Interest rate risk and how to manage it. University of Economics, 16/10/2014 Vladimir Sosovicka

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1 Interest rate risk and how to manage it University of Economics, 16/10/2014 Vladimir Sosovicka

2 2 Content 1. Interest rate risk what is it? 2. Management of interest rate risk: Basic tools (bonds, BPV, duration, IRS) Role of ALM Benchmarking 3. Main drivers of profitability 4. Liquidity and interest rate risk in insurance

3 3 Objectives Understand the importance of interest rate risk management in the banking sector Understand role of ALM in managing banking book Recognize main drivers of bank s profitability Understand the basic tools used in the management of IRR

4 4 Homework (interest income, interest rate risk) Financial products: Bond, IRS (selfstudy of basic features) Simple bank Assets: 100 mio. corp. loan, 10Y, rate refixed every 6M: 6M EURIBOR + 1% 100 retail mortgage, 20Y fixed rate 3% Liabilities: 50 mio. current account, rate 0,1% 50 saving account, 7D notice period, rate 1% 50 term deposits, 1Y, rate 1,5% 50 equity Current market rates are 1D-1Y: 1%, 10Y: 2% Expected market rates: 1D-1Y: 3%, 10Y: 5% What are the risks? Future profit?

5 Driver of interest income yield x asset (loan) margin Market yield curve Income RISK margin x liability (deposit) 5 maturity 5

6 Interest rate risk INTEREST RATE risk is risk of loss/profit in case of market interest rates movement The bank has to pay more (higher interest) for the funding The bank receives less (interest) from its assets Interest rate risk is measured by BPV (basis point value), duration gap IR risk is managed by ALM (treasury) department by: Set-up of internal FTP Investments in the banking book Using interest rate derivatives (e.g. interest rate swaps, options) INTEREST RATE RISK IS POTENTIAL SOURCE OF INTEREST INCOME!!! 6 6

7 Bond BOND is a debt (tradable) security, under which the issuer owes the holders a debt and is obliged to pay them interest (the coupon) and/or to repay the principal at the maturity date Coupon is paid annually or semiannually and can be: Fixed (till the maturity) Floating linked to the market interest rate (e.g. EURIBOR, inflation,...) Zero Coupon consists of two parts: Market rate Premium for default risk (credit spread) 7 7

8 Bond - example 8 8

9 1500 Bond example: cash flow D=8,

10 Bond example

11 BPV, Duration Measures of IRR Basis Point Value (BPV): how much money the positions will gain or lose for a 0.1% parallel movement in the yield curve. It quantifies the interest rate risk for small changes in interest rates Duration of the position is the weighted average of the times until all cash flows are received simplification of IR position PVi - the present value of the cash flow, ti is the time in years until the CFi will be received, V is the present value of all CF 11 1

12 Interest rate swap (IRS): Interest rate swap (non cash) financial derivative instrument exchanges interest rate cash flows, from a fixed rate to a floating rate (or vice versa) or from one floating rate to another. used for hedging IR risk or speculating How can be IRS used in the homework example? 12 1

13 Market risk - managed by ALM Trading book Financial instruments in a trading book are purchased or sold to facilitate trading for the institution's customers or on banks account, to profit from trading spreads between the bid and ask prices, or to hedge against various types of risk. Managed by dealing rooms valuated daily into P/L. Banking book assets and liabilities of the banks resulted from customer and bank s activities. Managed by Assets and Liabilities department (ALM). Liquidity is managed by ALM for the whole bank. These assets are not valuated in P/L (AFS or HTM category). AIM: long-term stabilization of the interest income 13 1

14 Role of ALM in the bank Managing of interest rick in the banking book Liquidity management (daily liquidity, structural liquidity) Optimization of the Balance sheet (Risk vs. Income) Funding of business activities How to achieve it? Matching of assets and liabilities via internal price (FTP) Hedging of IR risk Looking for the optimal funding possibilities Cooperation with management, business segments and Risk management Dpt. 14 1

15 FTP concept and liquidity premium ALM works as intermediary between business bank segments: deposit segment and loan segment. Its role is similar to the role of the Central bank in the economy. ALM buys funding from the Deposit segment and pays internal interest rates (FTP) and sells this funding to the Loan segment and receives FTP. FTP rate is based on market interest rates increased by liquidity premium. The liquidity premium is used to stimulate/motivate business segments to achieve targeted liquidity position of the bank. Segment 1 deposit funding FTP ALM funding FTP Segment 2 loans margin magin Client1 Client2 1

16 Benchmarking Benchmarking is the method used for increasing and stabilization of interest income for the bank. Used for liabilities without specific maturity: current and saving accounts How to achieve it? 1. Identify stable part of C/A and S/A 2. Regularly (cyclically) invest this funding on bond market with predefined duration 3. Keep part of money invested in short-term to cover volatility 4. The additional income is achieved thanks to the fact, that market yield curve is steepening (investment yield is higher than short-term rate) at normal market circumstances. 16 1

17 Interest rate risk management - benchmarking Benchmarking of current accounts Current accounts C/A - How long the funding will stay with us? - In which volume? sensitivity of C/A on the market changes C/A with the rate linked to market rate. FTP=O/N BRIBID C/A without link to market rate INVESTED IN O/N asets VOLATILE PART CORE BENCHMARKING Investment to (long-term) bonds 17 1

18 ROC and its main components Return on Capital (RoC): Yield on shareholder s investment Depends on net Income and amount of required capital RoC = Net income / Capital RoC = Net Income/Total Assets x Total Assets/Capital RoC = Return on Assets (RoA) x Leverage (L) RoC = Net Income/Revenue x Revenue/Total Assets x L RoC = Profit margin x Asset yield (AY) x L (DuPont formula) RoC = (Revenue Costs)/Revenue x AY x L RoC = (1 C/I) x AY x L 18 1

19 RoC how to improve RoC = (1 C/I) x AY x L 1. Decrease C/I cost management Keeping Costs relatively low in comparison with the Income Operational costs Interest costs Loan losses Taxes 2. Increase AY Margins Fees 3. Increase leverage increases potential return, but also financial risk (reduces solvency) And what are the boundaries that limit the leverage? RWA (mainly credit risk) NSFR (structural liquidity risk) Bank Levy (additional cost) 19 1

20 But... RoC = (1 C/I) x AY x L Increase of new loan production above market share could lead to: Worsening of margins also for the existing portfolio (AY ) e.g. re-fixing of existing mortgages Increase of administration costs even above the income level (C/I ) not all costs are fixed Increase of credit risk negative influence on capital 20 2

21 A what about insurance? Principle of the insurance business is to cover insurance risks Insurance asks an adequate fee for it (premium). Covering of the risk is done on the portfolio level using probability models Problem: the time difference between premium and insured event Creation of insurance provisions Investment of excess of premium on the financial market Interest rate risk Liquidity risk 21 2

22 Insurance balance sheet (very simplified) Assets Liabilities Bonds Deposits in banks (placement of the insurance reserves) Reserves (modeled) Timing discrepancy - Cash flow a BPV matching 22 2

23 Liquidity and interest rate risk in Insurance Balance sheet of the insurance company mainly consists of: Insurance reserves (Liability) modeled, based on actuarial models Financial assets (investment of reserves) Liquidity and IR position of the insurance BS is important especially for the Life insurance (because of long-term liabilities) and it is based on: Liquidity of financial instruments (possibility to sell them on the market quickly and without significant losses) ALM matching (on cash-flow base) of assets and liabilities Proper modeling of liabilities IRR is measured by BPV, duration gap Possible factors jeopardizing the liquidity/ir risk: Financial market crisis (decrease of bond market liquidity) Increase of lapses (cancelations) of life policies Default of bond issuer (credit risk) Decrease of market interest rates and high guaranteed rates (TIR) 2

24 Bank Insurance analogy Principle Profit Risks Regulation How? BANK Intermediary between the surplus and lack of money (portfolio approach) Difference between interest on assets and liabilities + fees Interest different duration of assets and liabilities Likvidity cashflow matching Credit Operational BASEL: Capital adequacy, liquidity,... Modeling of non-maturity deposits (statistical models, stress testing) INSURANCE Risk coverage (portfolio approach) Difference between written premium and costs of claims + net reserve creation + investment yield Interest different duration of assets and liabilities Likvidity cashflow matching Insurance risk Operational SOLVENCY: capital + other risks Modeling of reserves (probability models, stress testing) 24 2

25 Homework (Market and liquidity risk in insurance) Annual reports of Slovak insurances find the information about different types of market risks 25 2

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