The main forms of interest rate risk include repricing risk, yield curve risk, basis risk and optionality. Interest rate changes have a negative effect on both the bank’s earnings and its economic value.
Depending on the risk susceptibility of a bank or financial institution, risks could be reduced using various techniques that can be categorised as direct and synthetic methods.
The direct method of reorganising a balance sheet is based on altering the contract periods of assets and liabilities. This is done to achieve a specific duration or maturity. Conversely, the synthetic method is based on the use of instruments, such as interest rate swaps, futures, options, etc., to change the balance sheet risk exposure.
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As direct restructuring of a balance sheet is not always possible, banks depend on synthetic methods that offer a certain degree of flexibility to the asset liability management. Let us discuss some of the methods that banks and financial institutes use to manage interest rate risk.
Measures for Managing Interest Rate Risk
Interest rate swaps
These are contractual agreements between the bank and counterparties to exchange cash flows at specified periods based on a notional amount. The purpose of an interest rate swap is to hedge against the interest rate risk. By arranging for the counterparty to take up the interest payments, a bank hedges against the interest rate risk exposures. Banks and financial institutions use interest rate swaps to synthetically transform the floating rate liabilities into fixed rate liabilities.
The potential arbitrage that different comparative financing advantages offer, allows both parties of the contract to benefit from lower borrowing costs. In case of a decrease in interest rate, advance payment would increase with shortening of the asset’s average life. The bank may continue to exchange cash flows expected on an asset for a period longer than the average life of the asset.
To avoid such situations, banks may choose ‘swaptions’ that offer a call or put option in swaps. Call options on swaps enable the banks to call the swap. On the other hand, put options on swaps allow the banks to activate or put the swap after a certain time period.
Financial futures
A futures contract is an agreement between two parties to exchange a fixed quantity of a financial asset at an agreed price on a specified future date. Interest rate futures can be used to mitigate the risk that follows an asset-liability mismatch.
A buyer, holding a long position may purchase a futures contract anticipating fall in interest rates. The seller of the futures contract, on the other hand, may opt for a short position in the expectation of increase in interest rates in the future. Hedging provided by futures contract is balanced as losses (or gains) in the cash position is offset by gains (or losses) in the value of the futures position.
Banks and financial institutions should opt for futures contracts if hedging and risk ratio follows the statutory accounting rules related to the use of futures contracts.
Options
These are used to create numerous risk-return profiles using two essential factors—calls and puts. Call option is profitable in bullish interest rate conditions. On the other hand, put options may be deployed for providing insurance against price falls or minimising the risk in case the opposite occurs. Likewise, call options may be used to increase profits in case the market price increases restricting maximum loss to the premium.
Customised interest rate agreements
These are instruments, such as interest rate caps and floors. In lieu of the protection against rising liability costs, the buyer of a cap pays a premium to the seller. The pay-off profile of the investor who buys a cap is asymmetric because in case the interest rates remain low, the maximum loss would be limited to the cap’s premium.
Likewise, in lieu of the protection against decreasing asset returns, the buyer of a floor pays a premium to the seller. The pay-off profile of the floor buyer is also asymmetric as the maximum loss would remain confined to the floor premium.
When interest rates decrease, the pay-off to the floor buyer rises in proportion to the falling interest rates. Through the purchase of an interest rate cap and sale of an interest rate floor to offset the cap premium, banks are able to limit the cost of liabilities to an interest rate level. This strategy is known as an interest rate ‘collar’ and has the effect of limiting liability costs when anticipating increase in interest rates.
Measuring Interest Rate Exposure
The immediate effects of interest rate fluctuations are on the Net Interest Income (NII) or Net Interest Margin (NIM) of the bank. However, in the long-term, interest rate fluctuations impact the net worth of a bank.
Mismatches in the cash flow or mismatches in the repricing dates cause changes in the NII or NIM. Interest rate exposure of a bank can be viewed from ‘earnings perspective’ and ‘economic perspective’. These perspectives are explained as follows:
Earnings perspective
In this perspective, interest rate exposure of a bank is measured through analysing the impact of changes in the short-term earnings of the bank. The short-term earnings are measured by finding out the changes in the NII or NIM or the difference between total interest rate income and interest rate expenses.
Economic value perspective
In this perspective, interest rate exposure of a bank is measured after analysing the expected cash flows from assets less the expected cash flows from liabilities plus the net cash flows from off-balance-sheet items. Therefore, the economic value perspective focuses on the changes to the net worth of a bank because of interest rate movements.
In other words, the economic value approach is a long-term approach focusing on the long-term interest rate gaps.
Interest Rate Futures
Interest rate futures are an effective technique of mitigating interest rate exposure in banks. It refers to an agreement to buy or sell a debt instrument at a specified date in the future at a price fixed at present. These are derivative contracts in which a notional interest bearing instrument is the underlying asset. In interest rate futures, the buyer agrees to take delivery of the underlying debt instruments at the expiry of the contract.
On the other hand, the seller agrees to deliver the underlying debt instrument at the expiry of the contract. The value of interest rate futures contracts has inverse relationship with the interest rates. Therefore, bond prices fall with the decline in interest rates. This in turn results in fall in the futures prices of bonds.
The main economic rationale behind interest rate futures is that as interest rate increases, the opportunity cost of holding bonds decreases. This is because investors can earn greater profits by investing in other investments with higher interest rates. If a bank anticipates decrease in portfolio value with increase in interest rates, it can take a short position on interest rate futures to hedge the exposure.
In this case, if interest rate increases, the portfolio value would go down; however, because of the hedging, the bank will be able to avert the loss. Let us understand how interest rate futures help a bank in mitigating interest rate exposure with the help of an example. A certain investment in bonds earns 10% per annum rate of interest for a bank.
Now, suppose that the bank is expecting the interest rate to fall to 9%. In this case, the bank can purchase futures contract at market price. If the interest rate falls, the contract will quote at higher price as with the fall in interest rate, the value of instruments offering higher coupon rates goes up. The bank can sell the futures and gain profit.
The general rule of thumb for banks for using interest rate futures for mitigating interest rate risk management is as follows:
Interest rate exposure in asset portfolio:
- Buy interest rate futures, if interest rate is expected to fall: In case of fall of interest rate, the price of bond will increase. Sup- pose, a bank is looking forward to invest in bonds at a future date. In this case, the best strategy of the bank would be to hedge the risk of the bond price going up by locking the price at which the bank will be able to buy the bond at a future date i.e. buying bond futures.
- Sell interest rate futures, if interest rate is expected to rise: For example, suppose a bank anticipates that it needs to sell its certain bond holdings in 45 days to make payment for a liability to be matured in the same time. Now, if interest rate rises within this period, the bank will have to liquidate the bonds at a lower price as rise in interest rate causes the bond price to fall. The bank can avert this loss by selling bond futures to lock the selling price.
Interest rate exposure in liability portfolio:
- Sell interest rates futures, if interest rate is expected to fall: By selling interest rate futures, a bank can lock the price it will get from the sale of an underlying asset. By doing this, a bank would be able to avert any loss in value of the underlying asset due to fall in interest rate.
- Buy interest rate futures, if interest rate is expected to rise: By buying interest rate futures, a bank would be able to lock the price at which it can buy the underlying asset at a future date. By doing so, the bank can avert the loss due to increase in the price of an asset resulting from rise in interest rate.
Interest Rate Swaps
Interest Rate Swaps refer to agreements between two counterparties to make periodic interest payments to one another over the entire period of the agreement on certain fixed dates, on the basis of a notional principal account. In interest rate swaps, one party pays fixed interest rate and the counterparty pays floating interest rate.
The most common swap is a ‘plain vanilla’ interest rate swap. This involves the exchange of a fixed rate loan for a floating rate loan. An interest rate swap may last for a period from 2 to 15 years. An interest rate swap benefits from comparative advantage. Certain organisations may have an advantage in fixed rate markets over other organisations which in turn might have a comparative advantage in floating rate markets.
When organisations need to take loans, they look for cheaper options by borrowing from markets. Markets offer organisations with a comparative advantage. However, this may also often result in organisations borrowing loans at fixed rates when they expect a floating rate of interest or vice versa. A swap transforms this effect by exchanging a fixed rate loan for a floating rate or vice versa.
Interest rate swaps are very important tools of interest rate risk mitigation in banks. For example, when a bank pays a floating rate on its liabilities but receives fixed payment on the loans advanced to its customers, it may face a high amount of risk in case floating rate liabilities go up significantly.
Therefore, in such cases, a bank can mitigate the interest rate risk by swapping the fixed payments to be received from the loans advanced for a floating rate payment that is higher than the floating rate payments the bank requires to pay. This measure will ensure that the revenue generated by the bank exceeds its expenses, and it will not face any cash flow crunch.
Interest Rate Options
Interest rate option refers to an important investment, the payoff of which depends on the future interest rate levels, whose value is derived from an underlying interest rate, such as the yield on a 10-year fixed income bond. It is traded both through an exchange and over the counter.
Similar to equity options, there are two types of interest rate option contracts:
- Call option: A call gives the bearer the right, but not the obligation, to benefit from an increase in interest rates.
- Put option: A put gives the bearer the right, but not the obligation, to benefit from a decrease in interest rates.
Interest rate options are an important interest rate exposure mitigation tool for banks. For example, interest rate options are mainly sold by banks to corporations that borrow funds from them and want to mitigate interest rate risks.
A client of a bank does not need to borrow funds from it, as interest rate options are settled in cash. Therefore, when a client exercises its option, the cash settlement is paid to the client by the bank.
