Interest Rate Risk Assignment - Essay Example

Indeed, the credit was sold to the customer at a lower price (lower interest rate) than it could have been if it had been sold at a later time. Certainly, this is one of the simple examples, but we must consider that the value of the bank itself can be directly affected by the interest rate risk, through changes in its overall assets and liabilities values2 and given the time value of money. The repricing gap model is one of the simplest used by banks to determine the amount of exposure for their assets and is based on "the net differences between interest rate sensitive assets and liabilities maturing at different times"3).

Within established time bands (one day, 1 day 3 months, 3-6 months etc. up to assets and liabilities with maturities of over 5 years), total liability values are subtracted from total asset values to evaluate a gap between the two. Each gap value thus obtained can be multiplied by a the assumed change in interest rates in order to obtain the potential numerical expression of the impact the change in interest rates will have on the value of that respective bandwidth (evaluated as the gap between assets and liabilities). . Despite the fact that the repricing gap model is simple enough to be used by almost everybody, one of its biggest disadvantages refers exactly to this simplicity of the model.

Indeed, there is practically no other variable being taking into consideration other than the difference in value between assets and liabilities within a time band. The market conditions generally impose multiple variable, such as different maturing and repricing periods4 or payments that need to be taken into consideration, so we may point out towards the fact that this model is only an approximation of the level of exposure of a bank to the interest rate risk.The duration gap analysis is somewhat more complex and provides more answers for a proper interest rate exposure analysis.

It "focuses on managing NII or the market value of equity, recognizing the timing of cash flows"5, which is something that the repricing gap model ignored. According to the same source (Koch and MacDonald), an effective duration gap analysis will include three main steps. First of all, the bank management and analysis department will need to develop a forecast for the future levels of interest rate. Subsequently, the management determined the market value for all the assets and liabilities held by the bank.

Third of all, an estimation of the weighted duration of assets and of the weighted duration of liabilities is made. In order to be able to hedge the market value of the bank's equity, the management will evaluate the difference between the weighted duration of assets and the weighted duration of liabilities and will set the condition that this equals to 0. Upon calculation, the bank management's conclusion will hold either an adjustment of either asset or liability weighted duration.3.a)