Bank Management Questions
- Interest rate risk refers to the risk that market interest rates will increase more than the interest rate earned on investments, resulting in lowering their market value. GAP represents a way of viewing interest rate risk. Interest rate risk can be assessed using gap analysis. “Gap models are concerned with the exposure of net interest income-interest income less interest expense-to changes in interest rates” (Toevs, 1983, 20). The simplest form of doing do is using dollar-value gap analysis.
This measures the difference between the dollar value of the assets and the dollar value of liabilities, of a bank, that are sensitive to interest rate changes. A more erudite way of measuring the interest rate risk would be the employment of duration gap analysis. Duration gap measures the changes in rates on the market value of equity. The longer the duration, the larger will be the change in value of assets and liabilities, for a given change in interest rate. Net interest margins will rise for banks with positive interest rate gap, with rising interest rates and vice versa.
Further, GAP analysis comprises of forecasting interest rates, devising “time buckets” or intervals, grouping of assets and liabilities into these “time buckets”, calculating GAP for each “bucket” and determining the change in net interest income for assumed change in interest rates.
Example 1: A bank issues a loan of $1000 for a one year period which is funded by a $1000 CD for two years. In this case the bank’s one year GAP would be $1000 (positive). An increase in the interest rate will result in increase in net interest margin.
Example 2: A bank issues a loan of $1000 at a fixed rate of 8% for 3 years. It funds the loan with a Certificate of Deposit (CD) of $1000, at 4% for one year. The bank’s one year GAP will be the difference between the rate-sensitive assets (0) and rate sensitive liabilities (1000), that is -$1000. The Net Interest Income for one year is 40 (1000×8%-1000×4%). Net Interest Margin is 4%. If interest rates rise in 1 year, the bank’s interest margin will fall and vice versa.
Example 3: Considering the previous example, if the interest rates rise by 1% in the next year, the Net Interest Income would be 30 (1000×8%-1000×5%). The Net Interest Margin will be 3%. This shows that for a negative GAP, when interest rate rises, Net Interest Income and Net Interest Margin fall. The opposite is also true, meaning that for a positive GAP, when interest rate increases, NII and NIM will also increase.
Thus, to reduce risk, “a bank with a negative GAP would try to increase RSAs (variable rate loans or shorter maturities on loans and investments) and decrease RSLs (issue relatively more long-term CDs and fewer fed funds purchased)” (Koch & McDonald, 2006).
Therefore, GAP allows banks and organizations to measure and assess their interest rate margins and the risks involved with any changes therein.
- Derivatives are financial instruments whose price is dependent upon fluctuations in one or more underlying assets such as stocks, bonds, currencies, commodities, etc. Derivatives can be used to manage interest rate risks. The various derivatives that can be used for this purpose include:
Forward Rate Agreements: Under a forward contract, one party pays fixed rate of interest and receives a floating rate, referred to as the reference rate, which is determined two or three days before the date of payment, according to market conditions. The payments to be made are calculated on a notional amount, at predetermined intervals. Here only the net amount, that is the difference, is paid.
Example: Company A and Company B enter into an FRA wherein Company A will receive 5% fixed rate on $10000 for 2 years and Company B will receive the reference rate. The agreement will be settled in 2 years. If after 2 years, the reference rate is 6%, Company B will benefit and Company A will have to pay Company B $100, which is 10000×6% – 10000×5%.
Thus companies can hedge themselves against interest rate risks.
Futures: An Interest Rate Future is a futures contract by which lenders and borrowers commit themselves to the interest rates at which they will lend or borrow specified sums on a specified future date.
Example: X and Y enter into an agreement in which X will sell his bonds to Y for $2000 after 2 weeks. If the interest rate rises, the value of the contract falls as the potential investor can buy other bonds with better interest rates. Here Y will benefit. However, if the interest rate falls, the value of the contract increases and X will be in a more favorable position.
Options: Interest Rate Options are investments which provide the holder with the right but not the obligation to purchase or sell a bond on a given date at a particular price. The underlying security here is a debt obligation. An option can be a “Call” Option, which is the right to buy a security at a specified price (strike price) before a specific date (expiration date).
The opposite is a “Put” option wherein the holder has the right to sell his security at the strike price before the expiration date. If an investor believes that interest rates are going to rise, he may take a long position on a call option. On the other hand, if he deems interest rates to fall, he will opt for interest rate put options. Thereby, the risk involved in interest rate fluctuations can be reduced.
Example: A and B enter into an agreement in which A has the option to buy 100 bonds from B at $20 in two weeks’ time, which yield 5% interest. To compensate B, A pays him $2 per bond, that is, $200 as risk premium. Here, A has a call option, $20 is the strike price and two weeks is the expiration date. If interest rate rises, A will buy the bonds and vice versa. The opposite of this would be a put option in which A will have the option of selling the bonds.
Collar: This involves the simultaneous purchase of a “cap” and the sale of a “floor”.
“An interest rate cap is a series of interest rate call options set at the same exercise rate and that have expiration dates of the underlying liability. On the other hand, an interest rate floor is a series of interest rate put options with the same exercise rate and that have the same expiration dates of the underlying liability” (Griffeth, 2004, 1). If interest rate increases, the seller will pay the difference between the reference rate and predetermined cap rate as per the interest rate cap, and vice versa. Thus a person can know his future interest expense irrespective of changes in interest rates.
Thus, by adopting these investment instruments and tools, interest rate risk can be hedged. A company or an individual will be in a position to deal with interest rate risks better if they choose to invest in one or more of these products, depending upon the requirements of each case.
- Foreign exchange rate refers to the rate at which one currency is converted for another. Interest rate is the “rate charged or paid for the use of money” (Investorwords.com).
Foreign exchange rates and interest rates influence each other and changes in one will result in movements in the other. If higher rates of interest are being provided by one country, investors would prefer to invest in the securities of that particular economy. To do so they will have to purchase the securities in the respective currency of the country, thereby resulting in an increase in its demand. The increase in demand will lead to an increase in the value of the particular currency.
Hence, it can be said that the higher the interest rates prevalent in an economy, greater will be the foreign investment and higher will be the foreign exchange rate. Similarly, lower interest rates will result in lower foreign exchange rates for an economy. Foreign exchange rate and interest rate, consequently, share a direct relationship. This however is dependent on other factors such as the inflation rate in the economy, the trade system (imports and exports) and economic performance, amongst other things.
For example, investors in England find that the interest rates on treasury bonds are higher in America as compared to England. In order to purchase these bonds, they must buy them in dollars. Accordingly, the demand for dollars will increase and that for euros will decrease, resulting in an increase in the exchange rate of dollars and a decrease in the exchange rate for the latter.
It is highly imperative for business organizations, banks in particular, to understand the relationship between interest rates and foreign exchange rates. Any changes in the interest rate have an effect on the exchange rate and will influence the operations of the banks. Although the prime interest rates are set by the Central Bank of the country, banks have a certain degree of autonomy while fixing their interest rates. The interest rate set by the bank will determine the quantum of foreign investment into the bank.
The demand for the bank’s securities and services will depend upon the interest rate it is offering. Banks can, therefore, manipulate not only the exchange rates through their interest rates, but can also influence the extent of foreign investment. By maintaining stable interest rates, banks can ensure stable foreign exchange rates and steady inflow of foreign investment. Further, an appreciation in the value of a currency will result in higher disposable income for the people of that economy. More funds will be available for the purposes of saving and investment. Again, the bank will benefit as the demand for its securities will rise.
Multinational banks must understand the relation between exchange rates and interest rates as they operate with more than one currency and are affected by fluctuations in exchange rates. Banks must also recognize the importance of interest rates for exchange rates to be able to make more prudent investment decisions.
By comprehending the movements in interest rates and foreign exchange rates, and the relationship between the two, a bank would be in a better position to ensure that it is maximizing not only its own profitability but also the prosperity of the entire economy.
Businessdictionary.com. Definition of Interest Rate Futures. Retrieved August 14, 2010 from http://www.businessdictionary.com/definition/interest-rate-futures.html
Griffeth, T. (2004). Managing interest rate risk in a rising-rate environment. The RMA Journal, 1-5.
Investorwords.com. Definition of Interest Rate. Retrieved August 15, 2010 from http://www.investorwords.com/2539/interest_rate.html
Koch, T & McDonald S. (2006). Bank Management. Cincinnati: South Western Educational Publishing.
Toevs, A.L. (1983). Gap Management: Managing Interest Rate Risk in Banks and Thrifts. The Federal Reserve Bank of San Francisco’s Economic Review
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