Chapter 8 Interest Rate Risk Part I Class 15 February 22nd, 2010 Fixed vs. Floating When borrowing, customers (businesses as well as consumers) often have the choice of fixed vs. floating rates. Fixed rates are exactly that fixed at a specific rate e.g. 7% for the life of the loan. They will never vary. Typically, you would need to prepay your loan in order to take advantage of lower interest rates. Some loans of course have prepayment penalties. If not, you still need to consider what the upfront costs are on the new loan and amortize these over the life of the new loan to come up with an annual percentage rate (A.P.R.). Fixed rates are typically structured as a spread over US government bonds over the same tenor. Floating rates are based on some index. For corporations, it is usually LIBOR or Bankers Acceptances (B.A.s) while for consumers it is likely to be “Prime”. Short-term US government (Fed funds) rates and possibly others could be used as an index. Typically, interest rates for corporations reset every quarter or six months. Hence they will be indexed to 3 or 6 month LIBOR. Break-funding costs In the case of floating rate loans, banks may charge “break-funding costs” if the loan is repaid in the middle of a 3 month or 6 month period. This is because the bank claims it goes out and locks in an identical funding source when they lend the money e.g. Bank of NY (BONY) borrows $50 million from Bank of America at 3 months LIBOR and lends that money to General Motors at LIBOR plus 0.25 percent. If General Motors decides to repay after two months, BONY needs to find a new customer or deposit that money for a month. LIBOR rates may have gone down which means it cannot reinvest at the original LIBOR rate. However, it cannot undo its borrowing contract from BofA - hence the break-funding costs. In the case of fixed term loans to a corporation, banks usually have the borrower itself enter into a fixed vs. floating rate option (aka interest rate swap – derivative contract) since banks typically lend at floating rates. Insurers would lend at fixed rates. We will discuss the mechanics of swaps later in the quarter. LIBOR LIBOR is an acronym that stands for London inter bank offer rate. It is in theory the rate at which banks are willing to lend money to each other. (There is also LIBID is the bid rate – or the rate at which banks are willing to accept deposits from each other). This rate is typically the average of quotes of 16 different banks in London who offer to lend money to each other. There is a panel that then takes the middle 8 offers and then averages them to come up with the index or reference rate. Such a rate is referenced in many types of lending contracts, swaps, forwards, and other derivative contracts. So you will hear it a lot if you work in a financial institution. Usually, you see it as LIBOR plus 1.25% or even LIBOR minus 0.25%. The spread over LIBOR usually reflects the risk of the borrower. If the borrower e.g. is a better risk than most of the banks making up the index such as Toyota Motors, then you will see the “minus”. Central Banks and Interest Rate Risk Monetary Policy of the Federal Reserve Bank (our Central Bank) Lowering interest rates stimulates economic growth/raising of interest rates slows economic growth. Interest rates affect: (a) consumers inclination to save or spend (b) businesses to invest or wait. Monetary Policy If interest rates go up: (a) The expected return on investment (ROI) goes down due to the business’ higher cost of funds. (b) Consumers have more incentive to save and less incentive to buy since keeping money in savings instruments is attractive while borrowing money to finance e.g. a home or an automobile has got more expensive. (Also, existing floating rate debt becomes more expensive, leaving less money to spend). The opposite is obviously true as interest rates go down. Monetary Policy The fed will decrease rates to stimulate economic growth. The Fed will increase rates to slow economic growth so as to avoid the hazards of an over-heated economy – i.e. rising inflation and a more severe recession/depression than would normally occur as a result of the Normal Business Cycle. Monetary Policy Approaches Targeting Short Term Interest Rates by either selling or purchasing T-Bills in the open-market. Targeting Bank Reserves which affects banks willingness to lend by either increasing or decreasing their costs. Interest Rate Smoothing – small rate changes done as a reaction to economic data - seems to be the best approach. Global Market Integration Due to the tremendous amount of international trade and the globalization of stock and bond markets, no monetary decision can be taken in the US, Europe or Japan without considering how the rest of the world will react to that decision. For example, if the Federal Reserve increases rates, many global investors will likely invest more in US dollar fixed instruments which may cause a strengthening of the dollar vs. other currencies. Influx of foreign funds will decrease the impact of the rate increase while worsening the US’s Trade imbalance. Foreign governments may react by raising their interest rates thus limiting the impact of the US rate change on FX rates. Interest Rate Gap Measurements The Repricing or Funding Gap Model Banks required to report assets and liabilities on quarterly book value basis: (a) 1 day (b) 2 to 90 days (C) 91 to 182 days (d) 183 to 365 days (e) 366 days to 5 years (f) More than 5 years Repricing Gap Example Assets Liabilities Gap Cum. Gap 1-day $ 20 $ 30 $-10 $ - 10 >1day-3mos. 30 40 -10 - 20 >3mos.-6mos. 70 85 - 15 - 35 >6mos.-12mos. 90 70 +20 - 15 >1yr.-5yrs. 40 30 +10 - 5 >5 years 10 5 +5 0 Problems of the Re-pricing Model Imperfections are obvious: Ranges can be terribly imprecise i.e. overly aggregative and ignores runoffs. Book value does not take into account true market value of the assets and liabilities which are of course affected by a change interest rates. EG. If interest rates went up significantly, the difference in value of the longer term assets and liabilities could be enough to make the bank technically insolvent or wildly profitable whereas the Gap suggested between assets and liabilities times the percentage change may hide the long term impact if rates were not to come back to their original level. Other Models The Maturity Model simply re-prices each asset and liability on the banks books based on a net present value to attain their true market value. These values are then aggregated and the true asset/liability gap is determined which is actually just a re-measurement of the banks balance sheet. In the real world this is partly what happens in stock markets when interest rates change, the equity value of the bank gets re-measured much along the same lines to the extent there is enough information for analysts to determine their funding gap. Other Considerations FI’s don’t purely match assets and liabilities since there is also equity to be factored in so the “leverage” of the financial institution is an important factor. Maturity only measures the final payment. However, many assets such as mortgages and term loans amortize so that a portion of the principal is paid monthly, quarterly, semi-annually, and annually. Hence, maturity itself does not provide sufficient information about the asset and liability to be able to avoid funding gaps. Interest Rate Sensitivity The longer the maturity the more sensitive a financial asset is to interest rate movements. Calculating the price of a bond (loan) is fundamental in understanding the risks banks and other FI’s face in funding their portfolios. NPV of Bond’s cash flows = Bond’s price Portfolios FI’s hold many bonds and loans hence their risk is measured on a portfolio basis. Therefore, the maturity of any portfolio is the weighted average of the maturity of its components.