Question

Review the two models for measuring Interest Rate Risk, “The Repricing model and the Maturity model”  and present four (4) compelling arguments in support of each method.

Answer 1

what is interest rate risks:

it is the difference in the timing of the cash flows and the maturity of the assets and liabilities. As the interest rate increases, the assets having the longer maturity tends to fall faster than the liabilities. interest rate risk arises due to the changes in the value of the assets and liabilities due to the changes in the interest rates and also of the cash flows occurring in the middle of the of the financial asset like the coupon payments and there reinvestment rates.

there are two models which measure this interest rate risk:

1) repricing model 2) maturity model

the repricing model value the assets that will reprice and the value of the liabilities that will reprice due to the changes in the interest rates and hence the gap that will emerge as a result of the repricing.

repricing model for measures the net interest income: due to repricing happening the interest income that we will receive on the assets and the interest expense that we will pay on the liabilities will change. This model measures the net interest income which is the difference between the interest earned and the interest paid.

the maturity model measures the weighted average sensitivities as assets and the weighted average sensitivities of the liabilities.

it measures the :

1) maturity gap : which is the difference between the average maturity of assets and the average maturity of liabilities.

if this gap is zero , then there is a possibility of portfolio immunization , that is any changes in interest rates will result in equal offsetting changes in the assets and liabilities. but for immunization to happen, there is a critical assumption made that the timing of the cash flows should be the same.

large banks can measure their repricing and the reinvestment risks every day using this model.

the goal of this model is immunization, that is it should be immune to the changes in the interest rates.

arguments in support of each model:

repricing model:

• it is a simple model
• fewer inputs are used in the implementation of this model .
• it does not assume that the timing of the cash flows of the assets and liabilities is the same
• it is used by small banks to measure the changes in the value of their assets and liabilities due to the changes in the interest rates.

the maturity model:

• this model better represents the value of the assets and liabilities in the bank's portfolio. so this model depicts the economic reality better.
• it is used by large banks to determine the value of the assets and liabilities. so the repricing and the reinvestment risk can be estimated daily by them by using this model.
• another extension of this model is forecasting of interest rate changes , by using this model proper structuring of gaps can be made to immunize our portfolio .
• by using the maturity gap and the repricing gap , the banks can use strategies to change the value of the assets and liabilities and reduce the effect of interest rate changes on them.if the bank manager is certain of a possible direction the interest rates are moving he may use this maturity gap to take advantage and also to reduce the possible risks of a change in interest rates.