Interest rate risk management in vietcombank

Most of the banks now just payattention to the credit risk management and liquidity risk management but forgetsome very specific important basic risks of banking business which are FX ri

NATIONAL ECONOMIC UNIVERSITY

BUSINESS SCHOOL

BUSINESS SCHOOL

NGUYEN MANH QUAN

INTEREST RATE RISK MANAGEMENT

NATIONAL ECONOMIC UNIVERSITY

HANOI, 2015

I want to sincerely thank to Vietcombank Security Company for giving permission

to commence this dissertation in the first instance, providing me with the effectivedata, helped to supply relevant material and support me much for the competition ofthis dissertation

Without the support of all those people I could not complete my dissertation andgain a great knowledge for my field of research Thus, I want to thank all of themagain

EXECUTIVE SUMMERY

With the rapidly developed in the economy, globalization is not the strange conceptbut becoming a new necessary trend of development to every macro economy ofeach nation Official join the World Trade Organization (WTO) at November 7th

2006 and some local co-cooperation organizations, Vietnam in general and bankingsystem in particular now is taking some very first steps to integrate to the new trend

of development Considered as a developing country, Vietnam has many advantagesand along with disadvantage in changing the economic structure Specially, for eachnation to developing in the economy, the banking system must be considered as themost important factor to ensure the forward moving of this economy However,Vietnamese commercial banks business in the market economy is facing with manydifficulties and potential risks which have great impact to the business result andbanks’ prestige Therefore, to ensure the stable and effective development ofcommercial banking systems, all the commercial bank in Vietnam must monitor andminimize the potential risks through the act of risk management In recent years,risk management has gained the notice of all commercial banks in Vietnam,however, the consideration is not totally completed Most of the banks now just payattention to the credit risk management and liquidity risk management but forgetsome very specific important basic risks of banking business which are FX risk,interest rate risk …

In reality, the act of remaining the stable in interest rate in long period ofcommercial bank has made their administrators neglect the interest rate riskmanagement However, the interest rate risk is one of very specific risk of thebanking business which means that when the managers have the great effort tocontrol the risk, it will make their bank develop with the rapid speed Therefore, theadministrators of Vietnamese commercial banks must have heightened theawareness about the importance of interest rate risk management

TABLE OF CONTENT

ACKNOWLEDGEMENT 1

EXECUTIVE SUMMERY 2

TABLE OF CONTENT 3

ABBREVIATIONS 5

LIST OF TABLES AND FIGURES 6

INTRODUCTION 7

1 Rationale: 7

2 Research objective: 8

3 Research question: 8

4 Research methodology: 8

5 Research scope: 9

6 Research structure: 9

1 Chapter 1: Theoretical background on interest rate risk management in commercial banks: 10

1.1 Overview of interest rate risk management: 10

1.1.1 Interest rate risk: 10

1.1.2 Interest rate risk management: 12

1.1.3 The need of interest rate risk management in banking business: 12

1.2 Content of interest rate risk management 14

1.2.1 Identifying interest rate risk: 15

1.2.2 Measuring interest rate risk 16

1.2.3 Controlling interest rate risk: 20

1.3 Factors affecting interest rate risk management in commercial banks: 29

1.3.1 Internal factor: 30

1.3.2 External factors: 31

2 Chapter 2: Reality in interest rate risk management in Vietcombank 33

2.1 Introduction to Vietcombank 33

2.1.1 History: 33

2.1.2 Organizational structure: 34

2.1.3 Business performance 36

2.2 Reality in interest rate risk management in Vietcombank: 37

2.2.1 Identifying interest rate risk: 37

2.2.2 Measuring interest rate risk : 40

2.2.3 Controlling interest rate risk: 44

2.3 Evaluate the real interest rate management in Vietcombank: 45

2.3.1 Achievement: 45

2.3.2 Shortcoming: 46

2.3.3 Reasons: 48

3 Chapter 3: Solution to improve interest rate risk management in Vietcombank 54

3.1 Orienting the interest rates risks management of Vietcombank 54

3.1.1 Orienting the interest rates risks management in Vietnam’s banking system: 54

3.1.2 Orienting the interest rates risks management of Vietcombank: 55

3.2 Solution to improve interest rate management in Vietcombank 56

3.2.1 Improving the policies on interest rate risk management: 56

3.2.2 Improving method for measuring interest rate risk : 58

3.2.3 Improving method for controlling interest rate risk: 63

3.2.4 Other Solutions: 64

3.3 Recommendations: 67

3.3.1 Recommendation for the State: 67

3.3.2 Recommendations for central bank: 69

CONCLUSION 73

REFERENCES 74

ABBREVIATIONS

LIST OF TABLES AND FIGURES

FIGURE 1: RESEARCH PROCESS 8

FIGURE 1.1: MODEL OF RISKS IN COMMERCIAL BANKING BUSINESS 11

FIGURES 1.2: MODEL OF INTEREST RATE RISK MANAGEMENT 15

FIGURE 1.2: THE TRANSACTIONS OF HEDGING INTEREST RATE: 20

FIGURE 1.3: GRAPH OF INTEREST RATE FLUCTUATIONS AND CONTRACT CAPS 27

FIGURE 1.4 GRAPH OF INTEREST RATE FLUCTUATIONS AND CONTRACT FLOORS 28

TABLE 2.1: VCB BUSINESS RESULT IN PERIOD OF 2009-2013 36

TABLE 2.2: VALUE OF ASSET – LIABILITY IN EACH PERIOD IN 2013: 41

TABLE 2.3: REACTION WHEN THE SENSITIVE GAP IS POSITIVE 42

TABLE 2.4: REACTION WHEN THE SENSITIVE GAP IS NEGATIVE 42

TABLE 2.5: THE AVERAGE MATURITY OF LIABILITY – ASSET IN 2013: 43

TABLE 3.1: EXAMPLE FOR RE-PRICING MODEL 59

TABLE 3.2: THE VALUE OF ASSET AND LIABILITY DUE TO THE RE-PRICING PERIOD: 62

Introduction

1 Rationale:

- The essential of risk management is undeniable not only for the commercialbanks but also for all the firms which want survive and develop in themarket In 2014, the system of commercial banks in Vietnam has to face withthe huge numbers of problems despite the announcement of Standard &Poor, which is one of the Big three credit-rating agencies, about the advance

of banking business due to “the stable economic environment in Vietnam”.These are the high challenge of asset quality, the challenge of low revenueand the weakness of capital Those problems cannot be solved in one daywith only one or two methods However, the most relevant solution forcommercial banks in Vietnam to develop is to promote the act of riskmanagement This economic topic has a wide range of research Despite ofthat fact, each business will have the own specified risk and the interest raterisk is one of the most basic risk of banking business The nature of bankingbusiness is to get profit through the fluctuation in the rate Thus, the moresuccessful bank will be the bank which performs better in controlling therate To have the clarified awareness of the impact of interest rate riskmanagement, Vietcombank is one of the first commercial banks in Vietnam

to have paid consideration to this work However, some restrictions are stillexisted and have played a role to encumber the business of the bank itself.The biggest shortcoming of Vietcombank is not having the appropriatepolicies in managing the interest rate risk Hence, the dissertation will focus

on the interest rate risk management of Vietcombank and draw out somemethod to improve the act of interest rate risk management in Vietcombank

2 Research objective:

- Giving theoretical background on interest rate risk management incommercial banks

- Analysing the real in interest rate risk management in Vietcombank

- Recommending the potential solutions to improve the interest rate riskmanagement in Vietcombank

in VietcombankRecommendations

Collecting data

Theoreticalbackground Research

objectives

- Data collection:

In collecting data, secondary data collection method is applied in this researchwhich is used mainly as information for corporate valuation advisory service andthe other relevant materials These secondary data are used as theoreticalbackground and to draw out the reality picture of interest risk management inVietcombank

The data will be mainly on the financial report of Vietcombank from 2009 to 2013

- To solve the problem that is raised, the dissertation including 3 main chapter:

o Chapter 1: Theoretical background on interest rate risk management

in commercial bank

o Chapter 2: Reality in interest rate risk management in Vietcombank

o Chapter 3: Solution to improve interest rate risk management inVietcombank

The dissertation proposes some possible methods to reduce the interest rate risk inVietcombank but due to the lack of specialized knowledge and information aboutfinance state, monetary state and banking state, the dissertation cannot avoid someminor mistakes Hence, all the feedback and compliment will be welcome

1 Chapter 1: Theoretical background on interest rate risk management in

commercial banks

The trend of liberalization in Vietnam economy and globalization economy makesthe banking business become more and more complex with a the rise of many hugepotential risks such as credit risk, interest rate risk, foreign exchange risk, liquidityrisk, etc Along with the financial liberalization, interest rate risk becomes one ofthe most basic risks of commercial bank Within the scope of the research, thedissertation will just dig into the research of interest rate risk

1.1 Overview of interest rate risk management:

1.1.1 Interest rate risk:

There are many different interpretations of “risk”, therefore there are many differentway to define “risk” It is difficult to acquire a high accurate of definition about riskfor each different business environment as well as each stage of economicdevelopment in society That’s the reason why the most appropriate way toapproach to “risk” is to consider it as a possibility to occur the loss in finance Theterm “risk” is used as a meaning of “uncertain” to describe the variation inprofitable rate of a certain asset According to Frederic S.Mishkin, author of “Theeconomics of Money, Banking, and Financial Markets (1992)”, interest rate risk can

be defined as following:

Interest rate risk is the possibility of the bank to face with the decline of profit or loss of property due to the volatility of interest rate The incommensurate between the maturity of asset and liability charge a bank a risk of interest rates

The fluctuation in interest rates could lead to the risk in commercial bankingactivity:

In one specific case when the commercial bank decides to maintain the assets withthe longer term than the debt assets, it leads to the risk of interest rate in refinancing

the debt asset (invest in the asset with the fix interest rate but mobilizing with thefloating rate) Supposed that the deposit rate is 9% per year in one year period andthe investment rate is 10% per year in two year period, with the investment of 100million VND in 2 year period which is funded by the mobilizing capital in one yearperiod, the commercial bank will receive the profit of 1% by the interest spread.Although, the deposit rate can be changed in year two so that the commercial banksmay face with the risk of interest rate The risk of losing profit can become reality ifthe deposit rate continues to increase in the following year, which is higher than theinvestment rate For example, the deposit rate (one year period) in 2nd year is 11%,the profit from the investment will be a negative number: 100 mil VND x (10%-11%) = -1 mil VND.

In the case when the commercial bank mobilizes the long-term capital and invests inthe short-term investment, the bank faces with the interest rate risk (invest in theasset with floating interest rate but mobilize with the fixed interest rate) For morespecific, supposed that the commercial bank mobilizes the capital with the rate of9% per year in 2-year-term and invests in the asset with the rate of 10% per year in1-year-term, the, if the investment rate decreases to 8% per year in 2nd year, the loss

of the bank will be equal with 1% of the deposit rate

Figure 1.1: Model of risks in commercial banking business.

(Source: Basel Committee on Banking Supervision (2001), Consultative Document

“Principals for the Management and Supervision of Interest rate risk”)

1.1.2 Interest rate risk management:

Management in business and organizations is the function that coordinates theefforts of people to accomplish goals and objectives using available resourcesefficiently and effectively Management comprises planning, organizing, staffing,leading or directing, and controlling an organization to accomplish the goal.Resourcing encompasses the deployment and manipulation of human resources,financial resources, technological resources, and natural resources Management isalso an academic discipline, a social science whose objective is to study socialorganizations

Risk management is the identification, assessment, and prioritization of risks(defined in ISO 31000 as the effect of uncertainty on objectives) followed bycoordinated and economical application of resources to minimize, monitor, andcontrol the probability and/or impact of unfortunate events or to maximize therealization of opportunities According to that definition, we can define the interestrate risk management as:

Commercial bank

Interest

rate risk

FX risk Credit risk

Other risk

Interest rate risk management is the process of identifying, measuring and controlling the interest rate risk.

1.1.3 The need of interest rate risk management in banking business:

1.1.3.1 Interest rate risk is one of the most common risks of banking business.

In the former economy (centralizer economy), the activities of the bank isonly complied with the direct order from the government The banking system inthe centralizer economy does not run based on the normal economic rules,therefore, the risk management is not the major concern

When Vietnam switched to the market mechanism, the typical economiclaws such as the law of value, the law of supply and demand, competition rules …become more and more effective The risks of the market or for further, theeconomy make the direct or indirect impact on the banking business Banks andother non-bank financial institution are standing in the siege of 4 groups which havemoney or need money to invest in the economy, including: Household, Business,Government and Foreign investor The products that the commercial bank uses totrade in the market are the flowing capital services and other banking facilities.Essentially, banking business is the business that uses the reputation to attract theinvestment and uses their capability in managing risk to make profit by that source

of capital along with developing other service as the intermediary between thesupply forces and demand forces in banking service Thus, interest rate is the price

of input as well as the output of the bank The interest rate risks are always standing

in most of the banking operations of the bank due to the fluctuation

Banking business is the business that including many potential risks and theinterest rate risk is the most common risk of commercial banks This is thought thatthe banks need to evaluate every opportunity base on the relationship of risk andbenefit in order to seek out the true opportunities with the acceptable benefits whichworth to risk The commercial bank will work well if the risks that it incurs arereasonable and controllable

1.1.3.2 Business performance of commercial bank depends on the capability to

manage the interest rate risk:

In banking business, there are many objective factors and subjective factorsthat bring the interest rate risk, including many majeure factors so that thecommercial bank cannot avoid the risks In term of market volatility, the changing

in market interest rate can lead to the damage to property as well as can affect theincome of commercial banks The impact of interest rate risk can lead to the risk oflacking of available capital and may affect entire banking business operations.Therefore, annually, commercial banks have to set up a fund to offset risk andaccount it into cost The scale of the offset risk fund depends on the level and theprobability of risk If the probability of the risk and the level of them are low, theeconomic efficiency of the bank will increase and vice versa

Interest rate risk exists in every basic activity of the commercial bank.Capital mobilization, credit activities, foreign currency trading activities … are bothincluding many potential interest rate risks Thus, to maximize the banking businessperformance, the act of managing interest rate risk must be considered adequately

Interest rate risk management in particular also with the risk management ingeneral has the effect of reducing the impact to the commercial bank value when thefluctuations happen By reducing the volatility, risk management reduces theprobability of exhausted financial capacity

1.1.3.3 Success interest rate management is an important condition to improve

the quality of banking business:

With the trend of integration, the competition becomes more and more fierce.The operation quality becomes the initiate factors that decide the existence of eachcommercial bank If the acts of managing interest rate risk are concerned andimplemented effectively, it will lead to the increase in quality of other businessactivities in commercial bank due to the impact of the fluctuations in the interestrate on the major activities of the banks such as creating capital activity, mobilizing

capital… Focusing in managing the interest rate risk will facilitate the improvement

in quality of mobilizing capital activity and credit activity in particular along withentire business activities of the commercial bank in general

1.2 Content of interest rate risk management.

The content of interest rate risk management will be including 3 main processes:

- Identify interest rate risk

- Measuring interest rate risk

- Controlling interest rate risk

For specific, the interest rate risk management is one of the specified risks in bankingbusiness The act of identifying it actually is to identify the property that sensitive tointerest rate Therefore, to measure it, the commercial banks need to use the deviationgraph method in order to draw out the sensitive gap and maturity gap of 2 groups: Thesensitive Asset and sensitive Liability By evaluating the result the graph, theadministrators can decide how to manage interest rate risk

Figures 1.2: Model of interest rate risk management

Identifying interest

rate risk.

Mesuaring interest rate risk through the sensitive gap and maturity gap.

Controlling interest rate risk.

(Source:Basel Committee on Banking Supervision (2001), Consultative Document

“Principals for the Management and Supervision of Interest rate risk”.)

1.2.1 Identifying risks:

Assets/Liabilities held by a bank that are vulnerable to changes in interest rates.This change can occur either when the asset matures or when it is re-pricedaccording to an index rate The value of these assets/liabilities is adjusted according

to the rise or fall of a published rate or index Therefore, the act of identifying risk isthe act of identifying the asset and liability which is sensitive to interest rate Thesetwo types of properties can affect directly to the net income of a commercial bankdue to the fluctuation in its value when the interest rate changes The fact ofbanking business is to get money from the gap between interest rates (the depositinterest rate and loans interest rate) so even the smallest fluctuation in interest ratewill lead to the loss or gain in the net income By identifying those properties out ofother and put them in the order of maturity, the bank can easily see what situationthey may have to face with if there is a change in the market interest rate or marketvalue

1.2.2 Measuring the interest rate risk.

Measuring interest rate risk through the sensitive gap between Asset and Liability:

To manage the act of managing the sensitive gap, the commercial banks need to analyze the current term, re-pricing terms and the opportunities which related to theprofitable properties of the banks, deposit as well as the loans on market At any moments, the commercial banks can self-defend before the change in the market interest rate To ensure that, the banks must maintain the following balance:

Value of the sensitive property = Value of the sensitive liability.

- The sensitive property is the sensitive asset which can be re-priced when there is a change in interest rate: upcoming maturity loans, loans and

securities which have the floating rate …

- Sensitive liability is the capital whose interest rate is controlled and adjusted due to the change of market: short-term deposits, the deposits which have thefloating rate…

When there is the unbalance between the value of sensitive asset and the value of sensitive liability, the sensitive gap is formed:

Scale of sensitive Gap (R) = Value of sensitive asset – Value of sensitive liability

The change in profit = Scale of sensitive gap* The level of interest rate

changing.

In each period (day, month, year …), if the value of sensitive asset is greater than the value of sensitive liability, we have the positive result of sensitive gap or the sensitive asset gap And vice versa, if the value of sensitive asset is smaller than sensitive liability, the results of the gap will be negative or the sensitive liability gap

- In the case when R=0: the value of sensitive asset equal to the value of sensitive liability: When the interest rate increases or decreases, there is no impact to the profit of the commercial banks

- In the case when R>0: The value of sensitive asset is greater than the value

of sensitive liability: When the interest rate increases, the net income of the commercial bank will also increase and vice versa, when the interest rate decreases, the net income will decrease

- In the case when R<0: The value of sensitive asset is smaller than the value

of sensitive liability: When the interest rate decrease, the net income of the commercial bank will increase Vice versa, when the interest rate increases, the commercial bank will suffer the decrease in net income

Therefore:

- When R=0: The interest rate risk will not appear

- When R>0: The interest rate risk will appear if the market rate decreases In this case, the commercial bank can decide to do nothing and gamble on the

future increase or stable of the interest rate; decrease the value of sensitive assets or increase the value of sensitive liabilities; lengthen the maturity of sensitive assets or shorten the maturity of sensitive liabilities.

- When R<0: The interest rate risk will appear if the market rate decreases In this case, the commercial bank can decide to do nothing and gamble on the future decrease or stable of the interest rate; increase the value of sensitive assets or decrease the value of sensitive liabilities; lengthen the maturity of sensitive assets or shorten the maturity of sensitive liabilities

In the modern economy, strong commercial banks usually identify the value of sensitive asset and liability in different terms and the level of sensitive to interest rate managing based on the knowledge of risks management and the experience of their administrators However, the technique of managing sensitive gap still exist some restrictions The act of choosing what terms to analyze is completely up to the decision of each bank Along with that, the interest rate in banking business andmarket rate are changing differently and with the different speed At last, the aim ofmanaging the sensitive gap is not to guarantee the value of sensitive asset and specially is not to guarantee the net income of the banks To ensure those acts, the bank must analyze the maturity gap as well

Measuring interest rate risk through maturity gap of the property:

* The general rule in the management of interest rate risk for an asset as well as a portfolio of assets is:

- An increase (decrease) in market interest rates have led to a decrease(increase) the value of the property portfolio

- When market interest rates increase (decrease) the asset portfolio withlonger term will decrease (increase) the greater the damage, but the speed willdecrease as maturity increases

* Quantitate interest rate risk for a property:

∆ R: Changing rate of the interest (%)

P1M : Market value of the property when the interest rate changes

P1 : Market value of the property at that time

R1M : After changing interest rate

R1 : Interest rate at that time

* Quantitate interest rate risk for a specific property portfolio.

Applying the formula for calculating the amount of interest rate risk for a specificasset, but the market value of a specific portfolio of assets is calculated based on theaverage term to maturity of the portfolio assets Average term to maturity of theportfolio of assets is determined:

M A : Average term to maturity of the portfolio assets

M L : Average term to maturity of the portfolio liabilities

W Ai : Proportion of asset i

M Ai : Term to maturity of asset i

W Lj : Proportion of liability j

M Lj : Term to maturity of liability j.

*Quantitate interest rate risk for balance sheet:

A, L, E, respectively are the market value of assets, deposits and equity capital Anincrease (decrease) in market interest rates will change the market value of equitycapital The change in equity capital is defined as the difference between the change

in assets and deposits: ∆ E=∆ A−∆ L

Despite the fact that the commercial banks can use the maturity gap method easily,still the restrictions exist: It is hard to identify the assets and liability which have thepayback terms and repayment terms appropriate to the banks’ requirements Forsome properties which cannot be identified exactly the inflow and the outflow, it isimpossible to calculate the payback term and repayment term However, thismethod is still used in interest rate risk managing

1.2.3. Controlling:

The most common way to control the impact of interest rate risk is to hedge By using the derivative tools (type of contracts), the commercial banks can easily control the impact of interest rate risk and decrease the loss in the profit to ensure the survival and development themselves

Figure 1.2: The transactions of hedging interest rate:

(Source: Basel Committee on Banking Supervision (2004), Risk management

guidelines for derivatives.)

1.2.3.1. Forward contract:

Definition:

In finance, a forward contract or simply a forward is a non-standardized contractbetween two parties to buy or to sell an asset at a specified future time at a priceagreed upon today, making it a type of derivative instrument.[1][2] This is in contrast

to a spot contract, which is an agreement to buy or sell an asset on its Spot Date,which may vary depending on the instrument, for example most of the FX contractshave Spot Date two business days from today The party agreeing to buy theunderlying asset in the future assumes a long position, and the party agreeing to sell

The transactions of hedging interest rate

the asset in the future assumes a short position The price agreed upon is called thedelivery price, which is equal to the forward price at the time the contract is enteredinto.

Types of the forward contracts in hedging the interest rate:

a Bond forward contract:

Bond forward contract is a contract to trade the agreed bond at time t = 0 that thebond seller will be given to the buyer and the buyer pays the seller at the time ofexpiry

Market bond prices fluctuate inversely with market interest rates, if the case forecastmarket interest rates will rise in the future banks will implement the terms of thesale of bonds and vice versa if the case forecast market interest rates will decline inthe near future the bank will make a purchase term bonds to hedge interest rate

b Deposit forward contract:

Deposit forward contract is used when there is asymmetric in terms of assets andliabilities term With this type of contract, there are a useful help for the bank notonly to limit the damage caused by the fluctuation of interest rates but also but also

to avoid the liquidity risk

For example: At the time t 0 bank signed a credit agreement with a customer has a fixed interest rate, duration from t 0 to t 2 but only banks raise capital for a period of t 0 to t 1 (in which t 0 <t 1 <t 2 ) Also at the time t0, to hedge interest rate increase at the time t 1 bank signed a term deposit with the following partners: at the time t 1 bank pledged to recognize and partner commitment will send a certain amount of money at a fixed interest rate unchanged from t 1 to t 2 deadline With this agreement the bank deposit guarantee fund for loans from time t 1 to t 2 with interest rates in advance This will not be affected by fluctuations in interest rates in the future.

c Interest rate forward contract:

Features of interest rate futures contract is no forwarding principal amount thatrelates only to part exchange rate differences.

For example, at the time t0 the bank signed a credit agreement with a customer has afixed interest rate, the duration from t0 to t2 but banks commander

up funding for a period of t0 to t1 (where t <t1 <t1) with an interest rate rb Thus, attime t1 if market interest rates rise, the banks would face losses due to mobilizationwith higher rates for additional funds for loans To limit the risk may occur, at thetime t0 bank signed a interest rates future contract with the following contents:

- The contract value is P (the basis for calculation, in fact the parties to thecontract are not forwarding this amount)

- Contract duration: from t1 to t2

- The interest rate is fixed by contract rb (or a specific interest rate which shall

be mutually agreed)

At the time t1 if the market interest rate is rc which is greater than rb, the bank willreceive an offsetting interest rate is: P (rc – rb) (t2 – t1) and vice versa, if the rc issmaller than rb banks must spend an amount corresponding to the above.Thus, the term of the contract whether interest rates at the time t1 increase ordecrease the banks still have an income from the difference in interest rates andinterest rates are predetermined

Future contract:

Definition: In finance, a futures contract (more colloquially, futures) is a

standardized contract between two parties to buy or sell a specified asset ofstandardized quantity and quality for a price agreed upon today (the futures price)with delivery and payment occurring at a specified future date, the delivery date,making it a derivative product (i.e a financial product that is derived from anunderlying asset) The contracts are negotiated at a futures exchange, which acts as

an intermediary between buyer and seller The party agreeing to buy the underlyingasset in the future, the "buyer" of the contract, is said to be "long", and the party

agreeing to sell the asset in the future, the "seller" of the contract, is said to be

∆ P : The change in market value of bonds

P : Market price of the bond

D : Duration of bonds

∆ R: The level of interest rate changes expected

− The level of risk for the bank's own capital when market interest ratesfluctuate depending on:

o A disproportionate amount of time between assets

o Scale of assetsAnd this is measured by the formula:

(1+R)

∆ E : Change of the bank's own capital

D A : Duration of total assets

D L : Duration of total mobilizing capital

k : The ratio of mobilizing capital and assets, k = L / A

A : Scale of assets

∆ R

(1+R) : Level of the change in interest rate

Prices of futures contracts reflects the value of securities used in the purchasecontract, so when market interest rates rise, the price of the futures contract fell Theprice of the stock fell as much market interest rates rise depends on the amount ofthe securities According to the model, the amount of the price sensitivity of futurescontracts on interest rates is calculated as follows:

∆ P

∆ F : The change in value of the futures contract

D f : The duration of the bonds used in purchasing futures contracts

∆ R : The level of interest rate changes expected

F : The initial value of the futures contract

The initial value of the futures contract is determined as follows:

N F : Number of contracts

P F : The price of each futures contract

We can rewrite the formula as follows:

In order to hedge the interest rate on the entire balance sheet bank assets to makethe number of futures contracts necessary to balance sheet losses were offset byprofits from contracts hybrid sheet:

in the contract In contrast, the option seller is obliged not entitled to sell / buy aquantity of goods according to a pre-agreed price in the contract and collect a feefor selling the option The fee is paid to the seller at the time of signing the contract.Thus, for option trading, options buyer is the one who pay fees and the optionsseller is the one who charges.

Purchase interest rate option contract – Caps:

Buying Caps is buying call options or the purchase of a series of interest rate option

If market interest rates rise higher than the interest rate option trading (Caps interestrate), the option seller (seller Caps) will pay the difference in interest rates for thepurchase of call options (buyer Caps) According to the selling Caps contract, bankselling rate option collects a fee from the buyer the right to buy Time to followCaps contract may be a day or several days

In the case when the liabilities of the bank have the floating rate and the assets havethe fixed rate or when liabilities have a shorter duration than asset, with theexpectation of the rise in interest rate in the future, the bank which want to buy Capshave to pay for the Caps seller for the interest rate hedging

If market interest rates higher than the rates in the Caps contract, bank which buysCaps will receive an offset from the bank which sold Caps at certain times agreed inthe contract Compensation by the contract value multiplied by the differencebetween the Caps in market interest rates and interest rate of the caps contracts Thismoney is used to offset the cost of raising capital by increasing market interest rates

to compensate for the increase or decrease in the price of the bond in assets of thebank

If the market interest rate is lower than the interest in the Caps contract, the Capsseller do not have to pay any money to buy Caps.For example, at time t = 0 the bank bought Caps which value equals to 100 millionVND, Caps interest rate is 8% / year, the bank must pay a fee to buy the Caps equal

to C, on the value of the contract is t = 1 and t = 2

If at the time t = 1, market interest rates increased by 9% / year, the bank willreceive an offset is: (9% - 8%) x 100 = 1 million VND

If at the time t = 2 market interest rate is 7%, the bank will not receive an offsetfrom the Caps seller

Figure 1.3: Graph of interest rate fluctuations and contract Caps

Selling interest rate option contract – Floors:

Buying Floors contract is to buy put options on interest rates If interest rates fallbelow market interest rate option trading (Floors interest rate), the seller will paythe difference in interest rates for buyers Through the sale of the put optioncontract, the seller received a fee from the buyer Time to follow Floors contractmay be a day or several days

In the case when the liabilities of the bank have the fixed rate and the assets havethe floating rate or when assets have a shorter duration than liabilities, with theexpectation of the decrease in interest rate in the future, the bank which want to buyFloors have to pay for the Floors seller for the interest rate hedging

If the market interest rate is lower than the Floors interest rate, the Floors buyer will

be paid an amount equal to the value of contracts in the difference between theinterest rate and Floors interest rate in the market Compensation to compensate forreduced income due to reduced market interest rates

If market interest rates higher Floors interest rate, the Floors seller is not required topay any amounts for one who purchases Floors

For example, at time t = 0 to the bank bought a Floors contract with the value equal

to 100 million VND, Floors interest rate is 5% / year, the bank must pay a fee tobuy Floors equal to C, the date of the contract value is t = 1 and t = 2

If t = 1 to date on market interest rates fell to 4% / year, the bank will receive an

If the date t = 2 market rate is 6%, the bank will not receive an offset from the bank

to sell the contract Floors

Figure 1.4 Graph of interest rate fluctuations and contract Floors

Collars contract:

Collars contract occurs when the bank made simultaneously both transactions Capsand Floors, such as the simultaneous purchase of call options and put options(purchased both two contracts Caps and Floors) The bank bought Collars contract

in the case when assets at risk by the volatile interest rates and banks performed tocharging Collars contract to finance the transaction Caps or Floors

When purchasing contracts Collars, if market interest rates have lower volatilitythan Floors interest rate or greater than Caps interest in the Collars contract, thebank will receive payment from the Collars seller corresponding to the differencebetween market interest rates and interest rate in contracts Collars.

1.2.3.3 Swaps contract:

Definition: A swap is a derivative in which two counterparties exchange cash flows

of one party's financial instrument for those of the other party's financial instrument.The benefits in question depend on the type of financial instruments involved Forexample, in the case of a swap involving two bonds, the benefits in question can bethe periodic interest (coupon) payments associated with such bonds Specifically,two counterparties agree to exchange one stream of cash flows against anotherstream These streams are called the legs of the swap The swap agreement definesthe dates when the cash flows are to be paid and the way they are accrued andcalculated Usually at the time when the contract is initiated, at least one of theseseries of cash flows is determined by an uncertain variable such as a floatinginterest rate, foreign exchange rate, equity price, or commodity price

1.3 Factors affecting interest rate risk management in commercial banks:

The factors that affect the act of interest rate risk management in commercial banks can basically be divided in to 2 main groups: the internal factors and externals factors Each group can have the different impact to the interest rate management activities of the commercial bank However, the impacts of both groups have the same results which reflected directly to the profit of the commercial banks By having the deeply understanding about these 2 groups of factors, the managers can set up the programs to minimize the outcomes of the factors to their act of managinginterest rate risks

1.3.1 Internal factor:

a The awareness of interest rate risk in commercial banks

The most important factor which affects interest rate risk management in all commercialbank is the awareness of the managers toward “interest rate risk” With the fullyunderstand about the interest rate risk, the administrators can provide a good program fortheir bank in the act of interest rate risk managing In the former economy (centralizereconomy), the activities of the bank is only complied with the direct order from thegovernment The banking system in the centralizer economy does not run based onthe normal economic rules, therefore, the risk management is not the major concern

When Vietnam switched to the market mechanism, the typical economiclaws such as the law of value, the law of supply and demand, competition rules …become more and more effective The risks of the market or for further, theeconomy make the direct or indirect impact on the banking business Banks andother non-bank financial institution are standing in the siege of 4 groups which havemoney or need money to invest in the economy, including: Household, Business,Government and Foreign investor The products that the commercial bank uses totrade in the market are the flowing capital services and other banking facilities.Essentially, banking business is the business that uses the reputation to attract theinvestment and uses their capability in managing risk to make profit by that source

of capital along with developing other service as the intermediary between thesupply forces and demand forces in banking service Thus, interest rate is the price

of input as well as the output of the bank The interest rate risks are always standing

in most of the banking operations of the bank due to the fluctuation

Banking business is the business that including many potential risks and the interestrate risk is the most common risk of commercial banks This is thought that the banks need to evaluate every opportunity base on the relationship of risk and

benefit in order to seek out the true opportunities with the acceptable benefits which worth to risk The commercial bank will work well if the risks that it incurs are reasonable and controllable

b Commercial banks’ policies

The policies of the banks may also affect the interest rate risk management act Thepolicies can be about the providing money for hedging interest rate risk and for managing interest rate risk, the training program about interest rate risk and method

to measure it… Each policy of the commercial banks can be the direct factors leading to the interest rate risk, even the smallest one about changing in staff However, some of these just take a small part in which affects the interest rate risk management The most relevant policies which are considers as playing an

important role in affecting interest rate risk management may be

o The policy of company about setting up the interest rate risk control system

o The policy about evaluating and payment for cost of managing

interest rate risk activities

1.3.2 External factors:

a The overall economic climate.

The wider economic markets can have an impact on a company's interest rate risk

In times of economic decline or recession, a company can find refinancing and new borrowing more difficult and interest rates higher This is often a time when

revenues decline as fewer customers are financing purchases The uncertainty of incoming cash flow coupled with the increased outgoing cash flow from interest

payments increases the company's exposure to interest rate risk Therefore, the

market rate may be unstable with many fluctuation which affects directly to the managing interest rate activities of all Vietnamese commercial bank Even, the overall economic climate can be more worst if it has the negative impact to the foreign exchange rate – also is one of the external factor can affect the interest rate risk management Banks need the foreign currencies for paying foreign debt and also do their business on FX market in order to maximize their profit as well as for lending to other companies which do business on the foreign exchange rate such as credit institutions, export and import companies According to the true fact that the business of banking is based on the all kind of the rate, each change even the

smallest one can affect the act of interest rate risk management of the banks

b State policies

Have the same characteristic like one in the group of internal factors, the state policies also have impact on the managing interest rate activities In recent years, the government have been applying the tightening monetary policy in order to reduce the inflation rate This affects directly to the cash flow in the society with thechange of increasing in deposit To compete with each other, the race of interest ratewill be started Thus, the management in interest rate risk once again becomes a big concern to all the managers in commercial banks

2 Chapter 2: Reality in interest rate risk management in Vietcombank.

2.1 Introduction to Vietcombank

Vietcombank is one of stated- owned commercial bank of Vietnam Establish onApril 1st, 1963, Vietcombank is ranked one of 23 special corporations by the State.Vietcombank is one of the first members of the Vietnam Bankers Association and amember of many other associations including the Asian Bankers Association andAsia Pacific Bankers Clubs

With long experience in banking services and a contingent of well-trained, dynamicand enthusiastic staff, Vietcombanks continues to play a crucial role in VietnameseBanking Sector More specially, Vietcombank has always been regarded as the mostprestigious bank in Vietnam in terms of foreign exchange trading, internationalpayments and other international banking and financial services

2.1.1 History:

The former of Vietcombank was once called as “the foreign trade commercialbank” which was established and officially started the business as a stated-own-bank in January 4th 1963 Vietcombank was the first commercial bank to be decided

to be initial public offering by Vietnamese authority and started its business as acommercial bank in June 2nd 2008 In June 30th 2009, the stock of Vietcombank(code VCB) was officially listed on Ho Chi Minh stock exchange

After 50 years of developing, Vietcombank has been playing an important role inthe general development and stabilize the Vietnamese economy It also becomes themost successful Vietnamese commercial bank to have the important impact to thelocal financial community

With the start as a bank only working in the external economic business,Vietcombank now becomes a functional, multitask bank which has invested inmany fields of banking business Vietcombank offered to the customer the highvolume of financial services like brokerage, lending, borrowing … For a decade,Vietcombank has been considered as “the most successful commercial banks inVietnam”

2.1.2 Organizational structure:

Organizational structure of the VCB, after equalization, is built toward themodel of Parent company with the key bond is the commercial bank-the parent one,which is the major field of business activities; The VCB shareholders have therights and responsibilities to VCB and to all the enterprises, which is owned,dominated, invested by VCB

As directed by government, the Subsidiaries of the VCB will be equalization

to diversify forms of ownership, utilize the experience of strategic partners,especially the foreign strategic partners to contribute to building and development

of VCB Accordingly, investors can hold shares in these enterprises, or VCB, orboth, and have rights and responsibilities under the Charter of that unit

Figures 2.1: VCB structure (Parent company structure)

(Source: Introduction about Vietcombank on website

Goverment

The Parent Company Vietnam joint-stock bank for Foreign Trade (Vietcombank)

VCB Institute – Academy (Proposed)

VCB Training centre

Infrastructu re investment Company (Proposed)

Fifth Road Joint-stock Company

Real estate Investment Company

52%

VCB- Ben Thanh

Bonday-70% stock VCB Tower

16% stock VCB- Bonday

Joint-VCB Card Company (Proposed)

VCB Money Transfer (proposed)

Reinsurance

Company

Enterprises &

commercial banks dominated by VCB

Finance &

consumer credit Company (proposed)

Finance &

credit Pledge Company (proposed)

Asset Management Company

VCB Fund management

of Investment in infrastructure development Company (proposed)

Non-life

insurance

(Proposed)

VCB Fund Management Company

VCB Securities Company

Vinafico in Hong Kong

VCB Leasing Company

50% joint venture bank

45% of Joint

venture Life

insurance