Hello I am struggling to understand duration analysis in chapter 9 (interest rate risk) and chapter 10 (liquidity risk) of the core reading. For interest rate risk I understand that you are calculating the change in the net worth of a financial institution by changing the interest rate. I have a few queries; 1. Why is equity not just the share capital, why do we also add on reserves 2. Why is this easier to incorporate off balance sheet liabilities than maturity gap? For liquidity risk I have a few queries; 1. Is the discount rate used to find the present value of the assets and liabilities equal to the cost of borrowing? (I.e cost of funds = cost of borrowing?) 2. So you then repeat this PV calc using, say cost of funds -1% , and you can find a different value for the PV of Assets and liabilities... is the PV of the equity, i.e. market value = PVassets - PVliabilities? You can then find the net change in the market value (i.e. the liquidity risk elasticity) by subtracting these differing market values? 3. What is the liquidity risk elasticity? 4. How is this similar to the interest rate risk duration analysis? Is there a numerical example of this anywhere? Thanks in advance!
Hi. Colin is currently away and I'm sure he'll reply as soon as possible. Meanwhile if anyone else wants to chip in....
1. Equity is the sum of share capital + retained earnings, i.e. what is owned by shareholders ( residual value of assets after deducting liabilities). This is why some literature say shareholders have a residual claim to a company's assets
2. A maturity gap analysis considers the difference between risk solvent assets (RSA) & risk solvent liabilities (RSL) over a given period (say over the next quarter). The difference in nominal value is multiplied by change in interest rates to find how much outgo/income will change if short term interest rates change (i.e. assets or liabilities refinance aka issued at going market rates) Normally off balance sheet items are contingent hence are not included in RSL or RSA. However, when determining effective shareholders equity, the contingent assets and liabilities may be included using credit conversion equivalents which can then be subjected to duration analysis
Sorry for the late reply. I didn't see this thread on my return from hols. For interest rate risk I understand that you are calculating the change in the net worth of a financial institution by changing the interest rate. I have a few queries; 1. Why is equity not just the share capital, why do we also add on reserves The share capital on its own will not be meaningful. You need a number that represents the worth of the institution to the shareholders, and that is the share cap plus all shareholder reserves. 2. Why is this easier to incorporate off balance sheet liabilities than maturity gap? I am not sure where this comes from in the course. I would imagine that a duration report would be capable of incorporating off balance sheet instruments, as most can be categorised as a long and a short position combined. So a swap for example, would just be incorporated as a long fixed bonds and a short position in a floating bond. For liquidity risk I have a few queries; 1. Is the discount rate used to find the present value of the assets and liabilities equal to the cost of borrowing? (I.e cost of funds = cost of borrowing?) Yes - the initial analysis uses the current cost of funding, which will be some measure o the average rate of interest that the institution can raise its finance at. Probably an average of interbank borrowing and customer deposits. 2. So you then repeat this PV calc using, say cost of funds -1% , and you can find a different value for the PV of Assets and liabilities... is the PV of the equity, i.e. market value = PVassets - PVliabilities? I think this may only be applied to the "non equity" bits. So you apply it to the assets of the bank and the liabilities, but not the capital. You can then find the net change in the market value (i.e. the liquidity risk elasticity) by subtracting these differing market values? 3. What is the liquidity risk elasticity? The LRE is the change in the value of the bank given a specified increase in its cost of funding. So the if the bank had a reputational disaster and other banks were lending it money at 1% higher rates, this is the impact on the bank. It can be positive or negative, but the bigger it is, the more the institution is exposed to liquidity crisis. Ideally you want it to be near zero. 4. How is this similar to the interest rate risk duration analysis? I feel that the duration report does a similar thing - finds the impact on the banks value if interest rates change. The difference is that the duration report expresses it as duration (like the length of a bond) and the LRE expresses it as a physical loss or gain. Is there a numerical example of this anywhere? I don't know of any, but my tutorial slides contain a numerical example if you were on a tutorial. Thanks in advance!
