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8/12/2019 3_5-Interest Rate Risk Management
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Interest Rate Risk
Management
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Strategies to Manage Interest-rate Risk
Rearrange balance-sheet
Gap Management
Duration Gap Management
Off-Balance Sheet Adjustment
Interest-rate swap
Hedge with financial futures
Insurance
Transfer risk
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Off-balance sheet activities
Financial innovations that involve commitments
related to contingencies and generate fees from
financial services.
Financial claims do not appear on balance sheet until
they are exercised.
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Categories of Off-Balance Sheet Activities
Financial guarantees
Commitments based on a contingent claim. An
obligation by a bank to provide funds (lend funds or
buy securities) if a contingency is realized.
Derivative instruments
Commitments derived from an underlying financial
instrument.
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Off-Balance-Sheet Activities
Loan sales
Fee income from
Foreign exchange trades for customers
Servicing mortgage-backed securities
Guarantees of debt
Backup lines of credit
Trading Activities
Financial futures
Financial options
Foreign exchange futures and options
Swaps
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Standby letters of credit (SLCs)
Obligations accepted by a bank for an upfront and annualfees to pay the beneficiary if the concerned client defaults
on that financial obligation.
Bank client can transfer the credit obligation back to the
bank
Financial SLCs: backup lines of credit on bonds,notes, and commercial paper which serve as
guarantee.
Performance SLCs: guarantees such as completionof construction contracts before a given date.
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Standby letters of credit (SLCs)
Considered as contingent loans.
Based on a collateralized or backed by deposits.
Bankers risks from SLCs
Contingent risk
Liquidity risk
Capital risk
Interest rate risk
Legal risk
Material adverse change (MAC) clause that enables
the bank to withdraw its commitment if the risk of the
SLC changes substantially.
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Loan Commitments
Promise by a bank to a customer to make a future
loan under predetermined conditions
Most commercial and industrial loans are made under
some form of loan commitment
- Line of credit: informal commitment to lend funds to
a client company
- Revolving loan commitment: formal agreement
to lend funds on demand under a contract
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Loan Commitments
Customer pays the bank a commitment fee.
Protect customers from their business risk by pre-determined rates.
Bank is exposed to interest rate risk.
Bank incurs liquidity risk due to these loan commitments
Several borrowers availing loan commitments at thesame time
Likely to occur to the bank when the credit availableis limited.
Loan commitments could become a binding contract tothe bank and are hence irrevocable.
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Note Issuance Facili ties (NIF)
Medium-term agreements (2-7 years).
Example:
Bank guarantees the sale of a borrowers short-term debtsecurities at or below pre-determined interest rates.
Types of NIFs
Revolving underwriting facilities (RUFs)
Standby note issuance facilities (SNIFs)
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Note Issuance Facili ties (NIF)
Bank has a commitment to buy the securities of theborrower if the borrower cannot obtain short-termfunds from the securities.
- Issue of Certificate of Deposits by bank borrowers.
- Issue of Euronotes by non-bank borrowers(denominated in US dollars but sold outside of the
US).
Banks have contingent risk, credit risk and liquidityrisk.
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Securitization
Issue of debt instrument Payments are from revenues generated by a pre defined
pool of loans.
Loans are grouped on the basis of their risk similarity. Issuance of securities to investors who earn returns
based on repayments on the loans
Securitisation of collateralised industrial loans
collateralised loan obligations (CLOs)
commercial mortgage-backed securities (CMBSs)
Banks transfer loan risk to the market.
Banks reduce credit risk and interest rate risk.
Banks diversify loan portfolio to earn stable returns.
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Securitization
Banks are the loan originators.
Earn service revenues from securitizing loan.
Securitized loans are off balance sheet instruments.
- Transferred with recourse
- Banks are exposed to risk associated with
the underlying asset.
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Hedging
Hedging protects risk exposed financial transaction
offsets a long position by taking an additional short
position in a derivative market
offsets a short position by taking an additional long
position in a derivative market.
Long position Agreement to buy securities at future date at a
predetermined price
Short position
Agree to sell securities at future date at a
predetermined price
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