Interest rate risk and the

repricing gap model

Session 1
Andrea Sironi
Mafinrisk 2010
Market risk
2
Agenda

Interest rate risk

The repricing gap Model

Marginal and cumulative gaps

Problems of the repricing gap model

The standardized gap

3
Interest rate risk

Assets maturit ! liabilities refinancing risk

Assets maturit " liabilities reinvestment risk#

A change in the level of interest rates has a

double economic effect$

%irect effect$ change in the market value of A&' and

in the level of interests paid and received

Indirect effect$ change in the amounts of financial

activities
4
The Repricing Gap Model

(Income oriented model) target variable * +et

Interest Income ,+II- * Interest .evenues Interest
/0penses

Interest .ate 1ap difference bet2een assets and

liabilities sensitive to interest rates changes in a
predefined time period#

An asset or a liabilit is (sensitive) if3 in the relevant

time period ,(gapping period)-3 it reaches its maturit or
there is a renegotiation of the interest rate#
SL SA G
5
The repricing gap
4ensitive
'iabilities
,4'
t
-
+ot 4ensitive
'iabilities
,+4'
t
-
4ensitive
Assets
,4A
t
-
4ensitive
Assets
,4A
t
-
+ot 4ensitive
Assets
,+4A
t
-
Gap
t
(>0)
6
The model at work

4tarting point$

5e can also 2rite

If the change is the same for assets and liabilities6

interest rates$
( ) ( ) NSL SL i NSA SA i L i FA i IE II NII
p a p a
+ +
SL i SA i NII
p a

i i i
p a

( ) i G i SL SA NII
7
Follows
( ) i G i SL SA NII
Gap Positive Negative
Increase of int. rates
(i > 0)
Increase of net
interest income
(NII)
%ecrease of net
interest income (NII)
Decrease of int.
rates (i < 0)
%ecrease of net
interest income
(NII)
Increase of net interest
income (NII)
8
The model at work

4ome useful indicators$

impact on profitabilit of
lending activit

Impact on profitabilit
,.eturn on fin# assets-

scale independent
i
E
G
E
NII

,
_

i
FA
G
FA
NII

,
_

SL
SA
GapRatio
9
The timing problem

5e have made the assumption that a

change of the interest rate 2ill produce the
same effect for ever sensitive asset or
liabilit

7nder this assumption

In the real 2orld the effect is different for

ever A&' and is proportional to the time gap
bet2een the renegotiation time and the
ending of the gapping period
i G NII
10
Examples:
today 1 year p =1/12
fi0ed
rate
ne rate conditions
11 months
Gappping period: 12 months
time
8ase 1$
Interbank
deposit 2ith a
residual life
of 1 month
8ase 1$
Interbank
deposit 2ith a
residual life
of 1 month
today 1 year p =!/12
9i0ed rate ne rate conditions
6 months
Gappping period: 12 months
time
8ase 2$
88T
2ith repricing
in : months
8ase 2$
88T
2ith repricing
in : months
i as i p as ia
j j j j
< ) 1 (
For any
sensitive
asset:
the same applies
to sensitive
liabilities
11
The solution for the timing
problem

5e can 2rite
i
j
* current int# rate for the asset ;<th

* interest rate after variation

p
j
* is the time ,e0pressed as a fraction of the
gapping period- from toda to the ne0t renegotiation
of the int# rate
( ) ( )
j j j j j j j j
p i i SA p i SA II + + 1
( )
j j
i i +
( )

n
j
j j j
p i SA II
1
1
( )
j j j j
p i SA II 1
12
The solution for the timing
problem (follows

5e can do the same for liabilities

5e can calculate the (maturit ad;usted gap)

,ever A&' has a 2eight proportional to the
distance from the renegotiation period to the
end of the gapping period-
( )
k k k k
p i SL IE 1
( )

m
k
k k k
p i SL IE
1
1
( ) ( ) ( ) i E MAGAP i E p SL p SA IE II NII E
n
j
k
m
k
k j j

1
]
1

) ( 1 1 ) (
1 1
13
Marginal and cumulati!e gap

An alternative to Magap that can be used to estimate

the true e0posure of the bank to changes in interest
rates is the one based on the use of gaps relative to
different time periods#

Marginal Gap: the difference bet2een assets and

liabilities 2ith renegotiation of the interest rate in a
certain time period#

Cumulative Gap: difference bet2een assets and

liabilities 2ith renegotiation of the interest rate before
a certain date#

n
i
i
MG CG
1
14
"n example
1 month gap * 1=0
> months gap * >0
"##$%# & ' (I")I(I%I$# & '
%eposits 2ith banks ,1 month-
?@T ,> months-
88T ,A ears-
,ne0t rate revision : months-
4hort term loans ,A months-
9loating rate mortgages ,20 -
,ne0t rate revision 1 ear-
?TP ,A ears-
9i0ed rate mortgages ,10 -
?TP ,>0 ears-
200
>0
120
B0
C0
1C0
200
1>0
%eposits 2ith banks ,1 month-
9loating rate notes
,ne0t revision > months-
9loating rate notes
,ne0t revision : months-
9i0ed rate notes ,1 ear-
9i0ed rate notes ,A ears-
9i0ed rate notes ,10 -
Dunior debt ,20 -
4hareholders6 /Euit
:0
200
B0
1:0
1B0
120
B0
120
%ota* 1000 %ota* 1000
15
Marginal and cumulati!e gaps
The bank has a long net position for the first month and for the
period from > to : months and a short net position for the period
from 1 to > months and for the period from : to 12 months#
Time Period 4ensitive
Assets
4ensitive
'iabilities
Marginal
1AP
8umulative
1AP
0<1 months 200 :0 1=0 1=0
1<> months >0 200 <1C0 <>0
><: months 200 B0 120 F0
:<12 months C0 1:0 <F0 0
1<A ears 1C0 1B0 <10 <10
A<10 ears 200 120 B0 C0
10<>0 ears 1>0 B0 A0 120
%ota* 1000 ++0 < <
16
Follows
1iven the null 1 ear gap if in ever time sub<period the interest rate
change is adverse the bank can e0perience a decrease in the net interest
income#
%i'e
Period
,arg. G"P
(& '*n)
Int. rate
"ssets
Int. rate
(ia-i*ities
i it. respect
to %0
(-asis points)
$ffect on
t.e NII
T0 :#0G >G
1 month 1=0 A#AG 2#AG <A0

> months <1C0 :#>G >#>G H>0

: months 120 A#:G 2#:G <=0

12 months <F0 :#:G >#:G H:0

%ota*

17
18
The effect on #et Interest
Income

To Euantif the effect of the various interest

rate changes 2e have to keep track of the
length of the time period on 2hich ever
change has an effect#

/ven 2ith a null annual gap 2e can have a

non zero effect on the 1 ear net interest
income because ever interest rate change
has an effect on a different time period 2ith a
different marginal gap#
19
Follows

5e can 2eight ever marginal gap for the difference

bet2een the average renegotiation period inside the
marginal gap and the end of the evaluation period
,usuall 1 ear-#

T * global gapping period ,1 ear-

t
i
* average renegotiation period inside the i<th gapping
period

n * number of the time periods evaluated inside the

global gapping period

WGAPT * sensitivit of +II to changes of interest rates

duration of NII#
( ) ( ) ( ) ( ) i E WGAPT i E t T GAP NII E
i
n
i
i


1
20
$ome numbers
Time period
Marg.
GAP
( mln
Asset
!nt.
"ates
#iab.
!nt.
"ates
i
(b.p.
(GAP$i
( mln
T%ti
(T%ti $ GAPi
( mln
(T%ti $ GAPi
$ i
(
T0 :#0 >#0
1 month 1=0 C#0 =#0 100 1#= 0#F: 1>=#= 13>==3000
> months <1C0 C#0 =#0 100 <1#C 0#B> <1=1#C <13=1:3::C
: months 120 C#0 =#0 100 H1#2 0#:> CA#: CA:3000
12 months <F0 C#0 =#0 100 <0#F 0#2A <22#A <22A3000
%ota* 0 0 /!./ /!/0000
+ot 2eighted
1AP
Time
2eighted
1AP
21
%onclusion

+on zero marginal gaps can generate a non

zero variation of the interest margin even 2ith
a null cumulative gap for t2o main reasons$

The changes of interest rates can be non uniform

across different time sub<periods

The effect on the net interest income of the change

of interest rates is different across different time
sub<periods

To have a zero sensitivit of the +II 2e need

zero marginal gap for ever time sub period
22
Maturit&'ad(usted gap !ersus
time weighted cumulati!e gap

The maturit<ad;usted gap is more precise3 as it

considers the actual maturit of each asset and
liabilit

The time 2eighted cumulative gap ,based on

marginal gaps- considers one virtual maturit3
eEual to the median value

Io2ever3 marginal gaps have an advantage$

the allo2 to estimate the impact on +II of
different interest rate changes that ma occur
during the ear
23
)imits and problems
1# Assumption of a uniform change of assets and
liabilities6 interest rates#
2# Assets J 'iabilities 2ith no maturit ,e#g# call deposits-
># The model does not consider effects on the market
value of A&'#
=# Assumption of a uniform change of interest rates for
different maturities#
A# The model does not consider the effect of a variation
of interest rates on the volume of financial assets and
liabilities
24
"nswer to problem *:
$tandardi+ed Gap
The first problem can be addressed 2ith the follo2ing
procedure

5e identif a reference market rate3 for e0ample a >

months interbank rate

5e estimate the sensitivit of different assets6 and

liabilities6 interest rates to the reference rate

5e can calculate the standardized gap to evaluate the

sensitivit of the +II to a change of the reference rate
( ) ( )



n
i
m
j
j j i i
SL SA SG
1 1

25
$tandardi+ed Gap
Figure 4: example of an estimate of the beta of a rate-sensitive asset
r r r
j j
95 . 0
r
;
,rate
variations
on on<
demand
loans-
r
,three<month /uribor variations -
95 . 0 tan
j

26
"n example
1AP * 120 vs 4tandardized 1AP * 1C2

Iigher average sensitivit of Assets

5e can also solve the problem of call deposits and loans

"##$%# & ' (I")I(I%I$# & '
%eposits 2ith banks ,1m-
?@T ,>m-
9loating rate loans ,A-
9loating rate loans ,on call-
Kariable rate mortgages ,10-
,euribor H 100 basis points-
B0
:0
120
=:0
2B0
1310
130A
03F
03FA
1300
%eposits 2ith banks ,1m-
%eposits ,on call-
9loating rate notes
,ne0t revision >m-
9i0ed rate notes ,1-
9loating rate bonds ,10-
,euribor H A0 b#p#-
4hareholders6 /Euit
1=0
>B0
120
B0
1:0
120
1310
03B0
03FA
03F0
1300
%ota* 1000 %ota* 1000
27
Ans2er to problem 2$ ho2 to treat call
deposits and other (no maturit) AJ's
> steps$
1# Analse ho2 much and after ho2 long3 on
average3 historicall a market interest rate
change gets reflected in call deposits rates
2# %ivide 4A and 4' in coherent manner3
based on the historical empirical evidence#
># 8ompute the repricing gap based on the
ne2 values of 4A and 4'
28
"sset , liabilities with no maturit&
(e-g- current account deposits
12
232
102
+2
102
0#0
0#1
0#2
0#>
0#=
0#A
0#:
0#C
0#B
0#F
1#0
+ever
beond : m
5ithin : m
5ithin > m
4ame month
4irst step5 esti'ate
sensitivity to interest
rate c.anges
$6. Interest rate on deposits
1iven a 1G increase of the interbank rate3 the
interest rate on Italian banks6 deposits
increases b A bp immediatel3 2C bp the
follo2ing month3 other 10 bp in the follo2ing 2
monthsL
The total increase is A0 bp
,deposits have a 0#A beta-
#econd step5 a**ocate
deposits to different
corresponding 'at7rity
-7c8ets
29
.ne problem: sensiti!it& ma& be
as&mmetric
0#0
0#1
0#2
0#>
0#=
0#A
0#:
0#C
0#B
0#F
1#0
Increase .eduction
+ever
?eond : m
5ithin : m
5ithin > m
4ame month
%.e sensitivity coefficients 'ay
c.ange depending on t.e sign of
t.e interest rate c.ange
$6. Interest rate on deposits
30
Maturit& ad(usted Gap
standardi+ed and non'standardi+ed
+on standardized Ma1ap$ :>B#> :CB#> * <=0
4tandardizzato Ma1ap$ :1B#F :10#C * B32
Attivit& as' s' as' ((1%s' ' as' ((1%s' '
Prestiti a tasso varia-i*e (apert7re di
credito a vista) /!0 0 /!000 912 /:300
Depositi inter-. attivi a 1 ' +0 1/12 3:0: 1102 +003
);% a : 'esi !0 :/12 /100 1012 /30:
<rediti a* cons7'o a tasso varia-i*e a 1
anni (revisione tra ! 'esi) 120 !/12 !000 902 1/00
,7t7i a tasso var. a 10 anni (e7ri-or =
100 -asis points0 repricing tra 1 anno) 2+0 1 > 1002 >
%ota*e !:+0: !1+09
Passivit& ps' s' ps' ((1%s' ' ps' ((1%s' '
Depositi in c/c da c*iente*a :+0 0 :+000 +02 :0/00
Depositi inter-ancari a 1 ' 1/0 1/12 12+0: 1102 1/102
<D a tasso varia-i*e (prossi'a
revisione a : 'esi) 120 :/12 9000 912 +101
;--*iga?ioni a tasso var. a 10 anni
(e7ri-or = 10 -p0 repricing a ! '.) 1!0 !/12 +000 1002 +000
<D a tasso fisso a 1 anno +0 1 > 902 >
%ota*e !3+0: !1003
31
Residual problems
1# The model does not consider effects on the
market value of A&'#
2# Assumption of a uniform change of interest
rates for different maturities#
># The model does not consider the effect of a
change of interest rates on the volume of
financial assets and liabilities
32
/uestions , Exercises
1# 5hat is a (sensitive asset) in the repricing gap
modelM
A- An asset maturing 2ithin one ear ,or
renegotiating its rate 2ithin one ear-
?- An asset updating its rate immediatel 2hen
market rates change
8- It depends on the time horizon used as gapping
period
%- An asset the value of 2hich is sensitive to
changes in market interest rates
33
/uestions , Exercises
2# The assets of a bank consist of NA00 of floating<rate securities3
repriced Euarterl ,and repriced for the last time > months before-3
and of N13A00 of fi0ed<rate3 ne2l issued t2o<ear securitiesO its
liabilities consist of N13000 of demand deposits and of N=00 of
three<ear certificates of deposit3 issued 2#A ears before# 1iven a
gapping period of one ear3 and assuming that the four items
mentioned above have a sensitivit ,(beta)- to market rates ,e#g3
to ><month interbank rates- of 100G3 20G3 >0G and 110G
respectivel3 identif 2hich of the follo2ing statements is correct$
A- The gap is negative3 the standardised gap is positive
?- The gap is positive3 the standardised gap is negative
8- The gap is negative3 the standardised gap is negative
%- The gap is positive3 the standardised gap is positive
34
/uestions , Exercises
># ?ank @mega has a maturit structure of its assets and liabilities like the one
sho2n in the Table belo2#
9ind$
A- 8umulated gaps of different maturities
?- Marginal ,periodic- gaps relative to the follo2ing maturit buckets$ ,i- 0<1
month3 ,ii- 1<: months3 ,iii- : months<1 ear3 ,iv- 1<2 ears3 ,v- 2<A ears3
,vi- A<10 ears3 ,vii- beond 10 earsO
8- The change e0perienced b +II ne0t ear if lending and borro2ing rates
increase3 for all maturities3 b A0 basis points3 assuming that the rate
repricing 2ill occur e0actl in the middle of each time band ,e#g#3 after 1A
das for the band bet2een 0 and 1 month3 >#A months for the band 1<:
months3 etc#-#
#ensitive assets and *ia-i*ities for )an8 ;'ega (data in 'i**ion e7ros)
1 month :
months
1 ear 2 ears A ears 10 ears ?eond1
0 ears
Total sensitive assets A 1A 20 =0 AA BA 100
Total sensitive liabilities 1A =0 :0 B0 F0 FA 100

35
/uestions , Exercises
=# The interest risk management scheme follo2ed b ?ank 'ambda
reEuires it to keep all marginal ,periodic- gaps at zero3 for an
maturit band# The 8hief 9inancial @fficer states that3 accordingl3
the bank6s net interest income ,+II- is immune from an possible
change in market rates# 5hich among the follo2ing events could
prove him 2rongM
I- A change in interest rates not uniform for lending and borro2ing rates
II- A change in long term rates 2hich affects the market value of items
such as fi0ed<rate mortgages and bonds
III- The fact that borro2ing rates are stickier than lending rates
IK- A change in long term rates greater than the one e0perienced b
short<term rates
A- I and III
?- I3 III and IK
8- I3 II and III
%- All of the above
36
/uestions , Exercises
A# 7sing the data in the Table belo2 ,and assuming3 for simplicit3 a >:0<da ear made of 12
>0<da months-$
i- compute the one<ear repricing gap and use it to estimate the effect on +II of a 0#AG
increase in ratesO
ii- compute the one<ear magap and use it to estimate the effect on +II of a 0#AG increase in
ratesO
iii- compute the one<ear standardised magap and use it to estimate the effect on +II of a 0#AG
increase in ratesO
iv- compare the differences among the results under i-3 ii- and iii- and provide an e0planation#
Assets

Amount

%as to
maturit&
repricing


%emand loans 1000 0 F0G
9loating rate securities :00 F0 100G
9i0ed<rate instalment loans B00 2C0 B0G
9i0ed<rate mortgages 1200 C20 100G
iabilities

Amount

%as to
maturit&
repricing


%emand deposits 2000 0 :0G
9i0ed<rate certificates of deposit :00 1B0 F0G
9loating<rate bonds 1000 >:0 100G