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Chapter 8 Interest Rate Risk I.docx

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FIN 701
Patricia Mc Graw

FIN701 Financial Institutions Management CHAPTER 8 Interest Rate Risk I INTRODUCTION  FIs mismatch BS maturities to some degree, but excessive interest rate risk can have impact on IS and BS by squeezing net interest income (NII) – difference between FI’s interest income and interest expense o Measuring interest rate risk exposure by looking at size of maturity mismatch can be misleading THE LEVEL AND MOVEMENT OF INTEREST RATES  Loanable funds theory – theory of interest rate determination that views equilibrium interest rates in financial markets as a result of supply and demand for loanable funds o Aggregate quantity of funds supplied is positively related to interest rates (supply higher at i than i ) o Aggregate quantity of funds demanded is inversely related to interest rates  As long as competitive forces allowed to operate freely in financial system, equilibrium interest rate for that security is i*  Changes in underlying factors that determine demand and supply of loanable funds can cause continuous shifts in supply and/or demand curve o Central bank’s monetary policy strategy that most directly underlies level and movement of interest rate, which in turn affect FI’s cost of funds and return on assets THE BANK OF CANADA AND INTEREST RATE RISK  Bank of Canada sets target range for inflation (1%-3%) and then adjusts target for overnight rate – rate that FIs charge each other for one-day funds – to achieve inflation target (range midpoint, 2%)  Bank rate – rate changed by Bank of Canada on overnight loans to FIs – is always the upper limit of operating band, and overnight rate is at middle of band o Operating band – range (0.5% wide) overnight rates charged by Bank of Canada  Bottom of band is rate Bank of Canada will pay for deposits; top of band is rate charged by Bank of Canada on loans (bank rate) o If forecasts inflation below target rate, lowers target overnight rate so money is cheaper; if forecasts inflation above target rate, raises target overnight rate so money is expensive  Federal funds rate – rate charged by U.S. Federal Reserve on overnight loans to FIs o Federal Reserve actions targeted at short-term rates but usually feeds through to whole structure of interest rate  Bank rates are generally higher than federal fund rates o Reflects Bank of Canada’s focus on US/Canadian dollar exchange rate and flow of funds between the two countries as a result of interest rate differentials  Financial market integration increases speed with which interest rate changes and associated volatility are transmitted among countries  Bank of International Settlements called for regulations that require DTIs to have interest rate risk measurement systems that assess effects of interest rate changes on both earnings and economic value THE REPRICING MODEL  Repricing gap – difference between interest revenue earned on FI’s assets and interest paid on liabilities (or its net income interest) over particular period of time  Rate-sensitive assets or liabilities – asset or liability that is repriced at or near current market interest rates within maturity bucket  Maturity bucket – sum of all FI’s rate-sensitive assets or liabilities that are repriced over a particular time period 1. One day 2. More than one day to 3 months 3. More than 3 months to 6 months 4. More than 6 months to 12 months 5. More than one year to five years 6. More than five years  Banks report gaps in each maturity bucket by calculating rate sensitivity of each asset (RSA) and each liability (RSL)  Advantage of repricing model is its information value and its simplicity in pointing to FI’s net interest income exposure to interest rate changes in different maturity buckets  Refinancing risk – risk that cost of rolling over or reborrowing funds will rise above returns being earned on asset investments FIN701 Financial Institutions Management o Negative gap (RSA < RSL where interest expense will increase more than interest revenue), in that rise in short- term rates would lower FI’s net interest income since FI has more rate-sensitive liabilities than assets  Reinvestment risk – risk that returns on funds to be reinvested will fall below cost of funds o Positive gap (RSA > RSL where interest income will decrease by more than interest expense), in that drop in rates over this period would lower FI’s net interest income ( ) ( )  Capital loss effect when rates rise not accounted for in repricing model becaus
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