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Chapter 5 Interest rate risk: the repricing model Answers to end-of-chapter questions Questions and problems 1 How do monetary policy actions made by the Reserve Bank of Australia impact interest rates? Through its daily open market operations, such as buying and selling Treasury Bonds and Treasury Notes, the RBA seeks to influence the money supply, inflation and the level of interest rates. When the RBA finds it necessary to slow down the economy, it tightens monetary policy by raising interest rates. The normal result is a decrease in business and household spending (especially that financed by credit or borrowing). Conversely, if business and household spending decline to the extent that the RBA finds it necessary to stimulate the economy it allows interest rates to fall (an expansionary monetary policy). The drop in rates promotes borrowing and spending. 2 How has the increased level of financial market integration affected interest rates? Increased financial market integration, or globalisation, increases the speed with which interest rate changes and volatility are transmitted among countries. The result of this quickening of global economic adjustment is to increase the difficulty and uncertainty faced by the RBA Reserve as it attempts to manage economic activity through monetary policy in Australia. Further, because FIs have become increasingly more global in their activities, any change in interest rate levels or volatility caused by the actions of other central banks, such as the US Federal Reserve, more quickly impacts local markets, creating additional interest rate risk issues for these FIs. 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 rollover 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 that are 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(a) The repricing model requires specification of repricing buckets. Why must a bucket time period be specified? How does the choice of the repricing buckets impact on the delineation between rate sensitive and fixed rate assets and liabilities? The length of time over which the repricing gap is to be estimated must be specified in order to define rate-sensitive assets and rate-sensitive liabilities. The length of the repricing period determines whether a financial security is either rate sensitive or fixed rate. The longer the repricing period, the more securities either mature or reprice and therefore the more securities are classified as rate sensitive. (b) What determines the optimal length of the repricing period? What are the shortcomings of very short repricing periods? An excessively short repricing period omits consideration of the interest rate risk exposure of assets and liabilities that reprice in the period immediately following the end of the repricing period. That is, it understates the rate sensitivity of the balance sheet. (c) What are the shortcomings of very long repricing periods? 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. 6 Calculate the repricing gap and impact on net interest income of a 1 per cent increase in interest rates for the following positions: (a) Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $50 million. Repricing gap = RSA – RSL = $100 – $50 million = +$ 50 million. NII = ($50 million)(0.01) = +$0.5 million (b) Rate-sensitive assets = $50 million. Rate-sensitive liabilities = $150 million. Repricing gap = RSA – RSL = $50 – $150 million = –$100 million. NII = (–$100 million)(0.01) = –$1 million (c) Rate-sensitive assets = $75 million. Rate-sensitive liabilities = $70 million. Repricing gap = RSA – RSL = $75 – $70 million = +$5 million. NII = ($5 million)(0.01) = $0.05 million (d) Compare the interest rate risk exposure of the institutions in parts (a), (b) and (c). The FIs in parts (a) and (c) are exposed to interest rate declines (positive repricing gap) while the FI in part (b) is exposed to interest rate increases. However, the FI in (a) has greater exposure than the FI in part (b). The FI in part (c) has the least (most) amount of interest rate risk exposure since the absolute value of the repricing gap is the lowest (highest). 7 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 relations 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. 8 Which of the following is an appropriate change to make on a bank’s balance sheet when GAP is negative, spread is expected to remain unchanged and interest rates are expected to rise? 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. (a) Replace fixed-rate loans with rate-sensitive loans. Yes. This change will increase RSAs, which will increase GAP. (b) Replace marketable securities with fixed-rate loans. No. This change will decrease RSAs, which will decrease GAP. (c) Replace fixed-rate CDs with rate-sensitive CDs. No. This change will increase RSLs, which will decrease GAP. (d) Replace equity with demand deposits. No. This change will have no impact on either RSAs or RSLs. So, no impact on GAP either. (e) Replace vault cash with marketable securities. Yes. This change will increase RSAs, which will increase GAP. 9 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 Consider the following balance sheet positions for a financial institution: • Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million • Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $150 million • Rate-sensitive assets = $150 million. Rate-sensitive liabilities = $140 million (a) Calculate the repricing gap and the impact on net interest income of a 1 per cent increase in interest rates for each position. • Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100 million. Repricing gap = RSA – RSL = $200 – $100 million = +$100 million. NII = ($100 million)(.01) = +$1.0 million or $1 000 000. • Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $150 million. Repricing gap = RSA – RSL = $100 – $150 million = –$50 million. NII = (–$50 million)(.01) = –$0.5 million or –$500 000. • Rate-sensitive assets = $150 million. Rate-sensitive liabilities = $140 million. Repricing gap = RSA – RSL = $150 – $140 million = +$10 million. NII = ($10 million)(.01) = +$0.1 million or $100 000. (b) Calculate the impact on net interest income on each of the above situations assuming a 1 per cent decrease in interest rates. • NII = ($100 million)(–.01) = –$1.0 million or –$1 000 000. • NII = (–$50 million)(–.01) = +$0.5 million or $500 000. • NII = ($10 million)(–.01) = –$0.1 million or –$100 000. (c) What conclusion can you draw about the repricing model from these results? The FIs in parts (1) and (3) are exposed to interest rate declines (positive repricing gap), while the FI in part (2) is exposed to interest rate increases. The FI in part (3) has the lowest interest rate risk exposure since the absolute value of the repricing gap is the lowest, while the opposite is true for the FI in part (1). 11 What are the reasons for not including savings account demand deposits as rate-sensitive liabilities in the repricing analysis for a commercial bank? What is the subtle but potentially strong reason for including savings account demand deposits in the total of rate-sensitive liabilities? Can the same argument be made for other on-demand deposit accounts? The earnings rate available on savings deposit accounts is very low with interest often paid only on higher balances. Although some banks offer accounts on which interest can be paid on total balances, this interest rate seldom is changed and thus the accounts are not really interest rate sensitive. Whether or not interest is paid on such deposits, savings accounts do pay implicit interest in the form of not charging fully for cheque, ATM, EFTPOS and other services. Further, when market interest rates rise, customers draw down their deposit accounts, which may cause the bank to use higher cost sources of funds. The same or similar arguments can be made for all on-demand deposit accounts. 12 What is the gap ratio? What is the value of this ratio to interest rate risk managers and regulators? The gap ratio is the ratio of the cumulative gap position to the total assets of the FI. The cumulative gap position is the sum of the individual gaps over several time buckets. The value of this ratio is that it tells the direction of the interest rate exposure and the scale of that exposure relative to the size of the FI. 13 Which of the following assets or liabilities fit the one-year rate or repricing sensitivity test? (a) 91-day Treasury Notes (b) One year Treasury Bonds (c) 20 year Treasury Bonds (d) 20 year floating-rate corporate bonds with annual repricing (e) 30 year floating-rate mortgages with annual repricing (f) 30 year floating-rate mortgages with biannual repricing (g) Overnight interbank funds (h) Nine month fixed-rate term deposits (i) One year fixed-rate term deposits (j) Five year floating-rate corporate bonds with annual repricing (k) Common equity The following are rate sensitive: (a), (b), (d), (e), (g), (h), (i), (j). 14 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). 15 A bank manager is quite certain that interest rates are going to fall within the next six months. How should the bank manager adjust the bank’s six-month repricing gap and spread to take advantage of this anticipated rise? What if the manger believes rates will rise in the next six months? When interest rates are expected to fall, a bank should set its repricing gap to a negative position. Further, the manager would want to increase the spread between the return on RSAs and RSLs. In this case, as rates fall, interest income will fall by less than interest expense. The result is an increase in net interest income. When interest rates are expected to rise, a bank should set its repricing gap to a positive position. Again, the manager would want to increase the spread between the return on RSAs and RSLs. In this case, as rates rise, interest income will rise by more than interest expense. The result is an increase in net interest income. 16 Consider the following balance sheet for Watch over U Bank (in millions): Assets $ Liabilities and equity $ Floating-rate mortgages (currently 10% annually) 50 1-year term deposits (currently 6% annually) 70 30-year fixed-rate loans (currently 7% annually) 50 3-year term deposits (currently 7% annually) 20 Equity 10 Total assets 100 Total liabilities and equity 100 (a) What is Watch over U’s expected net interest income at year-end? Current expected interest income: $50m(0.10) + $50m(0.07) = $8.5m. Expected interest expense: $70m(0.06) + $20m(0.07) = $5.6m. Expected net interest income: $8.5m – $5.6m = $2.9m. (b) What will net interest income be at year-end if interest rates rise by 2 per cent? After the 200 basis point interest rate increase, net interest income declines to: 50(0.12) + 50(0.07) – 70(0.08) – 20(.07) = $9.5m – $7.0m = $2.5m, a decline of $0.4m. (c) Using the cumulative repricing gap model, what is the expected net interest income for a 2 per cent increase in interest rates? Watch over U’s repricing or funding gap is $50m – $70m = –$20m. The change in net interest income using the funding gap model is (–$20m)(0.02) = –$.4m. (d) What will net interest income be at year-end if interest rates on RSAs increase by 2 per cent but interest rates on RSLs increase by 1 per cent? Is it reasonable for changes in interest rates on RSAs and RSLs to differ? Why? After the unequal rate increases, net interest income will be 50(0.12) + 50(0.07) – 70(0.07) – 20(.07) = $9.5m – $6.3m = $3.2m, an increase of $0.3m. It is not uncommon for interest rates to adjust in an unequal manner on RSAs versus RSLs. Interest rates often do not adjust solely because of market pressures. In many cases the changes are affected by decisions of management. Thus, you can see the difference between this answer and the answer for part (a). 17 Use the following data to answer parts (a) through (c). Give bucks Bank Inc. ($ million) Assets $ Liabilities $ Rate-sensitive 50 Rate-sensitive 70 Fixed-rate 50 Fixed-rate 20 Equity 10 Note: All rate sensitive assets currently earn 10 per cent interest per annum. All fixed rate assets earn 7 per cent per annum. Rate sensitive liabilities currently pay 6 per cent per annum, while fixed rate liabilities offer 6 per cent annual interest. (a) What is Give bucks Bank’s current net interest income? Current interest income is $5m + $3.5m = $8.5m. Interest expense is $4.2m + $1.2m = $5.4m. Net interest income is currently $8.5m – $5.4m = $3.1m (b) What will the net interest income be if interest rates increase by 2 per cent? After the 200 basis point interest rate increase, net interest income declines to 50(0.12) + 50(0.07) – 70(0.08) – 20(0.06) = $9.5m – $6.8m = $2.7m. (c) What is Give bucks’ repricing or funding gap? Use it to check your answer to part (b). Give bucks’ repricing or funding gap is $50m – $70m = –$20m. The change in net interest income is (–$20m)(0.02) = –$0.4m. 18 Use the following information about a hypothetical government security dealer named MP Jorganson to answer parts (a) through (e). (Market yields are in parentheses.) MP Jorganson ($ million) Assets $ Liabilities $ Cash 10 Overnight interbank borrowing (7.00%) 170 T-notes 1 month (7.05%) 75 7 year fixed-rate subordinated debt (8.55%) 150 T-notes 3 months (7.25%) 75 T-notes two-year (7.50%) 50 Equity 15 T-notes 10-year (8.96%) 100 Corporate bonds 25 Total assets 335 Total liabilities and equity 335 (a) What is the repricing or funding gap if the planning period is 30 days? 91 days? Two years? (Recall that cash is a non-interest earning asset.) Funding or repricing gap over 30-day planning period = 75 – 170 = –$95 million. Funding or repricing gap over 91-day planning period = (75 + 75 + 25) – 170 = +$5 million. Funding or repricing gap over two-year planning period = (75 + 75 + 25 + 50) – 170 = +$55 million. (b) What is the impact over the next 30 days on net interest income if all interest rates rise by 50 basis points? Net interest income will decline by $475 000. That is: NII = FG(R) = –95(0.005) = –$0.475m (c) If the duration of assets is 3.41 years and the duration of liabilities is 3.5 years, what is MP Jorganson’s duration gap? Duration gap = DA – kDL: DG = 3.41– (3.5) = +0.07 years (d) What conclusions regarding MP Jorganson’s interest rate risk exposure can you draw from the duration gap in your answer to part (c)? From the repricing or funding gap (30 days’ planning period) in your answer to part (a)? MP Jorganson is exposed to interest rate increases. Positive duration gap implies that when interest rates increase, the market value of equity decreases. Negative repricing or funding gap implies that when interest rates increase, net interest income decreases. (e) Approximately how will the market value of the Treasury Note portfolio change if all interest rates increase by 50 basis points? Using the duration relationship, the 30-day Treasury Note portfolio: The 91-day Treasury Note portfolio: Note that since Treasury Notes are pure discount instruments, duration is equal to the time to maturity. The total change in the value of the Treasury Note portfolio is: P30 + P91 = $116 million. 19 A bank has the following balance sheet: Assets $ Avg. rate % Liabilities/equity $ Avg. rate % Rate sensitive 550 000 7.75 Rate sensitive 375 000 6.25 Fixed rate 755 000 8.75 Fixed rate 805 000 7.50 Nonearning 265 000 Non-paying 390 000 Total 1 570 000 Total 1 570 000 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 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(.0045) = $2475 IE = $375 000(.0035) = $1312.50 NII = $2475 – $1312.50 = $1162.50 (c) Explain how the CGAP and spread effects influenced the change in net interest income. The CGAP effect 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 effect, as spread increases, so does net interest income. 20 A bank has the following balance sheet: Assets $ Avg. rate % Liabilities/equity $ Avg. rate % Rate-sensitive 225 000 6.35 Rate-sensitive 300 000 4.25 Fixed-rate 550 000 7.55 Fixed-rate 505 000 6.15 Non-earning 120 000 Non-paying 90 000 Total 895 000 Total 895 000 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(.0635) + $550 000(.0755)) – ($300 000(.0425) + $505 000(.0615)) = $55 812.50 – $43 807.50 = $12 005 NIIa = ($225 000(.0635 + .0045) + $550 000(.0755)) – ($300 000(.0425 + .0035) + $505 000(.0615)) = $56 825 – $44 857.50 = $11 967.50 NII = $11 967.50 – $12 005 = –$37.5 (c) Explain how the CGAP and spread effects influenced this increase in net interest income. The CGAP effect worked to decrease net interest income. That is, the CGAP was negative while interest rates increased. Thus, interest income increased by more 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 effect, 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. 21 What are some of the weaknesses of the repricing model? How have large banks solved the problem of choosing the optimal time period for repricing? What is runoff cash flow, and how does this amount affect the repricing model’s analysis? The repricing model has four general weaknesses: (1) It ignores market value effects. (2) It does not take into account the fact that the dollar value of rate-sensitive assets and liabilities within a bucket are not similar. Thus, if assets, on average, are repriced earlier in the bucket than liabilities, and if interest rates fall, FIs are subject to reinvestment risks. (3) It ignores the problem of runoffs. That is, that some assets are prepaid and some liabilities are withdrawn before the maturity date. (4) It ignores income generated from off-balance-sheet activities. Large banks are able to reprice securities every day using their own internal models so reinvestment and repricing risks can be estimated for each day of the year. Runoff cash flow reflects the assets that are repaid before maturity and the liabilities that are withdrawn unexpectedly. To the extent that either of these amounts is significantly greater than expected, the estimated interest rate sensitivity of the FI will be in error. The following questions and problems are based on material in Appendix 5A located on the book’s website (www.mhhe.com/au/lange4e). 22 What is a maturity gap? How can the maturity model be used to immunise an FI’s portfolio? What is the critical requirement that allows maturity matching to have some success in immunising the balance sheet of an FI? Maturity gap is the difference between the average maturity of assets and liabilities. If the maturity gap is zero, it is possible to immunise 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): Assets $ Liabilities and equity $ Cash 60 Demand deposits 140 5-year Treasury Notes 60 1-year certificates of deposit 160 30-year mortgages 200 Equity 20 Total assets 320 Total liabilities and equity 320 What is the maturity gap for Nearby Bank? Is Nearby Bank more exposed to an increase or decrease in interest rates? Explain why? MA = [0 × 60 + 5 × 60 + 30 × 200]/320 = 19.6875 years, and ML = [0 × 140 + 1 × 160]/300 = 0.5333. 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 much 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. Assets $ Liabilities and equity $ Cash 20 Demand deposits 100 15-year commercial loan at 10% interest, balloon payment 160 5-year CDs at 6% interest, balloon payment 210 30-year mortgages at 8% interest, balloon payment 300 20-year debentures at 7% interest, balloon payment 120 Equity 50 Total assets 480 Total liabilities and equity 480 (a) What is the maturity gap for County Bank? MA = [0 × 20 + 15 × 160 + 30 × 300]/480 = 23.75 years. ML = [0 × 100 + 5 × 210 + 20 × 120]/430 = 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 per cent? If interest rates increase 1 per cent, the value and average maturity of the assets will be: Cash = $20 Commercial loans = $16 × VIFAn=15, i=11% + $160 × VIFn=15,i=11% = $148.49 Mortgages = $24 × VIFAn=30,i=9% + $300 × VIFn=30,i=9% = $269.18 MA = [0 × 20 + 148.49 × 15 + 269.18 × 30]/(20 + 148.49 + 269.18) = 23.54 years The value and average maturity of the liabilities will be: Demand deposits = $100 CDs = $12.60 × VIFAn=5,i=7% + $210 × PVIFn=5,i=7% = $201.39 Debentures = $8.4 × PVIFAn=20,i=8% + $120 × PVIFn=20,i=8% = $108.22 ML = [0 × 100 + 5 × 201.39 + 20 × 108.22]/(100 + 201.39 + 108.22) = 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 $480 to $437.67, or $42.33. The market value of the liabilities has decreased from $430 to $409.61, or $20.39. Therefore, the market value of the equity will decrease by $42.33 – $20.39 = $21.94, or 43.88 per cent. 25 If a bank manager is certain that interest rates were going to increase within the next six months, how should the bank manager adjust the bank’s maturity gap to take advantage of this anticipated increase? What if the manager believes rates will fall? Would your suggested adjustments be difficult or easy to achieve? When rates rise, the value of the longer-lived assets will fall by more than the shorter-lived liabilities. If the maturity gap is positive, the bank manager will want to shorten the maturity gap. If the repricing gap is negative, the manager will want to move it towards zero or positive. If rates are expected to decrease, the manager should reverse these strategies. Changing the maturity or repricing gaps on the balance sheet often involves changing the mix of assets and liabilities. Attempts to make these changes may involve changes in financial strategy for the bank which may not be easy to accomplish. Later in the text, methods of achieving the same results using derivatives will be explored. Integrated mini case: Calculating and using the repricing GAP Allied National Bank’s balance sheet is listed below. Market yields are in parenthesis, and amounts are in millions. Assets Million Liabilities and equity Million Cash 20 Demand deposits 250 Interbank lending (5.05%) 150 Savings accounts (1.5%) 20 3-month T-notes (5.25%) 150 Money market deposit accounts (4.5%) (no minimum balance requirement) 340 2-year T-Bonds (6.50%) 100 3-month CDs (4.2%) 120 8-year T-Bonds (7.50%) 200 6-month CDs (4.3%) 220 5-year corporate bonds (floating rate) (8.20%, repriced @ 6 months) 50 1-year CDs (4.5%) 375 6-month consumer loans (6%) 250 2-year CDs (5%) 425 1-year consumer loans (5.8%) 300 4-year CDs (5.5%) 330 5-year personal loans (7%) 350 5-year CDs (6%) 350 7-month commercial loans (5.8%) 200 Interbank borrowings (5%) 225 2-year commercial loans (floating rate) (5.15%, repriced @ 6-months) 275 Overnight repos (5%) 290 15-year variable rate mortgages (5.8%, repriced @ 6-months) 200 6-month bank accepted bills (5.05%) 300 15-year variable rate mortgages (6.1%, repriced @ year) 400 Subordinate notes: 3-year fixed rate (6.55%) 200 15-year fixed-rate mortgages (7.85%) 300 Subordinated debt: 7-year fixed rate (7.25%) 100 30-year variable rate mortgages (6.3%, repriced @ quarter) 225 Total liabilities 3545 30-year variable rate mortgages (6.4%, repriced @ month) 355 30-year fixed-rate mortgages (8.2%) 400 Premises and equipment 20 Equity 400 Total assets $3945 Total liabilities and equity $3945 (a) What is the repricing gap if the planning period is 30 days? 6 months? 1 year? 2 years? 5 years? Assets Repricing period Cash $20 Not rate sensitive Interbank Lending (5.05%) 150 30 days 3-month T-notes (5.25%) 150 6-months 2-year T-bonds (6.50%) 100 2 years 8-year T-bonds (7.50%) 200 Not rate sensitive 5-year corporate bonds (floating rate) (8.20%, repriced @ 6 months) 50 6 months 6-month consumer loans (6%) 250 6 months 1-year consumer loans (5.8%) 300 1 year 5-year personal loans (7%) 350 5 years 7-month commercial loans (5.8%) 200 1 year 2-year commercial loans (floating rate) (5.15%, repriced @ 6-months) 275 6 months 15-year variable rate mortgages (5.8%, repriced @ 6-months) 200 6 months 15-year variable rate mortgages (6.1%, repriced @ year) 400 1 year 15-year fixed-rate mortgages (7.85%) 300 Not rate sensitive 30-year variable rate mortgages (6.3%, repriced @ quarter) 225 6 months 30-year variable rate mortgages (6.4%, repriced @ month) 355 30 days 30-year fixed-rate mortgages (8.2%) 400 Not rate sensitive Premises and equipment 20 Not rate sensitive Liabilities and equity Repricing period Demand deposits $250 Not rate sensitive Savings accounts (1.5%) 20 30 days Money market deposits (4.5%) (no minimum balance requirement) 340 30 days 3-month CDs (4.2%) 120 6 months 6-month CDs (4.3%) 220 6 months 1-year CDs (4.5%) 375 1 year 2-year CDs (5%) 425 2 years 4-year CDs (5.5%) 330 5 years 5-year CDs (6%) 350 5 years Fed funds (5%) 225 30 days Overnight repos (5%) 290 30 days 6-month commercial paper (5.05%) 300 6 months Subordinate notes: 3-year fixed rate (6.55%) 200 5 years Subordinated debt: 7-year fixed rate (7.25%) 100 Not rate sensitive Equity 400 Not rate sensitive 30-day repricing gap: RSAs = $150m + $355m = $505m RSLs = $20m + $340m + $225m + $290m = $875m CGAP = $505m – $875m = –$370m 6-month repricing gap: RSAs = $505m + $150m + $50m + $250m + $275m + $200m + $225m = $1655m RSLs = $875m + $120m + $220m + $300m = $1515m CGAP = $1655m – $1515m = $140m 1-year repricing gap: RSAs = $1655m + $300m + $200m + $400m = $2555m RSLs = $1515m + $375m = $1890m CGAP = $2555m – $1890m = $665m 2-year repricing gap: RSAs = $2555m + $100m = $2655m RSLs = $1890m + $425m = $2315m CGAP = $2655m – $2315m = $340m 5-year repricing gap: RSAs = $2655m + $350m = $3005m RSLs = $2315m + $330m + $350m + $200m = $3195m CGAP = $3005m – $3195m = –$190m (b) What is the impact over the next six months on net interest income if interest rates on RSAs increase 60 basis points and on RSLs increase 40 basis points? ΔNII (6 months) = ΔII (6 months) – ΔIE (6 months) = $1655m(.0060) – $1515m(.0040) = $3.87m (c) What is the impact over the next year on net interest income if interest rates on RSAs increase 60 basis points and on RSLs increase 40 basis points? ΔNII (1 year) = ΔII (1 year) – ΔIE (1 year) = $2555m(.0060) – $1890m(.0040) = $7.77m Web questions 26 Go to the Reserve Bank of Australia’s website and to the Bulletin Statistics. Update Figure 5.1, and describe the movement in short-term and 10-year interest rates since 2011. 1. Short-Term Interest Rates: • Since 2011, short-term interest rates, typically represented by the Reserve Bank of Australia's (RBA) cash rate, have experienced significant fluctuations in response to changes in economic conditions and monetary policy decisions. • Following the global financial crisis of 2008, the RBA embarked on a series of interest rate cuts to stimulate economic activity and support growth. • From around 2011 to 2019, the RBA gradually reduced the cash rate from relatively higher levels to historically low levels, reaching record lows. • However, amid the economic fallout from the COVID-19 pandemic, the RBA further lowered the cash rate in 2020 to support the economy, reaching near-zero levels. • The RBA's monetary policy actions, along with domestic economic indicators and global market conditions, have influenced the movement of short-term interest rates during this period. 2. 10-Year Interest Rates: • 10-year interest rates reflect longer-term borrowing costs and are influenced by factors such as inflation expectations, economic growth prospects, and market sentiment. • Since 2011, 10-year interest rates have experienced fluctuations driven by changes in market expectations, economic conditions, and monetary policy. • During periods of economic uncertainty or risk aversion, investors may seek the safety of government bonds, leading to lower bond yields and interest rates. • Conversely, during periods of economic expansion or rising inflation expectations, 10-year interest rates may trend higher as investors demand higher yields to compensate for increased risks. • The movement of 10-year interest rates is influenced by a combination of domestic and global factors, including central bank policies, geopolitical events, and macroeconomic trends. Overall, the movement in short-term and 10-year interest rates since 2011 has been characterized by a mix of downward trends, driven by central bank actions to support economic growth, as well as periodic fluctuations influenced by market dynamics and external factors. For the most accurate and up-to-date information on interest rates, it is recommended to refer to official sources such as the Reserve Bank of Australia's Bulletin Statistics. 27 Go to Westpac’s website and find the latest Westpac New Zealand Disclosure Statement. Examine the document and discuss the sensitivities of Westpac NZ’s assets and liabilities to interest rate movements over the period covered by the report, and the impact that interest rate volatility had on net interest income. However, I can provide a general discussion about the sensitivities of a bank's assets and liabilities to interest rate movements and the potential impact on net interest income. 1. Assets and Liabilities Sensitivity: • Banks typically hold a variety of assets and liabilities with different maturities and interest rate characteristics. • Assets such as loans and securities may have fixed or variable interest rates and varying maturities. In a rising interest rate environment, the value of fixed-rate assets may decrease as their yields become less competitive compared to prevailing market rates. Conversely, in a falling interest rate environment, the value of fixed-rate assets may increase. • Liabilities such as deposits and borrowings may also have fixed or variable interest rates and different terms. In a rising interest rate environment, the cost of funding through deposits and borrowings may increase, potentially squeezing net interest margins. Conversely, in a falling interest rate environment, the cost of funding may decrease. • Banks manage their interest rate risk through various strategies, including asset-liability management, hedging, and adjusting the composition of their balance sheets. 2. Impact on Net Interest Income: • Net interest income (NII) is a key component of a bank's earnings and is derived from the difference between interest earned on assets and interest paid on liabilities. • Interest rate movements can impact NII through changes in the yield curve, repricing mismatches between assets and liabilities, and changes in customer behavior. • In a rising interest rate environment, banks may experience compression in net interest margins as the cost of funding increases more rapidly than the yield on assets. This can put pressure on NII. • Conversely, in a falling interest rate environment, banks may benefit from widening net interest margins as the yield on assets decreases at a slower pace than the cost of funding. This can boost NII. • Interest rate volatility can also affect the valuation of certain financial instruments, such as interest rate derivatives and mortgage-backed securities, which can impact NII through mark-to-market adjustments. In summary, the sensitivity of a bank's assets and liabilities to interest rate movements, along with the impact on net interest income, is an important consideration for banks' risk management and financial performance. Banks regularly assess and manage their interest rate risk exposure to mitigate potential adverse effects on earnings. For specific insights into Westpac New Zealand's interest rate risk management practices and their impact on net interest income, it would be necessary to review the latest Westpac New Zealand Disclosure Statement or related financial reports. Solution Manual for Financial Institutions Management Anthony Saunders, Marcia Cornett, Patricia McGraw 9780070979796, 9780071051590