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Lecture Financial markets and institutions (4/e) – Chapter 22

In this chapter we consider three specific types of options employed by business firms in their financing – the convertible security, the exchangeable bond, and the warrant. In the Appendix to the chapter, a detailed discussion of option pricing theory appears. | 8- McGraw-Hill/Irwin Chapter Twenty-Two Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet 22- McGraw-Hill/Irwin Interest Rate Risk The asset transformation function performed by financial institutions (FIs) often exposes them to interest rate risk FIs use (at least) two methods to measure interest rate exposure the repricing model (a.k.a. the funding gap model) examines the impact of interest rate changes on net interest income (NII) the duration model examines the impact of interest rate changes on the overall market value of an FI and thus ultimately on net worth 22- McGraw-Hill/Irwin Interest Rate Risk The U.S. central bank’s (the Federal Reserve’s) monetary policy is the most direct influence on the level and movement of interest rates Changes in the Federal Reserve’s fed funds target rate affect all interest rates throughout the economy expansionary monetary policy involves decreases in the target fed funds rate contractionary monetary policy involves increases in the target fed funds rate 22- McGraw-Hill/Irwin The Repricing Model The repricing or funding gap is the difference between those assets whose interest rates will be repriced or changed over some future period and liabilities whose interest rates will be repriced or changed over some future period Quarterly reporting of commercial bank assets and liabilities is detailed by maturity bucket (or bin) one day more than one day to 3 months more than 3 months to 6 months more than 6 months to 12 months more than 1 year to 5 years more than 5 years 22- McGraw-Hill/Irwin The Repricing Model The gap in each bucket or bin is measured as the difference between the rate-sensitive assets (RSAs) and the rate-sensitive liabilities (RSLs) rate-sensitivity measures the time to repricing of an asset or liability The cumulative gap (CGAP) is the sum of the individual maturity bucket gaps The cumulative gap effect is the relation between changes in interest rates and | 8- McGraw-Hill/Irwin Chapter Twenty-Two Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet 22- McGraw-Hill/Irwin Interest Rate Risk The asset transformation function performed by financial institutions (FIs) often exposes them to interest rate risk FIs use (at least) two methods to measure interest rate exposure the repricing model (a.k.a. the funding gap model) examines the impact of interest rate changes on net interest income (NII) the duration model examines the impact of interest rate changes on the overall market value of an FI and thus ultimately on net worth 22- McGraw-Hill/Irwin Interest Rate Risk The U.S. central bank’s (the Federal Reserve’s) monetary policy is the most direct influence on the level and movement of interest rates Changes in the Federal Reserve’s fed funds target rate affect all interest rates throughout the economy expansionary monetary policy involves decreases in the target fed funds rate contractionary monetary .