InterestRateRiskChapter 8RiskManagementandFinanciallnstitutions,3e,Chapter8,CopyrightJohnC.Hull2012
Interest Rate Risk Chapter 8 Risk Management and Financial Institutions, 3e, Chapter 8, Copyright © John C. Hull 2012 1
ManagementofNetInterestIncome(Table 8.1, page 159)Suppose that the market's best guess is that futureshort term rates will equal today's ratesWhat would happen if a bank posted the followingrates?Maturity (yrs)Deposit RateMortgageRate13%6%53%6%How can the bank manage its risks?2RiskManagementandFinancial Institutions,3e,Chapter8,CopyrightJohnC.Hull2012
Management of Net Interest Income (Table 8.1, page 159) ⚫ Suppose that the market’s best guess is that future short term rates will equal today’s rates ⚫ What would happen if a bank posted the following rates? ⚫ How can the bank manage its risks? Maturity (yrs) Deposit Rate Mortgage Rate 1 3% 6% 5 3% 6% Risk Management and Financial Institutions, 3e, Chapter 8, Copyright © John C. Hull 2012 2
Management of NetInterestIncomeMost banks have asset-liabilitymanagement groups to manage interestrate risk When long term loans are funded withshort term deposits interest rate swapscan be used to hedge the interest rate risk But this does not hedge the liquidity riskRiskManagementandFinancialInstitutions,3e,Chapter8,CopyrightJohnC.Hull20123
Management of Net Interest Income ⚫ Most banks have asset-liability management groups to manage interest rate risk ⚫ When long term loans are funded with short term deposits interest rate swaps can be used to hedge the interest rate risk ⚫ But this does not hedge the liquidity risk Risk Management and Financial Institutions, 3e, Chapter 8, Copyright © John C. Hull 2012 3
LIBORRates and Swap Rates LIBOR rates are 1-, 3-, 6-, and 12-monthborrowing rates for companies that have aAA-ratingSwap Rates are the fixed rates exchangedfor floating in an interest rate swapagreementRiskManagementandFinancialInstitutions,3e,Chapter8,CopyrightJohnC.Hull20124
LIBOR Rates and Swap Rates ⚫ LIBOR rates are 1-, 3-, 6-, and 12-month borrowing rates for companies that have a AA-rating ⚫ Swap Rates are the fixed rates exchanged for floating in an interest rate swap agreement Risk Management and Financial Institutions, 3e, Chapter 8, Copyright © John C. Hull 2012 4
Understanding Swap RatesA bank canLend to a series AA-rated borrowers for tensuccessive six month periodsSwap the LiBOR interest received for thefive-year swap rateThis shows that the swap rate has thecredit risk corresponding to a series ofshort-term loans to AA-rated borrowersRiskManagementandFinancialInstitutions,3e,Chapter8,CopyrightJohnC.Hull20125
Understanding Swap Rates ⚫ A bank can ⚫ Lend to a series AA-rated borrowers for ten successive six month periods ⚫ Swap the LIBOR interest received for the five-year swap rate ⚫ This shows that the swap rate has the credit risk corresponding to a series of short-term loans to AA-rated borrowers Risk Management and Financial Institutions, 3e, Chapter 8, Copyright © John C. Hull 2012 5