Interest Rate Risk Management: Internal and External Hedging (Excel) transcript

hello everyone and welcome again the nettle the best platform around for distance learning in business finance economics and much much more my name is Sava and today we're discussing interest rate risk management in financial institutions banks in particular and two main ways that banks can follow to reduce their interest rate poses in terms of various types interest rate risk earlier on we already discussed that improved Kingdom exposure and economic value factor and with regards to the latter we investigated the concept of duration and how to calculate it for various types of assets liabilities with varying profiles of their cash flow schedules but all right if the bank can measure its interest rate risk occurs either in terms of that interest income or economic value of equity what can it actually do to reduce or completely mitigate immunize itself against potential interest rate changes and first impact it might have or banks financial performance and its resilience that's exactly the topic of our today's video and it is very nicely aligned with derivatives as set of topics that we have been investigating recently in a lot of detail which is cut off Hilton prey default swaps and it turns out that another type of swaps can be used to hedge interest rate risk and immunize banks against interest rate changes the derivative that banks extensively use in external hedging of the interest rate risk is interest rate swap but without going too far ahead of ourselves let's first consider a simple example of a bank with made-up numbers and figure out how can it actually manage how can it actually protect itself against interest rate risk using derivatives and later on how can it do it without resorting to any external hedge in any external derivatives or other financial instruments how can it immunize itself using just a certain liability management agent so imagine a bank the certain mixture of rate sensitive and rate insensitive assets and liabilities that were the result of bank's policies in terms of funding and lending investment and tone and so forth and just to remind you rate sensitive and rate insensitive essence of liabilities can be classified in terms of repricing fixed and floating interest rates within certain time period so if we investigate a particular time horizon so for example one year then a certain liabilities that would be repriced interest rate on which be changed according to particular floating rate benchmarks within this one year so for example assets with healy repricing such as overnight loans for example assets with three-month six-month reprising intolerance or fault as a short-term bond or floating rate mortgages those would be rate sensitive assets and liabilities why do we consider them rate sensitive well because if interest rates that are the underlying for the interest rate benchmarks banks you to figure out the floating rate on their assets and liabilities then they would be sensitive in terms of net interest income to figure out the exposure of the bank to the pink in interest rates in terms of their net interest income the total model that is used is very simple and it's called the regression gap the repricing gap is just the difference between great sensitive assets and liabilities in out gate the bank holds assets the sum of nine hundred million dollars that are very tentative so they are being priced within one year period and respectively rate sensitive liabilities so that that Bank holds for short term deposits that the bank holds are equal to 600 million dollars though the repression gap would just be different of the two and what is the interpretation of the pricing gap well it's the exposure of the bank's net interest income to changes in interest rates for example if the bank calls more rate sensitive assets than residence if liabilities and unmet interest rates increase beep plus interest income would increase to a larger degree that grows interest expense so the bank would own that bin when the interest rates increase but if they decrease on the other hand but then the bank would get lose as receive less interest on its assets and less interest on disabilities but as assets constitute that high value then the decrease in gross income be overweight or have a decrease in broadsky interest expense so as our requested gap it's positive it would mean that in terms of net interest income the bank is suitably exposed to the increases in interest rates and negatively exposed decreases its rate so we could simulate certain scenarios for example if we assume that the interest rate would increase by 1 percent so we change Australians 1 percent positive 1 percent and we could easily figure out the respective change in net interest income but just multiplied the reporting gap by V and if interest rate so if interest rate increases by 1 percent the bank net gains 3 million dollars into not interesting as its reprising half is positive if the rates on the other hand decrease by 1/10 then the bank would not lose that's a very simple and intuitive model now we need to figure out the second type of interest rate risk exposure that banks face and that considers the economic value of equity of interest rate rate if II since the liabilities are rate insensitive within a particular time horizon so we can consider them as basically fixed rate as it's in viability and they would not be impacted by the interest rate changes in terms of their net interest income but they would be affected in terms of their fair value so what could potentially happen is if the banks rate insensitive as its liabilities are not balanced in terms of their sensitivities to interest rates with respect to their fair values and the economic value of equity so the difference between fair value of assets liabilities can decrease with interest rate changes and that would lead to and basically becoming insolvent and succumbing to short-term liquidity pressure if it's apparent that the fair value of bank's assets is lower than the fair value of its liabilities then it would induce around the bank and I've explained it in greater detail in the video when we dealt with duration so in our case we have this scenario where rate insensitive assets of this Bank 300 million dollars and the rate insensitive liabilities a two hundred forty billion dollars and we also need to know figure it out cut lips on how the modified duration of both rate insensitive assets and in our case let's assume that the modified duration of a sentence three years and modified duration of liabilities it's two years why do we need that well modified duration can be used as a proxy as a very good approximation at least for small movements in interest rate of the sensitivity of the fair value of an asset of liability to changes in interest rates so if the duration of assets is three years it means that approximately you the interest rates increase by 1% the fair value of those assets would drop by three times one percent three percent on the other hand if the interest rates decrease by one percent because of the present value logic and discounting the value of those assets would increase by three times one percent so three same can be said about the fair value of prospective rate insensitive liabilities so what we can do is we can figure out the exposure of assets and liabilities fair value to the changes in interest rate so to do that we could just multiply - the amount of assets times the respective modified duration and drag this formula down to figure out the similar concept regarding liabilities and then as we know that as interest rates increase both assets to liabilities depreciate in value we need to figure out the differences in the tail to calculate the exposure of the economic value of equity so we need to figure out what is the result for all so we subtract from the exposure of the assets value the exposure of the liabilities fair value and we see that approximately the exposure of the economic value of equity is minus foreign 20 million dollars it means that if the interest rates increase by one-tenth the Fen the value of equity would change by the exposure times the change of the interest rates and we see that in this scenario if interest rates increase by 1% the economic value of equity would drop by 0.2 million dollars and we don't need to account for 8 sensitive assets and liabilities and that pays as a floating rate as in some liabilities have the same fair value as both the cash flow count rate arguably increase and decrease by the same amount so in that case we can see that the bank faces a dilemma in this case as when interest rates increase the bank points in terms of its net interest income but on the other hand it loses in terms of the economic value of equity so that's why in interest rate risk management it's extremely important to simultaneously look at both facets of the risk well how the bank can use derivatives to offset to mitigate that threat so it's easiest to figure it out for the repricing gap well if your exposure to increasing interest rates is positive and you exposure to decrease in interest rates is negative well then you might want to offset that exposure by pain floating interest rate and receiving a fixed interest rate in terms of respective interest rate swap what would happen is that you might want to enter an interest rate swap contract with a neutral principal that's equal to the value to the absolute value of your reprising gap and at gains 300 million dollars and then the sign of the repricing gap so plus or minus so the direction of you exposure would determine whether you would want to be float in erisa fixed or be fixed and receive loading oddly key is very clear let's assume the downside powder pricing gap is positive so we lose when the interest rates decrease so we would want in terms of the flop to be on the other side of the transaction we would want to win if the interest rates decrease and lose when the interest rates increase because this would be offset by the positive change in our net impress income in that case it's beneficial for us in terms of hedging at least he'll pay floating and receive fixed so if exposure so repricing gap is greater than zero then you pay floating fixed on the other hand the exposure would be competitive for example if the situation would be reversed imagine that we had 300 million dollars of residence deficits only and the scenario would be exactly the reverse would be interested in paying fixed and receiving floating because as the interest rates would increase our net income would decrease and we would need to offset that by the net payoff of the interest rate for so that's the budget of hedging your net interest income exposure with a vigorous rate swap you look at the absolute value of your reprising cap and after your neutral principle and at the sign of your depression gap and that determines B side this mob you want to be in it's very analogous to that in case of the economic value of equity to volume again I want to stress that due to non-linearity of the sensitivity of assets and liabilities fair value to interest rate changes this is just the approximation exposure but it works very well when the changes in interest rates are modest and this exposure can be considered conservative as to the convexity of its relationship and interest rates increase the real depreciation of methods is lower than this modified duration model shows and if the interest rates fall the appreciation is higher than this modified duration will no shows so you could use that as a conservative estimate for the purpose of interest rates gratitude in that case again we look at the absolute value of the exposure and peak this value as our notional principal of the swap and then look at the sign of the exposure and again determine whether we want to pay for the new 2/5 or pay fixed and receive floating in that case our economic value of equity exposure is negative it means that it decreases when interest rates go up and that's very typical for banks as they undertake the maturity transformation they borrow trouble term so it's very hard to find a bank with negative duration k gap and with a positive film a fairly effective exposure but regardless in any case if your exposure is negative and you are incentivized in terms of hedging to pay fixed and receive floating in terms of the straight spot so when the interest rates increase your it Olivia difficulty would decrease for sure but you would gain net positive payoff from the interest rate swap that would offset completely that was that you me so we'll get some cash and you would be able to provide for this decrease in equity accordingly and if your code is greater than zero that's theoretically if your duration gap is for example well then he would want to be fallopian and receive edge this exposure from the listener but actually as the mechanism of edging of path of risk very similar when we look at what we could design a swap contract that would immunize our paint completely against those changes in interest rates and to do that we need to consider both simultaneously the repricing gap that includes intimate culture but tell us to pay floating and receive fixed because the victorious positive and the economic value of equity OSHA would tell us to be fixed and receive float those are two it's a fair price that we get from those two models so what to do in that case well in that case we just need to sum up the two exposures so me my fairly effective exposure and their pricing gap or the interest income exposure and we get minus 20 million dollars but now those exposures and then a sign and the absolute value of this figure would tell us the notional of an interest rate swap and the side of this mob we want to be in if desire to immunize the bank against both in that case has our absolute value of the total exposure its current 20 million we would like to enter a swap with a notional principal of hundred twenty million dollars and as the sign of the explosion is negative we would want to pay fixed and receive floating so that is how interest rate risk can be easily managed using sternal hedging in particular interest rate swap now let's investigate a slightly more complicated but arguably a more organic way of interest rate risk management that involves asset liability management all banks can do to immunize themselves against interest rate changes by just manipulating with the asset liability mix that they have so here you would have the same initial condition so rate sensitive assets and current sensitive liabilities are exactly the same and our representation actually stays the same we can take the exact same values from this case all right in sensitive assets and liabilities so three hundred and twenty fourteen and here we also need to know what are the total assets and liabilities that the bank vault so to sum up great sensitive and great intensity of assets to get total assets and rate sensitive and great insensitive liabilities get total liabilities and now we still can apply the very same logic in terms of Mario's when interest rates increase or decrease yeah we need to remember our exposures for I'll use and the economic value of equity exposure is asset exposure - liability exposure naturally and the total exposure is the sum of exposure and exposure so now what can banks do without going outside of its own business without entering into any interest rate swap contracts without engaging in any derivative trading at all who mitigate their exposure well it turns out that the bank can manipulate the values of their rate density of assets and liabilities because well banked have some powers and flexibility to negotiate the terms of their funding or their lending potentially you could fix the interest rate on some of the loan products that you're offering you could on the other hand change some of your fixed bones into floating rate loans and that would obviously adjust your exposures and potentially the exposures can be adjusted in certain way so that your total exposure is reduced to zero so what exactly should we do numerically to immunize ourselves even certain asset liability mix that we have in the first place well first of all we need to know our total exposure and we already know it from the last example it's - I'm 20 million dollars so on that we lose when interest rates increase and gain when interest rates decrease and then we can manipulate it we can mitigate our exposure open it by adjusting either our rate sensitive assets or rate sensitive liabilities and is formulas over here by how much do we need to change the value of our rate sensitive assets or liabilities to be immunized so what is the logic of this formula well if we increase our rate sensitive assets well we get more exposed to the net we get more exposed to interest rates changing in terms of net interest income but bear in mind you cannot just get your rate-sensitive assets out of nowhere you can just renegotiate your fixed and floating rate assets so if you want to increase your rate sensitive assets by thirty million dollars for example you would need to reduce your rate in sensitive assets by the same amount and if you reduce your rate in sensitive assets by a certain amount well what it would mean well the exposure of the economic value of equity is proportional to the modified duration of your assets so that's why the modified duration goes into the denominator as well so bearing that in mind let's use this formula to adjust the amount of rate sensitive assets and rate insensitive methods and see if we would successfully mitigate our interest rate risk podium so applying this formula as its Delton rate sensitive assets so we change of rate sensitive assets that we need to achieve we need to take the initial value of rate sensitive assets and subtract as there is a minus in front of this formula the total exposure and divide that by one plus the modified duration of assets we can see that we are left with 130 our rate sensitive liabilities would not change and stay at 600 and our oppression can now be equal to 330 what we need to do now to acknowledge that those two figures total assets and total liabilities do not change because an extra liability management you cannot just create new assets or new liabilities don't know so we need to make sure that those stay the same when we form our estimate liability management what it means them is that to figure out our rate insensitive assets will now need to subtract our rate sensitive assets from total essence so naturally as our rate sensitive assets increased by 30 million dollars our rate intensive assets reduced by 30 million dollars it would mean in terms of real business negotiations performed by the bank that for example it renegotiated 30 million bullets both of fixed rate mortgages till now be floating rate and what if the bank can do that in terms of visibility is a question but theoretically and numerically it could still do that because all of these figures stay positive and you can still maintain the same values of total assets and total liabilities and naturally total liabilities would not change but just to make sure we can subtract rate sensitive liabilities from food now we can still apply the scenario for the net interest income change given certain scenario and just copy across all of the formulas that we have put over here and we see that our asset liability management scenario has been successful because first of all our net interest intimately has increased by 30 million dollars and our economic value of equity exposure has increased by 90 million because our assets decreased by 30 million dollars in terms of rate intensity of assets and given the duration of three the exposure has increased by thirty times three ninety million dollars and overall it has resulted in our total exposure just getting to exact zero so that's how we can adjust our rate sensitive assets to immunize the bank against interest rate changes but we can also do the same by adjusting our liabilities our rate sensitive and rate insensitive liabilities what so in that case our rate-sensitive acids stain exactly the same but our rate sensitive liabilities need to be adjusted by this delta rate sensitive liabilities so need to add because yeah there is a plus in front of this ratio total exposure and the very start beautiful to that we seek to immunize divided by one plus the modified duration of liabilities and we see that in that case who would be to reduce our rate sensitive liabilities by forty million dollars and now given the fact that we have put formulas that maintain the same asset and liability mix we can just copy these formulas across and see how the exposures have been changed and whether we have achieved what we wanted so the immunization of the balance sheet to interest rate changes here we can see that we have increased our rate insensitive liabilities by the forty million dollars that went out of here over to here and what it meant essentially is that we have increased our net interest income exposure by 14 million dollars as we reduce the amount of rate sensitive liabilities and we reduced our economic value of equity exposure because we have increased our eight alternative liability and as the modified duration of my abilities is equal to two years then the change in exposure is 40 million dollars time to so it increased by eighty million dollars and forty plus eighty gave us hundred twenty million dollars that balanced out the total exposure of the balance sheet to interest rates how do you believe the in doubt the scenario of Essen liability management using liabilities is less realistic than the one using assets as here we have reduced the amount of rate-sensitive liabilities and increase the amount of rate insensitive liabilities what it would mean is that we would have to renegotiate our some of our floating rate funding and turn it into fixed-rate funding with respect to our horizon for example one year and what that would mean is that we would need first of all to succeed in our negotiations obviously but second we need for our durations of assets and liabilities to stay the same so we would need to negotiate that our previously rate sensitive liabilities would be converted into rate insensitive with their duration being on average equal to two and that's not always achievable because of basically business visibility of these negotiations so that's one of the reasons why in the real world in real financial practice banks largely prefer to resort to external hedgy just enter into a bunch of interest rate swaps or other derivatives contracts rather than adjusting the structure of your balance sheet and renegotiating the contracts regarding your assets liabilities but you can see here in theory it is possible for the bank to immunize itself against interest rate risk by just adjusting its business model the final point that would like to make regarding internal and external hedging for interest rate risk is that it's frequently said that interest rate swaps can be used to transform assets and liabilities from one form under the other that's exactly what we can see by engaging in the interest rate swap or the notion 120 million dollars and when we pay fix and mrs.

Bolton have effectively done the same in terms of our playoffs and exposures as if we would have adjusted the mix of our a tentative and breaks intensity of liabilities that is what is essentially meant by this transformative effect of derivatives and interest rate swaps in and that's it for interest rate risk management using internal and external hedging please leave a like under this video if you found it helpful I would be glad to read any further suggestions on business finance and economics videos in the comments below and don't forget to subscribe to our wonderful Channel thank you very much and stay tuned