Interest Rate Risk Management
Content
Interest Rate Risk Management
Overview
Managing interest rate risk Principles for establishing a conducive interest rate risk management environment environment. Operating a sound interest rate management process
Managing Interest Rate Risk g g
Introduction
Interest rate risk management is mainly hinged hi d on repositioning th strategic gap t iti i the t t i to desired levels. This can be done in broadly 3 ways, y; namely; 1) Pricing strategy 2) Asset Liability restructuring Asset-Liability 3) Derivative strategy
Introduction
For strategic reasons, the gap repositioning would be done, typically, within the context p g of the expected change in interest rates. The following broad strategy can be used;
Current Position Asset sensitive iti book
E[IR] Movement Upward U d Downward
Strategic Move Approach li it A h limit Reduce gap/switch to liability sensitive book b k Reduce gap/switch to g p liability sensitive book Approach li it A h limit
Liability sensitive book
Upward
Downward D d
Introduction
Thus the strategies can be broadly classified into 2: 1) Strategies where we are approaching asset sensitive gap limit 2) Strategies where we are approaching ) i h hi liability sensitive gap limit.
Pricing Strategy
1) Strategies which contribute to approaching th li bilit sensitive gap li it hi the liability iti limit include: Making interest rates on short term deposits g more attractive relative to long term deposits Increasing the interest rate on long term loans.
Pricing Strategy
Strategies which contribute to approaching the asset sensitive gap limit include: 1) Making interest rates on short term deposits less attractive relative to long term deposits. 2) Loans on l ) long term l loans to b re-priced be i d more regularly.
Pricing Strategy
The ability to implement the pricing strategy will mainly depend on: 1) the interest rate elasticity of demand for the assets and liabilities. 2) the value and number of positions that the ) h l d b f ii h h financial institution has ability to change the interest rate.
Volume Strategy
The relatively fastest way of repositioning a gap is through purchasing and / or selling the th required amount of assets. i d t f t The strategy of approaching the liability sensitive gap li i would generally i ii limit ld ll involve l purchasing more longer term instruments and less short term instruments instruments. The strategy of approaching an asset sensitive gap li it would generally i iti limit ld ll involve l purchasing more shorter term instruments and less long term instruments instruments.
Derivative Strategy
Instead of repositioning the gap, hedging against adverse movements i i d in interest rates can b d be done through interest rate derivatives. The most common types of derivative instruments used in developed financial markets include: Forward rate agreements: These are contracts traded over-the-counter that a certain rate will apply to a certain principal during a specified future period of time. p
Derivative Strategy
Interest rate futures: These are standardized forward contracts that are traded on a d i i f d h d d derivative exchange. Interest rate swaps: These are contracts where 2 parties agree to exchange interest payments ONLY on the same principal amount. As no principal is exchanged, the size and p p g , composition of the balance sheet of the 2 parties remains unchanged. g
Derivative Strategy
Suppose we have a liability sensitive gap and we anticipate an increase in interest rates Instead of rates. adjusting the gap, we buy a swap where we agree to pay the other party a fixed interest rate rate. If interest rates indeed increase, we get a net positive payment from the swap deal which will offset the decline in net interest income. If interest rates however decline we make a net decline, positive payment on the swap deal , which will offset an increase in net interest income.
Derivative Strategy
Suppose we have an asset sensitive gap and we anticipate a decrease in interest rates Instead of rates. adjusting the gap, we buy a swap where we agree to pay the other party a variable interest rate rate. If interest rates indeed decrease, we get a net positive payment from the swap deal which will offset the decline in net interest income. If interest rates however increase we make a net increase, positive payment on the swap deal , which will offset an increase in net interest income.
Principles for establishing a conducive interest rate risk management environment.
Principle 1
The board of directors should have overall responsibility for approving policies and strategies to be used to manage interest rate g g risk.
Principle 2
Senior management has the responsibility of: f
– developing the policies and procedures for
identifying, measuring, monitoring and id if i i i i d controlling interest rate risk – ensuring that the strategies and policies used to i h h i d li i d manage interest rate risk are appropriate and effective. effective
Principle 3
FI’s should identify the interest rate risk inherent in new products and activities and ensure that these are subject to controls and j adequate procedures before being introduced or undertaken undertaken. Major hedging or risk management activities should first be approved in advance by the board. y
Operating A Sound I t O ti S d Interest t Rate Risk Management Process
Principle 1
FIs should CLEARLY define the individuals and / or committees responsible g g for managing interest rate risk. The management of interest rate function should be clearly independent from the position taking functions of the financial institution.
Principle 2
The analysis and interest risk management activities should be delegated to competent g staff with the technical knowledge and/or experience consistent with the nature and scope of the FIs’ activities FIs activities.
Principle 3
FIs must have information systems that capture all the material sources of interest rate risk. The assumptions underlying the system should be clearly understood by management.
Principle 4
FIs must establish and enforce operating limits li it and other practices th t maintain d th ti that i t i exposures within levels consistent with their internal policies. i l li i Such limits should be appropriate to the pp p size, complexity, and equity of the FI. Limits can be set on individuals business individuals, units, portfolios or instrument types.
Principle 5
FIs should use stress testing when setting or reviewing limits and policies.
Principle 6
Interest rate risk reporting should be timely and should be provided to the board of directors, directors and management management. The basic structure of the reports should include the following information; 1) Summary of aggregate interest rate exposures 2) Report on compliance with limits and p policies. 3) Results on stress tests
Any Questions?
Overview
Managing interest rate risk Principles for establishing a conducive interest rate risk management environment environment. Operating a sound interest rate management process
Managing Interest Rate Risk g g
Introduction
Interest rate risk management is mainly hinged hi d on repositioning th strategic gap t iti i the t t i to desired levels. This can be done in broadly 3 ways, y; namely; 1) Pricing strategy 2) Asset Liability restructuring Asset-Liability 3) Derivative strategy
Introduction
For strategic reasons, the gap repositioning would be done, typically, within the context p g of the expected change in interest rates. The following broad strategy can be used;
Current Position Asset sensitive iti book
E[IR] Movement Upward U d Downward
Strategic Move Approach li it A h limit Reduce gap/switch to liability sensitive book b k Reduce gap/switch to g p liability sensitive book Approach li it A h limit
Liability sensitive book
Upward
Downward D d
Introduction
Thus the strategies can be broadly classified into 2: 1) Strategies where we are approaching asset sensitive gap limit 2) Strategies where we are approaching ) i h hi liability sensitive gap limit.
Pricing Strategy
1) Strategies which contribute to approaching th li bilit sensitive gap li it hi the liability iti limit include: Making interest rates on short term deposits g more attractive relative to long term deposits Increasing the interest rate on long term loans.
Pricing Strategy
Strategies which contribute to approaching the asset sensitive gap limit include: 1) Making interest rates on short term deposits less attractive relative to long term deposits. 2) Loans on l ) long term l loans to b re-priced be i d more regularly.
Pricing Strategy
The ability to implement the pricing strategy will mainly depend on: 1) the interest rate elasticity of demand for the assets and liabilities. 2) the value and number of positions that the ) h l d b f ii h h financial institution has ability to change the interest rate.
Volume Strategy
The relatively fastest way of repositioning a gap is through purchasing and / or selling the th required amount of assets. i d t f t The strategy of approaching the liability sensitive gap li i would generally i ii limit ld ll involve l purchasing more longer term instruments and less short term instruments instruments. The strategy of approaching an asset sensitive gap li it would generally i iti limit ld ll involve l purchasing more shorter term instruments and less long term instruments instruments.
Derivative Strategy
Instead of repositioning the gap, hedging against adverse movements i i d in interest rates can b d be done through interest rate derivatives. The most common types of derivative instruments used in developed financial markets include: Forward rate agreements: These are contracts traded over-the-counter that a certain rate will apply to a certain principal during a specified future period of time. p
Derivative Strategy
Interest rate futures: These are standardized forward contracts that are traded on a d i i f d h d d derivative exchange. Interest rate swaps: These are contracts where 2 parties agree to exchange interest payments ONLY on the same principal amount. As no principal is exchanged, the size and p p g , composition of the balance sheet of the 2 parties remains unchanged. g
Derivative Strategy
Suppose we have a liability sensitive gap and we anticipate an increase in interest rates Instead of rates. adjusting the gap, we buy a swap where we agree to pay the other party a fixed interest rate rate. If interest rates indeed increase, we get a net positive payment from the swap deal which will offset the decline in net interest income. If interest rates however decline we make a net decline, positive payment on the swap deal , which will offset an increase in net interest income.
Derivative Strategy
Suppose we have an asset sensitive gap and we anticipate a decrease in interest rates Instead of rates. adjusting the gap, we buy a swap where we agree to pay the other party a variable interest rate rate. If interest rates indeed decrease, we get a net positive payment from the swap deal which will offset the decline in net interest income. If interest rates however increase we make a net increase, positive payment on the swap deal , which will offset an increase in net interest income.
Principles for establishing a conducive interest rate risk management environment.
Principle 1
The board of directors should have overall responsibility for approving policies and strategies to be used to manage interest rate g g risk.
Principle 2
Senior management has the responsibility of: f
– developing the policies and procedures for
identifying, measuring, monitoring and id if i i i i d controlling interest rate risk – ensuring that the strategies and policies used to i h h i d li i d manage interest rate risk are appropriate and effective. effective
Principle 3
FI’s should identify the interest rate risk inherent in new products and activities and ensure that these are subject to controls and j adequate procedures before being introduced or undertaken undertaken. Major hedging or risk management activities should first be approved in advance by the board. y
Operating A Sound I t O ti S d Interest t Rate Risk Management Process
Principle 1
FIs should CLEARLY define the individuals and / or committees responsible g g for managing interest rate risk. The management of interest rate function should be clearly independent from the position taking functions of the financial institution.
Principle 2
The analysis and interest risk management activities should be delegated to competent g staff with the technical knowledge and/or experience consistent with the nature and scope of the FIs’ activities FIs activities.
Principle 3
FIs must have information systems that capture all the material sources of interest rate risk. The assumptions underlying the system should be clearly understood by management.
Principle 4
FIs must establish and enforce operating limits li it and other practices th t maintain d th ti that i t i exposures within levels consistent with their internal policies. i l li i Such limits should be appropriate to the pp p size, complexity, and equity of the FI. Limits can be set on individuals business individuals, units, portfolios or instrument types.
Principle 5
FIs should use stress testing when setting or reviewing limits and policies.
Principle 6
Interest rate risk reporting should be timely and should be provided to the board of directors, directors and management management. The basic structure of the reports should include the following information; 1) Summary of aggregate interest rate exposures 2) Report on compliance with limits and p policies. 3) Results on stress tests
Any Questions?
