Interest Rate Risk Management

Strategies to Manage Interest-rate Risk

• Rearrange balance-sheet

Gap Management

Duration Gap Management

• Off-Balance Sheet Adjustment

Interest-rate swap

Hedge with financial futures

Insurance

Transfer risk

Off-balance sheet activities

• Financial innovations that involve commitments

related to contingencies and generate fees from

financial services.

• Financial claims do not appear on balance sheet until

they are exercised.

Categories of Off-Balance Sheet Activities

Financial guarantees

Commitments based on a contingent claim. An

obligation by a bank to provide funds (lend funds or

buy securities) if a contingency is realized.

Derivative instruments

Commitments derived from an underlying

financial instrument.

Off-Balance-Sheet Activities

• Loan sales

• Fee income from Foreign exchange trades for customers Servicing mortgage-backed securities Guarantees of debt Backup lines of credit

• Trading Activities Financial futures Financial options Foreign exchange futures and options Swaps

Standby letters of credit (SLCs)

Obligations accepted by a bank for an upfront and annual fees to pay the beneficiary if the concerned client defaults on that financial obligation.

Bank client can transfer the credit obligation back to the bank

Financial SLCs: backup lines of credit on bonds, notes, and commercial paper which serve as guarantee.

Performance SLCs: guarantees such as completion of construction contracts before a given date.

Standby letters of credit (SLCs)

• Considered as contingent loans.

• Based on a collateralized or backed by deposits.

• Banker’s risks from SLCs

• Contingent risk

• Liquidity risk

• Capital risk

• Interest rate risk

• Legal risk

• Material adverse change (MAC) clause that enables the bank to withdraw its commitment if the risk of the SLC changes substantially.

Loan Commitments

• Promise by a bank to a customer to make a future loan under predetermined conditions

• Most commercial and industrial loans are made under some form of loan commitment

- Line of credit: informal commitment to lend funds to a client company

- Revolving loan commitment: formal agreement to lend funds on demand under a contract

Loan Commitments

• Customer pays the bank a commitment fee.

• Protect customers from their business risk by pre- determined rates.

• Bank is exposed to interest rate risk.

• Bank incurs liquidity risk due to these loan commitments

• Several borrowers availing loan commitments at the same time

• Likely to occur to the bank when the credit available is limited.

•Loan commitments could become a binding contract to the bank and are hence irrevocable.

Note Issuance Facilities (NIF)

Medium-term agreements (2-7 years).

Example:

Bank guarantees the sale of a borrower’s short-term debt securities at or below pre-determined interest rates.

Types of NIFs

• Revolving underwriting facilities (RUFs)

• Standby note issuance facilities (SNIFs)

Note Issuance Facilities (NIF)

• Bank has a commitment to buy the securities of the borrower if the borrower cannot obtain short-term funds from the securities.

- Issue of Certificate of Deposits by bank borrowers.

- Issue of Euronotes by non-bank borrowers (denominated in US dollars but sold outside of the US).

• Banks have contingent risk, credit risk and liquidity risk.

Securitization

•Issue of debt instrument

•Payments are from revenues generated by a pre defined pool of loans.

•Loans are grouped on the basis of their risk similarity.

•Issuance of securities to investors who earn returns based on repayments on the loans

•Securitisation of collateralised industrial loans

• collateralised loan obligations (CLOs)

• commercial mortgage-backed securities (CMBSs)

•Banks transfer loan risk to the market.

•Banks reduce credit risk and interest rate risk.

•Banks diversify loan portfolio to earn stable returns.

Securitization

• Banks are the loan originators.

• Earn service revenues from securitizing loan.

• Securitized loans are off balance sheet instruments.

- Transferred with recourse

- Banks are exposed to risk associated with the underlying asset.

Hedging

•Hedging protects risk exposed financial transaction

• offsets a long position by taking an additional short position in a derivative market

• offsets a short position by taking an additional long position in a derivative market.

•Long position

• Agreement to buy securities at future date at a predetermined price

•Short position

• Agree to sell securities at future date at a predetermined price