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Flashcards in risk management Deck (42)
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the floating exchange rates

increased volatility due to
• fluctuation in commodity prices
• stresses in global financial system
• large & ongoing current account deficits run by some


volatility of interest rates

cash S/T interest rates
increase and so L/T volatility


what does ALCO stand for?

(large banks) asset and liability
management committee (ALCO) i.e. risk management
committee - to identify operational & financial risk
exposures & analyse the impacts


define risk

the chance that actual outcome will differ from
expected outcome.

It equals uncertainty (usually of a loss).
Risk is assumed to arise out of variability


what risks do modern FIs face?

• Credit (default) risk
• Interest rate risk
• Liquidity risk
• Off-balance sheet risks
• Foreign exchange risk
• Operational/technology risk
• Country/sovereign risk


Interest Rate Risk For depository FIs

_______ of future cash flows & _____ of assets or liabilities-(for
borrower their liabilities, or lender their investments) to uncertain
changes in interest rates



(1)What are the two important aspects of interest rate risk?

1. refinancing risk
2. reinvestment risk


(1)refinancing risk

- risk that cost of
reborrowing funds > than returns earned on asset
investment. (assets have longer maturity than liabilities)

• if interest rates stay the same, FI can refinance its liabilities at
9% & lock in profit of 1%.
• if interest rates increase & FI can only borrow new 1 yr liabilities at
11%, then spread is negative (-1%)


(1)reinvestment risk

- the risk that the returns
on the funds to be reinvested will fall below the cost of the
funds. (Liabilities have longer maturity than assets)

• FI still locks in one-year profit of 1%.
At the end of first year, asset matures & funds have to be
reinvested. If interest rates decrease so that return on assets is 8%,
then FI faces a loss in second year of 1%.


(2)what is price risk?

it is Rising interest rates increase discount rates on future cash flows
& the price (market value) of that asset or liability decreases

-So FIs face price risk on their assets & any securities it holds


(2) FIs with assets that are _____ ______,
mismatching maturities by holding _______ assets than
liabilities means that when interest rates _____, the market value of the FI’s assets fall by a greater amount than its liabilities

1. Debt instruments
2. Longer-term
3. increase


relationship between interest rates & business cycle

Expansion phase:
all rates tend to rise BUT short-term rates tend to be more volatile than long-term & rise more quickly than long-term rates
peak & early stages of recession:
yield curve has negative

Once economy in recession:

all rates decrease BUT short-term tend to
fall more quickly than long-term
At some point in recession, yield curves have positive slope

trough & through
.process begins again


money supply approach to forecasting interest rates

– If projected money supply growth greater than projected GDP
income, then interest rates likely to fall
– If projected money supply growth less than projected GDP
income, then interest rates likely to rise


fisher effect to forecasting interest rates

- argument that observed changes in nominal interest rates will reflect changes in rate of inflation expected
by lenders


(3) what are the 3 methods to measuring interest rate risk?

1. maturity gap analysis
2. duration gap analysis
3. scenario analysis


(3) scenario analysis

-simulate how much net income changes when rate increase or decrease & use regression technique.

- Also can model impact on balance sheet through changes
in value of assets & liabilities


(3) GAP analysis (for identifying risk for net interest income)

-Identification of assets (loans) & liabilities (deposits) that are
sensitive to interest rate movements within defined planning period


what are interest rate sensitive assets (RSA)?

- those on which a floating rate
is payable; interest rate sensitive liabilities (RSL) similarly defined.





if banks expect rates to increase what should it do in relation to GAP?

it should have a positive gap & hold rate-sensitive assets in order
to take advantage of future rate increases & hold fixed-rate
liabilities to lock in current low rates


if banks expect rates to decrease what should it do in relation to GAP?

it should have a negative gap & hold fixed-rate assets to lock in high rates & rate-sensitive


duration =

average lifetime of an asset or liability found by
calculating weighted average time to receipt of each element of cash flow of security


duration analysis

Provides single measure of risk by applying to balance sheet & offers way to find effect of interest rate risk.


Usefulness of duration

- all securities of same duration will increase
(or decrease) in value by same % for any given change in interest


Duration GAP analysis

Involves the percentage decline in the value of a security
approximately equals the change in interest rates times the duration


Duration of a portfolio =

weighted duration of each asset or liability in


Use of duration

Managers try to immunise the portfolio by cancelling out reinvestment rate risk & price risk.


the easy way (1st) to cancel out reinvestment rate risk & price risk and decrease interest rate risk

invest in zero-coupon bonds.

No price risk if held to maturity & no reinvestment risk for coupons.


the 2nd way to decrease interest rate risk

Restructure asset & debt portfolio so duration of
portfolio matches investment horizon

increase DGAP if negative
Or decrease DGAP if DGAP is positive.


Gap analysis & management

Internal procedures for managing interest rate risk involve altering
the maturity spectrum of the assets & liabilities.