FIN 335 Module 7 Project Two Example

Interest Rate Risk Management Plan

[Student Name]

Southern New Hampshire University

FIN 335: Financial Markets

Project Two

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Interest Rate Risk Management Plan

Introduction

The rise in rates from 2022 to 2023 cut the Billings bank's margin, left its bonds deeply underwater and forced it to borrow from an emergency Fed program. Rates have since eased, but the bank's balance sheet has the same shape: deposits that can reprice quickly funding loans and bonds that cannot. This plan measures the bank's interest rate risk, compares it with the board's limits and recommends four actions to reduce it, with their costs and the risks they introduce.

Measuring the Risk

Duration measures how much a security's value changes when rates move. For a bank, the duration gap compares the duration of assets with that of liabilities, scaled by the ratio of liabilities to assets: duration gap equals asset duration minus that ratio times liability duration. The bank has $2.4 billion of assets with a weighted duration of 3.1 years and $2.19 billion of liabilities, so the ratio is 0.91.

The answer depends on how deposits are treated. If deposits are assumed to reprice immediately, liability duration is about 1.2 years and the gap is 2.0 years. Yet research shows (Drechsler et al., 2021) that banks pay deposit rates that rise far less than market rates and that many deposits stay for years, which gives them an effective duration much longer than their contractual one. Using the bank's own history of deposit rates and balances since 2022, liability duration is about 2.2 years and the gap is about 1.1 years.

The Exposure

The change in the economic value of equity, the value of assets minus liabilities, is approximately the negative of the duration gap times total assets times the rate change divided by one plus the current rate. For a 2 percentage point rise, with rates near 4.5 percent:

Economic value of equity at +200 basis points

Even with realistic deposit behavior, the exposure exceeds the board's limit. English et al. (2018) found that bank stock prices fall when rates rise unexpectedly and that banks with larger maturity gaps fall more, so the measure matters to investors as well as regulators. The bank's income model tells a similar story over twelve months: a two-point rise would cut net interest income by about 6 percent as deposit costs rise before loan yields.

The Plan

Each action narrows the gap. The table shows its effect measured on its own.

Actions and their effect on the duration gap

The bond sale is the partial restructuring recommended in Project One. In the swaps, the bank pays a fixed rate near today's five-year swap rate and receives the floating Secured Overnight Financing Rate on $150 million. If rates rise, the floating payments rise and the swap gains value, offsetting losses on fixed-rate loans and bonds. Each swap has a duration of roughly minus 4.2 years on its notional amount. Three-year advances lengthen the funding side. And pricing new commercial loans with three-year resets instead of five-year fixed periods steadily shortens asset duration as the loan book turns over.

Results

Together the actions reduce the duration gap from about 1.1 years to about 0.4 years. A two-point rise would then reduce equity value by about $18 million, or 8.5 percent, well inside the 15 percent limit. The income model shows a smaller 12-month decline in net interest income, about 2 percent instead of 6 percent.

The Other Side

A plan that only protects against rising rates could hurt if rates fall. With the swaps in place, a two-point drop would reduce net interest income by about 1 percent over twelve months, because the bank would keep paying the fixed swap rate while receiving less. Equity value would still rise slightly. That trade is acceptable: the bank's experience in 2023 showed that rising rates threatened its liquidity and capital, while falling rates mainly reduce earnings.

Costs and Risks

The plan has costs. The bond sale realizes an $11 million pretax loss, earned back in about 3.4 years. The advances cost somewhat more than overnight funding. The swaps require the bank to post collateral when they lose value, which ties up securities, and they need hedge accounting documentation so that their value changes do not create volatile earnings. Counterparty risk is limited because the swaps would be centrally cleared. Mishkin and Eakins (2018) stress that derivatives reduce risk only when they are sized to the exposure and monitored; an oversized swap position becomes a bet on falling rates.

Alternatives

Interest rate futures and caps were considered. Treasury futures could hedge the bond portfolio cheaply and flexibly, but they need daily margin management that the bank's small treasury team is not set up to handle, and their value tracks Treasuries rather than the bank's loans. An interest rate cap would protect against rising rates without any cost if rates fall, but it requires an upfront premium of several million dollars for meaningful protection. Selling the entire bond portfolio would cut the gap further but at a capital cost the board rejected in Project One. Swaps offer the best balance of cost, simplicity and fit for a bank of this size.

Governance

The asset-liability committee will review the duration gap, economic value of equity and income simulations each month and report quarterly to the board's risk committee. Deposit assumptions will be tested against actual behavior each year, since they drive the result more than any other input. If the gap moves outside 0.2 to 0.8 years, the committee will adjust swap notional or funding terms.

Conclusion

The bank's interest rate exposure, measured realistically, exceeds its own limit. Four actions, a partial bond restructuring, $150 million of swaps, longer advances and shorter loan resets, bring it within the limit at a manageable cost and leave the bank better prepared for the next rate cycle.

References

Drechsler, I., Savov, A., & Schnabl, P. (2021). Banking on deposits: Maturity transformation without interest rate risk. The Journal of Finance, 76(3), 1091-1143. https://doi.org/10.1111/jofi.13013

English, W. B., Van den Heuvel, S. J., & Zakrajsek, E. (2018). Interest rate risk and bank equity valuations. Journal of Monetary Economics, 98, 80-97. https://doi.org/10.1016/j.jmoneco.2018.04.010

Mishkin, F. S., & Eakins, S. G. (2018). Financial markets and institutions (9th ed.). Pearson.