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FINA 465 Chapter 7

Terms in this set (31)

ALM
-The management of a bank's entire balance sheet to achieve desired risk-return objectives and to maximize the market value of stockholder's equity
-Plans for, implements, and controls for A&L: rate, composition, and volume
-Focuses on liquidity, credit, and interest rate risk
Asset and Liability Committee (ALCO)
-Risk management committee responsible for:
1. Evaluating pricing, investment, funding, and marketing strategies
2. Measuring and monitoring interest rate risk
Interest Rate Risk
-Changes in the value of equity, assets, and income from unanticipated changes in interest rates
-4 Types
1. Mismatch/Repricing Risk
2. Basis Risk
3. Prepayment/Extension Risks
4. Yield Curve Risk
Mismatch/Repricing Risk
-Assets and liabilities reprice or mature at different times causing margins/spreads to fluctuate
-Causes a change in net interest income and stockholder's equity
Basis Risk
Changes in underlying index used to price assets and liabilities do not adjust in a correlated manner
Prepayment/Extension Risks
Asset prepayments accelerate in a declining rate environment or vice versa
Yield Curve Risk
Nonparallel changes in the yield curve can impact profitability and/or cash flows
Reinvestment Risk
Risk associated with reinvesting coupons received at yields different from the yield on the bond when purchased
Price Risk
The risk that when a bond is sold, it will need to be sold at a different price from what was expected
Market interest rates and bond prices vary inversely
Bond prices fall as interest rates rise and rise as interest rates fall
For a specific absolute change in interest rates, the proportionate increase in bond prices when rates fall is greater than the proportionate decrease in bond prices when rates rise. The difference increases with maturity and is larger the lower a bond's periodic interest payment
For the identical absolute change in interest rates, a bondholder will realize a greater capital gain when rates decline than capital loss when rates rise
Long-term bonds change proportionately more in price than short-term bonds for a given change in interest rates from the same base level
Investors will realize greater capital gains and capital losses on long-term securities than on short-term securities when interest rates change by the same amount
Low-coupon bonds change proportionately more in price than high-coupon bonds for a given change in interest rates from the same base level
Low-coupon bonds exhibit greater relative price volatility than do high-coupon bonds
Risk frameworks for interest rate sensitivity
1. Static GAP analysis
2. Earnings sensitivity analysis
3. Income Statement GAP
Risk framework for price sensitivity
Duration gap and economic value of equity analysis: emphasizes the market value of stockholders' equity by focusing on how these same changes affect the market value of assets vs. the market value of liabilities
What determines rate sensitivity of an asset or liability?
1. It matures
2. It represents an interim or partial principle repayment
3. It can be repriced
4. Contractural changes in rate
5. Changes in base rate or index
If any asset or liability matures within a time interval:
-The principal amount will be repriced
-Asset matures: banks must reinvest proceeds
-Liability matures: banks must replace with new funding
Contractural change in rate
-Some assets and deposit liabilities earn or pay rates that vary contractually with some index
-These instruments are repriced whenever the index changes
-If the index will contractually change within 90 days, the underlying asset or liability is rate sensitive within 0-90 days
Changes in base rate or index
-Some loans and deposits interest rates are tied to indexes that change with unknown frequency (i.e. WSJ Prime rate)
-For the most meaningful GAP analysis, management must forecast when such rates will change.
Static GAP analysis
-Interest rate risk is measured by calculating GAPs over different time intervals based on balance sheet data at a fixed point in time - static
-Static GAP focuses on managing net interest income in the short run
-Objective is to measure expected net interest income and identify strategies to stabilize or improve it
Earnings Sensitivity Analysis
Extends GAP analysis by focusing on the variation in bank's earnings across different "what if" interest rate scenarios
Income Statement GAP
-Simplified framework used by community banks
-Useful for banks without significant off-balance sheet transactions/without dramatic changes in complexity and size of assets and liabilities over short periods of time
-Modifies standard GAP to include embedded options and different speeds of repricing of specific assets and liabilities given interest rate change
*Includes an earnings change ratio: indicates how the yield on each asset and rate paid on each liability is assumed to change relative to a 1% move in prime
Changes in interest rates (parallel shift) affecting NII
-Negative GAP: When interest rates rise during the time interval, the bank pays higher rates on all repriceable liabilities and earns higher yields on all repriceable assets
-Positive GAP: When interest rates fall during the time interval, the bank pays lower rates on all repriceable liabilities and earns lower yields on all repriceable assets
Changes in the relationship between asset yields and liability costs (nonparallel shift) affecting NII
-NII may differ from what was expected if the spread between earning asset yields and the interest cost of interest-bearing liabilities changes
-Spread may change due to nonparallel shift in yield curve or change in the difference b/w different interest rates (basis risk)
Changes in volume affecting NII
-Varies directly with changes in volume of earning assets and interest-bearing liabilities regardless of interest rate levels
-If bank doubles in size w/out changing portfolio composition or interest rates, NII will double bc the bank earns the same interest spread on twice the volume of assets
Changes in portfolio composition affecting NII
-If portfolio mix of RSAs or RSLs changes, expected NII should also change
-*no fixed relationship b/w changes in portfolio mix and NII
Strengths of static GAP analysis
-Easy to understand
-Works well with small changes in interest rates
Weaknesses of static GAP analysis
-Ex-post measurement errors
-Ignores time value of money
-Ignores cumulative impact of interest rates on bank's risk position
-Considers demand deposits to be non-rate sensitive even though bank's tend to lose deposits when rates rise
-Ignores embedded options in assets and liabilities
Three issues of embedded options
1. Does the bank or its customer determine when the option is exercised?
2. How and by what amount is the bank being compensated for selling the option, or how much must it pay to buy the option?
3. Bank should forecast when the option will be exercised.
-Involves forecasting how much interest rates will change, when the loan will be prepaid when the bond will be called, and when the depositor will withdraw funds early.
-Will depend on the assumed rate environment.
Earnings sensitivity analysis benefits
Managers can estimate the impact of rate changes on earnings while allowing for:
-Interest rates to follow any path
-Different rates to change by different amounts at different times (banks are quick to increase base loan rates when interest rates increase, but slower to lower base loan rates when interest rates fall)
-Expected changes in balance sheet mix/volume
-Embedded options to be exercised at different times/in different int. rate environments
-Effective GAP to change when int. rates change
Steps to reduce risk in effective GAP management
1. Calculate periodic GAPs over short time intervals
2. Match fund repriceable assets with similar repriceable liabilities so that periodic GAPs approach 0
3. Match fund long-term assets with non-interest bearing liabilities
4. Use off-balance sheet transactions such as interest rate swaps and financial futures to hedge
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