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8/9/2019 Interest rate risk Management at Bank.pdf
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Management Of Interest
Rate Risk In Banks
Presenter:
Dr Vighneswara Swamy
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What is Interest Rate Risk
What are the types of Interest Rate Risks
Effects of Interest Rate Risks
Measurement of Interest Rate Risks
Strategies for Controlling Interest Rate Risks
Basel Committee Recommendations
Sound Interest Rate Risk Management
Practices
Agenda Items
for the Session:
12/17/2009 2Presenter: Dr. Vighneswara
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Interest Rate Risk (IRR)
Definition: It is the potential loss from
unexpected changes in interest rates
which can significantly alter a banksprofitability and market value of
equity.
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Interest Rate Risk .. explained
The amount at risk is a function of the
magnitude and direction of interest rate
changes and the size and maturity structure
of the mismatch position.
If interest rates rise, the cost of funds
increases more rapidly than the yield on
assets, thereby reducing net income. If the exposure is not managed properly it
can erode both the profitability and
shareholder value.
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Interest Rate Risks - Types
Interest Rate Risks
Repricing Risk Basis RiskYield Curve
Risk
Embedded
Option Risk
12/17/2009 5Presenter: Dr. Vighneswara
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Repricing Risk
Arises on account of mismatches in rates
Can be measured by the measure of risk in different timebuckets
Information needed
Balance sheet -on & off on a particular day
Business plan & expected income/ exp. ignored
Static vs Dynamic
Liabilities Assets Spread
Capital
(Crore)
@ ROI Maturity Investment(Crore)
@
ROI
Maturity
Scenario-1
Rs100 9% One year Rs100 10% Two year Profit
1%(1crore)
Scenario-2
Rs100 11% 2nd year Rs100 10% Two year Loss
1%(1crore)
12/17/2009 6Presenter: Dr. Vighneswara
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Mismatched Repricing Periods of Assets/Liabilities
Illustrations:
Liabilities Assets SpreadCapital
(Crore)
@ ROI Maturity Investment(Crore)
@ ROI Maturity
Scenario-1
Rs100 8% 91 days Rs100
Fixed Rate
10% 91 days
Profit
2%(0.49crore)
Scenario-2Rs100 9% 91 days Rs100
Fixed Rate11% 91 days
Profit2%(0.49crore)
Scenario-3
Rs100
Asset
Sensitive
8% 91 days Rs100
Float Rate
10%(1st month) 30 days
Profit
2%(0.164crore)
Float Rate
11%(2nd month) 61 days
Profit
3%(0.5crore)
Total: 0.664 Crore
Scenario-4
Rs100
LiabilitySensitive
8% 91 days Rs100 Fixed Rate
10% 5 years
9% 91 days
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Basis Risk
Interest rates on assets and liabilities do not change in thesame proportion.
When Bank Rate was raised by 2%, PLR was raised by 1% and
deposit rates by 1.5%
Interest rates movement is based on market perception of riskand also market imperfections.
Therefore, basis risk arises when interest rates of differentassets and liabilities change in different magnitudes.
The `basis form of IRR results from the imperfect correlationbetween interest adjustments when linked to different indexrates despite having the same re-pricing characteristics.
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Basis Risk An Illustration
Repricing Liabilities (Rs Crores) Repricing Assets(Rs Crores)Savings Deposit 50 Call Money 50
Fixed Deposit 50 Cash Credit 40
Total 100 Total 90
Gap(-) 10
Calculation of Standardised Gap Fall in Rates Fall in Amount
(Rs Crores)
Call Money 50 * 1.0% 0.50
Cash Credit 40 * 0.7% 0.28
A. Decrease in Interest Income (-) 0.78
Savings Deposit 50 * 0.5% 0.25
Fixed Deposit 50 * 0.4% 0.20
B. Decrease in Interest Expense (+) 0.45
Loss in Net Interest Income (A-B) (-) 0.33(Rs 33 Crores)12/17/2009 9Presenter: Dr. Vighneswara
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Embedded Option Risk
Risks arising out of prepayment of loans and bonds (with
put or call options) and / or premature withdrawal of
deposits before their stated maturity dates.
Liabilities Assets SpreadCapital
(Crore)
@
ROI
Maturity Loan
(Crore)
@ ROI Maturity
Scenario-1
Rs100 8%
90
days Rs100 10%
90
days
Profit
2%(0.49crore)
Scenario-2Rs100 8%
90days Rs100 10%
90days
2%(0.164crore)for 30days
Int. Rates
decline after
30 days to 9%
60
days
1%(0.164crore)for 60 days
Total 0.328 crore12/17/2009 10Presenter: Dr. Vighneswara
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Yield Curve Risk
Risks caused due to the changein the yield curve from time to
time depending on the repricingand various other factors.
Yield Curve is the relation between the
interest rate (or cost of borrowing) and
the time to maturity of the debt for agiven borrower in a given currency.
12/17/2009 11Presenter: Dr. Vighneswara
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What is
Yield Curveshape of
yield curveYield Curve Yield Curve
Risk
Yield Curve is
the relation
between the
interest rate
(or cost of
borrowing) andthe time to
maturity of the
debt for a
given borrower
in a given
currency.
The shape of the
yield curve is
influenced by supply
and demand. The
yield curve may also
be flat or hump-
shaped, due to
anticipated interest
rates being steady,
or short-term
volatility
outweighing long-
term volatility.
TEXT
The risk of
experiencing
an adverse
shift in
market
interest ratesassociated
with
investing in a
fixed income
instrument.
Yield Curve Risk ..
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Yield Curve Risk An Illustration
Date 91 T-Bill Deposit 364 T-Bill Loan Spread
22.05.2008 4.48% 5.48% 4.62% 7.62% 2.14%
08.08.2008 4.93% 5.93% 4.85% 7.85% 1.92%
08.12.2008 4.71% 5.71% 4.24% 7.24% 1.53%
Liabilities Assets Spread
Capital
(Crore)
@ ROI Maturity Loan
(Crore)
@ ROI Maturity
Scenario-1
Rs100Reference:
91 day [email protected]%
13.5%
3 yearfixed(quarterly
repriced)
Rs100
Loan
16%Reference:
364 day T-Bill @13%
3 yearfloat(quarterly
repriced)
Profit
2.5%(2.5crore)
Scenario-2
Rs100Reference:
91 day T-Bill
@14%
15%
90
days Rs100 16%Reference:
364 day T-Bill @13%
90
days
Profit
1.0%(1crore)
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Interest Rate Volatility
IMPACT OF INCREASE / DECREASE IN RATE OF INTEREST ON NII
COL1 COL2 COL3 COL4 COL5
Maturity pattern RSL - OUTFLOWS RSA - INFLOWS GAP - RSA - RSL CHANGE IN NII FOR
0.25 % DECREASE
1- 14 DAYS 18785.27 15920.09 -2865.18 7.16
15 - 28 DAYS 31772.55 31161.34 -611.21 1.5329 DAYS - 3 MTS 68403.39 77914.78 9511.39 (-23.78)
3-6 MONTHS 87629.72 90673.27 3043.55 (-7.61)
6-ONE YEAR 101260.22 98917.23 -2342.99 5.86
ONE - 3 YEARS 108310.71 106316.51 -1994.2 4.99
3-5 YEARS 114558.21 124538.91 9980.7 (-24.95)ABOVE 5 YRS 134964.33 137905.36 2941.03 -7.35
Impact of Interest Rate Volatility on the Net
Interest Income
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Approaches to Measure IRR
Maturity
GapAnalysis
Simulation
Duration
Gap
Analysis
Value at
Risk
Measurement of IRR
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Maturity Gap Analysis
MGA distributesinterest rate sensitiveassets, liabilities and OBS
positions into a certainnumber of predefined timebands according to theirmaturity(if fixed rate) ortime remaining to their next
repricing(if floating rate)
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Maturity Gap Analysis ..
Objective:
To improve thenet interest
income in the
short run over
discreet periods
of time called the
gap periods.
How is it done?The risk sensitive
assets and risk
sensitive liabilities
are grouped into
maturity buckets
based on maturity
and the time until the
first possible
repricing due tochange in the interest
rates
What is the Gap?The gap is then
calculated byconsidering the
difference between
the absolute
values of the RSAs
and RSLs.
RSG=RSAs-RSLs
Relative differences in each maturity bucket represents the sensitivity in
that band.12/17/2009 17Presenter: Dr. Vighneswara
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Maturity Gap Method (IRS)
Three Options:
A) RSA>RSL= Positive Gap
B) RSL>RSA= Negative Gap
C) RSL=RSA= Zero Gap
12/17/2009 18Presenter: Dr. VighneswaraSwamy
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Maturity Gap Analysis Option-1
Liability(Crores)
Rate%
Increased
Rate%
DecreasedRate%
200
1800* 10 11 9
3000 11 11 11
5000
Int
Expe
nse
510 528 492
NII=
Asset(Crores) Rate%Increased
Rate%
DecreasedRate%
200
800* 12 13 11
1000* 14 15 131000* 16 17 15
2000 18 18 18
5000
Int
income
756 784 728
246 256 236
A case of Positive Gap:
RSAs= Rs2800, RSLs=Rs1800 GAP=Rs2800-RS1800=Rs100012/17/2009 19Presenter: Dr. Vighneswara
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Liability(Crores)
Rate%
Increased
Rate%
DecreasedRate%
200
1800* 10 11 9
3000 11 11 11
5000
Int
Expe
nse
510 528 492
NII=
Asset(Crores) Rate%Increased
Rate%
DecreasedRate%
200
800* 12 13 11
1000 14 15 131000 16 17 15
2000 18 18 18
5000
Int
income
756 784 728
246 256 236
A case of Negative Gap:
RSAs= Rs800, RSLs=Rs1800 GAP=Rs800-Rs1800=(-)Rs1000
Maturity Gap Analysis Option-2
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Liability(Crores)
Rate% Increased
Rate%
DecreasedRate%
200
1800* 10 11 9
3000 11 11 11
5000
Int
Expe
nse
510 528 492
NII=
Asset(Crores) Rate% Increased
Rate%
DecreasedRate%
200
800* 12 13 11
1000* 14 15 131000 16 17 15
2000 18 18 18
5000
Int
income
756 784 728
246 256 236
A case of Zero Gap:
RSAs= Rs1800, RSLs=Rs1800 GAP=Rs1800-Rs1800=0
Maturity Gap Analysis Option-3
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Inferences from above options:
Rising Interest Rates
Declining Interest
Rates
Uncertain situation
(May not occur in reality)
Maintain a positive gap
Maintain a Negative gap
Maintain a Zero gap
No benefits
SCENARIO STRATEGY
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Factors Affecting Net Interest Income: An Example
Consider the following balance sheet:
Assets Yield Liabilities Cost
Rate sensitive 500$ 8.0% 600$ 4.0%
Fixed rate 350$ 11.0% 220$ 6.0%
Non earning 150$ 100$
920$
Equity
80$
Total 1,000$ 1,000$
GAP = 500 - 600 = -100
NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)
NIM = 41.3 / 850 = 4.86%
NII = 78.5 - 37.2 = 41.3
Expected Balance Sheet for Hypothetical Bank
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Factors Affecting Net Interest Income
Changes in the level of interest rates Changes in the composition of assets and liabilities
Changes in the volume of earning assets and
interest-bearing liabilities outstanding
Changes in the relationship between the yields on
earning assets and rates paid on interest-bearing
liabilities
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25
Examine the impact of the following
changes
A 1% increase in the level of all short-term rates? A 1% decrease in the spread between assets yields
and interest costs such that the rate on RSAs
increases to 8.5% and the rate on RSLs increase to
5.5%? Changes in the relationship between short-term
asset yields and liability costs
A proportionate doubling in size of the bank?
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1% increase in short-term rates
Assets Yield Liabilities Cost
Rate sensitive 500$ 9.0% 600$ 5.0%
Fixed rate 350$ 11.0% 220$ 6.0%
Non earning 150$ 100$
920$Equity
80$
Total 1,000$ 1,000$
GAP = 500 - 600 = -100
NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)
NIM = 40.3 / 850 = 4.74%
NII = 83.5 - 43.2 = 40.3
Expected Balance Sheet for Hypothetical Bank
With a negative GAP, more liabi l i t ies than assets repr ice higher; hence NIIand NIM fall12/17/2009 26Presenter: Dr. Vighneswara
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Maturity Gap Method Mathematical
Expressions
RSG = RSAs - RSLs
Gap Ratio = RSAs / RSLs
NII = Gap x rWhere,
NII = Change in Net Interest Income
r = Change in Interest Rates
NII = Earning Assets x NIM
1
2
3
4
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NII = Earning Assets x NIM x C
Where, C = % change in NIM
Since, NII = Gap x r Gap x r = Earning Assets x NIM x C
Therefore,
Earning Assets x NIM x C
GAP = ----------------------------------------------- r Where; Earning Assets = Total Assets of the Bank
NIM = Net Interest Margin
C = Acceptable Change in NIM
r = Expected Change in Interest Rates
Maturity Gap Method Mathematical
Expressions ..
5
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Bharat bank has earning assets worth Rs. 3000 crores and a Net
Interest Margin(NIM) of 3%. In a swift move Bharat Bank decided
that a 2% increase/decrease in the NIM can be the acceptable limit.
It further forecasts that a 0.75% increase in the interest rate. Now
you are required to calculate the target gap which the bank can
maintain to remain within the acceptable limits of NII.
Answer:
Earning Assets x NIM x C
GAP = ------------------------------------------------------
r
3000 x 0.03 x 0.02 1.8
GAP = --------------------------------------------- = ----------- = Rs. 240 Crore
0.0075 0.0075
Maturity Gap Method
Illustration
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Consider the Following Illustration of two banks which have a same GapRatio;
Inference: Gap level is more helpful than the Gap Ratio in taking
Positions
Maturity Gap Method Mathematical
Expressions .. Gap Ratio
Parameters Bank A Bank B
RSA
2900 1005
RSL
2000 695
GAP
900 310
GAP Ratio
1.45 1.45
NII
830 390
Decrease in Interest
0.5 0.5
Change in NII (GAP * Change in R)
4.5 1.55
change in NII (Change in NII /NII)
0.54 0.40
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Rate Adjusted Gap = ( RSA1 * WA1 + RSA2 * WA2 + . ) - ( RSL1 * W1 + RSL2 * W2 + . )
Where,
WA1 , WA2, . are Weights of the corresponding RSAs
WL1 , WL2, . are Weights of the corresponding RSLs
Illustration: The case of a Positive Gap turning Negative
Rate Adjusted Liabilities = 1800 x 0.75 = 1350
Rate Adjusted Assets = [(800 x 0.5) + (1000 x 0.25) + (1000 x 0.5)] = 1150
Rate adjusted Gap = 1150
1350 = (-) 200 Inference: By assigning weights the Positive Gap has actually become Negative
Maturity Gap Method Mathematical
Expressions .. Rate Adjusted Gap
Liability Rate Weight
Increased
Rate Assets Rate Weight
Increased
Rate
200 200
1800 10 0.75 10.75 800 12 0.5 12.5
3000 11 11 1000 14 0.25 14.25
1000 16 0.5 16.5
2000 18 18
6
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Statement Of
Interest Rate Sensitivity
Generated by grouping RSA,RSL & OFF-Balance sheet items in to various (8)timebuckets.
RSA: MONEY AT CALL
ADVANCES ( BPLR LINKED )
INVESTMENT
RSL:
DEPOSITS EXCLUDING CD
BORROWINGS
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Balance Sheet looked at from Interest Rates:
Balance Sheet Items
Whether Interest
bearing
Fixed / Floating
Rate Remarks
Liabilities
Capital No
Reserves & Surplus No
Deposits
- Current Deposits No
- Savings Deposits Yes Fixed
- Term Deposits Yes Fixed
Discretionary pricing for High
Value deposits & Inter bank
items
Borrowings
- From within India Yes Fixed
- From Outside India Yes Generally Fixed
Sometimes, floating, linked to
LIBOR
Other Liabilities
- Interest Payable Yes Fixed
- Subordinated Debts Yes Fixed
In a few cases, this is floating
rate item
- Others NO
Balance Sheet looked at from Interest Rates:
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Im pact o f Interes t Rate Changes on NIIRis ing In teres t Stab le In teres t Falling In teres t
Rate Scenario Rate Scenario Rate Scenar io
Negative Mis Matches in IRS Adverse No Impact Favourable
Mis Match in IRS is NIL No Impact No Impact No Impact
Pos itive Mis Matches in IRS Favourable No Impact Adverse
IRS & Interest Rate Scenario
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12/17/2009 Presenter: Dr. Vighneswara 35
To a larger extent depends on the accuracylevel of the forecasts made regarding thequantum and the direction of the interestrate changes
While gap measurement is easy,gap management is quite difficult.
It assumes that changein interest rates
immediately affects allRSAs and RSLs
Ignores Time Value
of
Money
Limitations of Maturity Gap
Analysis
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Duration Gap Analysis
Duration
Analysis:
Duration is ameasure of the
percentage
change in the
economic value
of a position thatoccurs given a
small change in
level of interest
rate.
Duration
Analysis:It concentrates
on the price risk
and the
reinvestment
risk whilemanaging the
interest rate
exposure.
Duration
Analysis:
It also measures
the effect of rate
fluctuation on
the market value
of the assets andliabilities and
NIM with the help
of duration.
12/17/2009 36Presenter: Dr. Vighneswara
Duration Gap Analysis What is it?
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Duration Gap Analysis ..Illustration
Assets and Liabilities chart of Bharath Bank is presented here below alongwith their durations and interest rates. Based on the information, identify the
RSG and the NIM. During the forecasting period of one year, if the interest
rates rise/fall by 2%, what would be its implication on the NIM of Bharath
Bank?
Liabiliti
es
Amount
(Crore)
Duration
(months)Int. Rate
(%)
Assets Amount
(Crore)
Duration
(months)Int. Rate
(%)
Equity 200 Cash 200
ST
Depo 1800 5.5 11.5
ST
Loans 1800 2.75 12.5
LTDepo 2500 23.7 15
LTLoans 2000 23 16.5
Others
500 11.5 11
Invest
ments 1000 10.5 13.5
5000 500012/17/2009 37Presenter: Dr. Vighneswara
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Duration Gap Analysis
Liabi
lities
AmountDuration Interest Increased Decreased Assets Amount Duration
Interest Increased Decreased
(crore) in MnthsRate(%) Int.
Rate(%)
Int.
Rate(%)
(crore) in
Mnths
Rate(%) Int.
Rate(%)
Int.
Rate(%)
Equity 200 Cash 200
ST
Depos 1800 5.5 11.5 13.5 9.5
ST
Loans 1800 2.75 12.5 14.5 10.5
LT
Depos 2500 23.7 15 15 15
LT
Loans 2000 23 16.5 16.5 16.5
Others 500 11.5 11 13 9 Investm 1000 10.5 13.5 15.5 11.5
5000 5000Int.
Expe637 683 591 Int
Income
690 746 634
NII 53 63 43
NIM 0.010
6
0.0126 0.0086
Answer:
RSG = RSAs RSLs = (1800+1000) (1800+500) = 500
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Using the Duration analysis to assess the sensitivity ofthe market value of Assets and Liabilities.
Ds x S = ( D x A ) - ( DL x L ) Where,
Ds = Duration Gap / Duration of Surplus
DA = Duration of Assets, DL = Duration of
Liabilities A = Assets L = Liabilities
S = Surplus / Gap
12/17/2009 Presenter: Dr. Vighneswara 39
7
Duration Gap Analysis
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Duration Gap Analysis .
9
Substituting L = A
S in the above eqn. We getDs = DL + ( A / S ) x ( DA - DL )
When there is a market fluctuation,
-D( r) x Current MVMV = ------------------------------------------
( 1 + r )
Where, MV = Change in the market valueD = Duration of assets or liabilities
r = Change in the interest rate
r = Current interest rate
MV = Market Value
Then,
New MV = Current MV + MV 9
8
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Duration Gap Analysis ..
Then, -D( r) x Current MVMV = -----------------------------------( 1 + r )
An Example:
The following is the information about Bharath Bank. Market value of
liabilities is Rs1800 crores, MV of Assets is Rs2000 Crores, Duration of
Assets is 5 years, Duration of Liabilities is 4 years, the ROI is 10% andChange in the ROI is +2%. You are required to asses the change in the MV of
the bank whose Equity is currently Rs200 crore.
Answer:
Parameter Change in MV Original MV New MV
Assets -5(0.02) x2000(1+0.1)
182 2000 1818
Liabilities -4(0.02) x1800
(1+0.1)
131 1800 1669
Equity 182 131 51 200 149
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Simulation
12/17/2009 Presenter: Dr. Vighneswara 42
What is it?Simulates performance underalternative interest ratescenarios and assesses theresulting volatility in NII / NIM/ ROA / ROE / MVE
A financial modelincorporating inter-relationship of assets,liabilities, prices, costs,
volume, mix and other business related variables
Computer generatedscenarios about future andresponse to that in a dynamicway
Data Requirement
Maturity and repricing
Rate scenarios
Alternative managementresponse under different
scenarios
Yield curves
Prepayment tables
Behavioural pattern of assets
and liabilitiesConsistency of assumptions
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Simulation- other information
Risk-Return policies - management appetite for risktaking
Regulatory framework
Ward against practices whichare considered unsafe and unsound
Capital strength and profitability
Experience and track record of management
Other risks embedded in the balance sheet - Liquidity /Credit / Forex risks
Business plan
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Simulation
12/17/2009 Presenter: Dr. Vighneswara 44
-AdvantagesForward looking
Dynamic
Lessens the role of crisismanagement
Increases the value ofstrategic planning
Enhances capability ofanalysis
Interpretation easy
Timing of cash flows capturedaccurately
-Disadvantages
Accuracy depends on qualityof data, strength of the model
and validity of assumptions
Time consuming
Huge investment in computer
Requires highly skilled
Personnel
Analysis paralysis
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Interest Rate Risk Management
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INTEREST RATE RISK MODELSRisk Measurement Systems
GAP
REPORT
EARNINGS
SIMULATION
ECONOMIC VALUATION
Short-Term
EarningsExposure
Yes Yes Generally does not distinguish short-term
accounting earnings from changes ineconomic value.
Long-term
Exposure
Yes Limited* Yes
Repricing Risk Yes Yes Yes
Basis Risk Limited* Yes Limited*
Yield Curve
Risk
Limited* Yes Yes
Option Risk Limited* Limited* Yes
* The ability of these types of models to capture this type of risk will vary with the
sophistication of the model and the manner in which bank management uses
Interest Rate Risk Management
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Benefits from IRR management
Defined financial targets based on corporate risk
tolerances
Reduced earnings volatility
Improved cash flow forecasting
Improved corporate credit ratings
Defined risk management and hedge methodologies
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Conclusion
Based on the quantity of interest rate risk
and quality of interest rate risk management,
we can evaluate the adequacy of the banks
capital.
Determine the component rating for
sensitivity to market risk.
Determine further the effect of interest rate
and earnings on the business in a
macroscopic view.
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