MARKET RISK

Prof. b.p.mishra
XIMB
XUB

1
Market Risk is the risk of loss in on and off Balance sheet positions
Arising from movement of market prices.
Financial Intermediaries are affected by movements in
the following MARKETS:
DEBT
EQUITY
FOREIGN EXCHANGE
COMMODITY

2
 VaR

VALUE at RISK (VaR) is defined as the potential loss in value

Over a certain period of time with a specific probability.
The time is usually a day.
A VaR of Rs 1 million at a 95% confidence level means that
The loss in the value of the portfolio over a day is likely to exceed
Rs 1million 5% of the time. It is not the actual loss, but probable loss.

3
 Concept.Yield
Coupon yield: refers to nominal interest payable on a fixed
income security like Government security.
Illustration: Coupon: 8.24% , Face Value: Rs.100
,Market Value: Rs.103.00 , Coupon yield = 8.24/100 =
8.24%
The coupon yield is simply the coupon payment as a
percentage of the face value
Current Yield: Current yield = (Annual coupon rate / purchase
price)*100
Illustration: The current yield for a 10 year 8.24%
coupon bond selling for Rs.103.00 per Rs.100 par
value is calculated below:
Annual coupon interest = 8.24% x Rs.100 = Rs.8.24
Current yield = (8.24/Rs.103)*100 = 8.00% 4
 Concept.Yield
Yield to Maturity : the expected rate of return on a bond if it
is held until its maturity.
Thus YTM is the discount rate which equates the
present value of the future cash flows from a bond to
its current market price. In other words, it is the
internal rate of return (IRR) on the bond.
Illustration: Taking the example of a two a year
security bearing a coupon yield of 8% and a price of
say Rs. 102 per face value of Rs. 100(Current
Yield8/102=7.84%). Semi annual Coupon
102 = 4/(1+r/2)1/2 + 4/(1+r/2)1 + 4/(1+r/2)3/2 + 104/(1+r/2)2
r is the YTM

5
 Concept..Price & Yield
The yield of a bond is inversely related to its price.
The relationship between yield to maturity and coupon rate may
be stated as follows:
When the market price of the instrument is less than the
face value, i.e., the instrument sells at a discount, YTM >
current yield > coupon yield.
When the market price of the instrument is more than its
face value, i.e., the instrument sells at a premium, coupon
yield > current yield > YTM.
When the market price of the bond is equal to its face
value, i.e., the bond sells at par, YTM = current yield =
coupon yield.

6
 Duration

Duration shows the sensitivity of the Bond Price

To change in YTM ( or Interest Rate).

Duration gives Bond price elasticity

in reference to change in YTM.

7
For most practical calculations, the Macaulay duration is calculated
Using the yield to maturity to calculate the

Where:
i indexes the cash flows,
PVi is the present value of the i th cash payment from an asset,
CFi is the cash flow of the i th payment from an asset,
Y is the yield to maturity (continuously compounded) for an asset,
ti is the time in years until the i th payment will be received,
V is the present value of all cash payments from the asset until maturity

8
 Problem-Duration
Calculate Duration of a two Year Bond (Face Value of Rs1000)
paying an annual coupon of 6% and having YTM of 8%.

Ans:-
Year Cash Flow PV of Cash
flow
(Discount rate
8%)
1 60 55.56
2 1060 908.78
Total (V) 964.33

DURATION- 55.556/964.33 X1 + 908.78 / 964.33 X 2 = 1.9424 years 9

 Modified Duration

Modified Duration shows how the Duration of a Bond

Change in response to change in YTM.
It measures the Sensitivity of % change in the Bond price
to change in the Yield.
MD is a more direct measure of price sensitivity of Bond
to interest changes.

10
In contrast to Macaulay duration, modified duration
(sometimes abbreviated MD) is a price sensitivity measure,
defined as the percentage derivative of price with respect to
yield. Modified duration applies when a bond or other asset
is considered as a function of yield. In this case one can
measure the logarithmic derivative with respect to yield:

Thus for fixed payment bonds, when the yield is expressed

continuously compounded, Macaulay duration and modified
duration are equal.

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Where

k is the compounding frequency per year

(1 for annual, 2 for semi-annual, 12 for monthly, 52 for
weekly, etc.),

yk is the yield to maturity for an asset, periodically

compounded

12
 Problem Modified Duration
Compute Duration & M Duration for 6%, 5 Year bond having
a YTM of 9%.Face Value Rs100.The bond Pays interest semi annually.
Period (t) Cash Flow PV of CF Wt tX Wt
0.5 3 2.87 0.033 0.016
1 3 2.75 0.031 0.031
1.5 3 2.63 0.030 0.045
2 3 2.52 0.029 0.057
2.5 3 2.41 0.027 0.068
3 3 2.30 0.026 0.078
3.5 3 2.20 0.025 0.087
4 3 2.11 0.024 0.096
4.5 3 2.02 0.023 0.103
5 103 66.32 0.753 3.763
TOTAL 88.131 DURATION 4.345
M-DURATION = 4.345 /[1 + (9%/2) ] = 4.16 Years 13
 (P+P) P > P (P-P)

P+P
P
Price
P-P

r-r r r+r

Interest Rate 14
 Total Change
DP =
Modified Duration * (Dr)..MDuration Effect

0.50 * (Dr)2 * Convexity ..Convexity Effect

P1 - P0 = - D* P0 r +C*0.5* P0(r)2

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Interest Rate Risk Management

16
 Interest Rate Risk
Interest Rate Risk

The potential loss from unexpected changes in

interest rates which can significantly alter a banks
profitability and market value of equity.
 Interest Rate Risk - Concept
Balance Sheet is a mix of assets and liabilities of
different maturities, rates and volumes with
different repricing dates
Banks are in fact in the business of maturity
transformation
Maturity transformation brings liquidity risk and
interest rate risk (IRR)
IRR refers to potential impact on NII / NIM / MVE
caused by unexpected changes in market interest
rates

18
 IRR - Evolution
The concept evolved when regulatory
prescriptions of interest rates ( 3-6-3
banking) was withdrawn by Fed in October
1979 - Death of S & L Institutions
Deregulation of interest rates unsettled
balance sheet management
Balance Sheet is no more a matched book
Mismatches (in repricing) of assets and
liabilities affects NII / NIM
Protection of NII / NIM and MVE becomes
strategic objective
19
 IRR - Evolution
NII / NIM focus - short term view of interest
rate risk management
MVE focus - long term view of interest rate
risk management

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 IRR - Types
Gap or Mismatch
Basis
Yield curve
Embedded Option
Price
Reinvestment

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Measuring Interest Rate Risk with GAP
Example:
A bank makes a $10,000 five-year loan to a
customer at fixed rate of 8.5%. The bank initially
funds the loan with a one-year $10,000 CD at a
cost of 4.5%. The banks initial spread is 4%.
5 YEAR LOAN 8.5%
1 YEAR CD 4.5%

What is the banks risk?

 Gap or Mismatch Risk
Holding assets and liabilities with different
principal amounts, maturity dates or repricing
/ reset dates (amount, maturity and rate)
Liability Asset Risk
3yr fixed depo 3 month CP A sensitive
5yr float bond 5yr GOI L Sensitive
5yr fixed depo 5yr fixed bond No IRR
Neutral

23
Factors Affecting Net Interest Income: An Example
Consider the following balance sheet:
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 500 8.0% $ 600 4.0%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)

NII = 78.5 - 37.2 = 41.3
NIM = 41.3 / 850 = 4.86%
GAP = 500 - 600 = -100
24
 Examine the impact of the following changes

A 1% increase in the level of all short-term rates?

A 1% decrease in the spread between assets yields
and interest costs such that the rate on RSAs
increases to 8.5% and the rate on RSLs increase to
5.5%?
Changes in the relationship between short-term
asset yields and liability costs
A proportionate doubling in size of the bank?

25
 1% increase in short-term rates
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 500 9.0% $ 600 5.0%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)

NII = 83.5 - 43.2 = 40.3
NIM = 40.3 / 850 = 4.74% With a negative GAP, more
GAP = 500 - 600 = -100 liabilities than assets reprice
higher; hence NII and NIM fall
26
 1% decrease in the spread
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 500 8.5% $ 600 5.5%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

NII = (0.085 x 500 + 0.11 x 350) - (0.055 x 600 + 0.06 x 220)

NII = 81 - 46.2 = 34.8
NIM = 34.8 / 850 = 4.09% NII and NIM fall (rise) with a
GAP = 500 - 600 = -100 decrease (increase) in the
spread.
27 Why the larger change?
Changes in the Slope of the Yield Curve

If liabilities are short-term and assets are

long-term, the spread will
widen as the yield curve increases in slope
narrow when the yield curve decreases in slope
and/or inverts

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 Proportionate doubling in size
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 1,000 8.0% $ 1,200 4.0%
Fixed rate $ 700 11.0% $ 440 6.0%
Non earning $ 300 $ 200
$ 1,840
Equity
$ 160
Total $ 2,000 $ 2,000

NII = (0.08 x 1000 + 0.11 x 700) - (0.04 x 1200 + 0.06 x 440)

NII = 157 - 74.4 = 82.6
NIM = 82.6 / 1700 = 4.86% NII and GAP double, but NIM
GAP = 1000 - 1200 = -200 stays the same.
What has happened to risk?
29
 Changes in the Volume of Earning Assets and
Interest-Bearing Liabilities

Net interest income varies directly with

changes in the volume of earning assets and
interest-bearing liabilities, regardless of the
level of interest rates

30
RSAs increase to $540 while fixed-rate assets decrease
to $310 and RSLs decrease to $560 while fixed-rate
liabilities increase to $260
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 540 8.0% $ 560 4.0%
Fixed rate $ 310 11.0% $ 260 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

NII = (0.08 x 540 + 0.11 x 310) - (0.04 x 560 + 0.06 x 260)

NII = 77.3 - 38 = 39.3
Although the banks GAP
NIM = 39.3 / 850 = 4.62%
GAP = 540 - 560 = -20
(and hence risk) is lower,
NII is also lower. 31
 Changes in Portfolio Composition and Risk

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 longer-term CDs and fewer fed
funds purchased)
Changes in portfolio composition also raise or
lower interest income and expense based on
the type of change

32
Changes in Net Interest Income are directly
proportional to the size of the GAP

If there is a parallel shift in the yield curve:

NII exp GAP iexp

It is rare, however, when the yield curve shifts
parallel
If rates do not change by the same amount and at
the same time, then net interest income may
change by more or less.
33
 Basis Risk
Interest rates on assets and liabilities do
not change in the same proportion
When Repo Rate was raised by 1%, Base
rate was raised by 1.5% and deposit rates
by 0.5%
Interest rates movement is based on
market perception of risk and also market
imperfections
Therefore, basis risk arises when interest
rates of different assets and liabilities
change in different magnitudes 34
 Basis Risk - Example (Rs in crore)
Liabilities Assets
Call money 50 Treasury Bills 30
Repo 50 Advances 120
Deposits 100
Total 200 150
Negative gap 50
What will happen if interest rate rises by 1% ?
Loss 0.5 crore
35
 Basis Risk - Example
Interest rates on assets and liabilities do not
change in same proportion
Call ( 50 ) goes up by 5% = (2.5)
Repo ( 50 ) goes up by 3% = (1.5)
Deposit ( 100 ) rate goes up by 4% = (4.0)
TB (30) yield goes up by 2% = 0.6
Base rate for advances (120) goes up by 2% =2.4
Loss = (2.4 + 0.6 ) - (2.5 + 1.5 + 4.0) = - 5 crore

36
 Yield Curve Risk
Even if interest rates on liabilities and
assets are of floating nature, there is
danger of Interest Rate Risk
How ?
If the floating rates are based on different
benchmarks for assets and liabilities
Bank prices its liabilities linked to 100 bp
above 91-day TBs and assets to 300 bp
above 364-day TBs
37
 Yield Curve Risk - Example

Yield on 91-day TBs 364-day TBs Spread

April 2015 8.75% 10.07% (1.32%)
June 2015 9.24% 10.32% (1.08%)
Aug. 2015 9.46% 10.28% (0.82%)
Nov 2015 9.16% 9.93% (0.77%)
Yield curves seldom shift parallel across all
maturities
Banks NII becomes volatile
38
 Embedded Option Risk
Pre-payment of loans in a falling interest rate
scenario ( for contracting new loan at low rate )
Premature withdrawal of deposits in rising
interest rate scenario ( for reinvestment at
higher rate )
In either case, bank will receive lower than
anticipated NII

39
 Interest Rate Risk:
Price Risk

If interest rates change, the market values of

assets and liabilities also change.
The longer is duration, the larger is the change in
value for a given change in interest rates.
Duration GAP considers the impact of
changing rates on the market value of equity.
 Price Risk
Price risk occurs when fixed income assets are
sold before maturity if YTM has increased
Bond prices and interest rates are inversely
related

41
 Interest Rate Risk:
Spread (Reinvestment Rate) Risk
If interest rates change, the bank will have to
reinvest the cash flows from assets or
refinance rolled-over liabilities at a different
interest rate in the future.
An increase in rates, ceteris paribus,
increases a banks interest income but also
increases the banks interest expense.
.
 Reinvestment Risk
Uncertainty with regard to interest rate at
which future cash flows can be invested is
called reinvestment risk
If interest rate declines, reinvestment at lower
rate
YTM assumes reinvestment at bonds at YTM
rate

43
Gap Analysis - Measurement of IRR
Measures mismatches ( gaps ) between rate
sensitive assets and rate sensitive liabilities
over different time intervals
Data needed
Balance sheet -on & off on a particular day
Business plan & expected income/ exp. ignored
Static vs Dynamic

44
 Steps
Determine number and length of time buckets
Whether an asset or liability is sensitive to interest rate
changes ?
If no, Non-sensitive asset or liability
If yes, When ?
The earlier of the following:
It matures
Represent interim / partial principal payment
Rates change contractually with a base rate - floating
rates
RBI changes policy rates
45
 Steps
Considerations for slotting different items
Repricing maturity or contractual maturity ?
Remaining maturity or original maturity ?
Interim cash flows or principal amount ?
Off-balance sheet items
Multi-currency balance sheet

46
 Gap Report
RSA> RSL= POSITIVE GAP
RSL> RSA= NEGATIVE GAP
RSA=RSL= NEUTRAL GAP
Compute
individual gaps for different time buckets and
cumulative gaps

47
 Gaps - A Comparison
Name Positive Gap Negative Gap
Sensitivity Asset Liability
Repricing A before L L before A
Position STA with LT L LTA with ST L
Effect of IR Rise NII rise NII fall
Effect of IR Fall NII fall NII rise

48
 IRR - Management
Prudential limits as a percentage of :
Total Assets
Earning Assets
Equity

49
IRR Management - Falling Interest Rate
Scenario
Increase maturities of fixed rate investment
portfolio
Increase fixed rate loans
Increase short-term deposits / borrowings
(reduce maturity of liability)
Increase floating rate deposits

50
IRR Management - Rising Interest Rate
Scenario
Reduce investment portfolio maturities
Increase floating rate / short-term assets
Increase long-term deposits / borrowings
Sell fixed rate assets

51
 IRR - Management - On Balance
Sheet
Introduction of fixed rate project lending -
Monetary & Credit Policy, April 1999
Introduction of tenor linked PLR - Monetary &
Credit Policy, April 1999
Measurement and management of IRR
becomes difficult in the absence of definite
reset dates of floating PLR

52
IRR - Management - Off Balance Sheet
If not possible on Balance Sheet, manage off
Balance Sheet through interest rate
derivatives like FRAs and IRSs
RBI to create conducive environment for
introduction of IRSs & FRAs - Governors
Credit Policy announcement in October 1998
& April 1999

53
 Measuring Interest Rate Risk with
the GAP Ratio

GAP Ratio = RSAs/RSLs

A GAP ratio greater than 1 indicates a
positive GAP
A GAP ratio less than 1 indicates a negative
GAP
 What is the Optimal GAP
There is no general optimal value for a bank's
GAP in all environments.
Generally, the farther a bank's GAP is from
zero, the greater is the bank's risk.
A bank must evaluate its overall risk and
return profile and objectives to determine its
optimal GAP
 Criticism of Gap Model

Basically a balance sheet concept and

captures only principal assets and liabilities
- revenue flows ignored
Static analysis and business growth totally
ignored
Assumes parallel shift in yield curve
Ignores time value of money
Emphasis on short-term and NII
56
 Criticism of Gap Model
Ignores the sensitivity of non-paying assets &
liabilities
Overlooks mismatches within the bucket
Forecasting of interest rates- difficult but
essential
Ignores basis risk
Behavioural aspects ignored
Therefore prepare adjusted gap
57
 IRR - Other Measurements
Maturity Gap Analysis - measures interest rate
sensitivity of earnings or NII
Duration Gap Analysis - measures interest rate
sensitivity of Equity
Simulation
Value at Risk

58
 Duration Gap Analysis
Duration essentially measures the time
period at which a bond becomes sensitive
to interest rate risk
It takes into account the present value of
the cashflows of a bond and their
reinvestments to compute a weighted
average life of a bond
Though duration is a property of a bond, it
can be extended to all items of assets and
liabilities in a banks balance sheet
59
 SHALL WE MOVE ON TO DURATION GAP
METHOD?

60
 Duration Gap Analysis
Duration of a coupon bond is < its maturity
Duration of a zero-coupon bond equals its
maturity
Duration of a floating rate bond is its
repricing maturity
Duration is additive
Modified Duration = Duration/(1+i)
measures interest rate sensitivity of a bond
- For 1% change in interest rate bond price
changes by modified duration percentage
61
 Duration Gap Analysis
Compute duration of individual items of
assets and liabilities
Duration of a portfolio of similar items of
assets and liabilities is the weighted
duration of all assets and liabilities in that
portfolio
Duration of all items of assets and liabilities
in the balance sheet is the weighted
duration of all assets and liabilities
62
 Duration Gap Analysis
Duration Gap (DG) = DA - (L/A)*DL
/\ E/TA = - DG * {Delta i/(1+i)}
Find /\ E
Duration of Equity={(DA*A - DL*L)/A-L}
Modified Duration of Equity = DE/(1+i)
For 1% change in interest rate, equity value
of bank will change by modified duration
percentage

63
 Strengths of Duration Gap Analysis
Takes into account time value of money
Computes impact of rate change on value
of equity as opposed to NII under
traditional Gap analysis - Long term outlook
Considers all cashflows - traditional Gap
analysis considers only principal amount of
assets and liabilities and not interest
income and expenses in future
A single measure or number of risk
64
 Weaknesses of Duration Gap
Analysis
Difficult concept and complex ?
Duration drift - due to passage of time and
changing rates
Data intensive
cashflows
yield for each item of asset and liability
Assumptions
parallel shift in yield curve
small and instantaneous change in yield
65
 Simulation
Gap analysis and Duration Gap ignores
dynamic nature of balance sheet
These methods assume that interest rate is
the only variable

66
 Simulation
Simulate performance under alternative
interest rate scenarios and assess the
resulting volatility in NII / NIM / ROA / ROE
/ MVE
A financial model incorporating inter-
relationship of assets, liabilities, prices,
costs, volume, mix and other business
related variables
Computer generated scenarios about
future and response to that in a dynamic
way
67
 Earnings Sensitivity Analysis
Earnings-at-Risk
The potential variation in net interest income across
different interest rate environments, given different
assumptions about balance sheet composition, when
embedded options will be exercised, and the timing of
repricings.
Demonstrates the potential volatility in earnings
across these environments
The greater is the potential variation in earnings
(earnings at risk), the greater is the amount of risk
assumed by a bank , or
The greater is the maximum loss, the greater is risk
 Income Statement GAP
Income Statement GAP
Forecasts the change in net interest income given
a 1% rise or fall in the banks benchmark rate
over the next year.
It converts contractual GAP data to figures
evidencing the impact of a 1% rate movement.
Income statement GAP is also know in the
industry as Beta GAP analysis
 Income Statement GAP Adjusts the
Balance Sheet GAP to Incorporate the
Earnings Change Ratio

The Earnings Change Ratio

This ratio indicates how the yield on each asset
and rate paid on each liability is assumed to
change relative to a 1 percent move in the
benchmark rate.
Managing the GAP and Earnings Sensitivity Risk
Steps to reduce risk
Calculate periodic GAPs over short time intervals.
Fund repriceable assets with matching
repriceable liabilities so that periodic GAPs
approach zero.
Fund long-term assets with matching
noninterest-bearing liabilities.
Use off-balance sheet transactions to hedge.
thanks

72