Chapter- 08

Interest rate risk 1

3. What is the repricing gap? In using this model to evaluate interest rate risk, what is
meant by rate sensitivity? On what financial performance variable does the repricing
model focus? Explain.
The repricing gap is a measure of the difference between the dollar value of assets that will
reprice and the dollar value of liabilities that will reprice within a specific time period, where
repricing can be the result of a roll-over of an asset or liability (e.g., a loan is paid off at or prior
to maturity and the funds are used to issue a new loan at current market rates) or because the
asset or liability is a variable rate instrument (e.g., a variable rate mortgage whose interest rate is
reset every quarter based on movements in a prime rate). Rate sensitivity represents the time
interval where repricing can occur. The model focuses on the potential changes in the net interest
income variable. In effect, if interest rates change, interest income and interest expense will
change as the various assets and liabilities are repriced, that is, receive new interest rates.
4. What is a maturity bucket in the repricing model? Why is the length of time selected for
repricing assets and liabilities important when using the repricing model?
The maturity bucket is the time window over which the dollar amounts of assets and liabilities are
measured. The length of the repricing period determines which of the securities in a portfolio are rate-
sensitive. The longer the repricing period, the more securities either mature or will be repriced, and,
therefore, the more the interest rate risk exposure. An excessively short repricing period omits
consideration of the interest rate risk exposure of assets and liabilities are that repriced in the period
immediately following the end of the repricing period. That is, it understates the rate sensitivity of the
balance sheet. An excessively long repricing period includes many securities that are repriced at different
times within the repricing period, thereby overstating the rate sensitivity of the balance sheet.

5. What is the CGAP effect? According to the CGAP effect, what is the relation between
changes in interest rates and changes in net interest income when CGAP is positive? When
CGAP is negative?
The CGAP effect describes the relation between changes in interest rates and changes in net
interest income. According to the CGAP effect, when CGAP is positive the change in NII is
positively related to the change in interest rates. Thus, an FI would want its CGAP to be positive
when interest rates are expected to rise. According to the CGAP effect, when CGAP is negative
the change in NII is negatively related to the change in interest rates. Thus, an FI would want its
CGAP to be negative when interest rates are expected to fall.
7. If a bank manager was quite certain that interest rates were going to rise within the next
six months, how should the bank manager adjust the bank’s six-month repricing gap to
take advantage of this anticipated rise? What if the manger believed rates would fall in the
next six months?
When interest rates are expected to rise, a bank should set its repricing gap to a positive
position. In this case, as rates rise, interest income will rise by more than interest expense. The
result is an increase in net interest income. When interest rates are expected to fall, a bank should
set its repricing gap to a negative position. In this case, as rates fall, interest income will fall by
less than interest expense. The result is an increase in net interest income.
10. What are the reasons for not including demand deposits as rate-sensitive liabilities in
the repricing analysis for a commercial bank? What is the subtle but potentially strong
reason for including demand deposits in the total of rate sensitive liabilities? Can the same
argument be made for passbook savings accounts?
The regulatory rate available on demand deposit accounts is zero. Although many banks are able
to offer NOW accounts on which interest can be paid, this interest rate seldom is changed and
thus the accounts are not really interest rate sensitive. However, demand deposit accounts do pay
implicit interest in the form of not charging fully for checking and other services. Further, when
market interest rates rise, customers draw down their demand deposit accounts, which may cause
the bank to use higher cost sources of funds. The same or similar arguments can be made for
passbook savings accounts.
13. What is the spread effect?
The spread effect is the effect that a change in the spread between rates on RSAs and RSLs has
on net interest income as interest rates change. The spread effect is such that, regardless of the
direction of the change in interest rates, a positive relation exists between changes in the spread
and changes in NII. Whenever the spread increases (decreases), NII increases (decreases).
After the unequal rate increases, net interest income will be 50(0.12) + 50(0.07) – 70(0.07) –
20(0.07) = $9.5m - $6.3m = $3.2m, an increase of $0.3m. It is not uncommon for interest rates to
adjust in an unequal manner on RSAs versus RSLs. Interest rates often do not adjust solely
because of market pressures. In many cases, the changes are affected by decisions of
management. Thus, you can see the difference between this answer and the answer for part a.

a. What is the repricing gap if the planning period is 30 days? 3 months? 2 years? Recall
that cash is a non-interest-earning asset.
Repricing gap using a 30-day planning period = $75m - $170m = -$95 million.
Repricing gap using a 3-month planning period = ($75m + $75m) - $170m = -$20
million. Reprising gap using a 2-year planning period = ($75m + $75m + $50m + $25m) - $170m = +$55
million
b. What is the impact over the next 30 days on net interest income if interest rates increase
50 basis points? Decrease 75 basis points?
If interest rates increase 50 basis points, net interest income will decrease by $475,000.
∆NII = CGAP(∆R) = -$95m (0.0050) = -$0.475m.
If interest rates decrease by 75 basis points, net interest income will increase by
$712,500. ∆NII = CGAP(∆R) = -$95m (-0.0075) = $0.7125m.
c. The following one-year runoffs are expected: $10 million for two-year business loans
and $20 million for eight-year mortgage loans. What is the one-year repricing gap?
The repricing gap over the 1-year planning period = ($75m. + $75m. + $10m. + $20m. +
$25m.) - $170m. = +$35 million
d. If runoffs are considered, what is the effect on net interest income at year-end if interest
rates increase 50 basis points? Decrease 75 basis points?
If interest rates increase 50 basis points, net interest income will increase by $175,000.
∆NII = CGAP(∆R) = $35m (0.0050) = $0.175m.
If interest rates decrease 75 basis points, net interest income will decrease by $262,500.
∆NII = CGAP(∆R) = $35m (-0.0075) = -$0.2625m.
 a. Calculate the bank’s CGAP and gap ratio.
Repricing GAP = $550,000 - $375,000 = $175,000
Gap ratio = $175,000/$1,570,000 = 11.15%
b. Assuming the bank does not change the composition of its balance sheet, calculate the
resulting change in the bank’s interest income, interest expense, and net interest
income.
∆II = $550,000(0.0045) = $2,475 ∆II= change in interest income
∆IE = $375,000(0.0035) = $1,312.50 ∆IE= change in interest expense
∆NII = $2,475 - $1,312.50 = $1,162.50
c. Explain how the CGAP and spread effects influenced the change in net interest income.
The CGAP affect worked to increase net interest income. That is, the CGAP was
positive while interest rates increased. Thus, interest income increased by more than
interest expense. The result is an increase in NII. The spread effect also worked to
increase net interest income. The spread increased by 10 basis points. According to
the spread affect, as spread increases, so does net interest income.

18.
Suppose interest rates fall such that the average yield on rate-sensitive assets decreases by
15 basis points and the average yield on rate-sensitive liabilities decreases by 5 basis
points.
a. Calculate the bank’s CGAP and gap ratio.
CGAP = $550,000 - $575,000 = -$25,000
Gap ratio = -$25,000/$1,570,000 = -1.59%
b. Assuming the bank does not change the composition of its balance sheet, calculate the
resulting change in the bank’s interest income, interest expense, and net interest
income.
∆II = $550,000(-0.0015) = -$825
∆IE = $575,000(-0.0005) = -$287.50
∆NII = -$825 – (-$287.50) = -$537.50
c. The bank’s CGAP is negative and interest rates decreased, yet net interest income
decreased. Explain how the CGAP and spread effects influenced this decrease in net
interest income.
The CGAP affect worked to increase net interest income. That is, the CGAP was
negative while interest rates decreased. Thus, interest income decreased by less than
interest expense. The result is an increase in NII. The spread effect, on the other hand,
worked to decrease net interest income. The spread decreased by 10 basis points.
According to the spread affect, as spread decreases, so does net interest income. In
this case, the increase in NII due to the CGAP effect was dominated by the decrease
in NII due to the spread effect.
19. The balance sheet of A. G. Fredwards, a government security dealer, is listed below.
Market yields are in parentheses, and amounts are in millions.

a. What is the repricing gap if the planning period is 30 days? 3 months? 2 years?
Repricing gap using a 30-day planning period = $150m - $340m = -$190 million.
Repricing gap using a 3-month planning period = ($150m + $150m) - $340m = -$40 million.
 Repricing gap using a 2-year planning period = ($150m + $150m + $100m + $50m) - $340m
= $110 million.
b. What is the impact over the next three months on net interest income if interest rates
on RSAs increase 50 basis points and on RSLs increase 60 basis points?
∆II = ($150m. + $150m.) (0.005) = $1.5m.
∆IE = $340m. (0.006) = $2.04m.
∆NII = $1.5m. – ($2.04m.) = -$0.54m.
c. What is the impact over the next two years on net interest income if interest rates on
RSAs increase 50 basis points and on RSLs increase 75 basis points?
∆II = ($150m. + $150m. + $100m. + $50m.) (0.005) = $2.25m.
∆IE = $340m. (0.0075) = $2.04m.
∆NII = $2.25m. – ($2.04m.) = $0.21m.
d. Explain the difference in your answers to parts (b) and (c). Why is one answer a
negative change in NII, while the other is positive?
(For the 3-month analysis, the CGAP affect worked to decrease net interest income.
That is, the CGAP was negative while interest rates increased. Thus, interest income
increased by less than interest expense. The result is a decrease in NII). (For the 2-
year analysis, the CGAP affect worked to increase net interest income. That is, the
CGAP was positive while interest rates increased. Thus, interest income increased by
more than interest expense. The result is an increase in NII).

20.

Suppose interest rates rise such that the average yield on rate-sensitive assets
increases by 45 basis points and the average yield on rate-sensitive liabilities
increases by 35 basis points.
a. Calculate the bank’s repricing GAP.
Repricing GAP = $225,000 - $300,000 = -$75,000
b. Assuming the bank does not change the composition of its balance sheet,
calculate the net interest income for the bank before and after the interest rate
changes. What is the resulting change in net interest income?
NIIb = ($225,000(0.0635) +$550,000(0.0755)) – ($300,000(0.0425) +
$505,000(0.0615)) = $55,812.50 - $43,807.50 = $12,005
NIIa = ($225,000(0.0635 + 0.0045) +$550,000(0.0755)) – ($300,000(0.0425
+ 0.0035) + $505,000(0.0615)) = $56,825 - $44,857.50 = $11,967.50
∆NII = $11,967.50 - $12,005 = -$37.50
c. Explain how the CGAP and spread effects influenced this increase in net
interest income.
 The CGAP affect worked to decrease net interest income. That is, the CGAP
was negative while interest rates increased. Thus, interest income increased by
less than interest expense. The result is a decrease in NII. In contrast, the
spread effect worked to increase net interest income. The spread increased by
10 basis points. According to the spread affect, as spread increases, so does
net interest income. However, in this case, the increase in NII due to the
spread effect was dominated by the decrease in NII due to the CGAP effect.
22. What is a maturity gap? How can the maturity model be used to immunize an
FI’s portfolio? What is the critical requirement that allows maturity matching to have
some success in immunizing the balance sheet of an FI?
Maturity gap is the difference between the average maturity of an FI’s assets and
liabilities. If the maturity gap is zero, it is possible to immunize the portfolio so that
changes in interest rates will result in equal but offsetting changes in the value of
assets and liabilities. Thus, if interest rates increase (decrease), the fall (rise) in the
value of the assets will be offset by an identical fall (rise) in the value of the
liabilities. The critical assumption is that the timing of the cash flows on the assets
and liabilities must be the same.

23. Nearby Bank has the following balance sheet (in millions):

What is the maturity gap for Nearby Bank? Is Nearby Bank more exposed to an
increase or decrease in interest rates? Explain why?
MA = [0x$60m + 5x$60m + 30x$200m]/$320m = 19.6875 years,
and ML = [0x$140m + 1x$160m]/$300m = 0.5333 years.
Therefore, the maturity gap = MGAP = 19.6875 – 0.5333 = 19.1542 years.
Nearby Bank is exposed to an increase in interest rates. If rates rise, the
value of assets will decrease by more than the value of liabilities.
24. County Bank has the following market value balance sheet (in millions, all
interest at annual rates). All securities are selling at par equal to book value.
a. What is the maturity gap for County Bank?
MA = [0x$20m + 15x$160m + 30x$300m]/$480m = 23.75 years.
ML = [0x$100m + 5x$210m + 20x$120m]/$430m = 8.02 years.
MGAP = 23.75 – 8.02 = 15.73 years.
b. What will be the maturity gap if the interest rates on all assets and liabilities
increase by 1 percent?
If interest rates increase one percent, the value and average maturity of the
assets will be:
Cash = $20m
Commercial loans = $16m x PVAn=15, i=11% + $160m x PVn=15,i=11%
= $148.49m
Mortgages = $24mxPVAn=30, i=9% + $300mxPVn=30,i=9% = $269.18m
MA = [0x$20m + 15x$148.49m + 30x$269.18m]/($20m + $148.49m +
$269.18m) = 23.54 years
The value and average maturity of the liabilities will be:
Demand deposits = $100m
CDs = $12.60mxPVAn=5,i=7% + $210mxPVn=5,i=7% = $201.39m
Debentures = $8.4mxPVAn=20,i=8% + $120mxPVn=20,i=8% = $108.22m
ML = [0x$100m + 5x$201.39m + 20x$108.22m]/($100m + $201.39m +
$108.22m) = 7.74 years
The maturity gap = MGAP = 23.54 – 7.74 = 15.80 years. The maturity gap
increased because the average maturity of the liabilities decreased more than
the average maturity of the assets. This result occurred primarily because of
the differences in the cash flow streams for the mortgages and the
debentures.
c. What will happen to the market value of the equity?
The market value of the assets has decreased from $480m to $437.67m, or
$42.33m. The market value of the liabilities has decreased from $430m to
$409.61m, or $20.39m. Therefore, the market value of the equity will
decrease by $42.33m - $20.39m = $21.94m, or 43.88 percent.