To The Bank`s CEO

To:The Bank’s CEO

From:The Risk Management Team

Interest Rate Risk

Banksface a perceived interest risk as a result of the fluctuation ofinterest rate risk. Banks on one hand enjoy the prospects ofincreased interest rates since they receive deposits from customersbut on the other hand they also borrow money. This puts banks at anawkward position because they have to balance the interest rate riskso that they do not lose all the depositors money. Interest rate riskseeks to reduce the bank’s exposure to risk to a bare minimum whilebearing in mind that a significant rise or decline in interest ratescould have an adverse effect on the banks assets and liabilitiesmaturities (Kalapo and Fapetu 2015). Our bank is therefore exposed toan interest rate risk as the banks net worth and earnings is peggedon interest rates which in this case have risen by 85 basis points or0.85%.

Accordingto new information from the accounts department it is inevitable thatthe interest rates will increase by 0.85%. The forecast is likely tohave an adverse effect on the bank’s assets as its bonds and otherfinancial instruments will experience a decline in their value. Bondshave an inverse relationship with the interest rates as an increasein interest rates will decrease the value of the bonds. On the otherhand, the banks liability position is likely to deteriorate since theborrowed funds by the bank will increase suggesting that the bankwill have to pay more interest on borrowed money. The banks equityposition will also be affected because of the change of the bank’sposition in both its assets and liabilities, the bank’s change inequity will be a factor of the change between the assets andliabilities.

Atthe moment, the bank’s total assets stand at $ 6,800,000,000 whileits liabilities amount to $ 5,900,000,000 making the bank’s equityhave a balance of $ 900,000,000. However, after the 85 basis pointincrease in interest rates, the bank is likely to lose its valuationon its assets while the bank liabilities will increase leading to adecrease in the shareholders’ equity. A summary of the bank’sassets following the interest rate increase shows the followingchanges. The interbank lending rate may decrease from $ 700,000,000to $ 699,174,000 as a result of the interest rate change. The 5 yearT-bond valuation may decrease from $ 600,000,000 to $ 561,614,000while the 10 year T-bond might decrease from $ 1,000,000,000 to $954,347,000. Meanwhile the cash, fixed rate mortgages and the bankspremises and equipment will remain unchanged as their value is notdependent on the interest rate (Appendix). The banks liabilities arelikely to increase as the bank will be required to pay more intereston what it owes. A quick snippet of the banks liabilities forinstance shows that the commercial paper which stands at $600,000,000 might increase to $ 613,635,000. The 6 months CDs mightalso increase by $ 7,824,000 as a result of the interest rate surge.The subordinated debt and the demand deposit will not be affected bythe increase in this case (Appendix). Other changes on the banksfinancial position in regard to their assets, liabilities and equityhave been highlighted on the attached appendix. As a result of thesechanges the bank’s overall financial position has been altered andthe following financial position is imminent. The bank’s assetswhich stood at $ 6,800,000,000 are likely to decrease to $6,303,254,000 suggesting a decline of the bank’s assets by almosthalf a billion as a result of the 85 basis point. The banksliabilities on the other hand are likely to experience a slightdecrease in their valuation by $ 45,000,000 million. This is adecrease in the bank’s liabilities and is a contrast to what wasexpected in case of the liabilities. The slight decrease in thebank’s liability position could be attributed to a decrease in boththe 1 year and 5 year CDs which the bank owes. The increase ininterest rates is likely to decrease their valuation since interestrates have an inverse relationship when it comes to borrowinginstruments. The 1 year CD which had been valued at $ 600,000,000 islikely to decline to $ 592 214,000 while the 5 year CD which wasvalued at $ 1,800,000,000 is likely to decrease to $ 1,724,178,000.As a result of these changes the bank’s shareholders’ equity willchange and its equity will be reduced to $ 448,000,000 up from $900,000,000 hence giving an impression that the shareholders of thebank have lost their wealth.

Inorder to reduce the bank’s risk as a result of the fluctuatinginterest rates. The bank could embark on the use of hedginginstruments such as the call or the put. A call is a financialinstrument that reduces the yield of the attached financialinstrument as the interest decreases. On the other hand, a put is afinancial instrument that decreases the yield of a financialinstrument when the interest rates surge. In this case, the bankshould have a put option for all its assets and liabilities. Thisshould reduce the banks position risk in regards to increasing yieldsas less price volatility will be experienced.

Appendix

5year Bond

Couponrate = 2.675%, N=5*2= 10, Pmt =13.5 M, FV= 600 M, 1/Y = 3.0% PV=561.614 M

10year Bond

Couponrate = 6.35%, N= 10, Pmt = 63.5 M, FV= 1,000 M, I/Y= 7%, PV =954.3467

Variablerate mortgage

=700*0.0715*0.50

=700 – 25.025

=674.975

1Yr CD

Couponrate = 2.0%, N= 1*2 = 2, PMT= 12.0M, FV= 600M, I/Y= 2.675%, PV=592.214 M

5Yr CD

Couponrate = 5.0%, N=5, PMT = 90 M, FV = 1,800 M, I/Y = 6.0%, PV =1,724.1775

Reference

Kalapo,T. F., Fapetu, Dapo, (2015) ‘The Influence of Interest Rate Risk onThe Performance of Deposit Money Banks in Nigeria.’ InternationalJournal of Economics, Commerce and Management 3, (5) 1218-1227.