Bank Financial Management Commercial Banking Company of Australia Limited

Executive summary

The interest rate risk in the banking sector refers to a bank’s exposure to extreme changes and movements in interest rates. Whether current of prospective, the interest rates affect the bank’s capital and assets while also affecting its earnings. The bank therefore has to develop strategies to manage this risk.

This risk is important to the banking industry and therefore if successfully managed it can have an important impact on the institutions profits and on the shareholder value. Excessive interest rate risk can pose a huge threat to a bank’s current capital base and on the future earnings if not managed properly.

The report below shows a detailed analysis of the institution’s current interest rate risk profile currently and also the predicted rates which gives a description of the current position that the institution is in.

The report also analyses and recommends the different strategies that the institution should adopt in order to ensure that it manages the interest rates risks effectively so as to continue making profits and increasing its asset base.

 

 

Table of Contents

Interest Risk. 4

Cash Flow Ladder for the Interest Rates. 4

Variance-covariance method. 7

Question 2. 8

Strategies to manage interest rates and their impact to the banks risk profile. 8

Swaps. 8

The use of interest rate futures to hedge income gap position. 9

The use of option contract 10

  1. d) Why I recommended the strategies. 11

References. 12

 

 

 

Interest Risk

Cash Flow Ladder for the Interest Rates

The tables below show the calculations and the obtained interest rate sensitive assets and liabilities using the indicated time buckets which then are used to represent the cash flow ladder.

Today   DATE YOU WANT  
28-Feb-18 01-Sep-17 28-Feb-18 28-Feb-22
      1.500000                   1.884302                 12.000000
Days -180 0 1461
 6 months      
Today    
28-Feb-18 01-Sep-17 01-Aug-18 28-Feb-22
      1.500000                   2.290346                 12.000000
Days -180 154 1461
1Year

28-Feb-18

01-Sep-17 28-Feb-19 28-Feb-22
      1.500000                   2.992407                 12.000000
Days -180 365 1461

18 Months

28-Feb-18 01-Sep-17 01-Aug-19 28-Feb-22
      1.500000                   3.637234                 12.000000
Days -180 519 1461

24 Months

28-Feb-18 01-Sep-17 28-Feb-20 28-Feb-22
      1.500000                   4.752156                 12.000000
Days -180 730 1461

30Months

28-Feb-18 01-Sep-17 01-Aug-20 28-Feb-22
      1.500000                   5.783513                 12.000000
Days -180 885 1461

3years

28-Feb-18 01-Sep-17 28-Feb-21 28-Feb-22
      1.500000                   7.556334                 12.000000
Days -180 1096 1461

42Months

28-Feb-18 01-Sep-17 01-Aug-21 28-Feb-22
      1.500000                   9.184633                 12.000000
Days -180 1250 1461

4 Years

28-Feb-18 01-Sep-17 28-Feb-22 28-Feb-22
      1.500000                 12.000000                 12.000000
Days -180 1461 1461

 

 

  1. b) I

DEAR means Daily Earnings at Risk represents the estimated potential loss of an institutions value over a particular period of time mainly one day which is mainly a result of the extreme changes in market conditions such as the interest rates.

 II

The Value at Risk also known as VaR analyses usually provide a measure of the risk that a company faces at a particular time. This VaR approach gives an indication of the maximum loss which a company could face if and when the market interest rates change adversely all of a sudden. Thus, VaR means the maximum loss that a company is likely to face within a given time period for a specific probability mainly with 95% probability.

III

I used the below method in my calculation

Variance-covariance method

This is a method that assumes a normal probability distribution of asset price volatility; it then calculates the maximum loss which is usually within the required probability. It also assumes the probability distribution of instruments’ value volatility. Variance-covariance is more often than not regarded as too simplistic for more complex, exotic instruments.

Assumptions

In the above calculations, the relationship assumes that the yield changes are independent which means that those losses which are incurred today are not related at all to those losses that were incurred yesterday or to those that will be incurred tomorrow.

  1. c) Meaning to the institution

The VaR or value at risk model and calculations measures the amount of financial risk that is associated with the total value of a firm. This is not just the interest rate risk associated with its cash flow. The value at risk also shows the amount of maximum potential loss that is within a specified period and with a degree of confidence. This contrary to earnings at risk, value at risk indicates the degree of confidence that a company’s losses will not exceed a certain amount of dollars over a specified period

Question 2

Strategies to manage interest rates and their impact to the banks risk profile

The descriptions below show the strategies that we have developed and come up with that will be used by the institution so as to manage the risks in the changes in the value of the portfolio as a result of the potential future interest rate changes that have been identified in the previous sections of the report.

Whenever the interest rates increase, firms are faced with a more difficult, challenging and potentially critical scenario. They therefore have to be smart and come up with strategies that shall ensure that they are well cushioned from the very likely effects that would occur which can include: high attrition, a reputation being at risk, increased portfolio at risk and reduced market share.

Swaps

Interest rate swaps mainly involve the trading of a variable rate loan structure for which one has a fixed rate or the opposite of it. Interest rate swaps and other hedging strategies are strategies which have for a long time provided a way for companies to help manage the potential impact on their loan portfolios of changes that take place on a daily basis on the rates of interests. An interest rate swap represents is a contract between two involved parties so as to exchange a stream of cash flows according to terms decided prior to that. The transaction involves trading costs which are related to two different types of loans; this mainly involves swapping the terms of a floating rate loan for those of a fixed rate loan or the opposite.

Impact of swaps on the Banks risk profile

They lock in a fixed interest rate, taking advantage of a favorable environment and removing interest rate risk as a consideration. This method also reduces current interest expense by swapping for a floating rate that is lower than the fixed rate currently being paid without having to refinance a loan and pay the associated costs. The bank is also able To effectively match interest rate sensitive assets and liabilities. The institution will also be able to diversify financial risks in a loan portfolio by converting a loan portfolio from all fixed or all variable to a very good mix of the two cases. The institution will also be able to change the interest rate composition of a current loan without facing the expense associated with refunding or issuing new debt.

The use of interest rate futures to hedge income gap position

Generally, there usually is a very close relationship that exists between the interest rates and the net interest margin in a way such that any slight fluctuation or change in the market the interest rate will be affected immediately to the margin. The increasing interest rate will lead to a very high net interest rate while the opposite is also true. It therefore becomes a necessity for the bank to buy one or more treasury bills which will be for future delivery.  In the event of a falling interest rate, the following decrease that occurs in net interest margin will definitely be taken care of by the gain that has occurred in the long hedge in a future market scenario in the negative income gap. Together with the long hedge, there is also use of short hedge in order to reduce the interest Rate risk in the negative dollar gap. As the interest rate rises, there is a likelihood that the unhedged bank will suffer significantly the net decline in its net interest margin. A combination of both the short and long hedge, the bank will benefit from future hedge that can be used in order to compensate for the loss in the net interest margin.

The use of option contract

This is a very common strategy that has been applied and tested in many institutions in the institutions ways of managing the risks associated with interest rate risks and can be applicable in the situation of CBC.

In the positive income gap, the investors and other parties involved or interested can buy call option so as to protect themselves from interest rate risks. From buying that option, the buyers can therefore have that ability to obtain the necessary instruments which is at a specific price. While that takes place, the sellers have to have the willingness to sell these instruments at the same price. If therefore the interest rates fall, the bank can lose a lot of cash. However, the gain from its open option position can help in a huge way to partially if not completely offset that loss that has been incurred before. If there is a rise in the interest rates, the gain in the net income will be only partially compensated by the other option.

Coming back to the negative impact income gap case, the investors can buy interest rate put option in order to deal with that risk. This put option will give those buyers the freedom to sell a certain specific underlying security which will be at the price that has been set prior in the contract and makes the seller to be obliged to buy the underlying security. This will automatically make the buyers to earn some profit from that put option and can use it tom compensate for the interest income loss from the negative dollar gap.

The above strategies if adopted will be of great importance to the bank in its future plans since it will have set ways of managing the risks associated with adverse changes in interest rates.

d) Why I recommended the strategies

I came up with the strategies that I have listed below since they have been used and experimented previously by other banks and found to be successful. They have successfully been used to manage the risk in the change in the value of the portfolio as a result of the potential future interest rate changes that have been identified in the previous sections of the report.

 

 

 

 


 

References

https://privatewealth.usbank.com/insights/managing-interest-rate-risk

Dowd, K., Blake, D. and Cairns, “Long-Term Value at Risk,” The Journal of Risk Finance, Vol. 5, No. 2, 52–57, 2004.

Basel Committee on Banking Supervision, “Interest Rate Risk on the Banking Book,” Basel, June 2015.

Harris, M., “Back testing Your Interest Rate Risk Model,” CFO & Finance Digest, Issue #1, August 2010. Available at http://www.wib.org/publications__resources/cfo__finance_digest/2010–12/augl0/harris.html.

 

 

Interest Risk

Cash Flow Ladder for the Interest Rates

The tables below show the calculations and the obtained interest rate sensitive assets and liabilities using the indicated time buckets which then are used to represent the cash flow ladder.

Today   DATE YOU WANT  
28-Feb-18 01-Sep-17 28-Feb-18 28-Feb-22
      1.500000                   1.884302                 12.000000
Days -180 0 1461
 6 months      
Today    
28-Feb-18 01-Sep-17 01-Aug-18 28-Feb-22
      1.500000                   2.290346                 12.000000
Days -180 154 1461
1Year

28-Feb-18

01-Sep-17 28-Feb-19 28-Feb-22
      1.500000                   2.992407                 12.000000
Days -180 365 1461

18 Months

28-Feb-18 01-Sep-17 01-Aug-19 28-Feb-22
      1.500000                   3.637234                 12.000000
Days -180 519 1461

24 Months

28-Feb-18 01-Sep-17 28-Feb-20 28-Feb-22
      1.500000                   4.752156                 12.000000
Days -180 730 1461

30Months

28-Feb-18 01-Sep-17 01-Aug-20 28-Feb-22
      1.500000                   5.783513                 12.000000
Days -180 885 1461

3years

28-Feb-18 01-Sep-17 28-Feb-21 28-Feb-22
      1.500000                   7.556334                 12.000000
Days -180 1096 1461

42Months

28-Feb-18 01-Sep-17 01-Aug-21 28-Feb-22
      1.500000                   9.184633                 12.000000
Days -180 1250 1461

4 Years

28-Feb-18 01-Sep-17 28-Feb-22 28-Feb-22
      1.500000                 12.000000                 12.000000
Days -180 1461 1461

 

 

  1. b) I

DEAR means Daily Earnings at Risk represents the estimated potential loss of an institutions value over a particular period of time mainly one day which is mainly a result of the extreme changes in market conditions such as the interest rates.

 II

The Value at Risk also known as VaR analyses usually provide a measure of the risk that a company faces at a particular time. This VaR approach gives an indication of the maximum loss which a company could face if and when the market interest rates change adversely all of a sudden. Thus, VaR means the maximum loss that a company is likely to face within a given time period for a specific probability mainly with 95% probability.

III

I used the below method in my calculation

Variance-covariance method

This is a method that assumes a normal probability distribution of asset price volatility; it then calculates the maximum loss which is usually within the required probability. It also assumes the probability distribution of instruments’ value volatility. Variance-covariance is more often than not regarded as too simplistic for more complex, exotic instruments.

Assumptions

In the above calculations, the relationship assumes that the yield changes are independent which means that those losses which are incurred today are not related at all to those losses that were incurred yesterday or to those that will be incurred tomorrow.

  1. c) Meaning to the institution

The VaR or value at risk model and calculations measures the amount of financial risk that is associated with the total value of a firm. This is not just the interest rate risk associated with its cash flow. The value at risk also shows the amount of maximum potential loss that is within a specified period and with a degree of confidence. This contrary to earnings at risk, value at risk indicates the degree of confidence that a company’s losses will not exceed a certain amount of dollars over a specified period

Question 2

Strategies to manage interest rates and their impact to the banks risk profile

The descriptions below show the strategies that we have developed and come up with that will be used by the institution so as to manage the risks in the changes in the value of the portfolio as a result of the potential future interest rate changes that have been identified in the previous sections of the report.

Whenever the interest rates increase, firms are faced with a more difficult, challenging and potentially critical scenario. They, therefore, have to be smart and come up with strategies that shall ensure that they are well cushioned from the very likely effects that would occur which can include: high attrition, a reputation being at risk, increased portfolio at risk and reduced market share.

Swaps

Interest rate swaps mainly involve the trading of a variable rate loan structure for which one has a fixed rate or the opposite of it. Interest rate swaps and other hedging strategies are strategies which have for a long time provided a way for companies to help manage the potential impact on their loan portfolios of changes that take place on a daily basis on the rates of interests. An interest rate swap represents is a contract between two involved parties so as to exchange a stream of cash flows according to terms decided prior to that. The transaction involves trading costs which are related to two different types of loans; this mainly involves swapping the terms of a floating rate loan for those of a fixed rate loan or the opposite.

Impact of swaps on the Banks risk profile

They lock in a fixed interest rate, taking advantage of a favorable environment and removing interest rate risk as a consideration. This method also reduces current interest expense by swapping for a floating rate that is lower than the fixed rate currently being paid without having to refinance a loan and pay the associated costs. The bank is also able To effectively match interest rate sensitive assets and liabilities. The institution will also be able to diversify financial risks in a loan portfolio by converting a loan portfolio from all fixed or all variable to a very good mix of the two cases. The institution will also be able to change the interest rate composition of a current loan without facing the expense associated with refunding or issuing new debt.

The use of interest rate futures to hedge income gap position

Generally, there usually is a very close relationship that exists between the interest rates and the net interest margin in a way such that any slight fluctuation or change in the market the interest rate will be affected immediately to the margin. The increasing interest rate will lead to a very high net interest rate while the opposite is also true. It therefore becomes a necessity for the bank to buy one or more treasury bills which will be for future delivery.  In the event of a falling interest rate, the following decrease that occurs in net interest margin will definitely be taken care of by the gain that has occurred in the long hedge in a future market scenario in the negative income gap. Together with the long hedge, there is also use of short hedge in order to reduce the interest Rate risk in the negative dollar gap. As the interest rate rises, there is a likelihood that the unhedged bank will suffer significantly the net decline in its net interest margin. A combination of both the short and long hedge, the bank will benefit from future hedge that can be used in order to compensate for the loss in the net interest margin.

The use of option contract

This is a very common strategy that has been applied and tested in many institutions in the institutions ways of managing the risks associated with interest rate risks and can be applicable in the situation of CBC.

In the positive income gap, the investors and other parties involved or interested can buy call option so as to protect themselves from interest rate risks. From buying that option, the buyers can therefore have that ability to obtain the necessary instruments which is at a specific price. While that takes place, the sellers have to have the willingness to sell these instruments at the same price. If therefore the interest rates fall, the bank can lose a lot of cash. However, the gain from its open option position can help in a huge way to partially if not completely offset that loss that has been incurred before. If there is a rise in the interest rates, the gain in the net income will be only partially compensated by the other option.

Coming back to the negative impact income gap case, the investors can buy interest rate put option in order to deal with that risk. This put option will give those buyers the freedom to sell a certain specific underlying security which will be at the price that has been set prior in the contract and makes the seller to be obliged to buy the underlying security. This will automatically make the buyers to earn some profit from that put option and can use it tom compensate for the interest income loss from the negative dollar gap.

The above strategies if adopted will be of great importance to the bank in its future plans since it will have set ways of managing the risks associated with adverse changes in interest rates.

d) Why I recommended the strategies

I came up with the strategies that I have listed below since they have been used and experimented previously by other banks and found to be successful. They have successfully been used to manage the risk in the change in the value of the portfolio as a result of the potential future interest rate changes that have been identified in the previous sections of the report.

 

References

https://privatewealth.usbank.com/insights/managing-interest-rate-risk

Dowd, K., Blake, D. and Cairns, “Long-Term Value at Risk,” The Journal of Risk Finance, Vol. 5, No. 2, 52–57, 2004.

Basel Committee on Banking Supervision, “Interest Rate Risk on the Banking Book,” Basel, June 2015.

Harris, M., “Back testing Your Interest Rate Risk Model,” CFO & Finance Digest, Issue #1, August 2010. Available at http://www.wib.org/publications__resources/cfo__finance_digest/2010–12/augl0/harris.html.

 

 

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s