Interest Rate Risk Management

There is complete deregulation of Interest rates on Fixed Deposits, Recurring Deposits, and SB
Deposits above Rs. 1.00 lac. Banks are also free to determine Interest rates on NRE Deposit
accounts. This has led to interest rate Volatility resulting into greater Interest Rate Risk.
Adverse movement of Interest rates has direct impact on NII as well as NIM. Market Interest
rate also has impact on Present Value of Bonds and Securities. 1% rise in market rate of return
will cause lesser valuation of securities. Also 1% fall in interest rate will cause higher valuation
of securities resulting into increase in Mark to Market Price.
Types of Interest Rate Risk
Following are various types of Interest Rate Risk:
1. Mismatch or Gap Risk
This is risk of gap between maturities of Assets and Liabilities. Sometimes, Long term
loans are funded by short term deposits. After maturity of deposits, these liabilities are
get repriced and Gap of Interest rates between Assets and Liabilities may become
narrowed thereby leading to reduction of profits.
2. Basis Risk
Change of Interest rates on Assets and Liabilities may change in different magnitudes
thus creating variation in Net Interest Income. It tries to explain what will be the %age
effect on Earnings due to increase or decrease in interest rates by 1bps.
3. Net Interest Position Risk
If the bank has more assets than the liabilities, 1% decrease in interest rate will result
into less earnings and more expenditure on account of interest. This will directly affect
NII and NIM.
4. Embedded Option Risk
Adverse movement of Interest Rate may result into pre-payment of CC/DL and TL. It
may also result into pre-mature withdrawal of TDs/RDs. This will also result into reduced
NII. This is called Embedded Risk.
5. Yield Curve Risk
Yield is Internal Rate of Return on Securities. Higher Interest Rate scenario will reduce
Yield and thereby reduction in the value of assets. Adverse movement of yield will
certainly affect NII (Net Interest Income).
6. Price Risk
In financial market, when assets are sold before maturity in order to meet liquidity
requirements, loss may occur due to lower selling price.
7. Re-investment Risk
It is uncertainty with regard to interest rate at which future cash flows could be reinvested.
Effects of Interest Rate Risk
Effect on Earnings.
Effect on Economic value of share
Embedded Losses



Measurement of Interest Rate Risk
1. Re-pricing Schedules
All Assets and Liabilities are assigned to Re-pricing time bands according to past
judgment and experience of the banks. The schedule distributes Interest Sensitive
Assets, Liabilities and Off Balance Sheet Items into certain number of pre-defined time
bands.
Under this method, steps are as under:
Ist step---------Adjusted Gap is calculated by netting Interest bearing assets and interest
bearing liabilities.
2nd step---------Re pricing of assets is done as per the following example
3rd step---------Standard Gap is calculated after deducting Re pricing liabilities from Re
pricing Assets.
How it is calculated?
A bank has following Assets and Liabilities:
Call Money -------500 crore
Cash Credit—----400 crore
Cash in hand –---100 crore
SB Deposits-------500 crore
Fixed Deposits----500 crore
Current Deposits--200 crore
There is reduction in interest rates by 0.5% in call money, 1% in CC, 0.1% for SB and
0.8% for FD
Calculate Adjusted Gap
Adjusted Gap = (Call Money +CC) – (SB+FD) = 900 - 1000 = 100 crore Negative
Calculate Re pricing Assets
Re pricing Assets = (500*.5) + (400*1) = 250+400=650 crore
Calculate Re pricing Liabilities
Re pricing Liabilities = (500*.1) + (500*.8) = 50+400 = 450 crore
Calculate Standard Gap
Standard Gap = Re Pricing Assets – Re Pricing Liabilities
= 650 – 450 = 200 crore positive
2. Gap Analysis
Gap is Difference between RSA (Risk Sensitive Assets) and RSL (Risk Sensitive
Liabilities)
If RSA >RSL , it is called Positive Gap or Asset Sensitive Gap.
If RSA < RSL, it is called Negative Gap or Liability Sensitive Gap.
3. Duration Approach
Duration is the time that a bond holder must wait till nos. of years (Duration)to receive
Present Value of the bond.



E.g.5 year bond with Face Value of Rs. 100 @ 6% having McCauley Duration 3.7 years.
It means Total Cash Flow of Rs. 130 to be received in 5 years would be discounted with
Present Value which will be equivalent as amount received in 3.7 years. The Duration of
the Bond is 3.7 Years.
Formula of Calculation of McCauley Duration = ΣPV*T
ΣPV
Modified Duration = Duration
1+Yield
Approximate % change in price = Modified Duration X Change in Yield
4. Simulation Approach: It involves detailed assessment of potential effects of changes in
interest rates on earnings and economic value by simulating the future path of interest
rates and their impact on cash flows.
Simulation techniques could be
 Static simulation – on the basis of existing Assets and Liabilities
 Dynamic simulation – Detailed assumption about future structure of interest
rate regime.
Measures to Control Interest Rate Risk
1. Reduce Asset Sensitivity
Extend Investment portfolio maturity, Increase of Floating rate Deposits, Increase of
Fixed Rate lending, and Increase of short term borrowings and Long term Lending.
2. Reduce Liability Sensitivity
Reduction of Investment portfolio maturity, Increase of Floating rate lending, Increase of
Long term Deposits and Short term Lending.
3. Control and Supervision
 Board and Senior Management of Oversight Interest Rate Risk.
 Board of Directors must have proper control over Interest rate regime.
 Senior Management should be responsible for implementing policy.
 Lines of Authority and Responsibility must be clearly defined.