont.)
• Convexity is curvature in the price/yield curve of a security (cont.)– The duration formula can now be adjusted to incorporate
convexity (i.e. the curvature or error)
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-42
Chapter Organisation
14.1 Interest Rate Risk
14.2 Exposure Management Systems
14.3 Assets Repriced Before Liabilities Principle
(ARBL)
14.4 Pricing Financial Securities
14.5 Repricing Gap Analysis
14.6 Duration
14.7 Convexity
14.8 Interest Rate Risk Management Techniques
14.9 Summary
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-43
14.8 Interest Rate Risk Management Techniques
• 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
Asset and liability repricing• E.g. seek fixed-rate funds in periods when interest rates are
rising
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-44
14.8 Interest Rate Risk Management Techniques (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
– E.g. switch from one security to another with different frequency of interest payments
Reduced reliance on interest rates• E.g. introduction of other fees on loans by a bank
Prepayment and pre-redemption conditions• E.g. early payment penalties to discourage borrowers repaying
floating-rate loans early in periods of rising interest rates
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-45
14.8 Interest Rate Risk Management Techniques (cont.)
– External methods External methods involve using off-balance-sheet strategies
• 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, options and swaps (discussed in Part 6)
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-46
Chapter Organisation
14.1 Interest Rate Risk
14.2 Exposure Management Systems
14.3 Assets Repriced Before Liabilities Principle
(ARBL)
14.4 Pricing Financial Securities
14.5 Repricing Gap Analysis
14.6 Duration
14.7 Convexity
14.8 Interest Rate Risk Management Techniques
14.9 Summary
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-47
14.9 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 including forecasting the future balance sheet structure and the related interest rate environment
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by VineySlides prepared by Anthony Stanger
14-48
14.9 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