Tài chính doanh nghiệp - Chapter 14: Interest rate risk measurement

Chapter 14Interest RateRisk MeasurementCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonLearning ObjectivesDescribe interest rate risk and its formsIdentify the components of an interest rate risk exposure management systemExplain the interest rate risk management principle of asset repricing before liabilitiesDescribe the interest rate risk measurement models repricing gap analysis, duration (and convexity)Outline internal and external interest rate risk management techniquesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation14.1 Introduction14.2 Interest Rate Risk14.3 Exposure Management Systems14.4 Assets Repriced Before Liabilities Principle (ARBL)14.5 Pricing Financial SecuritiesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation (cont.)14.6 Repricing Gap Analysis14.7 Duration14.8 Convexity14.9 Interest Rate Risk Management Techniques14.10 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.1 IntroductionChapter 13 considered theMacro-economic context of interest ratesLoanable funds approach to interest rate determinationA number of theories that explain the shape of the yield curveUnknown is the timing and extent of interest rate changesInterest rate risk needs to be managedCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation14.1 Introduction14.2 Interest Rate Risk14.3 Exposure Management Systems14.4 Assets Repriced Before Liabilities Principle (ARBL)14.5 Pricing Financial SecuritiesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.2 Interest Rate RiskInterest rate risk takes two formsReinvestment riskImpact of a change in interest rates on a firm’s future cash flowsPrice riskImpact of a change in interest rates on the value of a firm’s assets and liabilitiesAn 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 versaCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.2 Interest Rate Risk (cont.)Interest rate risk exposures may also be described asDirectReinvestment and price risk IndirectRelate 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 loansCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.2 Interest Rate Risk (cont.)Interest rate risk exposures may also be described as (cont.)BasisOccurs when pricing differentials exist between markets e.g. futures market and the underlying physical marketCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation14.1 Introduction14.2 Interest Rate Risk14.3 Exposure Management Systems14.4 Assets Repriced Before Liabilities Principle (ARBL)14.5 Pricing Financial SecuritiesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.3 Exposure Management SystemsAn exposure management system involves structured procedures that enable a firm to effectively measure and manage risk, includingForecastingStrategies and techniquesManagement and reporting systemsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.3 Exposure Management Systems (cont.)ForecastingA firm needs to understand factors that will impact upon risk exposures and its environmentA firm must know the current structure of its balance sheet and forecast future changes in its assets, liabilities and equities with regard toFuture business activity growthFuture interest ratesFuture financing needs, and use of debt financingCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.3 Exposure Management Systems (cont.)Strategies and techniquesThe strategies and techniques used relate to the types of interest cash flows associated with a firm’s assets and liabilities, and includeMonitoring and adjusting the maturity structure of assets and liabilities, taking into account the term structure of interest ratesMaturity structure is the relative proportion of assets and liabilities maturing at different time intervalsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.3 Exposure Management Systems (cont.)Strategies and techniques (cont.)The strategies and techniques used relate to the types of interest cash flows associated with a firm’s assets and liabilities, and include (cont.)Specified proportions of fixed-interest versus floating-interest debtCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.3 Exposure Management Systems (cont.)Strategies and techniques (cont.)The strategies and techniques used relate to the types of interest cash flows associated with a firm’s assets and liabilities, and include (cont.)Liability diversification—where a firm raises funds from a range of different sources, thereby reducing its exposure to potential interest changes in a particular marketCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.3 Exposure Management Systems (cont.)Strategies and techniques (cont.)Two broad interest rate risk management techniques, internal and external methods, are discussed laterCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.3 Exposure Management Systems (cont.)Management reportingPolicies and procedures need to provide clear instructions onThe type of information to be reportedFrequency of reportsReport hierarchyDelegation and staff responsible to act on the reportsThe need for audit and review of policies and proceduresCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation14.1 Introduction14.2 Interest Rate Risk14.3 Exposure Management Systems14.4 Assets Repriced Before Liabilities Principle (ARBL)14.5 Pricing Financial SecuritiesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.4 Assets Repriced Before Liabilities Principle (ARBL)Repricing of assets and liabilities is essential in interest rate risk measurement and managementPositive ARBL gap exists when assets are repriced before liabilitiesFor e.g., if interest rates are forecast to riseA bank increases the interest rate on loans (assets) before increasing the rate on deposits (liabilities)A firm increases the price of its goods before or at the same time as interest rates rise on its loanCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.4 Assets Repriced Before Liabilities Principle (ARBL) (cont.)Repricing of assets and liabilities is essential in interest rate risk measurement and management (cont.)Negative ARBL gap exists when liabilities are repriced before assetsFor e.g., if interest rates are forecast to fallA bank lowers the interest rate on deposits (liabilities) before lowering the rate on loans (assets)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.4 Assets Repriced Before Liabilities Principle (ARBL) (cont.)A firm should measure its ARBL interest rate sensitivity of its balance sheet assets and liabilities over a range of planning periodsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation14.1 Introduction14.2 Interest Rate Risk14.3 Exposure Management Systems14.4 Assets Repriced Before Liabilities Principle (ARBL)14.5 Pricing Financial SecuritiesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.5 Pricing Financial SecuritiesThe 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(14.1)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.5 Pricing Financial Securities (cont.)Example 1: A company is to issue a ninety-day bank bill, with a face value of $500,000 yielding 9.5 per cent per annum. What amount will the company raise on the issue?Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.5 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, the rollover date, in ninety-days time. If the yield at the next rollover date is 9.25 per cent per annum the company will xxx.In this example the cost of borrowing has fallen by $294.45.Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation (cont.)14.6 Repricing Gap Analysis14.7 Duration14.8 Convexity14.9 Interest Rate Risk Management Techniques14.10 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.6 Repricing Gap AnalysisRepricing gap analysis is the monitoring of the interest rate sensitivities of assets and liabilities over specified planning periodsInterest rate sensitivity relates to the repricing of an asset or liability within the planning periodThe longer the planning period, the more likely a security is to be rate sensitiveCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.6 Repricing Gap Analysis (cont.)The repricing gap is rate sensitive assets minus rate sensitive liabilitiesThree groupings of assets and liabilities assist in determining the repricing gapInterest-sensitive assets financed by interest-sensitive liabilitiesFixed-interest assets financed by fixed-interest liabilities and equitiesInterest-sensitive assets financed by fixed-interest liabilitiesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.6 Repricing Gap Analysis (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.6 Repricing Gap Analysis (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.6 Repricing Gap Analysis (cont.)Change in profitability = Gap x change in rates x period (14.3) = $15 billion x 0.005 x 1 = $75 millionCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation (cont.)14.6 Repricing Gap Analysis14.7 Duration14.8 Convexity14.9 Interest Rate Risk Management Techniques14.10 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.7 DurationDuration is another tool for the measurement and management of interest rate risk exposuresIt is a measure in years, that considers the timing and present values of cash flows associated with a financial asset or liabilityDuration is calculated as the weighted average time over which cash flows occur, where weights are the relative present values of the cash flowsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.7 Duration (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.7 Duration (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.7 Duration (cont.)Duration can also be used to determine the dollar impact of a change in interest rates on the price of a security using equation 14.5(14.5)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.7 Duration (cont.)Duration can also be used to determine the dollar impact of a change in interest rates on the price of a security using equation 14.5(14.5 [cont.])Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.7 Duration (cont.)The duration of a portfolio of securities is the weighted duration of each asset or liability in the portfolioGiven a forecasted change in interest rates, the dollar change in the equity position of a firm can be calculated from equation 14.6(14.6)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.7 Duration (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation (cont.)14.6 Repricing Gap Analysis14.7 Duration14.8 Convexity14.9 Interest Rate Risk Management Techniques14.10 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.8 ConvexityConvexity is curvature in the price/yield curveThis overcomes the limitation of the duration method which reflects a linear relationship between yield and priceConvexity is illustrated in the following exampleA 2% interest rate change on one-year, two-year and three-year bonds that have a face value of $1000 and pay a fixed annual coupon of 8% p.a.Figure 14.1 illustrates that the percentage change in price relationships for the one, two and year bonds is not linear, but convexCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.8 Convexity (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.8 Convexity (cont.)Figure 14.2 indicates the difference in the price of the following bond using the duration and convexity approaches, assuming a forecast interest rate rise of 2%$1000 bond paying 5% coupon pa, maturing in four years, currently yielding 5% p.a.The problem with duration can be compensated for by adjusting for convexity% price = - duration [r%] + 0.5(convexity)(r2) (14.8) (1+r)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.8 Convexity (cont.)Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation (cont.)14.6 Repricing Gap Analysis14.7 Duration14.8 Convexity14.9 Interest Rate Risk Management Techniques14.10 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.9 Interest Rate Risk Management TechniquesInterest rate risk management techniques also include internal and external methodsInternal methods involve the restructuring of a firm’s balance sheet and associated cash flowsAsset and liability portfolio restructuringE.g. a funds manager sells part of its bond portfolio and invests the funds in shares or propertyCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.9 Interest Rate Risk Management Techniques (cont.)Interest rate risk management techniques also include internal and external methods (cont.)Internal methods (cont.)Asset and liability repricingE.g. seek fixed-rate funds in periods when interest rates are risingCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.9 Interest Rate Risk Management Techniques (cont.)Interest rate risk management techniques also include internal and external methods (cont.)Internal methods (cont.)Cash flow timingChange the timing of cash flows to minimise the effect of interest rate changes or to take advantage of forecast rate movements byE.g. switching from one security to another with different frequency of interest paymentsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.9 Interest Rate Risk Management Techniques (cont.)Interest rate risk management techniques also include internal and external methods (cont.)Internal methods (cont.)Reduced reliance on interest ratesE.g. introduction of other fees on loans by a bankCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.9 Interest Rate Risk Management Techniques (cont.)Interest rate risk management techniques also include internal and external methods (cont.)Internal methods (cont.)Prepayment and pre-redemption conditionsE.g. early payment penalties to discourage borrowers repaying floating-rate loans early in periods of rising interest ratesCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.9 Interest Rate Risk Management Techniques (cont.)Interest rate risk management techniques also include internal and external methods (cont.)External methodsExternal methods involve strategies outside the balance sheetPrimarily 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, interest options and swapsCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye WatsonChapter Organisation (cont.)14.6 Repricing Gap Analysis14.7 Duration14.8 Convexity14.9 Interest Rate Risk Management Techniques14.10 SummaryCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.10 SummaryInterest rate risk is the sensitivity of the value of balance sheet assets and liabilities and cash flow to movements in interest ratesInterest rate risk exists in the form of reinvestment risk and price riskA firm must establish an effective interest rate exposure management systemCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson14.10 Summary (cont.)ARBL is a basic principle of interest rate risk managementModels for measuring interest rate risk include repricing gap analysis, duration (and convexity)A range of internal and external interest rate risk management techniques existCopyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by WillisSlides prepared by Kaye Watson