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Two measures often used to report firm’s performance
- Return on assets
- Return on equity
Return on assets
- Profit/dollar of total assets
- Norms for banks = less than 1% on assets
Return on equity
- profit/dollar of equity capital
- roughly 14%-15%
- Chance that actual outcome will differ from expected outcome.
- Equals uncertainty
The modern FI faces several risks to consider, measure & control
- Interest rate risk
- Credit (default) risk
- Liquidity risk
- Off-balance sheet risks
- Foreign exchange risk
- Operational/technology risk
- Country/sovereign risk
Interest Rate Risk For FIs
- Sensitivity of future cash flows & value of assets or liabilities-(for borrower their liabilities, or lender their investments) to uncertain changes in interest rates
- For FIs, the deposits of FIs often have different maturity & liquidity characteristics than the assets (loans in the case of a bank) they sell.
- The mismatching of maturities of assets & liabilities ⇒ FIs exposed to risk of lower than expected net interest income.
Two important aspects of interest rate risk
- Refinancing risk
- Reinvestment risk
risk that cost of reborrowing funds > than returns earned on asset investment
Example of refinancing risk: Consider an FI that issues 1-yr maturity liabilities (deposits) to provide funds for their term loans (assets ) with 2-yr maturity
- i.e. maturity of assets longer than maturity of liabilities)
the risk that the returns on the funds to be reinvested will fall below the cost of the funds.
Example of reinvestment risk: Suppose FI issues securities (borrows funds) at 9% pa for 2 yrs & invested the funds in assets that yield 10% for 1 yr.(has 1-yr loans)
- i.e. maturity of assets smaller than maturity of liabilities.
- Rising interest rates increase discount rates on future cash flows & the price (market value) of that asset or liability ↓.
- So FIs face price risk on their assets & any securities it holds
Price risk arises from the important relationship
Between interest rates & prices of financial assets.
Price risk: Example of debt security - Pricing of fixed-interest security e.g. 2 yr bond coupon 8.0% p.a., par value $1,000 with semi-annual interest payments, current market rates 8%
Price risk: Example of debt security - Part 2 - If firm is seen as more risky i.e. if market expects 10% or comparable current market instruments are now offering 10%:
For same coupon - Example
a) For 2-year bond, 8% p.a. semi annual coupon, face value $1,000 & market interest rates are 8%
b) For 10-year bond, 8% p.a. semi annual coupon, face value $1,000 & market interest rates are 8%
Now interest rates increase to 10%
- 2-year bond price is now $964.54
- 10-year bond is now $875.38
So for bonds with the same coupon interest rate...
Longer-term bonds change proportionately more in price than shorter-term bonds for a given interest rate change.
For same maturity - Example
(i) for 10-year bond, 8% p.a. semi-annual coupon, face value $1,000 & market rates 8% p.a., price is $1,000
(ii) for 10-year bond, 4% pa semi-annual coupon, face value $1,000 & market rates 8%, price is $728.19
Now interest rates increase to 10% pa
- For (i) price is now $875.38 = 12.5% change
- For (ii) price is now $626.13 = 13% change
So for bonds with same time to maturity...
Price volatility of the lower coupon bond is higher than that of a higher coupon bond.
Overall, sensitivity of bond prices to interest rate movements depends mainly on...
- Bond's time to maturity
Forecasting Interest Rates
- Pattern observed with phases of business cycle & interest rates what is the business cycle?
- interest rates tend to ↑ during expansion
Forecasting Interest Rates - "As businesses & consumers borrow more"
- Interest rate spreads tend to narrow during expansion due to default risk
- Interest rates tend to ↓ during a recession
Forecasting Interest Rates - "Businesses & consumers borrow less"
Interest rate spreads tend to widen during recession
Some Approaches to forecasting interest rates
- Money Supply Approach
- Fisher Effect
- Econometric models
Some Approaches to forecasting interest rates - Money supply approach
- If projected money supply growth > projected GDP income, then interest rates likely to fall
- If projected money supply growth < projected GDP income, then interest rates likely to rise
Some Approaches to forecasting interest rates - Fisher Effect
Argument that observed changes in nominal interest rates will reflect changes in rate of inflation expected by lenders
Three methods of measuring interest rate risk:
- Maturity GAP analysis
- Duration GAP analysis
- Scenario analysis
Measuring Interest rate risk - 1. GAP Analysis (for identifying risk for net interest income)
Identification of assets (loans) & liabilities (deposits) sensitive to interest rate movements within defined planning period
- RSA - interest rate sensitive assets = those on which a floating rate is payable
- RSL - interest rate sensitive liabilities
- Risk committee need to group balance sheet items according to what assets & liabilities are exposed
- The Gap (re-pricing gap) is the difference between RSL & RSA
- GAP = RSA- RSL Change in income ∆I = Gap × rate change × period
GAP, RSA, RSL - Example 1 - "Bank A has RSA at $100m & RSL at $85m (RSA>RSL). If market rates are expected to ↑ by 2 % over a year, what are potential effects?"
- Currently cash flow is: GAP = RSA - RSL
- = $15m positive gap
For change in income
- ∆I = GAP × ∆i
- = 15× 0.02
- = $0.3m
Positive gap means? So when interest rates rises?
- Positive gap means bank with value of RSAs > RSLs
- When interest rates rise, more assets (loans) are repriced so net interest income rises
GAP, RSA, RSL - Example 2 - If Bank B has RSA= $48m & RSL= $60m where RSA< RSL, find GAP & change in income if market rates are expected to ↓ by 5 % over a year?"
- GAP = 48-60
- GAP = -12M therefore "negative gap"
Interest rate decrease by 5%, Change in income:
Negative gap means? If interest rates rise?
- Bank with value of RSLs > RSAs
- So, bank can pay lower rates on RSLs so interest expense lowers
If interest rates rise, bank pays higher rates on the RSLs as well as earning higher yields on RSAs
- But the interest expense rises more as more liabilities
- Net interest income falls when rates rise
GAP, RSA. RSL - Example 3 - "If Bank B has RSA= $100m & RSL= $60m where RSA > RSL, find GAP & change in income if market rates are expected to ↓ by 2 % over a year?"
- GAP = 100-60
- GAP = 40M therefore positive gap
Interest rate decreases by 2%, Change in income: ∆I = GAP × ∆I
Then rates fall by 2% so bank pays lower rates on RSLs when repriced to new rates as well as on RSAs
BUT RSAs value greater so receives less income relatively speaking
If a bank expects rates to ↑...
- Should have a positive gap
- Hold rate-sensitive assets in order to take advantage of future rate increases & hold fixed-rate liabilities to lock in current low rates (GAP is +)
Bank expects interest rates ↓...
- Should have a negative gap
- Hold fixed-rate assets to lock in high rates & rate-sensitive liabilities
Management of interest rate risk by duration - 2. Duration Analysis (for measuring risk for value of assets/liabilities)
Provides single measure of risk by applying to balance sheet & offers way to find effect of interest rate risk
Average lifetime of an asset or liability found by calculating weighted average time to receipt of each element of cash flow of security
Duration Analysis formula
- D = duration,
- i = interest rate as decimal
- t = number of periods
- Ct = cash payment at period t
- N = number of cash flows
Duration gap analysis - Example 4 - "The duration of a three-year bond, with face value $1000, annual coupon payments & mkt rates i are both 10% is..."
- Duration = 2734.4/999.60
- Duration = 2.7355 years
Duration & Percentage change in the value of a security
Duration & Percentage change in the value of a security - Example - " A bank manager works out that the bank has a total portfolio asset value of $500 million & its asset duration of 2.90 years, & then wants to know what will be the change in bank’s assets when interest rates fall from 9% to 7.5%?"
- Du(assets) = 2.9
- Rchange = -1.5% = -0.015
- r = 9% = 0.09
- %∆P = 2.90 x -0.01376
- %∆P = 3.99%
Market value of assets grows by
- = 3.99% ×$500 million
- = $19,954,128.44
- So value of its equity rises
Problems with duration gap analysis
- Assumption when interest rates change, interest rates on all maturities change by same amount- flat yield curve/ parallel
- Making estimates of proportion of fixed rate assets & liabilities that may be interest rate sensitive
Credit (Default) risk
Refers to chance borrower will default on the repayment of principal loan or fails to service interest payments when due
Credit (Default) risk and FIs
- FIs need to both monitor & collect info about any firms whose assets are in their portfolio e.g. corporate bonds.
- One of the advantages FIs have is the ability to diversify away some credit risk by using large numbers
- Most still hold some assets exposed to this risk
Managing Credit (Default) Risk
Use framework of adverse selection & moral hazard to understand the principles that financial managers or loans officer follow
Managing Credit (Default) Risk - For all FIs
need to make assessment of the credit quality of potential borrower by criteria
- Borrower’s capital position
- Borrower's capacity to service loan
- Borrower's management skills
- Quality of the security to back loan
Derivatives- Credit Default Swaps CDS
- Credit risk protection
- Aim: transfer credit risk from one party to another
- Similar to insurance for bond investors
Credit Default Swaps (CDS) - Two parties to CDS
- 1. Protection seller who agrees to compensate protection buyer if credit default event specified in contract occurs - e.g. a company with low debt, sells CDS contract to buyer
- 2. Protection buyer who has bought some debt instrument or a loan provider & seeks to transfer credit risk to seller
So if credit default happens, then...
- Protection seller has to pay specified amount to protection buyer
- Or protection buyer delivers the debt specified to protection seller who has to compensate buyer with the specified cash amount
- when an FI’s liability holders want immediate cash for their financial claims.
- FI must either borrow extra funds or sell off assets to meet demands.
Management of Liquidity Risk
- First, avoid lumpiness in FI’s liabilities, e.g. for banks to repay deposits by spreading deposit maturity dates.
- Debt scheduling - mismatch of terms applying to deposit & loan contracts - encouraged by changing market conditions
Two liquidity management strategies
- Borrow funds either from regulators or financial markets (larger FIs can access Euromarkets)
- Have strategy of diversified funding & use asset management & sell securities from securities portfolio e.g. T-bills
Off-balance Sheet Business & Risk
Off-balance sheet business involves the creation of contingent assets & liabilities (affects future balance sheet)
Example of off-balance Sheet Business & Risk
- The issuance of stand-by letter of credit guarantees by insurance companies & banks to back issuance of corporate bonds.
- This guarantees payment should the company face problems in either paying the interest &/or principal
Management of Foreign Exchange (FX) Risk
- To avoid FX risk & be approximately hedged the FI must match its assets & liabilities in each foreign currency (needs to be of same size & maturity to avoid FX risk).
- Domestic FIs may reduce FX risks by trading forward & entering a currency swap agreement or by operating a currency hedge.
Operational and Technology Risk
FIs have invested heavily in internal & external communications, computers & expanded technological infrastructure in order to ↓ operating costs, ↑ profits & gain new markets.
Operational and Technology Risk - "Technological risk"
Occurs when these investments don’t produce anticipated savings - diseconomies of scale due to excess capacity, redundant technology & inefficiencies
Operational and Technology Risk - "Operational risk"
When existing technology &/or back-office systems break down. Could get situation where funds borrowed not recorded but funds lent ⇒ huge net payment on funds lent.
Country or Sovereign risk - "Country risk"
Difference in laws may not protect FI from legal address for defaulting loans
Country or Sovereign risk - "Sovereign risk"
e.g. govts of Argentina, Peru & Brazil have imposed restrictions on debt repayments in hard currencies