FINA 465 Exam 2
Consider the following balance sheet positions for a financial institution: * Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million * Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $150 million * Rate-sensitive assets = $150 million. Rate-sensitive liabilities = $140 million a. Calculate the repricing gap and the impact on net interest income of a 1 percent increase in interest rates for each position.
* Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million. Repricing gap = RSA - RSL = $200 - $100 million = +$100 million. DNII = ($100 million)(0.01) = +$1.0 million, or $1,000,000. * Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $150 million. Repricing gap = RSA - RSL = $100 - $150 million = -$50 million. DNII = (-$50 million)(0.01) = -$0.5 million, or -$500,000. * Rate-sensitive assets = $150 million. Rate-sensitive liabilities = $140 million. Repricing gap = RSA - RSL = $150 - $140 million = +$10 million. DNII = ($10 million)(0.01) = +$0.1 million, or $100,000.
Real Estate Portfolio
-has bond and stock like characteristics - Leases have periodic payments like bond's coupons -Uncertainty in the future that is affected by multiple factors is similar to stocks
Duration of a 5 year 0 coupon bond
5 years
5 C's of Credit
Character, Capacity, Capital, Collateral, Conditions
Why is the degree of collateral as specified in the loan agreement of importance to a lender? If the book value of the collateral is greater than or equal to the amount of the loan, is the credit risk of a lender fully covered? Why, or why not
Collateral provides the lender with some assets that can be used against the amount of the loan in the case of default. However, collateral has value only to the extent of its market value, and thus a loan fully collateralized at book value may not be fully collateralized at market value. Further, errors in the recording of collateralized positions may limit or severely reduce the protected positions of a lender.
Foreign Exchange Risk
Foreign exchange risk is the risk that exchange rate changes can affect the value of an FI's assets and liabilities denominated in foreign currencies. An FI is net long in foreign assets when the foreign currency-denominated assets exceed the foreign currency-denominated liabilities. In this case, an FI will suffer potential losses if the domestic currency strengthens relative to the foreign currency when repayment of the assets will occur in the foreign currency. An FI is net short in foreign assets when the foreign currency-denominated liabilities exceed the foreign currency-denominated assets. In this case, an FI will suffer potential losses if the domestic currency weakens relative to the foreign currency when repayment of the liabilities will occur in the domestic currency.
What are compensating balances? What is the relationship between the amount of compensating balance requirement and the return on the loan to the FI?
A compensating balance is the portion of a loan that a borrower must keep on deposit with the credit-granting FI. Thus, the funds are not available for use by the borrower. As the amount of compensating balance for a given loan size increases, the effective return on the loan increases for the lending institution.
What is a consol bond? What is the duration of a consol bond that sells at a yield to maturity of 8 percent? 10 percent? 12 percent? Would a consol bond trading at a yield to maturity of 10 percent have a greater duration than a 20-year zero-coupon bond trading at the same yield to maturity? Why?
A consol bond is a bond that pays a fixed coupon each year forever. A consol bond trading at a yield to maturity of 10 percent has a duration of 11 years, while a 20-year zero-coupon bond trading at a ytm of 10 percent, or any other ytm, has a duration of 20 years because no cash flows occur before the twentieth year.
Leverage Adjusted Duration Gap
A leverage-adjusted measure of the difference between the durations of assets and liabilities; which measures a bank's overall interest rate exposure.
How does a policy of matching the maturities of assets and liabilities work (a) to minimize interest rate risk and (b) against the asset-transformation function of FIs?
A policy of maturity matching will allow changes in market interest rates to have approximately the same effect on both interest income and interest expense. An increase in rates will tend to increase both income and expense, and a decrease in rates will tend to decrease both income and expense. The changes in income and expense may not be equal because of different cash flow characteristics of the assets and liabilities. The asset-transformation function of an FI involves investing short-term liabilities in long-term assets. Maturity matching clearly works against successful implementation of this process.
Differentiate between a secured and an unsecured loan. Who bears most of the risk in a fixed-rate loan? Why would FI managers prefer to charge floating rates, especially for longer-maturity loans?
A secured loan is backed by some of the collateral that is pledged to the lender in the event of default. A lender has rights to the collateral, which can be liquidated to pay all or part of the loan. With a fixed-rate loan, the lender bears the risk of interest rate changes. If interest rates rise, the opportunity cost of lending is higher, while if interest rates fall the lender benefits. Since it is harder to predict longer-term rates, FIs prefer to charge floating rates for longer-term loans and pass the interest rate risk on to the borrower.
How does a spot loan differ from a loan commitment? What are the advantages and disadvantages of borrowing through a loan commitment
A spot loan involves the immediate takedown of the loan amount by the borrower, while a loan commitment allows a borrower the option to take down the loan any time during a fixed period at a predetermined rate. This can be advantageous during periods of rising rates in that the borrower can borrow as needed at a predetermined rate. If rates decline, the borrower can borrow from other sources. The disadvantage is the cost: often an up-front fee is required in addition to a back-end fee for the unused portion of the commitment.
Why is commercial lending declining in importance in the U.S.? What effect does this decline have on overall commercial lending activities
Commercial bank lending has been declining in importance because of disintermediation, a process in which customers are able to access financial markets directly such as by issuing commercial paper. The total amount of commercial paper outstanding in the U.S. has grown dramatically over the last thirty years. Historically, only the most creditworthy borrowers had access the commercial paper market, but more middle-market firms and financial institutions now have access to this market. As a consequence of this growth, the pool of borrowers available to banks has become smaller and riskier. This makes the credit assessment and monitoring of loans more difficult, yet important.
What are the two major classes of consumer loans at U.S. banks? How do revolving loans differ from nonrevolving loans?
Consumer loans can be classified as either nonrevolving or revolving loans. Automobile loans and fixed-term personal loans usually have a maturity date at which time the loan is expected to have a zero balance, and thus they are considered to be nonrevolving loans. Revolving loans usually involve credit card debt, or similar lines of credit, and as a result the balance will rise and fall as borrowers make payments and utilize the accounts. Many banks often recognize high rates of return on these loans, even though in recent years, banks have faced chargeoff rates in the range of four to eight percent.
Country or Sovereign Risk
Country or sovereign risk is the risk that repayments to foreign lenders or investors may be interrupted because of restrictions, intervention, or interference from foreign governments. A lender FI has very little recourse in this situation unless the FI is able to restructure the debt or demonstrate influence over the future supply of funds to the country in question. This influence likely would involve significant working relationships with the IMF and the World Bank.
What are covenants in a loan agreement? What are the objectives of covenants? How can these covenants be negative? Positive?
Covenants are restrictions that are written into loan or bond contracts that affect the actions of the borrower. Negative covenants in effect restrict actions, that is, they are "thou shall not..." conditions. Common examples include the nonincrease of dividend payments without permission of the lender, or the maintenance of net working capital above some minimum level. Positive covenants encourage actions such as the submission of quarterly financial statements. In effect both types of covenants are designed and implemented to assist the lender in the monitoring and control of credit risk.
Credit Risk Management
Credit risk management is important for FI managers because it determines several features of a loan: interest rate, maturity, collateral and other covenants. Riskier projects require more analysis before loans are approved. If credit risk analysis is inadequate, default rates could be higher and push a bank into insolvency, especially if the markets are competitive and the margins are low. Credit risk management has become more complicated over time because of the increase in off-balance-sheet activities that create implicit contracts and obligations between prospective lenders and buyers. Credit risks of some off-balance-sheet products, such as loan commitments, credit guarantees, and interest rate swaps, are difficult to assess because the contingent payoffs are not deterministic, making the pricing of these products complicated.
Dollar Duration
Dollar duration is the dollar value change in the price of a security to a one percent change in the return on the security. Duration is a measure of the percentage change in the price of a security for a one percent change in the return on the security. The dollar duration is intuitively appealing in that we multiply the dollar duration by the change in the interest rate to get the actual dollar change in the value of a security to a change in interest rates.
What are the two different general interpretations of the concept of duration, and what is the technical definition of this term? How does duration differ from maturity?
Duration measures the weighted-average life of an asset or liability in economic terms. As such, duration has economic meaning as the interest rate sensitivity (or interest elasticity) of an asset's value to changes in the interest rate. Duration differs from maturity as a measure of interest rate sensitivity because duration takes into account the time of arrival and the rate of reinvestment of all cash flows during the assets life. Technically, duration is the weighted-average time to maturity using the relative present values of the cash flows as the weights.
What are some of the special risks and considerations when lending to small businesses rather than large businesses?
Besides the obvious difference in the sizes of the borrowers, for a large business there is also a more well defined corporate structure and a clearer delineation of the corporate assets from the personal assets of the owners. The large business borrower is also more likely to have a track record to use as a basis for future performance. Small-business loans are also more complicated because the FI is frequently asked to assume the credit risk of an individual whose business cash flows require considerable analysis, often with incomplete accounting information available to the credit officer. The payoff for this analysis is also small, by definition, because loan principal amounts are usually small. A $50,000 loan with a 3 percent interest spread over the cost of funds provides only $1,500 of gross revenues before loan loss provisions, monitoring costs, and allocation of overheads. This low profitability has caused many FIs to build small business scoring models similar to, but more sophisticated than, those used for mortgages and consumer credit. These models often combine computer-based financial analysis of borrower financial statements with behavioral analysis of the owner of the small business.
What is the difference between book value accounting and market value accounting? How do interest rate changes affect the value of bank assets and liabilities under the two methods? What is marking to market?
Book value accounting reports assets and liabilities at the original issue values. Market value accounting reports assets and liabilities at their current market values. Current market values may be different from book values because they reflect current market conditions, such as current interest rates. FIs generally report their balance sheets using book value accounting methods. This is a problem if an asset or liability has to be liquidated immediately. If the asset or liability is held until maturity, then the reporting of book values does not pose a problem. For an FI, a major factor affecting asset and liability values is interest rate changes. If interest rates increase, the value of both loans (assets) and deposits and other debt (liabilities) fall. If assets and liabilities are held until maturity, interest rate changes do not affect the valuation of the FI. However, if deposits or loans have to be refinanced, then market value accounting presents a better picture of the condition of the FI. The process by which changes in the economic value of assets and liabilities are accounted is called marking to market. The changes can be beneficial as well as detrimental to the total economic value of the FI.
Liquidity Risk
Liquidity risk is the risk that a sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at less than fair market prices. In times of normal economic activity, depository institutions meet cash withdrawals by accepting new deposits and borrowing funds in the short-term money markets. However, in times of harsh liquidity crises, the FI may need to sell assets at significant losses in order to generate cash quickly.
Modified Duration
Macaulay's duration divided by 1 + yield to maturity. Measures interest rate sensitivity of bond.
What is meant by the phrase marginal default probability? How does this term differ from cumulative default probability? How are the two terms related?
Marginal default probability is the probability of default in a given year, whereas cumulative default probability is the probability of default across several years. For example, the cumulative default probability across two years is given below, where (pt) is the probability of nondefault in a given year.
Market Risk
Market risk is the risk incurred from assets and liabilities in an FI's trading book due to changes in interest rates, exchange rates, and other asset prices. Market risk affects any firm that trades assets and liabilities. The risk can surface because of changes in interest rates, exchange rates, or any other prices of financial assets that are traded rather than held on the balance sheet. Market risk can be minimized by using appropriate hedging techniques such as futures, options, and swaps, and by implementing controls that limit the amount of exposure taken by market makers.
What is duration and how to use the formula to calculate it.
Modified duration = Duration/(1+ R) = 6.994/1.08 = 6.4759. Some practitioners find this value easier to use because the percentage change in value can be estimated simply by multiplying the existing value times the basis point change in interest rates rather than by the relative change in interest rates. Using modified duration will not change the estimated price sensitivity of the asset
What is the mortality rate of a bond or loan? What are some of the problems with using a mortality rate approach to determine the probability of default of a given bond issue?
Mortality rates reflect the historic default risk experience of a bond or a loan. One major problem is that the approach looks backward rather than forward in determining probabilities of default. Further, the estimates are sensitive to the time period of the analysis, the number of bond issues, and the sizes of the issues
Why are most retail borrowers charged the same rate of interest, implying the same risk premium or class? What is credit rationing? How is it used to control credit risks with respect to retail and wholesale loans?
Most retail loans are small in size relative to the overall investment portfolio of an FI, and the cost of collecting information on household borrowers is high. As a result, most retail borrowers are charged the same rate of interest that implies the same level of risk.
Refinancing Risk
Refinancing risk is the risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments. This risk occurs when an FI is holding assets with maturities greater than the maturities of its liabilities. For example, if a bank has a ten-year fixed-rate loan funded by a 2-year time deposit, the bank faces a risk in that new deposits may only be obtained, and the loans refinanced, at a higher rate in two years. These interest rate increases would reduce net interest income. The bank would benefit if interest rates decrease as the cost of renewing the deposits would decrease, while the interest rate earned on the loan would not change. In this case, net interest income would increase.
What is the CGAP effect? According to the CGAP effect, what is the relation between changes in interest rates and changes in net interest income when CGAP is positive? When CGAP is negative?
The CGAP effect describes the relation between changes in interest rates and changes in net interest income. According to the CGAP effect, when CGAP is positive the change in NII is positively related to the change in interest rates. Thus, an FI would want its CGAP to be positive when interest rates are expected to rise. According to the CGAP effect, when CGAP is negative the change in NII is negatively related to the change in interest rates. Thus, an FI would want its CGAP to be negative when interest rates are expected to fall.
If the Swiss franc is expected to depreciate in the near future, would a U.S.-based FI in Bern City prefer to be net long or net short in its asset positions? Discuss.
The U.S. FI would prefer to be net short (liabilities greater than assets) in its asset position. The depreciation of the Swiss franc relative to the dollar means that the U.S. FI would pay back the net liability position with fewer dollars. In other words, the decrease in the foreign assets in dollar value after conversion will be less than the decrease in the value of the foreign liabilities in dollar value after conversion.
Identify and define the borrower-specific and market-specific factors that enter into the credit decision. What is the impact of each type of factor on the risk premium?
The borrower-specific factors are: Reputation: Based on the lending history of the borrower; better reputation implies a lower risk premium. Leverage: A measure of the existing debt of the borrower; the larger the debt, the higher the risk premium. Volatility of earnings: The more stable the earnings, the lower the risk premium. Collateral: If collateral is offered, the risk premium is lower. Market-specific factors include: Business cycle: Lenders are less likely to lend if a recession is forecasted. Level of interest rates: A higher level of interest rates may lead to higher default rates, so lenders are more reluctant to lend under such conditions.
Altman's Z-Score
Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 0.999 X5 3 < Z = company is safe 2.7 < Z < 2.99 = possible future problems 1.8 < Z < 2.7 = chance of going bankrupt it 2 years Z < 1.8 = Financial embarrassment is very high.
Identify and discuss three criticisms of using the duration gap model to immunize the portfolio of a financial institution.
a Immunization is a dynamic problem because duration changes over time. Thus, it is necessary to rebalance the portfolio as the duration of the assets and liabilities change over time. b Duration matching can be costly because it is not easy to restructure the balance sheet periodically, especially for large FIs. c Duration is not an appropriate tool for immunizing portfolios when the expected interest rate changes are large because of the existence of convexity. Convexity exists because the relationship between security price changes and interest rate changes is not linear, which is assumed in the estimation of duration. Using convexity to immunize a portfolio will reduce the problem
Which of the following is an appropriate change to make on a bank's balance sheet when GAP is negative, spread is expected to remain unchanged, and interest rates are expected to rise
a. Replace fixed-rate loans with rate-sensitive loans. Yes. This change will increase RSAs, which will increase GAP. b. Replace marketable securities with fixed-rate loans. No. This change will decrease RSAs, which will decrease GAP. c. Replace fixed-rate CDs with rate-sensitive CDs. No. This change will increase RSLs, which will decrease GAP. d. Replace equity with demand deposits. No. This change will have no impact on either RSAs or RSLs. So, will have no impact on GAP. e. Replace vault cash with marketable securities. Yes. This change will increase RSAs, which will increase GAP.
off-balance-sheet activities
bank activities that involve the trading of financial instruments and the generation of income from fees and loan sales, all of which affect bank profits but are not visible on bank balance sheets
Revolving Loans
credit cards, cell phones, department store credit cards (JC Penney); they are more risky because the debtor can control how much he pays each month When you constantly borrow and repay
Market Expectations
examples include news about future market fundamentals and traders' opinions about future exchange rates
The net worth of a bank
is determined by subtracting liabilities from assets.
What are the purposes of credit scoring models? How do these models assist an FI manager to better administer credit?
redit scoring models are used to calculate the probability of default or to sort borrowers into different default risk classes. The primary benefit of credit scoring models is to improve the accuracy of predicting borrower's performance without using additional resources. This benefit results in fewer defaults and charge-offs to the FI. The models use data on observed economic and financial borrower characteristics to assist an FI manager in (a) identifying factors of importance in explaining default risk, (b) evaluating the relative degree of importance of these factors, (c) improving the pricing of default risk, (d) screening bad loan applicants, and (e) more efficiently calculating the necessary reserves to protect against future loan losses.
Liquidity Premium
the portion of a nominal interest rate or bond yield that represents compensation for lack of liquidity
Calculate the FI's profit spread and dollar value of profit in year 1.
1. ROA Percent - Liabilities Percent 2. % x $ of Liabilities Its profit for the second year, however, is uncertain. The risk always exists that interest rates will change between years 1 and 2.
Consider the coefficients of Altman's Z score. Can you tell by the size of the coefficients which ratio appears most important in assessing the creditworthiness of a loan applicant? Explain.
Although X3, or EBIT/Total assets, has the highest coefficient (3.3), it is not necessarily the most important variable. Since the value of X3 is likely to be small, the product of 3.3 and X3 may be quite small. For some firms, particularly those in the retail business, the asset turnover ratio, X5 may be quite large and the product of the X5 coefficient (1.0) and X5 may be substantially larger than the corresponding number for X3. Generally, the factor that adds most to the Z-score varies from firm to firm and industry to industry.
The sales literature of a mutual fund claims that the fund has no risk exposure since it invests exclusively in federal government securities which are free of default risk. Is this claim true? Explain why or why not.
Although the fund's asset portfolio is comprised of securities with no default risk, the securities are exposed to interest rate risk. For example, if interest rates increase, the market value of the fund's Treasury security portfolio will decrease. Further, if interest rates decrease, the realized yield on these securities will be less than the expected rate of return because of reinvestment risk. In either case, investors who liquidate their positions in the fund may sell at a Net Asset Value (NAV) that is lower than the purchase price.
Why could a lender's expected return be lower when the risk premium is increased on a loan? In addition to the risk premium, how can a lender increase the expected return on a wholesale loan? A retail loan?
An increase in risk premiums indicates a riskier pool of clients who are more likely to default by taking on riskier projects. This reduces the repayment probability and lowers the expected return to the lender. The lender often is able to charge fees that increase the return on the loan. However, the fees may become sufficiently high as to increase the risk of nonpayment or default on the loan
What conclusions can you reach about the relationship between duration and the time to maturity
As maturity decreases, duration decreases at a decreasing rate. Although the graph below does not illustrate with great precision, the change in duration is less than the change in time to maturity.
What is the difference between firm-specific credit risk and systematic credit risk? How can an FI alleviate firm-specific credit risk?
Firm-specific credit risk refers to the likelihood that a single asset may deteriorate in quality, while systematic credit risk involves macroeconomic factors that may increase the default risk of all firms in the economy. Thus, if S&P lowers its rating on IBM stock and if an investor is holding only this particular stock, he may face significant losses as a result of this downgrading. However, portfolio theory in finance has shown that firm-specific credit risk can be diversified away if a portfolio of well-diversified stocks is held. Similarly, if an FI holds a well-diversified portfolio of assets, the FI will face only systematic credit risk that will be affected by the general condition of the economy. The risks specific to any one customer will not be a significant portion of the FIs overall credit risk
Insolvency Risk
Insolvency risk is the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities. This risk involves the shortfall of capital in times when the operating performance of the institution generates accounting losses. These losses may be the result of one or more of interest rate, credit, liquidity, sovereign, foreign exchange, market, off-balance-sheet, and technological risks
How does the change in the yield to maturity affect the duration of this coupon bond?
Increasing the yield to maturity decreases the duration of the bond.
Reinvestment Risk
Reinvestment risk is the risk that the return on funds to be reinvested will fall below the cost of funds. This risk occurs when an FI holds assets with maturities that are shorter than the maturities of its liabilities. For example, if a bank has a two-year loan funded by a ten-year fixed-rate time deposit, the bank faces the risk that interest rates might decrease. In this case, it might be forced to lend or reinvest the money at lower rates after two years, perhaps even below the deposit rates. Also, if the bank receives periodic cash flows, such as coupon payments from a bond or monthly payments on a loan, these periodic cash flows will also be reinvested at the new lower interest rates. In this case, net interest income would decrease. If interest rates increase, the bank would be able to lend or reinvest the money at higher rates after two years. In this case, net interest income would increase. Besides the effect on the income statement, reinvestment risk may cause realized yields on assets to differ from the a priori expected yields.
What are the primary characteristics of residential mortgage loans? Why does the ratio of adjustable-rate mortgages to fixed-rate mortgages in the economy vary over an interest rate cycle? When would the ratio be highest?
Residential mortgage contracts differ in size, the ratio of the loan amount to the value of the property, the maturity of the loan, the rate of interest of the loan, and whether the interest rate is fixed or adjustable. In addition, mortgage agreements differ in the amount of fees, commissions, discounts, and points that are paid by the borrower. The ratio of adjustable-rate mortgages to fixed-rate mortgages is lowest when interest rates are low because borrowers prefer to lock in the low market rates for long periods of time. When rates are high, adjustable-rate mortgages allow borrowers the potential to realize relief from high interest rates in the future when rates decline.
What is RAROC? How does this model use the concept of duration to measure the risk exposure of a loan? How is the expected change in the credit risk premium measured? What precisely is DLN in the RAROC equation
Risk Adjusted Rate of Return on Capital RAROC is a measure of expected loan net income in the form of interest plus fees less cost of funding relative to some measure of asset risk. One version of the RAROC model uses the duration model to measure the change in the value of the loan for given changes or shocks in credit quality. The change in credit quality (DR) is measured by finding the change in the spread in yields between Treasury bonds and corporate bonds of the same risk class on the loan. The actual value chosen is the highest change in yield spread for the same maturity or duration value assets. In this case, DLN represents the change in loan value or the change in capital for the largest reasonable adverse changes in yield spreads. The actual equation for DLN looks very similar to the duration equation.
verify the principles of interest rate-price relationships for fixed-rate financial assets.
Rule 1. Interest rates and prices of fixed-rate financial assets move inversely. Rule 2. The longer is the maturity of a fixed-income financial asset, the greater is the change in price for a given change in interest rates. Rule 3. The change in value of longer-term fixed-rate financial assets increases at a decreasing rate Rule 4. Although not mentioned in Appendix 9A, for a given percentage (±) change in interest rates, the increase in price for a decrease in rates is greater than the decrease in value for an increase in rates
What is technology risk? What is the difference between economies of scale and economies of scope? How can these economies create benefits for an FI? How can these economies prove harmful to an FI?
Technology risk occurs when investment in new technologies does not generate the cost savings expected in the production and expansion of financial services. Economies of scale occur when the average cost of production decreases with the production of or an expansion in the amount of financial services provided. Economies of scope occur when an FI is able to lower overall costs by producing new products with inputs similar to those used for other products. In financial service industries, the use of data from existing customer databases to assist in providing new service products is an example of economies of scope. Failure to produce the perceived synergies or costs savings can result in major losses in competitive efficiency of an FI and, ultimately, in an FI's long-term failure.
Calculate the value of MMC's rate-sensitive assets, rate sensitive liabilities, and repricing gap over the next year.
The five repriced liabilities ($37.50 + $50 + $25 + $75 + $25) sum to $212.5 million, and the four repriced assets of $62.50 + $37.50 + $43.75 + $50 sum to $193.75 million. Given this, the cumulative one-year repricing gap (CGAP) for the bank is: CGAP = (One-year RSA) - (One-year RSL) = RSA - RSL = $193.75 million - $212.5 million = -$18.80 million
What is a maturity bucket in the repricing model? Why is the length of time selected for repricing assets and liabilities important when using the repricing model?
The maturity bucket is the time window over which the dollar amounts of assets and liabilities are measured. The length of the repricing period determines which of the securities in a portfolio are rate-sensitive. The longer the repricing period, the more securities either mature or will be repriced, and, therefore, the more the interest rate risk exposure. An excessively short repricing period omits consideration of the interest rate risk exposure of assets and liabilities are that repriced in the period immediately following the end of the repricing period. That is, it understates the rate sensitivity of the balance sheet. An excessively long repricing period includes many securities that are repriced at different times within the repricing period, thereby overstating the rate sensitivity of the balance sheet
What is the repricing gap? In using this model to evaluate interest rate risk, what is meant by rate sensitivity? On what financial performance variable does the repricing model focus? Explain.
The repricing gap is a measure of the difference between the dollar value of assets that will reprice and the dollar value of liabilities that will reprice within a specific time period, where repricing can be the result of a roll over of an asset or liability (e.g., a loan is paid off at or prior to maturity and the funds are used to issue a new loan at current market rates) or because the asset or liability is a variable rate instrument (e.g., a variable rate mortgage whose interest rate is reset every quarter based on movements in a prime rate). Rate sensitivity represents the time interval where repricing can occur. The model focuses on the potential changes in the net interest income variable. In effect, if interest rates change, interest income and interest expense will change as the various assets and liabilities are repriced, that is, receive new interest rates.
What are some of the weakness of the repricing model? How have large banks solved the problem of choosing the optimal time period for repricing? What is runoff cash flow, and how does this amount affect the repricing model's analysis?
The repricing model has four general weaknesses: (1) It ignores market value effects. (2) It does not take into account the fact that the dollar value of rate-sensitive assets and liabilities within a bucket are not similar. Thus, if assets, on average, are repriced earlier in the bucket than liabilities, and if interest rates fall, FIs are subject to reinvestment risks. (3) It ignores the problem of runoffs. That is, that some assets are prepaid and some liabilities are withdrawn before the maturity date. (4) It ignores income generated from off-balance-sheet activities. Large banks are able to reprice securities every day using their own internal models so reinvestment and repricing risks can be estimated for each day of the year. Runoff cash flow reflects the assets that are repaid before maturity and the liabilities that are withdrawn unexpectedly. To the extent that either of these amounts is significantly greater than expected, the estimated interest rate sensitivity of the FI will be in error.
