Interest Rate Risk - vfccu.orgWhat is INTEREST RATE RISK? Threat that a change in market interest rates may: • Reduce net interest income • Adversely affect the economic values

Interest Rate Risk Lisa Boylen

VP ALM Services

Session Objectives •  Understand the risk associated with

changes in interest rates •  Gain a basic understanding of the various

sources of interest rate risk

What is INTEREST RATE RISK?

Threat that a change in market interest rates may:

•  Reduce net interest income •  Adversely affect the economic values of

financial assets and liabilities •  Impair capital, elevating the risk of

insolvency •  Impair liquidity

IRR – Why is it Important? The majority of our assets and liabilities

are financial instruments We buy and sell money Income - We sell loans and receive interest. Expense - We buy shares and pay a dividend

The income we earn is therefore affected by future economic

circumstances and future interest rates.

SOURCES OF INTEREST RATE RISK • Repricing Risk • Basis Risk • Yield Curve Risk • Option Risk

REPRICING RISK Repricing risk is the risk resulting when

assets and liabilities have different average maturities or repricing dates.

Earnings change when there is a change in the level of rates.

WHAT CAUSES REPRICING RISK? Borrowing short term to fund long-term assets

•  Problematic when rates rise Borrowing long term to fund short-term assets

•  Problematic when rates fall

Repricing Risk Example

Balance Sheet

Year 1 Year 2 – Fed Raises

Rates 1%

Rate Income/ Expense

Rate

Income/ Expense

$5,000,000 15 year Mortgage 5.25% $262,500 5.25% $262,500

$5,000,000 1 Year Certificate 2.00% $100,000

3.00% $150,000

Net Interest Income 3.25% $162,500 2.25% $112,500

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BASIS RISK

•  This is the risk from unequal movements in interest rates on a credit union’s assets and liabilities with the same maturity or repricing.

Basis Risk Example ASSET Home Equity Line of Credit

•  Loan Rate = Prime + 1 •  Resets Annually •  Initial Rate

Ø Prime 3.25% Ø Spread 1.00% Ø Rate 4.25%

LIABILITY Member Certificate

•  1 Year Maturity •  Renewable Annually at

Prevailing Rate •  Initial Rate

Ø 1.50%

Basis Risk Example

Balance Sheet

Year 1 Year 2 – Prime Increases 1%

Year 3 – Prime Decreases 1.5%

Rate Income/ Expense

Rate

Income/ Expense

Rate Income/ Expense

$5M HELOC 4.25% $212,500 5.25% $262,500 3.75% $187,500

$5M 1 Year Certificate

1.50% $75,000

2.00% $100,000 1.25% $62,500

Net Interest Income

2.75% $137,500 3.25% $162,500 2.50% $125,000

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Yield Curve Risk

•  Risk of short-term rates changing by more or less than the change in long-term rates.

•  Rule of Thumb •  Short term rates are often more volatile than

intermediate and long-term rates.

YIELD CURVE RISK

Yield Curve Risk Example

Balance Sheet

Year 1 Year 2 – Fed Raises

Fed Funds 3%

Rate Income/ Expense

Rate

Income/ Expense

$5,000,000 15 year Mortgage Matures in Year 2

5.25% $262,500 6.00% $300,000

$5,000,000 1 Year Certificate 2.00% $100,000

4.00% $200,000

Net Interest Income 3.25% $162,500 2.00% $100,000

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OPTION RISK

Option risk is the risk of adverse

consequences from customer decisions to exercise options in products, such as

prepay loans

CAUSES OF OPTION RISK

Option risk arises whenever credit union

products give customer the right, but not the obligation, to alter the quantity or

the timing of cash flows

EXAMPLES OF OPTION RISK •  Contractual Options

§  Call/Put options in securities §  Interest rate caps, floors

•  Ambiguous Options §  Loan prepayments/payoffs §  Revolving balance accounts, credit cards, lines of

credit §  Withdrawal of shares §  “Implicit” rate caps and floors

Review Questions Interest rate risk refers to the risk that the

credit union’s earnings and capital may be affected by changes in market interest rates

q  True q  False

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Review Questions Which of the following are sources of

interest rate risk (Select all that apply) q Yield Curve Risk q Option Risk q Credit Risk q Repricing Risk q Reputation Risk q Basis Risk

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