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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%

Risk
 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
 Offbalance 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

Refinancing risk
risk that cost of reborrowing funds > than returns earned on asset investment

Example of refinancing risk: Consider an FI that issues 1yr maturity liabilities (deposits) to provide funds for their term loans (assets ) with 2yr maturity
 i.e. maturity of assets longer than maturity of liabilities)

Reinvestment risk
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 1yr loans)
 i.e. maturity of assets smaller than maturity of liabilities.

Price risk
 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 fixedinterest security e.g. 2 yr bond coupon 8.0% p.a., par value $1,000 with semiannual 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 2year bond, 8% p.a. semi annual coupon, face value $1,000 & market interest rates are 8%
b) For 10year bond, 8% p.a. semi annual coupon, face value $1,000 & market interest rates are 8%
Now interest rates increase to 10%
 2year bond price is now $964.54
 10year bond is now $875.38

So for bonds with the same coupon interest rate...
Longerterm bonds change proportionately more in price than shorterterm bonds for a given interest rate change.

For same maturity  Example
(i) for 10year bond, 8% p.a. semiannual coupon, face value $1,000 & market rates 8% p.a., price is $1,000
(ii) for 10year bond, 4% pa semiannual 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
 Coupon

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, RSL
 RSA  interest rate sensitive assets = those on which a floating rate is payable
 RSL  interest rate sensitive liabilities

Repricing analysis
 Risk committee need to group balance sheet items according to what assets & liabilities are exposed
 The Gap (repricing 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 = 4860
 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 = 10060
 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 ratesensitive assets in order to take advantage of future rate increases & hold fixedrate liabilities to lock in current low rates (GAP is +)

Bank expects interest rates ↓...
 Should have a negative gap
 Hold fixedrate assets to lock in high rates & ratesensitive 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

Duration definition
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
 C_{t} = cash payment at period t
 N = number of cash flows

Duration gap analysis  Example 4  "The duration of a threeyear 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%?"
 D_{u}(assets) = 2.9
 R_{change} = 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

Liquidity Risk
 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. Tbills

Offbalance Sheet Business & Risk
Offbalance sheet business involves the creation of contingent assets & liabilities (affects future balance sheet)

Example of offbalance Sheet Business & Risk
 The issuance of standby 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 backoffice 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

