Measure the interest rate risk Acase study of Vietcombank Luận văn thạc sĩ

Then it will analyze the gap dollar gap in Vietcombank financial statement to measure the interest rate risk that affected to the income of the bank.. LIST OF TABLES Table 2.1 Exposure t

MINISTRY OF EDUCATION AND TRAINING

UNIVERSITY OF ECONOMICS HO CHI MINH CITY

PHAM THI XUAN LIEN

MEASURE THE INTEREST RATE RISK:

A CASE STUDY OF VIETCOMBANK

ECONOMICS MASTER THESIS

HOCHIMINH CITY, 2010

MINISTRY OF EDUCATION AND TRAINING

UNIVERSITY OF ECONOMICS HO CHI MINH CITY

PHAM THI XUAN LIEN

MEASURE THE INTEREST RATE RISK:

A CASE STUDY OF VIETCOMBANK

Major: Financial and Banking

Major Code: 60.31.12

ECONOMICS MASTER THESIS

Supervisor: Dr Le Thai Thuong Quan

HOCHIMINH CITY, 2010

ACKNOWLEDGEMENT

I would like to express my honest gratitude to my devoted research Supervisor, Dr

Le Thai Thuong Quan, for his assistance and valuable guidance during the course of fulfillment this thesis

I would like to thank my colleagues from Vietcombank, who have helped me in collecting data for this thesis: Ms Nguyen Thi Minh Trang from An Giang Branch,

Ms Le Mai Trinh from Dong Thap Branch Especially, I would like to express my

her recommendation to Ms Phung Nguyen Hai Yen, Deputy Director of Finance and Accounting Department in Vietcombank head office

I would like to avail this opportunity to express my appreciation to Professor Nguyen Dong Phong, UEH Board of Director for conceiving the Banking Master Program in English I also would like to express my sincere gratitude to all mu teachers at Post-graduate Faculty- University of Economics Hochiminh City for their teaching and guidance during my Master in Banking course

Finally, I would like to extend my deepest gratitude to my beloved family, special thanks to my husband, Pham Trung Khanh, my son, Tony for their endless love and great support during study period

ABSTRACT

With the volatility in the interest rate recent years, the interest rate more becomes a vital problem of Vietnamese bankers Fluctuations in the interest rate since 2008 that effected sharply to the bank‟s interest income and value, making interest rate risk management decisive to its success It is necessary to call for high

interest rate risk exposure through the use of various hedging strategies and instruments as well as balance sheet adjustment

This qualitative research measures the interest rate risk in Vietcombank - the leader in interest rate maker in domestic banks by using the gap model (dollar gap) also referred to as the funding gap or the maturity gap The research shall investigate the movement of the Vietnam interest rate in financial market since 2008 Then it will analyze the gap (dollar gap) in Vietcombank financial statement to measure the interest rate risk that affected to the income of the bank Finally, there shall be some suggested solutions in improve the gap as well as the net interest income

Keywords: Gap, Gap analysis, interest rate, interest rate risk, interest rate risk measurement, asset and liability management, Vietcombank, financial statement, SBV, VNIBOR

CONTENTS

Acknowledgement

Abstract

Contents

List of Tables

List of Figures

Abbreviations

1.2 Why is the problem worth addressing? 2

1.3 Objectives/goals of the research 3

1.4 Methodology 4

1.5 Data analysis and finding 5

1.6 Study structure 5

Chapter 2: THEORY OF INTEREST RATE RISK AND INTEREST RATE RISK MEASUREMENT 2.1 Background 6

2.2 Risks assumed by banks 7

2.2.1 Credit risk 7

2.2.2 Interest rate risk 8

2.2.3 Operational risk 8

2.2.4 Liquidity risk 9

2.2.5 Price risk 9

2.2.6 Compliance risk 9

VITECOMBANK INTEREST RATE POLICY Y

3.2 Interest rate policy in Vietcombank 31

COMMERCIAL JOINT STOCK BANK FOR FOREIGN TRADE OF VIETNAM (VIETCOMBANK)

5.3.2 Off – balance sheet 60

References

Appendix

ABBREVIATIONS

ALCO Asset and Liability Committee

VCB The Bank for Foreign Trade of Vietnam

RSC Rate Sensitivity Viability

LIST OF TABLES

Table 2.1 Exposure to interest rate

Table 2.2 Classification of Assets and Liabilities by interest rate sensitivity Table 2.3 The relation in Gap, Interest rate changes and net interest income Table 2.4 Distinction incremental gap and cumulative gap

Table 4.1 VCB balance sheet in 2009

Table 4.2 VCB Classification of Assets and Liabilities by interest rate

sensitivity Table 4.3 VCB Gap, Relative gap, interest sensitivity ratio

Table 4.4 Maturity buckt of loans and deposits from customer at

31.12.2009 Table 4.5 VCB Reprcing mismatch in 2008, 2009 and first six months in

2010 Table 4.6 The compnent of net interest income in each maturity bucket Table 4.7 The effect f changing interest rate to NII

LIST OF FIGURE AND EQUATION

FIGURE

Figure 2.1 Payoff for unhedged call option

Figure 2.2 Payoff for unhedged put option

Figure 2.3 Using an interest rate swap to hedge liability and asset sensitive

position Figure 3.1 SBV report – Credit and Deposit growth

Figure 3.2 Movement of interest rate since 2006

Figure 3.3 Interest expenses from 2005-2009 of Vietinbank, Vietcombank,

Sacombank, Eximbank and Asiabank Figure 3.4 VCB lending and fund mobilization growth from 2001-2010 Figure 3.5 VCB movement of lending and deposit rate

Figure 3.6 VCB difference between interest income and interest expenses

from 2001-Jun 2010 Figure 3.7 VCB movement of lending and deposit rate in 2008

Figure 3.8 VCB movement of lending and deposit rate in 2009

Figure 3.9 VCB movement of lending and deposit rate in Jun 2010

Figure 4.1 Gaps in the period of 2002-06ms/2010

Figure 4.2 Turnover of loan and deposit from customer at 31.12.2009 Figure 4.3 The repricing mismatch in each maturity bclet from 208-

06ms/2010 Figure 4.4 The component of NII in 06ms/2010

EQUATION

Equation 2.1 Gap Model

Equation 2.2 Calculation delta net interest income

Equation 2.3 Relative gap

Equation 2.4 Interest sensitivity ratio

Equation 2.5 Number of contract to hedge an asset sensitive position

1.1 BACKGROUND, CONTEXT AND RATIONALES FOR THE

RESEARCH

The Vietnamese financial market has rapidly expanded over the past few years and has gained great strategic importance at the global level With the rapid liberalization, privatization and globalization of the market, Vietnam has become a preferred destination of international financial investors The key financial sectors

„banking‟ and „insurance‟ are attracting huge foreign investment as both of these sectors represent highly untapped potential

Thanks to the "Doi Moi" policy in the year 1986, the economy of Vietnam showed marked improvement associated with market oriented Improvement was also seen

in the banking sector indicated the interactive relation between financial liberalization and economy reform The proof of this innovation is the dramatic decline in inflation in 1988 (700 percent) to 67 percent in 1990, and it has continued

to decline though 1994 Moreover, the banking system was gradually improved and became more effective intermediation of financial resources Banking sectors has a significant contribution in fund mobilization serving manufacture, economy stimulus and the core channel of socio-economic capital They are in charge of mobilization the idle resources from population and credit fund to demanded economic sectors to boost the priority tasks of modernization and industrialization The General council of World Trade Organization approved Vietnam‟s membership

the WTO, the State Bank of Vietnam has continued its efforts to perfect its legal regulations in conformity with international commitments and Vietnam's situation Many legal documents have been issued to facilitate banking activities in Vietnam

The central bank have also taken initiative in implementing measures to develop the monetary, foreign currency market, strengthen its capacity in implementing monetary and foreign exchange policies, carry out administrative reforms, expand international co-operation to exchange and learn more experiences

However, the global financial crisis has impacted to the economy associated with some risks in domestic financial environment The recent volatility in the VNIBOR rate appears to be liquidity story of domestic bankers Bankers are in the war of fund mobilization by offer a negotiable interest rate and lending it with higher rate The interest rate risk management in Vietnam bankers are became vital banking activities

Risk management is defined by Dickson (1989: 18) in Valsamakis et al (1992: 13)

as “the identification, analysis and economic control of those risks which threaten the assets or earning capacity of an organization.” As such the management of risk has, explicitly or implicitly, become part of a strategic component of the modern organization‟s survival and development (Waring and Glendon, 1983:3)

Bernstein (1998) in De la Rosa (2003: 55) identifies that the principals of modern risk management were first established in the 1600s when mathematical concepts were first used in games of chance Twentieth century authors such as Knight (1921) and Keynes (1921) provided noteworthy insight into the development of uncertainty, probability and the law of large numbers-concepts which today underpin risk management

particular loans and about how to fund their investment and lending activities These

decisions are based, in part on their outlook for interest rates, the composition of their assets and liabilities and the degree of risk that they are willing to take Collectively, these decisions affect the bank‟s net interest income and balance sheet values The process of making such decisions about the composition of assets and liabilities and the risk assessment is known as asset/liability management (ALM) The decisions are usually made by the asset/liability management committee (ALCO) that is responsible for the overall financial direction of the bank

1.2 WHY IS THE PROBLEM WORTH ADDRESSING?

As one of the biggest well-known bank in Vietnam, the research will provide a range of alternatives which Vietcombank can incorporate into its interest rate risk management strategy The practicality of interest rate risk measurement model will

be applied in the chaos specified period and specific business circumstance, its interest rate risk position and market conditions over the specified period

Furthermore, the thesis will analyze the component of the net interest income matched to the maturity bucket of Vietcombank asset and liability Recommendations will be provided on the basis of a theoretical asset and liability structure which may further aid the Vietcombank in its management interest rate risk

1.3 OBJECTIVES AND GOALS OF THE RESEARCH

The objective of this thesis is to

1 To investigate the movement of the interest rate in financial market since 2008

2 To analyse the Vietcombank specific business practices and its interest rate risk exposure

3 To analyse the gap in Vietcombank financial statement to measure the interest rate risk that affected to the income of the bank

4 And also to find out the component of net interest income according to the maturity bucket

and the component of the interest income/expenses according to the maturity bucket which is closely to the asset and liability sensitivity There will be some main questions to answer in this study:

1 What are theoretically bank practices and/or solutions to deal with interest rate riks?

2 What is the extent of interest rate risk in Vietcombank? Whether or not such risk affect to its profit?

1.4 METHODOLOGY

The research methodology of the thesis is a case study The case study method allows for both the generating and the testing of hypotheses and allows the researcher to identify and include certain elements, conditions and information that may be unique to individuals and organizations, thus permitting a more holistic study (Tellis, 1997; Kennedy and Luzar, 1999)

Robert K.Yin, 2005 recognises the case study methodology as “an empirical inquiry that investigates a contemporary phenomenon within its real life context, when the boundaries between phenomenon and the context are not clearly evident, and in which multiple sources of evidence are used It is particularly valuable in answering

The thesis requires intimate knowledge of the Vietcombank business practices, legal requirements and unique balance sheet structure, all of which provide the rationale for the use of a case study methodology In order to conduct a thorough analysis, a number of practices specific to the case study methodology must be used More specifically, the researcher will have access to public Vietcombank achievement records, historical Vietcombank balance sheet structures and interviews with Vietcombank senior management The researcher also conducts interviews with a number of other branches in the whole system of Vietcombank in order to generate hypotheses for the practicality of certain interest rate managing techniques

1.5 DATA ANALYSIS AND FINDING

The study is mainly used books, scientific articles and statistic to get better understanding of Asset and Liability Management The data will be collected from Annual Vietcombank‟s financial statement since the interest rate has become volatility in 2008 Besides of that, questionnaires were designed and directly asked

to interviewees to collect data related to VCB‟s assets and liabilities management The findings are not just to help measuring the interest rate risk of Vietcombank but also to show some difficulties as well as the strength of a SOCB in financial market

On the other hands, the findings will be an evidence to manage the interest rate risk aggressively in Vietcombank

2.1 Background

For many centuries, banks have played a vital role in the financial system That vital role continues today although the forms of banking have changes with the needs of the economy Commercial banks play an important role in the financial system and the economy As a key component of the financial system, banks allocate funds from savers to borrowers in an efficient manner They provide specialized financial services, which reduce the cost of obtaining information about both savings and borrowing opportunities These financial services help to make the overall economy more efficient

Banks can be described as intermediaries between lenders and borrowers For competitive reasons, bank may be obliged to accept client funds with varying maturities that could potentially alter the structure of the balance sheet to an interest rate sensitive position (UBS, 1987:37)

Banks tend to lend long and borrow short This natural exposure of banks looks beneficial when long term interest rates than are above short term interest rates Often, bank effectively lend at higher rates then the cost of their debts, because of positive spread between long terms rates and short terms rate

Besides of the traditional business in deposit and loan, nowadays bank may have developed some other functions:

customers, and holding Treasury Bills and bank notes and coin for such purpose;

 Discounting commercial paper for its customers;

 Issuing letters of credit; bank guarantees,…

(or) on bonds, shares and other securities

 Make other banking services such as: transfer money, issuing credit cards and supply other banking services

2.2 Risks assumed by banks

According to Bessis (2002), there are a large number of risks in the banking industry, of which most are well known Risk and the management of it are important to banking and with this in mind it is somewhat surprising that risk quantification remained limited until recently Risk management requires an entire set of models and tools for linking risk management issues with financial views on risks and profitability (Ibid) This is supported by Galai et al (1999) who state that the recent financial failures in the banking industry confirm the need for various form of risk management Therefore managers of banks need reliable risk measures

in order to be able to direct capital to activities with the best trade off between risk and return Risk management is the process of identifying key risks, acquiring understandable risk measures, choosing which risk to reduce and which to increase and by what means, and finally ascertaining procedures to monitor the resulting risk position (Galai et al 1999)

According to Gup & Kolari (2005), banking is the management of risk; banks accept risk in order to earn profits They must balance alternative strategies in terms

of their risk/return characteristics with the goal of maximizing shareholder wealth

In doing so, banks recognize that there are different type of risk that the impact of particular investment strategy on shareholders depend on the impact on the total risk

of the organization These risks are stipulated as follows:

2.2.1 Credit risk

Credit risk is one of the earliest risks recognized in banking Credit risk is the risk to earnings and capital that an obligor may fail to meet the terms of any contract with the bank It is usually associated with loans and investment, but it can also arise in connection with derivatives, foreign exchange and other extension of bank credit Although bank fails for many reasons, the single most important reason is bad loan

At the time the loans were made the decisions seemed correct However, unforeseen changes in economic conditions, and other factors such as interest rate shocks, changes in tax laws, and so on, have resulted in credit problems Credit risk is the primary cause of bank failures, and it is the most visible risk facing the bank managers

2.2.2 Interest rate risk

Interest rate risk is the risk to earnings and capital that market rates of interest may change unfavorably This risk arises from differences in timing of rate changes and the timing of cash flows (repricing risk), from change of the shape of the yield curve (yield curve risk) and from option values embedded in bank products (option risk)

In essence, the market value of a bank‟s assets (i.e.,loan and securities) will fall with

increases in interest rates In addition, earning from assets, fee, and the cost borrowed funds are affected by changes in interest rates Bank can reduce their interest rate risk by hedging worth derivatives securities and by using the asset/liability management techniques

2.2.3 Operational risk

Operational risk (also referred to as transaction risk) is the risk to earnings or capital arising from problems associated with the delivery or service of a product Operational risk encompassed the efficiency and effectiveness of all back-office operations including management information systems, personnel, compliance, external and internal frauds, lawsuits and so on

2.2.4 Liquidity risk

Liquidity risk is the risk to earnings or capital related to a bank‟s ability to meet its obligations to depositors and the needs of borrowers by turning assets into cash quickly with minimal loss, being able to borrow funds when needed, and having funds available to execute profitable securities trading activities Given the large amount of bank deposits that must be paid on demand or within a very short period, liquidity risk is of crucial importance in banking

2.2.5 Price risk

Price risk is the risk to earning or capital related to market-making, dealing, or taking positions in securities, derivatives, foreign exchange, or other financial instruments For example, as a result of financial crisis in Asia in 1998, several large

banks (including Bankers Trust, Bank America and Citicorp) suffered losses in their foreign exchange and derivatives positions

2.2.6 Compliance risk

Compliance risk is the risk to earnings or capital arising from violations of laws, rules, regulations, and so on For example, banks failing to meet minimum capital requirements must raise new capital, or they may be closed, forced to merge or required to take some other corrective action

2.2.7 Foreign Exchange risk

Foreign exchange risk is the risk to earnings or capital due to changes in foreign exchange rates

2.2.8 Strategic Risk

Strategic risk is the risk to earnings or capital arising from making bad business decisions that adversely affects the value of the bank

2.2.9 Reputation risk

Reputation risk is the risk to earnings or capital arising from negative public opinion

of the bank Negative public opinion can arise from poor service, failure to serve the credit needs of their communities, and for other reasons Regulators feared that negative public opinion would contribute to a loss of market share and be potential source litigation

2.3 Interest rate risk

Interest rate risk is regarded by a number of authors such as Heffernen (1996), Bessis (2002) and Sinkey (2002) as one of the most prominent financial risks faced

by a bank According to Van Son & Hassan (1997) mismanagement of interest rate risk, first manifests itself in reported earnings and, if unchecked, results in liquidity and solvency problems Thus, the monitoring of interest rate risk, whether through risk-based capital requirements or a separate measure, should not be ignored by bank managers Furthermore Van Son & Hassan (1997) suggest that the management of interest rate risk varies with bank size, and larger banks use more sophisticates methods for managing interest rate risk and receive more and closer scrutiny from the market

Gup & Kolari (2005) defined that interest rate risk is the risk to earnings and capital that market rates of interest may change unfavorably This risk arises from differences in timing of rate changes and the timing of cash flows (repricing risk), from changes in the shape of the yield curve (yield curve risk), and from option values embedded in bank products (option risk) In essence, the market value of a bank‟s assets (i.e.,loans and securities) will fall with increase in interest rate In addition, earning from assets, fees, and the cost of borrowed funds are affected by changes in interest rates

Interest rate risk stems from asset and liabilities maturing at different times, and can

be encompassed in three elements, namely “the margin between the earned on assets and paid on liabilities, the reprising potential of assets and liabilities at different point in time, resulting in mismatches in various time bands between assets,

liabilities and derivates and finally, the period during which these mismatches persist”

Interest rate risk is the exposure of a bank's financial condition to adverse movements in interest rates Accepting this risk is a normal part of banking and can

be an important source of profitability and shareholder value However, excessive interest rate risk can pose a significant threat to a bank's earnings and capital base Changes in interest rates affect a bank's earnings by changing its net interest income and the level of other interest-sensitive income and operating expenses Changes in interest rates also affect the underlying value of the bank's assets, liabilities and off-balance sheet instruments because the present value of future cash flows (and in some cases, the cash flows themselves) change when interest rates change Accordingly, an effective risk management process that maintains interest rate risk within prudent levels is essential to the safety and soundness of banks

Saunders (2000) state that interest rate risk is the risk that evolves when a bank mismatches the maturity of its assets or liabilities When banks hold longer term assets relative to liabilities, it potentially exposed itself to refinancing risk This is the risk that the cost of rolling over reborrowing funds could be more than the return earned on asset investments There is also a possibility of reinvestment risk, which

is that the returns on funds to be reinvested will fall below the cost of funds In addition to suffering a refinancing or reinvestment risk that occurs when interest rates change, a bank faces market value risk as well Market value of an asset or liability is equal to the discounted future cash flows of that asset or liability

Therefore a rise in interest rates will increase the discount rate on those cash flows and reduce the market value of that asset or liability and the opposite is true if the interest rate will decrease Ultimately, when mismatching maturities by holding longer term assets than liabilities, a rise interest rate will decrease the value of the bank‟s assets more than the value of its liabilities

Table 2 1: Exposure to interest rate

Rate 

- +

+

-

Source: Gup & Kolari (2005)

2.4 The model of measuring the interest rate risk

With the increased volatility of interest rates that occurred in recent years, financial institutions become more concerned about their exposure to interest rate risk Interest rate risk measurement aims to quantify the interest rate risk profile of a bank The correct measurement of the bank‟s interest rate risk exposure is necessary

to ensure proficient risk management There are several models of measuring the interest rate risk sensitivity of a bank such as:

 Maturity structure analysis

 Balance sheet projection

In which, the simplest and most common technique to measure the interest rates risk

is gap analysis This thesis will focus on such model to measure the interest rate risk

The gap model (income gap)

2.4.1 Definition

Gap analysis was widely adopted by financial institutions during the 1980s The gap model or repricing model as it‟s also called is basically a book value account cash flow analysis of the repricing gap between the interest revenues earned on assets and interest expenses paid on liability over a certain period When using the gap model, a bank calculates the gap in each maturity period by looking at the mean time for assets and liabilities to reprice, also called rate sensitively of each asset and liability Simply put, this means how long a bank manager has to wait to change the posted rates on any asset or liability

2.4.2 Calculation

According Mishkin (2006), gap model is simple and quick approach to measuring the sensitivity of banks income to changes in interest rate, in which the amount of rate sensitive liabilities is subtracted from the amount of rate sensitive assets This calculation can be written as:

GAP = RSA – RSL (2.1)

Where

RSA: rate sensitive assets

RSL: rate sensitive liabilities

Table 2.2: The classification of Asset and Liabilities by interest rate sensitivity

Source: Gup & Kolari (2005: 192)

Multiplying GAP times the change in the interest rate immediately reveals the effect

on bank income:

Where

NII: the expected change in the dollar amount of net interest income

i: the expected change in interest rates in percentage points

For bank with positive gap, net interest income will rise or fall as interest rates rise

or fall For bank with a negative gap, net interest income will rise or fall inversely with interest rate changes; that is, net interest income will increase with falling interest rates and fall with rising interest rates In contrast, banks with a zero gap should experience no change in their net interest income because of changing interest rates

Table 2.3 The relation in Gap, Interest rate changes and net interest income

GAP, INTEREST RATE CHANGES, AND NET INTEREST INCOME

rates

Change in net interest income (NII)

Source: Gup and Kolari (2005:124)

UBS (1987:48) defines a positive gap as an imbalance that indicates a larger amount

of assets are maturing and/or being repriced than liabilities, and a negative gap as the converse, where a larger amount of liabilities are maturing and/or being repriced than assets

Gup & Kolari (2005: 122-123) recognize that in order to correctly benchmark the interest rate sensitivity of one institution to another, one should incorporate the use

of ratio analysis such as the relative gap ratio and the interest-sensitivity ratio, expressed algebraically below:

The relative gap is:

Relative gap = Gap$/Total Assets (2.3)

The interest sensitivity ratio is:

Interest sensitivity ratio = RSA$/RSL$ (2.4)

The relative gap ratio expresses the dollar amount of gap as percentage of total assets The interest sensitivity ratio expresses the dollar amount of RSAs as a fraction of the dollar amount of RSLs

According to Gup & Kolari (2005), gap analysis classifies assets and liabilities according to their interest sensitivity, so the focus of gap is on net interest income Interest sensitive assets are those that reprice within some defined period (e.g 0-30 days, 31-60 days, 61-90 days, and so on) Similarly, interest rate sensitive liabilities are those that reprice in the same defined period However, longer-term maturities assets and liabilities with variable rates of interest, which are repriced when changes

in the general level of interest occur (such as floating rate), also are interest-rate sensitive Therefore, rate sensitively depends on the frequency of repricing

A distinction must be made between the incremental gap and the cumulative gap:

rate-sensitive assets and rate-sensitive liabilities over increments of the planning horizon”, while the cumulative gap measures the same difference between rate-sensitive assets and liabilities over a larger time horizon The distinction between the incremental gap and the cumulative gap is illustrated in Table 2.4

Table 2.4: Distinction incremental gap and cumulative gap

INCREMENTAL AND CUMULATIVE GAPS (RAND MILLION)

maturing or repriced within

Liabilities maturing of repriced within

Incremental gap

Cumulative gap

2000

2500

500

0

Source: Gup & Kolari (2005:124)

2.4.3 Limitation of gap model

However, the gap model has three weaknesses as:

1 It ignores market value effects The reason for this is that the model uses book value accounting, which means that asset and liabilities values are reported at their historic values or costs Thus interest rate changes affect only current interest income or interest cost Therefore, this model doesn‟t account for the capital loss This weakness is also confirmed by Hudson et al (2000) who state that it only show how interest rates will affect the assets and liabilities and not by how much

2 Overaggregation The problem of defining periods over a range of maturities

is that information regarding the distribution of assets and liabilities within the period is ignored For example average liabilities may be repriced at the end of the period, while assets may be repriced at the beginning The shorter

period gaps are calculate the smaller this problem is The optimum approach would be to calculated one day period gaps Many large banks have internal systems that can show their repricing gaps on any given day in the future

3 Problem of runoffs In reality bank continuously originate and retire loan as it creates and retires deposits In addition almost all long term loan pay at least some principal and interest back to the bank each month As a result of this banks receive a runoff cash flow from it loan that can be reinvested at current market rates This makes the runoff cash flow rate sensitive A bank manager can easily deal with this by identifying for each asset and liability item the proportion that will runoff, reprice or mature This sensitivity of runoffs to interest rate changes is a further weakness of the gap model

2.5 Interest rate risk management

Interest rate risk was usually managed by Asset and Liability Management

the ALCO must decide whether to use on-balance sheet or off-balance sheet instruments

2.5.1 On balance sheet adjustment

Balance sheet positioning strategies rely on the bank‟s ability to alter the mix and volume of financial assets and liabilities in order to take advantage of different interest rate environments and repricing frequencies of financial instruments The balance sheet positioning strategies included:

 Net interest income smoothing

 A volume strategy

 An interest rate pricing strategy

 The ideal portfolio

 Immunization

On balance sheet adjustment involves changing the portfolio of assets and liabilities

in order to change the manner in which the profitability of the bank or the amount of its assets and liabilities changes as interest rates changes

2.5.2 Off-balance sheet adjustments

2.5.2.1 Using interest rate futures to hedge a dollar gap position

Equivalent adjustments in the interest sensitivity position of the bank can be achieved through transactions in the futures markets A long, or buy, hedge can be used to protect the bank against failing interest rates

In case of positive dollar gap

Gup & Kolari (2005: 149), assumed that if the interest rate increased, the bank would benefit through higher net interest margin Conversely, if the interest rate fell, the bank‟s net interest margin would be deteriorating In such case, bank could engage in a long hedge by purchasing one or more T-bills contracts for future delivery In that case, if interest rates fell, the reduction in the net interest margin would be offset by the gain on the long hedge in the futures market Of course, if interest rates increased, the gain in the net interest margin would be offset by the loss on the futures transaction

In case of negative dollar gap

A short hedge may be used to reduce the interest rate risk in case of negative dollar gap If interest rate increased, the unhedged bank would suffer a reduction

in its net interest margin With the short hedge position, the bank would

experience a gain from the future hedge that would offset the reduction in the net interest margin And in case the interest rate fells, the increased net interest margin would be offset by the loss on the futures contract

The number of contracts to hedge an asset-sensitive position can be calculated using equation:

Number of contract = b

MF

MC F

V: value of the cash flow to hedge

MC: Maturity of the anticipated cash asset

MF: Maturity of the futures contract

b: the ratio of the variability of the cash market to the variability of the futures market

2.5.2.2 Using forward contract

The forward contract is an agreement between two investors with variety of

financial instruments and currencies Gup & Kolari (2005:155) define that forward contracts differ from future contracts in the following ways:

 Less standardize

 Traded over OTC (Over The Counter)

 Not marked to market daily

Since the forward contract is not marked to the market, there is no liquidity risk However, they are more difficult to close out early due to the need to negotiate with the original counterparty Most transactions on forward contracts are completed on

the expiration date By using forwards contracts the bank immunize its asset against interest rate risk

2.5.2.3 Using option contract

Bank management can use options contract to hedge interest rate risk In case of the negative dollar gap, in the circumstance of the increased in interest rate, the bank can buy an interest rate put option A put option gives the buyer the right (although not the obligation) to sell a specified underlying security at the price stipulated in the contract and obligates the seller to buy the underlying security Through buying the put, the bank would earn a profit on the put option and could use it to reduce or eliminate the net interest income loss from the negative dollar gap

Conversely, a bank with a positive dollar gap could buy call option in order to hedge its interest rate risk A call option gives the buyer the right (but not the obligation) to buy an underlying instrument at a specified price and obligates the seller to sell

Figure 2.1 PAYOFFS FOR UNHEDGED CALL OPTIONS

Source: Gup & Kolari (2005: 159)

Loss

0 Profit

Sell Call

C

such instrument at the same price If interest rates fall, the bank would lose on its cash or spot market portfolio, but the gain from its options position would partially

or completely offset that loss If interest rate rises, the gain in net interest income would only be partially offset by the option cost

2.5.2.4 Using interest rate swap

One of the most recent techniques devised to manage interest rate risk (and also for other purpose) is the interest rate swap Banks usually enter into interest rate swap because they need to fix the interest structure of their balance sheet, especially their interest rate sensitivity gaps

Hempel & Simonson (1999) state that one bank may have fixed-rate assets and floating rate liabilities, and another bank may have floating rate assets and fixed rate

Buy Put

P

0 Profit

Loss

F

Sell Put

S

Figure 2.2 PAYOFFS FOR UNHEDGED PUT OPTIONS

Source: Gup & Kolari (2005: 159)

liabilities These can then convert the basis of their existing balance sheet by contracting as counterparties in a fixed for floating swap

Swaps are useful for tailoring the interest rate risk characteristic of investment toward that which is desired, thus it is a mechanism to reduce interest rate risk The principal purpose of an interest rate swap is to reduce the degree of interest rate risk

by more closely synchronizing the interest sensitivity of cash inflows and outflows Swaps may be customized to meet the exact needs of the bank with following reasons:

 Firstly, swaps are negotiated contracts, the terms of maturity and other dimensions of the swap can be tailored to the needs of the bank

 Secondly, the swap can be established for long term arrangement, most swaps have maturities of three or ten years

However, the cost to close out a swap contract prior to maturity than other contracts such as future or forward

Payments : Floating interest on liabilities

Fixed interest through swap

Receipts: Floating interest on assets

Fixed interest through swap

2.6 Manage interest rate risk with dollar gap

The principal purpose of ALM traditionally has been to control the size of the net interest income This control can be achieved through defensive or aggressive ALM The goal of defensive ALM is to insulate the net interest income from changes in interest rate; that is to prevent interest rate changes from decreasing or increasing the net interest income While the aggressive ALM focuses on increasing the net interest income through altering the portfolio of the institution

Figure 2.3 illustrate the using an interest rate swap to hedge liability and

assets sensitive position

Source: Gup & Kolari (2005: 164, 165)

Payments: Floating interest on assets

Fixed interest through swap

Receipts: Floating interest on liabilities

Fixed interest through swap

2.6.1 Aggressive management

The management of a bank may choose to focus on the dollar gap in controlling the interest rate risk of its portfolio With an aggressive interest rate risk management program, such a strategy would involve two steps First, the direction of future interest rates must be predicted Second, adjustments must be made in the interest sensitivity of the assets and liabilities in order to take advantage of the projected interest rate changes The prediction of rising interest rate generally results in shifting the portfolio to a positive gap position

2.6.2 Defensive management

A defensive strategy attempts to prevent interest rate movements from reducing the profitability of the financial institution An aggressive strategy thus seeks to raise the level of net interest income while defensive strategy attempts to reduce the volatility of net interest income A defensive strategy attempts to keep the dollar amount of rate sensitive assets in balance with the amount of rate sensitive liability over a given period so the dollar gap will be near zero

2.7 Conclusion:

It will be clear that bank risk affects the profitability of the bank from a number of distinct sources This chapter has briefly described the risks assumed by bank and particular attention to interest rate risk The major concern in this chapter is introduction the gap model to measure the interest rate risk - one of the simplest and most common models applied to measure the interest rate risk The rest of chapter

gives knowledge about the interest rate risk management by adjustment on balance sheet and off balance sheet by using derivative instrument to hedge the interest rate risk Chapter three shall focus on the interest rate movement in Vietnam and interest