Table of Content

1. Executive summary 2. Introduction 3. Repricing Model I) Refunding or funding gap II) Advantage/Disadvantage 4. Maturity Model

iv 2 2 3 4-5 6-10 11 12-15 15 16-20

5. Weakness of maturity model 6. Duration Model 7. Limitation of Duration model

8. Case Study Brac Bank Ltd

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INTRODUCTION:
Interest Rate Risk - In the process of FIs performing their asset-transformation function, FIs are exposed to Interest Rate Risk, from Mismatched Maturity/Duration: Borrowing Short, Lending Long. The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (e.g. through an interest rate swap). Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.

REPRICING MODEL
Repricing Model is a CF analysis of interest income (+cfs) from loans; and interest

expense (-CF) on deposits, looking at Rate-Sensitive Assets (RSAs) vs. Rate-Sensitive Liabilities (RSLs). Rate sensitivity results from either: a) variable rate loans or deposits that adjust to market rates, or b) maturing loans or deposits that will adjust, and roll over to current market rates. Until recently, Fed required quarterly reporting of repricing gaps.

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Refunding or Funding Gap:

The difference between assets whose interest rates will be re-priced or charged over some future period (rate-sensitive assets) and liabilities whose interest rates will be re-priced or charged over some future period (rate-sensitive liabilities). i.e. Refunding or Funding Gap = RSAs - RSLs, over some period from 1 day to 5+ years. Maturity mismatch exposes an FI to a possible Refunding/Funding Gap.

If RSA < RSL and interest rates increase, the FI's net income will decrease, because the interest expense on deposits will rise faster than interest income on loans. Formula: NII = GAP * (R), where:

NII = Change in Net Interest Income ($) GAP = (RSA - RSL) R = Change in Interest Rates For the first time period (1 day), for every 1% increase in R: NII = (-$10m) x .01 = -$100,000 For the third time period (3-6 months), for every 1% increase in R: NII = (-$15m) x .01 = -$150,000 We can also calculate cumulative gaps (CGAP) over a certain period, e.g. 1 YR: CGAP (one-year): -$10m + -$10m + -$15m + $20m = -$15m NII (one-year) = (-$15m) x .01 = -$150,000 Changes in interest rates also affect the market value (PV) of the loans and deposits, and these balance sheet changes are not accounted for in the Funding Gap Model, which assumes historic or book values of assets and liabilities (loans and deposits). Rules: 1. When RSA > RSL, then CGAP > 0. 2. When RSA < RSL, then CGAP < 0. 3. If CGAP > 0, if interest rates rise (fall), NII will rise (fall). 4. If CGAP < 0, when interest rate rise (fall), NII will fall (rise).
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Equal Rate Changes on RSAs, RSLs : NIIi = (GAPi) Ri = (RSAi - RSLi) Ri

Example: Suppose rates rise 1% for both RSAs and RSLs. Expected annual change in Net Interest Income (NII) is, NII = CGAP R = $15 million .01 = $150,000 Conclusion: With positive CGAP, rates change and NII move in the same direction, vice versa. Changes proportional to CGAP assuming no spread effect
Unequal Changes in Rates: If changes in rates on RSAs and RSLs are not equal, the spread changes. In this case, NII = (RSA RRSA ) - (RSL RRSL ) Spread effect: the effect a change in the spread between the rates on RSAs and RSLs has on net interest income as interest rate changes.

Advantages of Repricing Model:

Easy to understand, easy to work with, easy to forecast changes in profitability from interest rate changes.

Disadvantages/Limitations of Repricing Model:

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1. Does not account for balance sheet changes in the market value (PVA and PVL) of

the bank when interest rates change, so is only a partial model of interest rate risk.
2.

Within a given time period (bucket), e.g. 1-5 years, the dollar values of RSAs and RSLs may be equal (indicating no interest rate risk), but the assets may be repriced early, and the liabilities repriced late, within the bucket time period, exposing the FI to interest rate risk not accurately captured by the Repricing Model. Ignores CF patterns within a maturity bucket, e.g. one-year ARM rates might be re-set on a different date than the maturity patterns of 1 year CDs.

3. Assumes NO prepayment of RSAs or RSLs, when there can actually be a high

volume of refinancing, e.g., recent years (2002-2003) for mortgages when rates fell to 50 year lows. Also, assumes no reinvestment risk for rate-insensitive assets (loans). Fixed-rate "rate-insensitive" loans generate CFs that are rate-sensitive because of reinvestment. A 30-year fixed-rate mortgage might not get repriced for 30 years, but its CFs have to be reinvested at the current market rates.
4. Considers only balance-sheet items, and ignores interest rate risk/CFs from off-

balance-sheet (OBS) activities e.g., interest rate futures, loan commitments, etc. Example: Futures contracts produce daily CFs because of daily settlement, and expose an FI to OBS interest rate risk.

Maturity Model

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At any given time, the relationship between the price, or market value, of a security of a certain maturity and a fixed cash flow in inversely related to the market yield-to-maturity (ytm) of instruments of like default risk, liquidity, and maturity. Using the example of a 10-year default free bond, a face value of $1,000, issued at par, and paying a 7 percent coupon interest semiannually, the price of this instrument at a 7 percent yield to maturity is $1,000. At a market yield to maturity of 9 percent, this bond will be priced at $869.92 (Table 1). The price of a fixed coupon bond is computed as follows:

P=

C F + k (1 + ytm / f ) M k =1 (1 + ytm / f )

where P is the market price of the bond, C is the fixed coupon of one-half the annual coupon rate times the face value, F is the face value of the bond ($1,000 in the example), f is the payment frequency per year (2 in the example), ytm is the yield to maturity for the bond at this maturity, and M is the number of periods to maturity (number of years times the frequency of payment). All payments are assumed to be made at the end of each period. Applying this formula to the bond with a ytm of 7 percent, M is 20 periods (a 10 year maturity), F of $1,000, f of 2 payment periods per year, and a coupon payment of $35, the value of this bond is (Table 1):

P=

35 1,000 + = $ 1,000 k (1+.07 / 2) 20 k =1 (1+.07 / 2)

20

This bond is priced at par or $1,000.

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Changes in market interest rates will affect the market values of securities such as the one in the example. Table 1 shows how the price of this security varies inversely with yields to maturity ranging from 0.5 percent to 22 percent. For example, if interest rates immediately rise, before the next coupon payment, to 9 percent, a 200 basis point (bp) rise, the value of the bond drops from $1,000 to $869.92, a decline of 13 percent in value for a 28 percent increase in interest rates. By contrast, a 200 bp decline in interest rates, from 7 percent to 5 percent, results in a bond value of $1,155.89 and a 16 percent increase in value for a 28 percent decrease in interest rates. NOTE: There is an asymmetry in the price change: Interest rate increase, the price declined by $130.08 Interest rate decrease, the price increased by $155.89.

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Table 1

Yields, Bond Price and Duration 10-Year Maturity Yield Price 10Yr %Delta Price Duration-10 Yr 8.00 -3.90 -3.86 -3.83 -3.80 -3.77 -3.74 -3.70 -3.67 -3.64 -3.61 -3.57 -3.54 -3.51 -3.47 -3.44 -3.41 -3.37 -3.34 -3.31 -3.27 -3.24 7.95 7.91 7.86 7.81 7.76 7.72 7.67 7.62 7.56 7.51 7.46 7.41 7.35 7.30 7.25 7.19 7.14 7.08 7.02 6.97 6.91

Yields, Bond Price and Duration 20-Year Maturity Yield Price 20Yr %Delta Price Duration-20 Yr 14.10 -6.73 -6.61 -6.49 -6.37 -6.25 -6.13 -6.00 -5.88 -5.75 -5.63 -5.51 -5.38 -5.26 -5.14 -5.02 -4.90 -4.78 -4.66 -4.54 -4.43 -4.32 13.88 13.66 13.43 13.20 12.97 12.73 12.49 12.26 12.02 11.77 11.53 11.29 11.05 10.81 10.57 10.34 10.10 9.87 9.64 9.41 9.19

0.005 1,633.25 0.010 1,569.62 0.015 1,508.97 0.020 1,451.14 0.025 1,395.98 0.030 1,343.37 0.035 1,293.18 0.040 1,245.27 0.045 1,199.55 0.050 1,155.89 0.055 1,114.20 0.060 1,074.39 0.065 1,036.35 0.070 1,000.00 0.075 0.080 0.085 0.090 0.095 0.100 0.105 0.110 965.26 932.05 900.29 869.92 840.87 813.07 786.46 760.99

0.005 2,235.65 0.010 2,085.17 0.015 1,947.29 0.020 1,820.87 0.025 1,704.86 0.030 1,598.32 0.035 1,500.40 0.040 1,410.33 0.045 1,327.42 0.050 1,251.03 0.055 1,180.59 0.060 1,115.57 0.065 1,055.52 0.070 1,000.00 0.075 0.080 0.085 0.090 0.095 0.100 0.105 0.110 948.62 901.04 856.92 815.98 777.96 742.61 709.72 679.08

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0.115 0.120 0.125 0.130 0.135 0.140 0.145 0.150 0.155 0.160 0.165 0.170 0.175 0.180 0.185 0.190 0.195 0.200 0.205 0.210 0.215 0.220

736.61 713.25 690.88 669.44 648.90 629.21 610.33 592.22 574.85 558.18 542.19 526.83 512.09 497.93 484.33 471.26 458.69 446.62 435.01 423.84 413.09 402.75

-3.20 -3.17 -3.14 -3.10 -3.07 -3.03 -3.00 -2.97 -2.93 -2.90 -2.87 -2.83 -2.80 -2.77 -2.73 -2.70 -2.67 -2.63 -2.60 -2.57 -2.54 -2.50

6.85 6.79 6.73 6.68 6.62 6.56 6.50 6.44 6.38 6.32 6.26 6.20 6.14 6.08 6.01 5.95 5.89 5.83 5.77 5.71 5.65 5.59

0.115 0.120 0.125 0.130 0.135 0.140 0.145 0.150 0.155 0.160 0.165 0.170 0.175 0.180 0.185 0.190 0.195 0.200 0.205 0.210 0.215 0.220

650.51 623.84 598.93 575.63 553.83 533.39 514.22 496.22 479.31 463.39 448.40 434.27 420.94 408.35 396.44 385.17 374.49 364.36 354.75 345.62 336.94 328.67

-4.21 -4.10 -3.99 -3.89 -3.79 -3.69 -3.59 -3.50 -3.41 -3.32 -3.23 -3.15 -3.07 -2.99 -2.92 -2.84 -2.77 -2.70 -2.64 -2.57 -2.51 -2.45

8.97 8.76 8.54 8.34 8.14 7.94 7.75 7.56 7.37 7.20 7.02 6.86 6.69 6.54 6.38 6.24 6.09 5.95 5.82 5.69 5.57 5.45

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Figure 1

Price-Interest Rate Relationship

2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12 0.13 0.14 0.15 0.16 0.17 0.18 0.19 0.20 0.21 0.22

Price ($)

(10-Yr and 20-Yr bonds, 7 percent Coupon)

20-Year Bond Price

10-yr Bond Price

Interest Rates -- YTM

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Duration years
15.00

Interest Rate-Duration Relationship

14.00

13.00

12.00

Duration 20Yr

11.00

10.00

9.00

8.00

7.00

Duration 10Yr

6.00

5.00

4.00 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12 0.13 0.14 0.15 0.16 0.17 0.18 0.19 0.2 0 0.21 0.22

Interst Rates -- YTM

Weaknesses of The Maturity Model :

1. It does not account for the degree of leverage in the FIs balance sheet; 2. It ignores the timing of the cash flows from the FIs assets and liabilities.

Duration Model
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Duration (weighted-average maturity) measures interest rate risk, i.e., changes in PV of securities when interest rates change: % PV Security = - D * R / (1 + R) FI's exposure to interest rate risk can be measured by its Duration Gap, which takes into account the usual duration/maturity mismatch: DA > DL. Equity (E) = Assets (A) - Liabilities (L), and E = A - L % A, which is equal to: ( A ) = - DA * (R) A (1 + R) % L, which is equal to: ( L ) = - DL * (R) L (1 + R) A = A * - DA * L = L * - DL * (R) (1 + R) , or

(R) (1 + R) And through substitution and rearranging we have E$ = - (DA - k DL) * A$ * R 1+R

where k = L / A = Measure of the FI's leverage, or D / A ratio. Interest rate risk (changes in market value of FI's net worth (E) is determined by 3 factors: 1. Leverage-adjusted duration gap (DA - k DL), measured in years and reflects duration mismatch. The higher the duration gap, the higher the interest rate risk. 2. Size of FI, measured by Assets (A$). The larger the size of FI, the greater the risk exposure from a change in interest rates, i.e., the greater the change in E, or market value. 3. Size of interest rate shock, R. The greater the R, the greater the E.
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Interest Rate Risk Exposure: E$ = - Adjusted Duration Gap * Asset Size$ * Interest Rate Shock

Using Duration Gap. a) If Duration Gap is POS (DA > DL), the bank is worried about an INCREASE in interest rates, because an INCREASE in interest rates will DECREASE the Value of the Bank (E). Interest Rates and Bank Value are inversely (neg.) related. b) If Duration Gap is NEG (DA < DL), the bank is worried about a DECREASE in interest rates, because a DECREASE in interest rates will DECREASE the Value of the Bank (E). Interest Rates and Bank Value are directly (pos) related. Duration Gap is Pos (DA= 5 YRs and DL = 3 YRs). If interest rates rise from 10% to 11%, the value of the bank will fall by -$2.09m, from $10m to $7.91m. Net Worth to Asset (E/A) has fallen from 10% to 8.29% ($7.91m / $95.45m). Note: This is only a 1% increase in interest rates. We get the same result considering A and L separately: A = $100m x (-5) x (.01/1.10) = -$4.545m L = $90m x (-3) x (.01 / 1.10) = -$2.454m E = -$4.545m - (-$2.454m) = -$2.09m To counter this effect, the bank could adjust the Duration Gap to immunize against interest rate changes/risk. Setting DA = DL won't result in 100% immunization because A > L ($100m > $90m), see p. 616 (if DA = DL = 5 yrs.). FI would will still be exposed to interest rate risk, bank value would fall by -$0.45m if interest rate rise by 1%.

Immunization formulas:
a. A * DA = L * DL
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$100m * 5yrs = $90m * x (where x = DL that will immunize 100%) x = DL = 5.556 years b. DA = (L / A) * DL and

DA = k * DL (where k = L / A) 5 = .90 x x = DL = 5.556 years Result of immunization is E = 0 E = - [5 - (.9) 5.556] * $100m * (.01/1.10) E = - (0) * $100m * (.01 / 1.10) Other strategies to immunize 100%: 1. Reduce DA (Leave L the same). DA * $100m = ($90m * 3 yrs), solve for DA

DA = 2.7 years (Reduce DA from 5 years to 2.7 years) 2. Reduce DA (X) and increase DL (Y) at the same time. $100m X = $90m * Y One solution would be DA = 4 yrs. and DL = 4.4444 yrs. 3. Increase L (and k) and increase DL. $100m * 5 = $95 * 5.2632 yrs. SUMMARY: A * DA > L * D L $100m * 5 > $90m * 3 500 > 270
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Decrease DA, increase DL, and/or increase L (assuming that A will not change) Point: Duration Model can be used to immunize bank against interest rate risk, i.e., the bank value (E = 0) will be unaffected by interest rate changes. Duration model is endorsed by the Federal Reserve Bank and the Bank for International Settlements (BIS) to measure and monitor interest rate risk for banks.

Limitations of Duration Model.

1. Might be time-consuming and costly to make changes to balance sheet to immunize. However, with advances in information technology and more advanced capital and money markets (e.g., Fed Funds, securitization of mortgages, etc.), transaction costs have come down over time. Also, duration model can be used to immunize with off-balancesheet instruments like interest rate futures, forwards, options, and swaps. 2. Immunization is a dynamic problem, changes constantly as DA, DL, A and L change over time, and requires continual monitoring and periodic changes and rebalancing to keep bank immunized (A * DA = L * DL). 3. Duration assumes a simple linear relationship between changes in interest rates (R) and %PV, when the true relationship is non-linear, see Figure 22-2 on p. 618. As changes in interest rates increase, the Duration Model becomes less accurate and precise.

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Case Study: BRAC BANK

LTD.

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Introduction:
BRAC Bank started its journey in 2001 and in just 8 years proved to be country's fastest growing bank. Today, the bank has 74 Branches, 60 SME Service Centers, 3 SME/Krishi Branches, more than 212 ATMs and 424 SME Unit offices across the country. It has disbursed over BDT10,000 crores of SME loan and has over 500,000 individual customers who access online banking facilities. Its services cuts across all strata of clientele, be it corporate, retail or SME.

Application of Duration Gap model:

In the annual report of Brac Bank there is no maturity breakdown as required for the model. In this model the stated maturity breakdown is hypothetical; all other data collected from annual report of Brac Bank Ltd.

Assumptions:
Duration-Gap Model. The correct expression for the duration of any balance sheet item is dependent on the assumed stochastic process driving interest rate/profit rate movements. For the sake of simplicity, is assumed here that there is a flat term structure for all On-Balance-Sheet accounts at all times, so that the interest rates/profit rates are yields to maturity. It is also assumed that duration can be summarized as a single factor model and assume that the interest rates/profit rates are equal for each asset account and each liability account. In determining the average maturity of an asset or liability item, the mid point is taken as the average. For example, loans classified as having maturity between 1 to 2 years would be taken to have an average maturity of 1.5 years. Where loans are classified without a specific upper limit, for example, loans stated as having maturity above (>) 10 years, these, for computation purposes, would be considered to have average maturity of 15 years. In all such cases, determined average maturity to be 50% above the lower limit provided. Since duration of all loans/deposits with interim cash flows is always lower than maturity, the standard approach is used of using a scale factor. We use a factor of 0.80, which means that if average maturity of an item is 5 years, than the duration would be 4.0 years (5 x 0.8). Finally, in order to get the Net Worth (NW) risk in BDT, we multiply the % NW risk calculated using the model with Total Assets in the Balance Sheet. In Tables 1 and 2 we use the example of Brac Bank Ltd. to present our process of estimating duration.

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Table 1: Sample Calculation Duration of Liabilities (Financing vs Deposit)

BRACBANK LTD. 1 Assets (Financing) 2010 Maturities Break-Down Up to 1 Month Over 1 Month to 3 Months Over 3 Months to 6 Months Over 6 Months to 1 2 Months Over 1 2 Months to 24 Months Over 24 Months to 36 Months Over 36 Months to 60 Months Over 60 Months to 120 Months Over 120 Months total Yield Rate Assets Amount BDT (000) Proportion 3,907,196 7,576,684 5,207,382 929,282 1,677,937 2,787,873 2,216,682 487,821 2,1 31,108 2 3 3 x 0.8 = 4 1x4 = 5 Duration of the Assets (Yrs)

Estimated Estimated Estimated Avg Maturity Duration Maturity (Yrs) (Yrs) (Months) 2.00 4.50 9.00 1 8.00 30.00 48.00 90.00 180.00 0.1 7 0.38 0.7 5 1.50 2.50 4.00 7.50 1 5.00 0.1 3 0.30 0.60 1.20 2.00 3.20 6.00 1 2.00

0.02 0.03 0.01 0.04 0.1 2 0.16 0.07 0.5 7 1.03

44,851,1 1 500 . total Duration of the Assets (Yrs)

The impact of rate changes on a banks NW is the result of changes in the market values of assets and liabilities. When interest rates change, the market values of assets and liabilities change. The rate of change or sensitivity depends on the asset or liabilitys duration. A banks interest rate risk is indicated by comparing the Page 18 of 20

weighted average duration of assets with the weighted average duration of liabilities. Accordingly, duration gap is below. determined using the four-step process

(i) Determine the duration of each asset and liability item on the balance

sheet on which an interest income/profit is earned or paid by the bank;

(ii) Find the weight (proportion) of each item within its category. For

example, weight of the asset item to total interest earning assets;

(iii) Using the result of steps (i) and (ii), determine the weighted duration

of assets and liabilities;

(iv)

Determine the gap, by subtracting the duration of liabilities from the duration of assets.

Table 2: Sample Calculation Duration of Liabilities (Financing vs Deposit)

1 Liabilities (Deposit) 2010 Maturities Break-Down Up to 1 Month Over 1 Month to 3 Months Over 3 Months to 6 Months Over 6 Months to 1 2 Months Over 1 2 Months to 24 Months Amount PKR (000) 6,914,931.00 5,923,024.00 3,549,645.00 3,373,349.00 1,940,807.00 2 3 3 x 0.8 = 4 1x4 = 5

Proportion Estimated Estimated Estimated Duration of Avg Maturity Maturity Duration the Liabilities (Months) (Yrs) (Yrs) (Y rs) 0.1 7 0.1 4 0.09 0.08 0.05 2.00 4.50 9.00 1 8.00 0.1 7 0.38 0.7 5 1.50 0.1 3 0.30 0.60 1.20 0.02 0.03 0.05 0.06

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Over 24 Months to 36 Months Over 36 Months to 60 Months Over 60 Months to 120 Months Over 120 Months total Yield Rate Liabilities

1,552,577.00 957,502.00 2,1 1 8910.00 , 41,675,264.00

0.04 0.02 0.05

30.00 48.00 90.00

2.50 4.00 7.50

2.00 3.20 6.00 -

0.07 0.07 0.3 1 0.60

total Duration of the Liabilities (Yrs)

The impact of rate changes on the value of assets, liabilities and banks NW can be determined given the Duration Gap. The relationship can be shown as follows:

i
In Value of Assets = % P = -DA x

(1 + i )
i

In Value of Liabilities = % P = -DL x

(1 + i )

The impact on the banks Net Worth can be determined using the following equation;

i
NW = -DGAP x

(1 + i )

DGAP is Duration Gap, where the total amount of interest bearing asset and liabilities are not equal therefore: NW = Change in Net Worth Risk

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