Tài chính kế toán - Chapter 14: Interest rate risk measurement

Chapter 14Interest raterisk measurementLearning 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 liabilitiesRevisit financial securities repricing and interest rate riskAnalyse the structure and benefits associated with interest rate risk measurement using duration and convexityAppreciate the availability of both internal and external interest rate risk management techniquesChapter organisation14.1 Interest rate risk14.2 Exposure management systems14.3 Assets repriced before liabilities principle (ARBL)14.4 Pricing financial securities14.5 Repricing gap analysis14.6 Duration14.7 Convexity14.8 Interest rate risk management techniques14.9 Summary14.1 Interest rate riskChapter 13 considered the:macro-economic context of interest ratesloanable funds approach to interest rate determinationtheories that explain the shape of the yield curveThe timing and extent of interest rate changes is unknownInterest rate risk needs to be managed(cont.)14.1 Interest rate risk (cont.)During and after the GFC, interest rate risk were an important topicAs credit risks emerged during 2007 and 2008, interest rates rose sharplySharp and sudden rises in interest rates exposed many individuals and firms to higher borrowing costsThe identification and management of interest rate risk is important for firms and financial institutions14.1 Interest rate risk (cont.)Interest rate risk takes two forms1. Reinvestment riskImpact of a change in interest rates on a firm’s future cash flows2. Price 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 versa(cont.)14.1 Interest rate risk (cont.)Interest rate risk exposures may also be described as:DirectReinvestment and price risk IndirectRelating 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 loansBasisOccurs when pricing differentials exist between markets, e.g. futures market and the underlying physical marketChapter organisation14.1 Interest rate risk14.2 Exposure management systems14.3 Assets repriced before liabilities principle (ARBL)14.4 Pricing financial securities14.5 Repricing gap analysis14.6 Duration14.7 Convexity14.8 Interest rate risk management techniques14.9 Summary14.2 Exposure management systemsAn exposure management system involves structured procedures that enable a firm to effectively measure and manage risk, including:ForecastingStrategies and techniquesManagement reporting systems(cont.)14.2 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 to:future business activity growthfuture interest ratesfuture financing needs and use of debt financing(cont.)14.2 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 include:Specified proportions of fixed-interest versus floating-interest debt, with remaining portion available to take advantage of forecast changes(cont.)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 ratesMaturity structure is the relative proportion of assets and liabilities maturing at different time intervalsLiability diversification—where a firm raises funds from a range of different sources, thereby reducing its exposure to potential interest changes in a particular market(cont.)14.2 Exposure management systems (cont.)Strategies and techniques (cont.)Two broad interest rate risk management techniques are discussed later1. Internal methods2. External methods(cont.)14.2 Exposure management systems (cont.)Management reportingPolicies and procedures need to provide clear instructions on:the 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 proceduresChapter organisation14.1 Interest rate risk14.2 Exposure management systems14.3 Assets repriced before liabilities principle (ARBL)14.4 Pricing financial securities14.5 Repricing gap analysis14.6 Duration14.7 Convexity14.8 Interest rate risk management techniques14.9 Summary14.3 Assets repriced before liabilities principleInterest rate risk is the sensitivity of assets, liabilities and cash flows to changes in interest ratesAssets repriced before liabilities (ARBL) is a risk management technique that ensures net margins and profitability are protectedA firm should measure the ARBL interest rate sensitivity of its balance sheet assets and liabilities over a range of planning periods(cont.)14.3 Assets repriced before liabilities principle (cont.)Positive ARBL gap exists when assets are repriced before liabilities and an organisation is able to benefit; e.g.:Interest rates are forecast to riseA 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)(cont.)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 fallA bank lowers the interest rate paid on deposits (liabilities) before lowering the rate received on loans (assets)Interest rates are forecast to riseA bank may implement strategies to narrow the negative ARBL gap Chapter organisation14.1 Interest rate risk14.2 Exposure management systems14.3 Assets repriced before liabilities principle (ARBL)14.4 Pricing financial securities14.5 Repricing gap analysis14.6 Duration14.7 Convexity14.8 Interest rate risk management techniques14.9 Summary14.4 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(cont.)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?(cont.)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 9.75% per annum the company will raise:In this example the cost of borrowing has increased by $294.09.Chapter organisation14.1 Interest rate risk14.2 Exposure management systems14.3 Assets repriced before liabilities principle (ARBL)14.4 Pricing financial securities14.5 Repricing gap analysis14.6 Duration14.7 Convexity14.8 Interest rate risk management techniques14.9 Summary14.5 Repricing gap analysisThis is the monitoring of the interest rate sensitivities of assets and liabilities over specified planning periodsInterest rate sensitivity (or repricing gap) relates to the repricing of an asset or liability during a planning periodDefined as rate-sensitive assets minus rate-sensitive liabilitiesThe longer the planning period, the more likely a security is to be rate sensitiveE.g. a 90-day discount security is not interest rate sensitive over a one-month planning period, but it would be over a six-month planning period(cont.)14.5 Repricing gap analysis (cont.)Three groupings of assets and liabilities assist in determining the repricing gap1. Interest-sensitive assets financed by interest-sensitive liabilitiesAre both sides of the balance sheet affected at the same time and to the same extent?2. Fixed-rate assets financed by fixed-rate liabilities and equityAre not exposed to interest rate risk during a planning period as the cost of funds and return on funds is fixed3. Rate-sensitive assets financed by fixed-rate liabilities or vice versaOne side of the balance sheet is exposed to interest rate risk while the other is not(cont.)14.5 Repricing gap analysis (cont.)(cont.)14.5 Repricing gap analysis (cont.)(cont.)14.5 Repricing gap analysis (cont.)Change in profitability = Gap x change in rates x period = $15 billion x 0.005 x 1 = $75 millionChapter organisation14.1 Interest rate risk14.2 Exposure management systems14.3 Assets repriced before liabilities principle (ARBL)14.4 Pricing financial securities14.5 Repricing gap analysis14.6 Duration14.7 Convexity14.8 Interest rate risk management techniques14.9 Summary14.6 DurationDuration is another tool for the measurement and management of interest rate risk exposuresIt is a measure in years and 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 flows(cont.)14.6 Duration (cont.)(cont.)14.6 Duration (cont.)The duration calculations in Table 14.4 can also be achieved using Equation 14.5(cont.)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 securityThe change in value will be proportional to the duration, but in the opposite direction(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:(cont.)14.6 Duration (cont.)14.6 Duration (cont.)Duration can also be applied to a portfolio of assets and a portfolio of liabilitiesDuration of a portfolio is the weighted duration of each asset and liability in a portfolio(cont.)14.6 Duration (cont.)(cont.)14.6 Duration (cont.)Change in the value of equity = change in the value of asset portfolio + change in the value of the liability portfolioLimitations of duration as a measure of interest rate riskUnrealistically assumes changes in interest rates occur along the entire maturity spectrum; i.e. parallel shift in yield curveAssumes yield curve is flat; i.e. yields do not vary over timeDuration 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 liabilitiesAssumes linear relationship between interest rate changes and price, whereas pricing of fixed-interest securities exhibits convexityChapter organisation14.1 Interest rate risk14.2 Exposure management systems14.3 Assets repriced before liabilities principle (ARBL)14.4 Pricing financial securities14.5 Repricing gap analysis14.6 Duration14.7 Convexity14.8 Interest rate risk management techniques14.9 Summary14.7 ConvexityConvexity is curvature in the price/yield curve of a securityThis overcomes the limitation of the duration method, which reflects a linear relationship between yield and priceExample: A bond with a face value of $1000, coupon 5% per annum, maturing in four years, current yield 5% per annum, and interest rates forecast to rise by 200 basis pointsThe duration price approximation calculation indicates the bond price would drop from $1000 to $929.08The bond pricing formula indicates the bond price would drop from $1000 to $932.26(cont.)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 pricefall, duration underestimates the change in priceThe problem with duration can be compensated for by adjusting for convexity, which is given by:(cont.)14.7 Convexity (cont.)(cont.)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)Chapter organisation14.1 Interest rate risk14.2 Exposure management systems14.3 Assets repriced before liabilities principle (ARBL)14.4 Pricing financial securities14.5 Repricing gap analysis14.6 Duration14.7 Convexity14.8 Interest rate risk management techniques14.9 Summary14.8 Interest rate risk management techniquesInclude 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 propertyAsset and liability repricingE.g. seeking fixed-rate funds in periods when interest rates are rising(cont.)14.8 Interest rate risk management techniques (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 movementsE.g. switching from one security to another with different frequency of interest paymentsReduced reliance on interest ratesE.g. the introduction of other fees on loans by a bankPrepayment and pre-redemption conditionsE.g. early payment penalties to discourage borrowers from repaying floating-rate loans early in periods of rising interest rates(cont.)14.8 Interest rate risk management techniques (cont.)External methodsExternal methods involve using off-balance-sheet strategiesThese involve primarily 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)Chapter organisation14.1 Interest rate risk14.2 Exposure management systems14.3 Assets repriced before liabilities principle (ARBL)14.4 Pricing financial securities14.5 Repricing gap analysis14.6 Duration14.7 Convexity14.8 Interest rate risk management techniques14.9 Summary14.9 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 system, including forecasting the future balance-sheet structure and the related interest rate environment(cont.)14.9 Summary (cont.)ARBL is a basic principle of interest rate risk managementModels for measuring interest rate risk include repricing gap analysis and duration (and convexity)A range of internal and external interest rate risk management techniques exist