Risk Management

INTEREST RATE RISK

Dr. Ika Pratiwi Simbolon

THE LEVEL AND MOVEMENT OF
INTEREST RATES
Loanable funds theory
The Management of Net Interest Income
A key risk management activity for a bank is
the management of net interest income.

The net interest income is the excess of

interest received over interest paid.

It is the role of the asset-liability management

function within the bank to ensure that the net
interest margin, which is net interest income
divided by income-producing assets, remains
roughly constant through time.
Consider a simple situation where a bank offers consumers
a one-year and a five-year deposit rate as well as a one-
year and five-year mortgage rate.

The rates are shown in table:

Maturity Deposit Mortgage

(yrs) Rate Rate
1 3% 6%
5 3% 6%
Management of Net Interest Income

Suppose that the markets best guess is that future short term
rates will equal todays rates

What would happen if a bank posted the following rates?

Maturity (yrs) Deposit Rate Mortgage
Rate
1 3% 6%
5 3% 6%

How can the bank manage its risks?

Would you choose to deposit your money for one year at 3%
per annum or for five years at 3% per annum?

The chances are that you would choose one year because
this gives you more financial flexibility. It ties up your funds
for a shorter period of time.

Now suppose that you want a mortgage. Would you choose a

one year mortgage at 6% or a five year mortgage at 6%?

The chances are that you would choose a five-year mortgage

because it fixes your borrowing rate for the next five years
and subjects you to less refinancing risk.
 This creates an asset/liability
mismatch for the bank and subjects
its net interest income to risks.

If interest rates rise, the deposits

that are financing the 6% mortgages
will cost more than 3% and net
interest income will decline.
 Most banks have
asset-liability
management groups
to manage interest rate
risk
In our example, the matching can be achieved by
increasing the five-year rate on both deposits and
mortgages.

Maturity (yrs) Deposit Rate Mortgage Rate

1 3% 6%

5 4% 7%
This would make five-year deposits relatively more attractive and
one-year mortgages relatively more attractive. This may lead to
the maturities of assets and liabilities being matched.

If there is still an imbalance with depositors tending to choose a

one-year maturity and borrowers a five-year maturity, five-year
deposit and mortgage rates could be increased even further.
Eventually the imbalance will dissapear.

The net result of all banks behaving in the way we have just
described is that long-term rates tend to be higher than those
predicted by expected future short-term rates. This phenomenon
is referred to as liquidity preference theory, that leads to long-
term rates to be higher than short-term rates.
Most banks have asset-liability management
groups to manage interest rate risk.

Many banks now have sophisticated systems for

monitoring the decisions being made by customers
so that, when they detect small differences
between the maturities of the assets and liabilities
being chosen, they can fine-tune the rates they
offer.
LIBOR Rates
LIBOR is short for London Interbank Offered Rate.

LIBOR rates are 1-, 3-, 6-, and 12-month

borrowing rates for companies that have a AA-
rating.

The floating rate in most interest rate swap

agreements is the London Interbank Offered Rate
(LIBOR). It is the rate of interest at which a bank is
prepared to deposit money with other banks that
have a AA credit rating.
LIBOR rates are 1-, 3-, 6-, and 12-month
borrowing rates for companies that have a
AA-rating.

Just as prime is often the reference rate of

interest for floating-rate loans in the
domestic financial market, LIBOR is a
reference rate of interest for loans in
international financial markets.
Swap Rates
Swap Rates are the fixed rates exchanged for floating in an
interest rate swap agreement.

The most common type of swap is an interest rate swap.

In this swap a company agrees to pay cash flows equal to

interest at a predetermined fixed rate on a notional principal
for a predetermined number of years.

In return, it receives interest at a floating rate on the same

notional principal for the same period of time.
MECHANISM OF INTEREST RATE SWAP
Swap: an agreement between the two companies to
exchange cash flows in the future.

Approval define the date when the cash flows are paid and
the ways in which those cash flows are calculated.

The most common type of swap is an interest rate swap.

A company agreed to pay the cash flows equal to interest

at a fixed rate on a predetermined principal for several
years.
Instead, these companies receive interest at a floating rate
on the same principal during the same time period.

Interest rate swap: the exchange between floating rate and

fixed interest rate on a certain principal installment.

The floating rate used is always LIBOR.

LIBOR: the interest rate offered by banks on deposits of

other banks in the Eurocurrency markets.
As the main reference interest
floating rate for loans in
domestic financial markets,
LIBOR is also used as the
benchmark interest rate for
loans in the international
financial markets.
 Typical Uses of an Interest Rate Swap

Converting a liability from:

fixed rate to floating rate

floating rate to fixed rate
 Liability
Converting a liability from
floating rate to fixed rate
Eg. Microsoft has arranged to borrow
$100 million at LIBOR plus 10 basis points
(LIBOR + 0.10%)
With a swap, Microsoft:
Pays LIBOR plus 0.1%
Receives LIBOR under the swap agreement
Pays 5% fixed under the swap agreement
Net is that Microsoft pays 5.1%
 Converting a liability from
fixed rate to floating rate
Eg.
Intel has arranged to borrow $100 million at 5.2%
fixed

With a swap, Intel:

Pays 5.2%
Receives 5% under the swap agreement
Pays LIBOR under the swap agreement

Net is that Intel pays LIBOR + 0.2%

An Example of a Plain Vanilla Interest
Rate Swap

An agreement by Microsoft to receive 6-

month LIBOR & pay a fixed rate of 5%
per annum every 6 months for 3 years
on a notional principal of $100 million

Next slide illustrates cash flows

Cash Flows to Microsoft

---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar.1, 1998 4.2%
Sept. 1, 1998 4.8% +2.10 2.50 0.40
Mar.1, 1999 5.3% +2.40 2.50 0.10
Sept. 1, 1999 5.5% +2.65 2.50 +0.15
Mar.1, 2000 5.6% +2.75 2.50 +0.25
Sept. 1, 2000 5.9% +2.80 2.50 +0.30
Mar.1, 2001 6.4% +2.95 2.50 +0.45
Valuation of an Interest Rate Swap

Interest rate swaps can be valued as the

difference between the value of a fixed-rate
bond and the value of a floating-rate bond.

Fixed Receive: Vswap = Vfixed Vfloating

Fixed Pay: Vswap = Vfloating - Vfixed
Example 1

On January 1, 2006, Jacobs Company

borrowed $ 200,000 from the State Bank. The
loan term of three years with a variable interest
rate and must be paid annually.

The interest rate for the first year is set 9%.

Interest rates for subsequent years based on
the interest rate of LIBOR + 2%, set the end of
each year to be paid in the following year.
Because Jacobs Company does not want to bear
the risk of interest rate hikes in the future, the
company decided to protect themselves (hedging)
of such risks.

On January 1, 2006, Jacobs entered into an

agreement of pay-fixed, receive variable interest
rate swap with Watson for the last two interest
payments. Jacobs agreed to pay the rate specified
interest 9% to Watson and will instead receive
LIBOR + 2%.
On December 31, 2006 LIBOR interest
rate of 4%, LIBOR + 2% equal to 6%.

Jacobs has agreed to pay a fixed rate of

9%, so Watson benefit from a variable
interest rate that is lower and accept the
difference 3%, while 6% will be paid to the
State Bank Jacobs.
On December 31, 2007, LIBOR interest rate
of 8%, LIBOR + 2% is equal to 10%. Jacobs
will pay the State Bank 10%, but will also
receive 1% from Watson, so that the net
interest paid remained 9%.

In other words, hedging activities undertaken

by Jacobs is intended to stabilize the cash
flows related to loans to the State Bank.
Example 2
PT X borrowed Rp. 100 Million to Bank B with a floating interest rate
(LIBOR + 1) per year.

To anticipate any change in interest rates in the future, PT X had

interest rate swap contracts with a fixed interest rate of 7% to Bank B.

When LIBOR at 7%, then the floating interest rate to 7% + 1% = 8%.

PT X still pays an interest rate of 7%, thus there is a gain of 8% - 7% =

1%.

When LIBOR interest rate to 5%, then the floating interest rate to 5% +
1% = 6%, thus PT X suffered losses of 7% - 6% = 1%.
Bond
The bonds are long-term debt issued by companies or
governments

Party that issued bonds: has debt

Party buying: investor

Terms to know:
Parvalue: Nominal value of bonds (the amount of money
owed the company will be repaid at maturity the future)
Maturity date: The maturity date of the bond, date of the
bonds repaid by the company
 When a corporation or
government wishes to borrow
money from the public on a
long-term basis, it usually does
so by issuing or selling debt
securities that are generically
called bonds.
WHY BOND?

BANKS DEBT
SAVINGS/ Credit/
DEPOSIT BANKS DEBT
Investor/ Company/
BANK
Savers Borrower
i = 13% i = 20%

OBLIGASI

BOND
Investor/ Company/
Savers Borrower
i = 17%
Duration
Duration is the weighted-average time to maturity on
the loan using the relative present values of the cash
flows as weights.

On a time value of money basis, duration measures

the period of time required to recover the initial
investment on the loan.

Any cash flows received prior to the loans duration

reflect recovery of the initial investment, while cash
flows received after the period of the loans duration
and before its maturity are the profits, or return
 In order to measure interest-rate risk, the
manager of a financial institution needs
more precise information on the actual
capital gain or loss that occurs when the
interest rate changes by a certain amount.

To do this, the manager needs to make use

of the concept of duration, the average
lifetime of a debt securitys stream of
payments.
The Duration of Interest-Bearing Bonds
A ten-year 10% coupon bond with a face value of $1,000
has cash payments :
Calculating Duration on a $1,000 Ten-Year 10% Coupon
Bond When Its Interest Rate Is 10%
You can calculate the duration (or Macauleys
duration) for any fixed-income security that pays
interest annually using the following general
formula.
The duration calculation done in Table can be
written as follows:
Please calculate duration on
a $1,000 ten-year 10%
coupon bond when its
interest rate is 20%
Duration on a $1,000 Ten-Year 10% Coupon Bond When
Its Interest Rate Is 20%
 Conclusion:
All else being equal, when interest
rates rise, the duration of a coupon
bond falls.
The Duration of a Zero-Coupon Bond
Because there are no intervening cash flows such
as coupons between issue and maturity, the
following must be true:

DB = MB

That is, the duration of a zero-coupon bond equals

its maturity. Note that only for zero-coupon bonds
are duration and maturity equal.
The Duration of a Consol Bond
(Perpetuities)
A consol bond pays a fixed coupon each year. The novel
feature of this bond is that it never matures; that is, it is a
perpetuity:

Mc =

The formula for the duration of a consol bond is:

where R is the required yield to maturity. Suppose that the
yield curve implies R = 5 percent annually; then the
duration of the consol bond would be:

After 21 years, the bond produces profit for the bondholder.

Moreover, as interest rates rise, the duration of the consol

bond falls. When some yields rose to around 20 percent on
long-term government bonds. Then:
Duration of Portfolio
Duration is important to bond portfolio
managers.

The duration of a portfolio is the

weighted average duration of all the
bonds in the portfolio weighted by
their dollar values.

(w1xD1)+ (w2xD2)+ (wnxDn)

A manager of a financial institution is holding 25% of a
portfolio in a bond with a five-year duration and 75% in a
bond with a ten-year duration. What is the duration of the
portfolio?

The duration of a portfolio of securities is the weighted

average of the durations of the individual securities, with
the weights reflecting the proportion of the portfolio
invested in each.

This fact about duration is often referred to as the additive

property of duration, and it is extremely useful, because it
means that the duration of a portfolio of securities is easy
to calculate from the durations of the individual securities
Solution

The duration of the portfolio is 8.75 years.

=(0.25x5) + (0.75x10)
= 1.25 + 7.5
= 8.75 years
Duration and Interest-Rate Risk
Now that we understand how duration is calculated, we
want to see how it can be used by managers of financial
institutions to measure interest-rate risk.

Duration is a particularly useful concept, because it

provides a good approximation, particularly when interest-
rate changes are small, for how much the security price
changes for a given change in interest rates, as the
following formula indicates
A pension fund manager is holding a ten-year 10% coupon
bond in the funds portfolio and the interest rate is currently
10%.

What loss would the fund be exposed to if the interest rate

rises to 11% tomorrow?

Solution
The approximate percentage change in the price of the
bond is 6.15%. The duration of a ten-year 10% coupon
bond is 6.76 years.
Now the pension manager has the option to
hold a ten-year coupon bond with a coupon
rate of 20% instead of 10%.

As mentioned earlier, the duration for this

20% coupon bond is 5.98 years when the
interest rate is 10%.

Find the approximate change in the bond

price when the interest rate increases from
10% to 11%
Solution

This time the approximate change in

bond price is 5.4%. This change in
bond price is much smaller than for the
higher-duration coupon bond:
The relationship of duration and interest-rate
risk:

The greater the duration of a security, the

greater the percentage change in the market
value of the security for a given change in
interest rates.

Therefore, the greater the duration of a

security, the greater its interest-rate risk.
MODIFIED DURATION

To calculate the percentage change in bond prices due to

changes in certain interest rate, then we could use a
duration that has been modified in the following ways:

Modified Duration D D (1 i)

D* = modified duration
i = interest rate

The duration is 3.797 and interest rate of 16%, then the

modified duration is
The duration is 3.797 and interest rate of
16%, then the modified duration is 3.273.

Means:
For every 1 percent change in market interest
rates,
the market value of the bond will move inversely
by 3.273 percent.
 Fight

Thank you fellas

God bless, Good Luck and with love,

Dr. Ika Pratiwi Simbolon