Jaco van der Walt October 2006 - First Rand · PDF file66 Managing interest rate risk. ... • Repricing gap • NII (or NI) sensitivity • Earnings at risk • Economic value perspective

Jaco van der Walt

October 2006

11 What is interest rate risk?

Presentation overview

22 Isolating interest rate risk

33 Interest rate risk measurement

44 Hedging repricing risk with swaps

55 Practical aspects of hedging

66 Managing interest rate risk








-

5,000

10,000

15,000

20,000

25,000

30,000

35,000

0 5 10 15 20 25

5yr swap rate (%)

FTSE

JSE

Bank

s' In

dex

Share price vs interest rates

Volume growth

Endowment effect

Rising bad debt

Endowment effect

• Interest rate risk is…• The sensitivity of the balance sheet and income statement due to

unexpected, adverse movements of interest rates

• Basel II• Treats the interest rate risk in the banking book as a separate risk type,

incorporates it into Pillar II of the Basel II framework• Mismatch arises naturally and can be an important source of profitability

• No standardised approach to the treatment of interest rate risk globally

Definition of interest rate risk

Optionality

Basis risk

Twist risk

Repricing risk

Sour

ces

of IR

R

Income statementBalance sheet

Share price

Sources of interest rate risk

6

8

10

12

14

16

Twist risk

3m JIBAR 5yr swap

Example: Curve inversion for fixed rate loans

Optionality

Example: Prepayments on fixed rate loans

56789

101112131415161718192021222324

Example: Endowment risk on core deposits

Repricing risk

Example: Prime-JIBAR or swap spreads

0

1

2

3

4

5

6

7

Basis risk








Isolating interest rate risk

AssetsLiabilities

EquityBal

ance

she

et

Interest income

Interest expense

Net interest income

– =

– =

–

+ =

Client rate –

Asset transfer rate

Client rate –

Liability transfer rate

Asset margin Liability margin Credit, liquidity & other

Interest rate mismatch

Inco

me

stat

emen

t

Separating credit, liquidity and interest rate risk

Interest rate risk

Liquidityrisk

Credit risk

Other

Pricing

Asset margin

Liability margin

Mismatch

Transferring interest rate risk

Business unit

Business unit

Interest rate risk management

Yie

ld (%

)

Term (yrs)








Measurement of interest rate risk

• Earnings perspective• Cash flows• Risk measures

• Repricing gap• NII (or NI) sensitivity• Earnings at risk

• Economic value perspective • PV of cash flows• Risk measures

• EV sensitivity• Effective duration of equity• Economic value at risk

Risk = Exposure x Volatility

Most banks mainly focus on repricing risk

Assumptions are key (no standardisation)








Hedging repricing risk with swaps• Drop in level of rates is the main source of earnings risk facing SA banks

• Assets reprice as rates drop, but rates on core deposits have a floor

• Can hedge this risk by selling swaps (receive fixed, pay floating)

• Only profit if rates drop by more than implied forwards

• Apply cash flow hedging to reduce volatility of income (IAS32, IAS39)

• Hedges must be unwound if rates rise

8.48.58.68.78.88.99.09.19.29.3

0X3

3X6

6X9

9X12

12X1

5

15X1

8

18X2

1

21X2

4

24X2

7

27X3

0

30X3

3

33X3

6

Impl

ied fo

rwar

d ra

tes (%

)

Profit if rate outcome is below implied forwards

Practical example: repricing risk

Primelinkedassets

Equity

Issuance

Asset margin

Liability margin

Balance sheet Interest rate mismatch Example: Level shift

Coredeposits

Earnings at risk due to level shift

Liquids

Mismatch


Driver of repricing risk (volatility)

-300

-200

-100

0

100

200

300

400

500

Mar-9

5Se

p-95

Mar-9

6Se

p-96

Mar-9

7Se

p-97

Mar-9

8Se

p-98

Mar-9

9Se

p-99

Mar-0

0Se

p-00

Mar-0

1Se

p-01

Mar-0

2Se

p-02

Mar-0

3Se

p-03

Mar-0

4Se

p-04

Mar-0

5Se

p-05

Mar-0

6Se

p-06

Chan

ge in

YC

rate

(m/m

, bps

)

5

7

9

11

13

15

17

19

21

Feb-

95Au

g-95

Feb-

96Au

g-96

Feb-

97Au

g-97

Feb-

98Au

g-98

Feb-

99Au

g-99

Feb-

00Au

g-00

Feb-

01Au

g-01

Feb-

02Au

g-02

Feb-

03Au

g-03

Feb-

04Au

g-04

Feb-

05Au

g-05

Feb-

06Au

g-06

Aver

age o

f 3yr

and

5yr s

wap

rate

(%)

Level of curve Changes in level

Monthly average: -5bps

Monthly std dev: 67bps

Annualised std dev: 232bps


Exposure to repricing risk (gap)Risk = Exposure x Volatility

Gap after hedgesGap before hedges

-100

-80

-60

-40

-20

0

20

40

60

80

100

ON

to 3

m

4m-1

2m

1yr -

2yr

2yr -

5yr

>5yr

Non

-rate

Nom

inal

(Rbn

)

Assets LiabilitiesEquity HedgesCumulative gap

-100

-80

-60

-40

-20

0

20

40

60

80

100

ON

to 3

m

4m-1

2m

1yr -

2yr

2yr -

5yr

>5yr

Non

-rate

Nom

inal

(Rbn

)

Assets Liabilities

Equity Cumulative gap

Receive swaps to protect against rate cuts

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

-200 -100 0 100 200

Change in rates (bps)

Pro

ject

ed N

II fo

r 1st

12m

(Rbn

)

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

-200 -100 0 100 200

Change in rates (bps)

Pro

ject

ed N

II fo

r 1st

12m

(Rbn

)

Earnings sensitivity to repricing riskRisk = Exposure x Volatility

After hedges

Before hedges

After hedges

Before hedges








Practical aspects of hedging (1)• Repricing risk

• Manifests heavily in endowment effect through core deposits and capital• Hedge instruments include:

• Swaps and FRAs• Liquid assets (government securities)• Options are seldom used to hedge repricing risk by SA banks

• Not all SA banks hedge this risk actively• Some international banks target a rolling average

• Basis risk (1)• Prime-JIBAR basis

• Not enough liquidity in prime basis swaps to hedge prime books• Some banks use replicating portfolio technology• Risk generally retained in business units and priced accordingly

Practical aspects of hedging (2)• Basis risk (2)

• Swap-government basis• Manifests itself predominantly in the liquid asset portfolio if longer bonds are

included• This risk is generally actively managed

• Option risk• Exists mainly due to prepayments in fixed rate products (e.g. auto loans)• Generally hedged on a macro basis according to the prepayment tendency• Increasing number of new products contain embedded optionality








Managing interest rate risk

Interest rate risk management processes

Modelling & analytics

View / macroeconomics

Hedging strategies & portfolio management

Transfer economic risk (FTP)

Fram

ewor

ks &

man

date

s

Gov

erna

nce

& ri

sk m

anag

emen

t

Rep

ortin

g

Documents

Jaco van der Walt October 2006 - First Rand · PDF file66 Managing interest rate risk. ... • Repricing gap • NII (or NI) sensitivity • Earnings at risk • Economic value perspective