Interest rate risk

Interest rate risks are market- interest-related assets and income risks, the acquisition will be compensated on the capital market with a risk premium. These are systematic risks that are correlated with aggregate economic variables and have a lasting impact on the welfare of economic agents. You can either present value or are measured at current market values .

2.1 Active versus passive Treasury Strategies
2.2 Risk avoidance with risk limits
2.3 Risk reduction and risk transfer through Derivative Instruments 2.3.1 Interest rate swaps
2.3.2 Forward Rate Agreement
2.3.3 Interest Rate Futures
2.3.4 Interest rate options

3.1 Interest rate risk in the banking book
3.2 Interest rate risk in the trading book
3.3 Capital requirements for general market risk 3.3.1 Duration method 3.3.1.1 Determination of the partial capital charge for general interest rate risk
3.3.1.2 Offsetting within maturity bands
3.3.1.3 Offsetting within run time zones
3.3.1.4 Offsetting between the respective maturity zones
3.3.1.5 Open Positions

Analysis of interest rate risk

Factors

The main factors influencing the interest rate risk can be summarized to two preambles. On the one hand is the interest rate risk from interest rate exposure ( internal component ), on the other hand of the market interest rate volatility ( external component ) dependent.

The interest rate exposure summarizes internal company factors such as the open fixed-rate position, the limit processes and the interest elasticity together. The market interest rate volatilities provide both interest rate changes and twists in the yield dar. The more pronounced these two factors is present, that is the greater, for example, the fixed-rate position in comparison to the variable interest rate position is, or the more moves the level of interest rates, the higher ceteris paribus also the interest rate risk.

Instruments for interest rate risk analysis

The instruments for interest rate risk analysis can be distinguished according to whether they are primarily developed and used for the analysis of net interest income risk or a risk to a present value. In addition, a distinction based on static or dynamic approaches is possible. While the static approaches are reporting date, taking into account also usually only at that date already contracted interest rate transactions, even new and connection agreements will be integrated into the analysis in the dynamic approaches. Therefore, the static instruments aimed particularly at the operational business. Dynamic approaches are particularly suitable for strategic risk analysis, however.

Net interest income and interest margins risks

Looking at the long-term development of the interest margins of a major bank, a savings bank and a credit union based on the Bundesbank statistics, we provide over time strongly fluctuating interest margins fixed.

Bank interest margins of selected groups in the period 1970-2000

While interest margins of the savings banks and the cooperative banks in this period had a standard deviation of .30 to .34 percentage points, it was just under 0.56% - points with the major banks. Obviously, the interest rate risk in the large banks was more pronounced. A consideration of the coefficient of variation as a relative control amount reinforced this impression.

Influencing factors and forms of interest income risk

The main effect relationships can illustrate with the help of a balance consideration, the correlations have in the same way for off-balance sheet business validity.

The total interest income of a bank can be divided into two layers which differ in their ability to adapt to emerging market interest rate changes:

Fixed-rate exposures

These transactions comprise all the items that have a pre-arranged and constant in its height interest rate for a specified period.

Variable interest rate transactions

This interest rate transactions have either no interest period or only a very short. Thus, these shops are partially or fully zinsreagibel.

Net interest income risk always exists when there is no Zinsbindungskongruenz between the asset and liability positions. Occurring mismatches lead to corresponding on amount or time open positions.

The classic case of net interest income risk is the fixed interest rate risk so-called. This arises when a fixed-rate block ( risk in market interest rates increase ), or vice versa, an adjustable-rate item on the assets side by a fixed-rate position on the liability side is financed on the assets side by a floating-rate item on the liabilities side of the balance is financed (risk a fall in interest ).

Gap analysis

The gap analysis is a tool that can be identified with the interest rate risks and quantified. It has been used increasingly in the 70s and especially with the rise in interest rates at the beginning of the 80s to the analysis of interest rate risk in banks. As a consequence, the resulting from the high interest rate phase imbalances of individual institutions, the Federal Financial Supervisory Authority ( BaFin) has introduced the obligation to draw up interest rate gap for all banks.

In the gap analysis all asset and liability fixed-income positions are compared and determines the resulting open positions for future periods. An open position, either as active overhang or a surplus of liabilities is interest rate risk.

As a fixed-rate business should thereby following the BaFin usually all transactions are taken as a basis, which have a residual rate fixation of over 180 days. Likewise, this management plan should also address the non -bearing interest-sensitive assets and liabilities.

Usually, the gap analysis considered in the determination of net interest income risk, a market interest rate increase of 1%. That is, the designated risk is the amount in EUR represents the net interest income will decline if interest rates rise by 1%.

Formal structure

The gap analysis is part of the current account. The following table shows a gap analysis with a positive maturity transformation and the overall balance, which also includes other Market Interest rate business.

The gap analysis has the disadvantage that a decline compared to the original expectation may be at a interest rate, although no fixed interest rate gap exists. The change stems from the other market -related business.

Example of a gap analysis

Thus, a net interest income risk in the amount of 8 units occurs in the above case.

Criticism

Changes in interest rates may also adversely impact earnings when maturities ( matching the volumes on both the asset and the liability side in terms of residual maturity) there. This is due to the fact that changing the variable lending and deposit interest rates vary.

Usually there will be a widening of the gap analysis by the present value considerations in practice. The net interest income risks of the following periods are discounted at the appropriate discount rate.

Interest rate gap analysis

Here, the fixed interest stocks are imaged at multiple time points.

The interest elasticity concept

This about the mid-80s in particular by Rolfes developed concept ( Rolfes, 1985) is geared to the different Zinsreagibilitäten in the variable interest rate business. One speaks here of interest rate elasticities. Thus, These describe the adaptability of variable interest rate positions to changes in market interest rates.

It is assumed that the interest rates of the individual balance sheet items and banking products are linked to the money and capital market interest rate.

Mathematically represented the interest elasticity is calculated as follows:

With = Product Interest in t = Product Interest in period 0, = market interest rate in t = market interest rate in period 0

Since the height of the so- determined interest rate elasticity but is highly dependent on the two observation periods, it is useful to calculate the elasticities using regression analyzes.

Static elasticity balance

The basis for interest elasticity studies regularly forms the static elasticity balance. In it, all assets and liabilities are recognized at their volumes and interest rate elasticities compared with each other. In the basic model of the static elasticity balance sheet, the total interest rate risk is composed of two components: the fixed-rate risk from the open fixed-rate position and the variable interest rate risk.

In the remaining block of 3,600 million euros variable business on the asset side, an average interest rate adjustment elasticity results in the amount of 0.70%. However, together with related variable passive agents have only an average elasticity of 0.50 %. An increase in the market interest rate of 1 %, the interest income would thus rise faster than the interest expense. It thus would result in an interest rate opportunity for the bank.

With = interest elasticity Active, Passive = interest elasticity and = total assets.

Thus, for the credit institution a chance to interest rate amounting to 5.2 million euros.

Dynamic elasticity balance

Subject of the dynamic elastic balance are extensive strategic balance and interest rate risk simulations. These are carried out with the help of PC solutions with limited effort, and corresponding programs are offered both by consulting firms as well as individual banking associations.

These simulations are based on the information of the gap analysis and the static elasticity balance.

On the basis of assumptions to be made, such as future interest rates, occur here on a variety of forecasting problems.

Criticism

The interest rate to be measured elasticities have no temporal stability.

Present value risk

Interest rate-related cash or market value risk arises in the consideration of individual fixed income securities to securities portfolios in the foreground. Here is an imminent rise in market interest rates leads to an adjustment of securities prices.

Rate risk of fixed-income securities

The price of a bond is influenced by factors such as the nominal interest rate and the remaining term.

In general, can the market value (MW ) of a fixed income security is calculated as follows:

Duration analysis

Duration is a time variable in years, which indicates the period of time that is required for a fixed-rate securities, so that the resulting from a change in interest rate and just compensate compounding effects again and where so that the original yield is saved ( see also duration).

Since a certain fixed value is independent of the incoming market interest rate at the time of duration, can be an immunization against interest rate risk using duration.

The targeting on risk compensation method such as the duration must recognize risks despite all stages of development yet (residual). Moreover, since the uncertainty should be better captured in terms of the factors of risk, was already here of a need for more advanced methods exist for the analysis of price risks. Added to this was the growing interest in a suitable measure to measure the overall risk position of a bank. Therefore, the concept of Value at Risk has been developed.

Starting from a downside - oriented concept of risk that understands a risk as a negative deviation between actual and expected results, the risk measure VaR as the negative change in value of an asset item, the maximum occur depending on an assumed distribution assumption with a certain predefined probability in a given period is defined can.

It thus represents a threshold that do not exceed the actual losses with the given probability.

Management of interest rate risk

The classification of risk control measures in the active and passive risk management can in principle also be applied to the management of interest rate risk.

Active versus passive Treasury Strategies

Active Treasury strategies are characterized in that, depending on specific interest rate forecasts aware of open interest positions or deviations from a defined benchmark be addressed in order to achieve a higher return than the benchmark.

Passive treasury strategies, however, are rule-based strategies that can be pursued independently of interest rate forecasts. It will seek to maintain a given cash flow structure over longer periods as constant as possible.

Risk aversion with risk limits

In the context of active risk management, risk avoidance is first to lead on the basis of limit systems. In addition to limiting the overall bank risk are also usually sub-limits to limit certain risk positions, such as the risk of price fluctuations used.

The quantification of risk limits is carried out in practice, the above-mentioned value-at -risk concept.

Risk reduction and risk transfer through Derivative Instruments

In addition to accounting tools for risk reduction and shifting as in particular are off-balance sheet derivative financial instruments.

The accounting control can be both client as well as in the interbank market. On the customer side, however, is to consider that the acceptance of the customer is required to increase, for example, the fixed interest rate in customer business. Because the different patterns of demand from the customer's perspective will arise due to market cycles, the internally derived strategies for risk reduction and shifting as it is probably very difficult to implement.

Thus, it is promising for a bank to try to implement the strategy defined in the interbank market.

Interest rate swaps

Interest rate swaps involve the exchange of two different interest payment obligations relating to a uniform underlying notional amount. Since only the obligation to pay interest is exchanged and the notional amount does not flow arises between the parties, no capital requirement.

Forward Rate Agreement

In a FRA two parties agree on a fixed date interest rate ( forward rate ) on a specified notional amount for a date in the future period. They also agree to pay compensation, provided a fixed reference interest rate at the beginning of the past in the future period is above or below the agreed forward rate.

Interest rate futures

Interest rate futures represent the exchange-based counterpart to the OTC forward rate agreements; they do not pose a real futures dar. In contrast to the FRAs is, however, the interest between the buyer and seller, but agreed the resulting from the interest rate of the paper. It thus is ultimately the standardized purchase / sale of a bond by appointment.

Interest rate futures are traded as futures contracts on numerous futures exchanges. In Europe in particular, the Eurex in Frankfurt and the Liffe in London.

As a basis for the bond purchase serve Federal bonds ( Bund futures ), government bonds ( Bobl Future), the Treasury ( Treasury futures ) and money market instruments ( one-and three - month Euribor futures).

The main features of a futures contract are:

The contract size,
The tradable due dates,
The regulations on the safety performance and final settlement.

Interest rate options

Through its financial instruments out above requirements, other instruments designed for optional hedge against interest rate and market price risks are:

Cap: a hedge against rising interest rates
Floor: Protection against falling interest rates
Collar: fixing a interest rate cap and interest rate floor

Regulation of interest rate risk

A distinction is made between interest rate risk in the banking book and the trading book.

Interest rate risk in the banking book

Interest rate risk in the banking book are not regulated in principle 1; this also applies to Basel II, this can be considered in column 2.

Thus, in support of Pillar 2 of the Basel Committee (2004) "Principles for the management and supervision of interest rate risk " is established, in which, among other things, the concept of outlier institutions ( banks outlier ) is defined. This will include those banks where a standard interest rate shock or its equivalent (eg, a 200 basis point interest rate shock for exposures in G10 currencies ) results in a net present value loss in the banking book of more than 20 % of the liable capital (Tier 1 and Tier 2 capital). The national bank regulators should be outliers institutions to especially vigilant concerning the adequate equipment to regulatory capital.

The regulatory treatment of interest rate risk in the banking book was until November 2011 in Circular 07 /2007 ( BA) regulated by BaFin, the by Circular 11 /2011 ( BA) were replaced on November 9, 2011. The regulations for the internal management of interest rate risk in the banking book are found especially in the Minimum Requirements for Risk Management ( MaRisk).

For the German banking system, the interest rate risk in the banking book, the Deutsche Bundesbank and BaFin were first collected in the years 2005/2006 as part of a voluntary survey among German banks. The detailed results of this survey, interest rate risk, however, were not published until now.

The Basel Committee (2004) has also issued a standardized model framework by which the interest rate risk in the banking book for banks via external ( accounting ) variables by the national supervisory authorities can be quantified. Similar models are already being used in other countries such as the United States (Economic Value Model, EVM). More sophisticated models include the Net vaue Portfolio Model ( NPV ) of the Office of Thrift Supervision, or the Time Series Accounting -Based Model ( TAM), by which the interest rate risk of German banks was analyzed.

Interest rate risk in the trading book

For interest rate risk in the trading book initially a net interest position must be determined. This is generally the case for market price risks. It results from interest-earning securities and cash positions, securities-related derivatives and interest rate derivatives market.

For interest- sensitive securities and cash positions offsetting opposing positions is made. It is the net interest position in the same securities.

In securities-related derivatives netting of securities-related component is made with offsetting positions.

The market interest rate related components of equity-based derivatives as well as the market interest rate derivatives offset. This applies largely corresponding positions.

Capital requirements for general market risk

Duration method

: Change in market value
: Modified duration
: Market value
: Change of interest rate

Determination of the partial capital charge for general interest rate risk

Net interest positions are classified according to their duration in time bands. Then the corresponding price change is calculated.

Offsetting within maturity bands

Closed bank positions have a 5 % weighting

Offsetting within run time zones

There shall be three maturity zones: a short-term with duration less than one year, a medium with a duration of less than 3.6 years and a long-term, with over 3.6 years. A closed position, receives a 40% weighting, if it is short, medium and long at a 30 % weight.

Balancing between the respective maturity zones

Then the open positions are netted. For short and medium a closed zones balance shall be 40 % for medium and long, if the medium is open.

Open Positions

Cover any remaining open position at 100%.

An unbalanced Durationsbilanz can be compensated by the following measures:

By the inclusion of liabilities with high duration and investment of assets with lower duration, this also applies to new contracts
By the use of suitable derivatives

Years Bandmethode

See: Annual Bandmethode

Bond duration Benchmarking Bond (finance) Interest rate cap and floor Collar (finance) Basel Committee on Banking Supervision Derivative (finance)

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