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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