Flashcards in risk management Deck (42)

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1

## 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

countries

2

## volatility of interest rates

###
cash S/T interest rates

increase and so L/T volatility

3

## 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

4

## 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

5

## 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

6

##
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

###
Sensitivity

Value

7

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

###
1. refinancing risk

2. reinvestment risk

8

## (1)refinancing risk

###
- risk that cost of

reborrowing funds > than returns earned on asset

investment. (assets have longer maturity than liabilities)

Example:

• 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%)

9

## (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)

example:

• 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%.

10

## (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

11

##
(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

12

## 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

slope

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

13

## 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

14

## fisher effect to forecasting interest rates

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

by lenders

15

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

###
1. maturity gap analysis

2. duration gap analysis

3. scenario analysis

16

## (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

17

## (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

18

## what are interest rate sensitive assets (RSA)?

###
- those on which a floating rate

is payable; interest rate sensitive liabilities (RSL) similarly defined.

19

## GAP=?

### RSA - RSL

20

## 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

21

## 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

liabilities

22

## duration =

###
average lifetime of an asset or liability found by

calculating weighted average time to receipt of each element of cash flow of security

23

## duration analysis

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

24

## Usefulness of duration

###
- all securities of same duration will increase

(or decrease) in value by same % for any given change in interest

rates.

25

## Duration GAP analysis

###
Involves the percentage decline in the value of a security

approximately equals the change in interest rates times the duration

26

## Duration of a portfolio =

###
weighted duration of each asset or liability in

portfolio

27

## Use of duration

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

28

## 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.

29

## the 2nd way to decrease interest rate risk

###
Restructure asset & debt portfolio so duration of

portfolio matches investment horizon

= DGAP

increase DGAP if negative

Or decrease DGAP if DGAP is positive.

30