Interest Rate Risk-1

Objective.
At the end of the session ,participants will Comprehend the following two
variants of Interest Rate Risk.

Mismatch /gap risk

Embedded option risk
Gap/Mismatch Risk
Gap risk arises from holding assets and liabilities with different
principal amounts, maturity dates or reprising dates ,thereby
exposing them to unexpected changes/volatility in the level of
interest rates.
The gap is the difference between the amount of assets and liabilities
on which the interest rates are reset or re-priced during a given
period/time horizon.
Usually the assets and liabilities mature or fall due for reprising at
different time intervals.
Gap/Mismatch Risk
For instance an investment in five year Government of India security
by using funds raised by issuing one year deposit clearly results in
liquidity mismatch.
In addition there is a re-pricing mismatch between the asset and
liability.
The deposits will have to be re-priced ,may be at a higher interest
rate at the end of one year while the asset will continue to provide
the fixed return for the remaining period of four years.
If the interest rate rises by the time deposit matures, bank will be
able to raise new deposit only at a higher interest rate prevailing in
the market.
This will result in the interest spread between deposit and
investment getting reduced and in turn adversely affect the Net
Interest Income of the bank.
Gap/Mismatch Risk
Deposits ,borrowings, loans ,investments etc. are interest sensitive
items, where as premises, stationary, computers etc. are non
sensitive to changes in interest rates in the market .
Often it is difficult to determine the precise point of time when some
of the items of interest sensitive asset/liability become due for re-
pricing.
On any day or during a specified period it is possible that there could
be more rate sensitive assets getting re-priced /maturing than
liabilities or vice-versa ,resulting in an interest rate mismatch.
If more interest rate sensitive assets re-price/mature on any day or
over a time interval than the interest sensitive liabilities during the
same period, the gap is called Positive Gap and if more liabilities
re-price than assets during the period such gaps are called Negative
Gap
Gap/Mismatch Risk
The relationship between interest rate changes and their impact on net
interest income are shown in the table below.

GAP Interest Rate change Impact on NII
Positive Increases Positive
Positive Decreases Negative
Negative Increases Negative
Negative Decreases Positive
Embedded Option Risk
Traditionally ,banks provide an option to depositors to prematurely
close the deposits and to borrowers to prepay the advances.
Banks customers would be exercising this option at a time most
unfavorable to the bank.
Depositors may prematurely close the deposits when interest rate
increase and redeposit at higher rates .
When interest rate decline, borrowers may opt to prepay the loans
and renew the same at the lower rate.
In both the cases banks net interest income is adversely affected.
The faster and higher the magnitude of changes in interest rate, the
greater will be embedded option risk to the banks NII.
Therefore most of the banks impose penalties for prepayment of
loans and premature closure of deposits in order to protect
themselves from this risk.