CHAPTER FOUR

RISK MANAGEMENT

4.1. RISK MANAGEMENT

A major objective of FI management is to increase the FI’s returns for its owners. This often
comes, however, at the cost of increased risk. Due to this financial institution faces many
risks. The dictionary definition of risk, the “possibility of loss or injury,” highlights the perils
of putting oneself in a situation in which the outcome is unknown. Risk is a measure of
uncertainty about the future payoff to an investment, assessed over some time horizon and
relative to a benchmark. The main risks which financial institution faces are: credit risk,
liquidity risk, interest rate risk, market risk, off-balance-sheet risk, foreign exchange risk,
country or sovereign risk, technology risk, operational risk, and insolvency risk.
4.2. CREDIT RISK

Credit risk arises because of the possibility that promised cash flows on financial claims held
by FIs, such as loans and bonds, will not be paid in full. Virtually all types of FIs face this
risk. However, in general, FIs that make loans or buy bonds with long maturities are more
exposed than are FIs that make loans or buy bonds with short maturities. Depository
institutions and life insurers are more exposed to credit risk than are money market mutual
funds and property–casualty insurers, since depository institutions and life insurers tend to
hold longer maturity assets in their portfolios than mutual funds and property–casualty
insurers.
4.2.1. CREDIT Risk ANALYSIS
Credit analysis includes credit for real estate lending, consumer and small-business lending,
mid-market commercial and industrial lending, and large commercial and industrial lending.
I. Real Estate Lending
Because of the importance of residential mortgages to banks, savings institutions, credit
unions, and insurance companies, residential mortgage loan applications are among the most
standardized of all credit applications. Two considerations dominate an FI’s decision to
approve a mortgage loan application: (1) the applicant’s ability and willingness to make
timely interest and principal repayments and (2) the value of the borrower’s collateral.
Two ratios are very useful in determining a customer’s ability to maintain mortgage
payments: the GDS (gross debt service) and the TDS (total debt service) ratios. The gross
debt service ratio is the customer’s total annual accommodation expenses (mortgage, lease,
condominium management fees, real estate taxes, etc.) divided by annual gross income.
The total debt service ratio is the customer’s total annual accommodation expenses plus all
other debt service payments divided by annual gross income. These can be represented as
follows:

Annual mortgage payments+ Property taxes

GDS=
Annual gross income

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 Annual total debt payments
TDS=
Annual gross income
As a general rule, for an FI to consider an applicant, the GDS and TDS ratios must be less
than an acceptable threshold. The threshold is commonly 25 to 30 percent for the GDS ratio
and 35 to 40 percent for the TDS ratio.
FIs often combine the various factors affecting the ability and willingness to make loan
repayments into a single credit score. A credit-scoring system is a quantitative model that
uses observed characteristics of the applicant to calculate a “score” representing the
applicant’s probability of default (versus repayment). Credit-scoring systems are developed
by using borrower characteristics (e.g., income, age, loan payment history) for some past
period.
The theory behind credit scoring is that by selecting and combining different economic and
financial characteristics, an FI manager may be able to separate good from bad loan
customers based on the characteristics of borrowers who have defaulted in the past. One
advantage of a credit-scoring system is that a loan applicant’s credit quality is expressed as a
single numerical value, rather than as a judgmental assessment of several separate factors.
Rather than develop and use a proprietary credit scoring model, many (particularly smaller)
FIs use FICO scores to evaluate mortgage (and consumer) loans. Developed by Bill Fair and
Earl Isaac (Fair Isaac Corp.), the FICO score uses 10 factors to determine a loan applicant’s
score. In order of importance, they are:
1. Major derogatory items on the credit report (bankruptcy, foreclosures, slow pay)
2. Time at present job
3. Occupation
4. Time at present address
5. Ratio of balances to available credit lines
6. Currently a homeowner (yes or no)
7. Number of recent inquiries
8. Age
9. Number of credit lines on the applicant’s credit report
10. Years the applicant has had a credit in the credit bureau database
II. Consumer (Individual) and Small-Business Lending
Although definitions of mid-market corporates vary, they typically have sales revenues from
$5 million to $100 million a year, have a recognizable corporate structure (unlike many small
businesses), but do not have ready access to deep and liquid capital markets (as do large
corporations). Commercial loans can be made for periods as short as a few weeks to as long
as eight years or more.
The techniques used for mortgage loan credit analysis are very similar to those applied to
individual and small-business loans. Individual consumer loans are scored like mortgages,
often without the borrower ever meeting the loan officer. Unlike mortgage loans for which
the focus is on a property, however, nonmortgage consumer loans focus on the individual’s
ability to repay. Thus, credit-scoring models for such loans would put more weight on
personal characteristics such as annual gross income, the TDS score, and so on.

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 III. Mid-Market Commercial and Industrial Lending
Credit analysis of a mid-market corporate customer differs from that of a small business
because, while still assessing the character of the firm’s management, its main focus is on the
business itself. The credit process begins with an account officer gathering information by
meeting existing customers, checking referrals, and meeting with new business prospects.
Having gathered information about the credit applicant, an account officer decides whether it
is worthwhile to pursue the new business, given the applicant’s needs, the FI’s credit policies,
the current economy, and the competitive lending environment. If it is, the account officer
structures and prices the credit agreement with reference to the FI’s credit granting policy.
This includes several areas of analysis, including the five Cs of credit, cash flow analysis,
ratio analysis, and financial statement comparisons
Five C’s of Credit. To analyze the loan applicant’s credit risk, the account officer must
understand the customer’s character, capacity, collateral, conditions, and capital (sometimes
referred to as the five C’s of credit ). Character refers to the probability that the loan applicant
will try to honor the loan obligations. Capacity is a subjective judgment regarding the
applicant’s ability to pay the FI according to the terms of the loan. Collateral is represented
by assets that the loan applicant offers as security backing the loan. Conditions refer to any
general economic trends or special developments in certain geographic regions or sectors of
the economy that might affect the applicant’s ability to meet the loan obligations. Capital is
measured by the general financial condition of the applicant as indicated by an analysis of the
applicant’s financial statements and leverage. Some important questions that provide
information on the five C’s are information relating to Production, management, marketing
and capital of the applicant.
IV. Large Commercial and Industrial Lending
Large corporations are able to issue debt and equity directly in the capital markets as well as
to make private placements of securities. Also, they typically maintain credit relationships
with several FIs and have significant in-house financial expertise. The FI’s relationship with
large corporate clients goes beyond lending. The FI’s role as broker, dealer, and advisor to a
corporate client may rival or exceed the importance of its role as a lender.
In providing a credit service to large corporations, credit management remains an important
issue. Large corporations frequently use loan commitments (a contractual commitment to
loan to a firm a certain maximum amount at a given interest rate), performance guarantees
(such as letters of credit), and term loans, as do mid-market corporates. Also, because of
these customers’ additional complexities and large credit risk exposures, FIs can use
sophisticated credit-scoring models in the credit review process based on accounting and/or
financial market data. The two such credit-scoring models used to analayse in customer credit
review are.
1. Credit-Scoring Models.
Credit-scoring models use data on observed borrower characteristics either to calculate the
probability of default or to sort borrowers into different default risk classes. By selecting and
combining different economic and financial borrower characteristics, an FI manager may be
able to:
1. Numerically establish which factors are important in explaining default risk.
2. Evaluate the relative degree or importance of these factors.

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 3. Improve the pricing of default risk.
4. Screen high-risk loan applicants.
5. Calculate any reserves needed to meet expected future loan losses.

To employ credit-scoring models in this manner, the FI manager must identify objective
economic and financial measures of risk for any particular class of borrower. For consumer
loans, the objective characteristics in a credit-scoring model might include income, assets,
age, occupation, and location. For commercial loans, cash flow information and financial
ratios such as the debt-to-equity ratio are usually key factors. After data are identified, a
statistical technique quantifies or scores the default risk probability or default risk
classification.
2. Altman’s Z-Score. E. I. Altman developed a Z-score model for analyzing publicly traded
manufacturing firms in the United States. The indicator variable Z is an overall measure
of the borrower’s default risk classification. This classification, in turn, depends on the
values of various financial ratios of the borrower ( X j ) and the weighted importance of
these ratios based on the observed experience of defaulting versus non defaulting
borrowers derived from a discriminant analysis model.
Altman’s credit-scoring model takes the following form:
Z = 1.2X1 + 1.4X2 + 3.3X3+ 0.6X4+ 1.0X5
where
X 1= Working capital / Total assets
X 2 =Retained earnings/ Total assets
X 3 = Earnings before interest and taxes/ Total assets
X 4 =Market value of equity/Book value of long-term debt
X 5 = Sales/ Total assets
The higher the value of Z, the lower the borrower’s default risk classification. Thus, low or
negative Z values may be evidence that the borrower is a member of a relatively high default
risk class.
According to Altman’s credit-scoring model, any firm with a Z-score of less than 1.81 should
be considered a high default risk, between 1.81 and 2.99 an indeterminate default risk, and
greater than 2.99 a low default risk. Thus, the FI should not lend to this borrower until it
improves its earnings performance.
Use of the Z-score model to make credit risk evaluations has a number of problems.
The first problem is that this model usually discriminates only among three cases of borrower
behaviour: high, indeterminate, and low default risk. But in the real world various gradations
of default exist, from non payment or delay of interest payments (nonperforming assets) to
outright default on all promised interest and principal payments.
The second problem is that there is no obvious economic reason to expect that the weights in
the Z-score model—or, more generally, the weights in any credit-scoring model—will be
constant over any but very short periods. The same concern also applies to the scoring
model’s explanatory variables (X j ). Specifically, due to changing financial market
conditions, other borrower-specific financial ratios may come to be increasingly relevant in
explaining default risk probabilities.

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The third problem is that this model ignores important, hard-to-quantify factors that may play
a crucial role in the default or no-default decision.
A fourth problem relates to the infrequency (e.g., quarterly or annually) with which
accounting variables are updated. This allows scores to be changed at generally infrequent
intervals.
4.3. Liquidity risk management
Liquidity risk arises when an FI’s liability holders, such as depositors or insurance
policyholders, demand immediate cash for the financial claims they hold with an FI or when
holders of off-balance-sheet loan commitments (or credit lines) suddenly exercise their right
to borrow (draw down their loan commitments).
4.3.1. CAUSES OF LIQUIDITY RISK
Liquidity risk arises for two reasons—a liability-side reason and an asset-side reason. The
liability-side reason occurs when an FI’s liability holders, such as depositors or insurance
policyholders, seek to cash in their financial claims immediately. To generate interest
revenues, most FIs invest in less liquid and/or longer-maturity assets. While most assets can
be turned into cash eventually, for some assets this can be done only at a high cost when the
asset must be liquidated immediately. The price the asset holder must accept for immediate
sale may be far less than it would receive with a longer horizon over which to negotiate a
sale. Some assets may be liquidated only at low fire-sale prices, thus threatening the
solvency of the FI. Alternatively, rather than liquidating assets, an FI may seek to purchase or
borrow additional funds.
The second cause of liquidity risk is asset-side liquidity risk, such as the ability to fund the
exercise of off-balance-sheet loan commitments. A loan commitment allows a customer to
borrow (take down) funds from an FI (over a commitment period) on demand. When a
borrower draws on its loan commitment, the FI must fund the loan on the balance sheet
immediately; this creates a demand for liquidity. As with liability withdrawals, an FI can
meet such a liquidity need by running down its cash assets, selling off other liquid assets, or
borrowing additional funds.
4.3.2. Liquidity Risk and Depository Institutions
A. Liability Side Liquidity Risk
Depository institution’s (DI’s) balance sheet typically has a large amount of short-term
liabilities, such as demand deposits and other transaction accounts, which fund relatively
long-term, illiquid assets such as commercial loans and mortgages. Demand deposit accounts
and other transaction accounts are contracts that give the holders the right to put their
financial claims back to the DI on any given day and demand immediate repayment of the
face value in cash.
In reality, a DI knows that normally only a small proportion of its demand deposits will be
withdrawn on any given day. Most demand deposits remain with the DI, thus behaving as
core deposits on a day-by-day basis, providing a relatively stable or long-term source of
funding for the DI. Moreover, deposit withdrawals may in part be offset by the inflow of new
deposits. The DI manager must monitor the resulting net deposit withdrawals or net deposit
drains (the difference between deposit withdrawals and deposit additions). A net deposit
drain means that a DI is receiving insufficient additional deposits (and other cash inflows) to

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offset deposit withdrawals, which means that the liability side of its balance sheet is
contracting.
Major liquidity problems can arise, however, if deposit drains are abnormally large and
unexpected. Abnormal deposit drains may occur for a number of reasons, including:
 Concerns about a DI’s solvency relative to that of other DIs.
 Failure of a related DI, leading to heightened depositor concerns about the solvency of
surviving DIs (a contagion effect).
 Sudden changes in investor preferences regarding holding nonbank financial assets
(such as T-bills or mutual fund shares) relative to DI deposits.
In such cases, sudden and unexpected surges in net deposit withdrawals risk triggering a bank
run, which could force a DI into insolvency.
An FI can manage a drain on deposits in two major ways: (1) purchased liquidity
management and/or (2) stored liquidity management. Traditionally, DI managers relied on
stored liquidity as the primary mechanism of liquidity management. Today, many DIs—
especially the largest banks with access to the money market and other non deposit markets
for funds—rely on purchased liquidity, whereas smaller DIs—such as community banks—
more often look to stored liquidity.
I. Purchased Liquidity Management. A DI manager who purchases liquidity to
offset a deposit drain turns to the markets for purchased funds, such as the federal
funds market and/or the repurchase (repo) agreement markets, which are interbank
markets for short-term loans. Alternatively, a DI manager could issue additional
fixed-maturity certificates of deposit or additional notes and bonds. Purchased
liquidity management can insulate the asset side of the balance sheet from normal
drains on the liability side of the balance sheet. This is one of the reasons for the
enormous growth in recent years of DI purchased liquidity management
techniques and associated purchased fund markets such as fed funds, repurchase
agreements, and CDs among DIs.
II. Stored Liquidity Management. Instead of meeting the net deposit drain by
purchasing liquidity in the money markets, the DI can use stored liquidity
management . That is, the FI can liquidate some of its assets, thus utilizing its
stored liquidity. The cost to the DI of using stored liquidity, apart from decreased
asset size, is that it must hold excess low interest rate assets in the form of cash on
its balance sheet. Thus, the cost of using cash to meet liquidity needs is the
forgone return (or opportunity cost) of being unable to invest these funds in loans
and other higher income-earning assets.
Finally, note that although stored liquidity management and purchased liquidity management
are alternative strategies for meeting deposit drains, a DI can combine the two methods by
using some purchased liquidity management and some stored liquidity management to meet
liquidity needs.
B. Asset Side Liquidity Risk
Just as deposit drains can cause a DI liquidity problems, so can loan requests, resulting from
the exercise, by borrowers, of loan commitments and other credit lines. In recent years,
depository institutions, especially commercial banks, have increased their loan commitments
tremendously, with the belief they would not be exercised.

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 4.3.3. Measuring a Bank’s Liquidity Exposure
There are several methods currently used to measure the extent of a DI’s liquidity risk
exposure. These methods take into account the DI’s excess cash reserves and its ability to
raise additional purchased funds.
A. Sources and Uses of Liquidity.
a DI’s liquidity risk arises from the on going conducting of business, such as a withdrawal of
deposits or new loan demand, and the subsequent need to meet these demands by liquidating
assets or borrowing funds. Therefore, a DI manager must be able to measure the DI’s
liquidity position on a daily basis, if possible. A useful tool is a net liquidity statement, which
lists sources and uses of liquidity and, thus, provides a measure of a DI’s net liquidity
position. The DI can obtain liquid funds in three ways. First, it can sell its liquid assets such
as T-bills immediately with little price risk and low transaction costs. Second, it can borrow
funds in the money/purchased funds market up to a maximum amount (this is an internal
guideline based on the manager’s assessment of the credit limits that the purchased or
borrowed funds market is likely to impose on the bank). Third, it can use any excess cash
reserves over and above the amount held to meet regulatory imposed reserve requirements.
B. Peer Group Ratio Comparisons.
Another way to measure a DI’s liquidity exposure is to compare certain of its key ratios and
balance sheet features—such as loans to deposits, core deposits to total assets, borrowed
funds to total assets, and commitments to lend to assets ratios—with those for DIs of a
similar size and geographic location. A high ratio of loans to deposits and borrowed funds to
total assets and/or a low ratio of core deposits to total assets means that the DI relies heavily
on the short-term money market rather than on core deposits to fund loans. This could mean
future liquidity problems if the DI is at or near its borrowing limits in the purchased funds
market. Similarly, a high ratio of loan commitments to assets indicates the need for a high
degree of liquidity to fund any unexpected takedowns of these loans by customers—thus,
high-commitment DIs often face more liquidity risk exposure than do low-commitment DIs.

C. Liquidity Index.
A third way to measure liquidity risk is to use a liquidity index. This index measures the
potential losses a DI could suffer from a sudden or fire-sale disposal of assets compared to
the amount it would receive at a fair market value established under normal market
conditions. The larger the differences between immediate fire-sale asset prices ( P i ) and fair
market prices ( P i* ), the less liquid is the DI’s portfolio of assets. Define an index I such
that:
N
I =∑ ¿ ¿
i=1

Where
w i = Percentage of each asset in the DI’s portfolio
w i =1
P i = Price it gets if a DI liquidates asset i today
Pi*= Price it gets if a DI liquidates asset i at some future point in time, e.g., in one month

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 D. Financing Gap and the Financing Requirement.
A fourth way to measure liquidity risk exposure is to determine the DI’s financing gap. On
average, most demand deposits stay at DIs for quite long periods, often two years or more.
Thus, a DI manager often thinks of the average deposit base, including demand deposits, as a
core source of funds that over time can fund a DI’s average amount of loans. We define a
financing gap as the difference between a DI’s average loans and average (core) deposits, or:
Financing gap = Average loans - Average deposits
If this financing gap is positive, the DI must find liquidity to fund the gap. This funding come
via either purchased liquidity management (i.e., borrowing funds) or stored liquidity
management (i.e., liquidating assets), as discussed above. Thus:
Financing gap = - Liquid assets + Borrowed funds
We can write this relationship as:
Financing gap + Liquid assets =Financing requirement (borrowed funds)
As expressed in this fashion, the liquidity and managerial implications of the financing
requirement (the financing gap plus a DI’s liquid assets) are that the level of core deposits
and loans as well as the amount of liquid assets determines the DI’s borrowing or purchased
fund needs. In particular, the larger a DI’s financing gap and liquid asset holdings, the higher
the amount of funds it needs to borrow in the money markets and the greater is its exposure to
liquidity problems from such a reliance.
E. BIS Approach: Maturity Ladder/Scenario Analysis.
It is recognized that liquidity is crucial to the on going viability of a DI, the Bank for
International Settlements (BIS) outlined a Maturity Laddering method for measuring liquidity
risk and, specifically, net funding (financing) requirements. At a minimum, liquidity
measurement involves assessing all cash inflows against cash outflows. Once identified, a
maturity ladder model allows a comparison of cash inflows and outflows on a day-to-day
basis and/or over a series of specified time periods. Daily and cumulative net funding
requirements can then be determined from the maturity ladder.
F. Liquidity Planning.
Liquidity planning is a key component in measuring (and being able to deal with) liquidity
risk and its associated costs. Specifically, liquidity planning allows managers to make
important borrowing priority decisions before liquidity problems arise. Such forward
planning can lower the cost of funds (by determining an optimal funding mix) and can
minimize the amount of excess reserves that a DI needs to hold. A liquidity plan has a
number of components. The first component is the delineation of managerial details and
responsibilities. Responsibilities are assigned to key management personnel should a liquidity
crisis occur. The second component of a liquidity plan is a detailed list of fund providers
most likely to withdraw as well as the pattern of fund withdrawals. The third component of
liquidity planning is the identification of the size of potential deposit and fund withdrawals
over various time horizons in the future (one week, one month, one quarter, etc.) as well as
alternative private market funding sources to meet such withdrawals (e.g., emergency loans
from other FIs and the Federal Reserve). The fourth component of the plan sets internal limits
on separate subsidiaries’ and branches’ borrowings as well as bounds for acceptable risk
premiums to pay in each market (fed funds, RPs, CDs, etc.).

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 4.4. Interest rate risk
Asset transformation is a special or key function of FIs. Asset transformation involves an FI
buying primary securities or assets and issuing secondary securities or liabilities to fund the
assets. The primary securities that FIs purchase often has different maturity characteristics
from the secondary securities those FIs sell. In mismatching the maturities of its assets and
liabilities as part of its asset transformation function, an FI potentially exposes itself to
interest rate risk. Interest rate risk is the exposure of a bank's financial condition to adverse
movements in interest rates
While many factors influence the level and movement of interest rates, it is the central bank’s
monetary policy strategy that most directly underlies the level and movement of interest rates,
which in turn affect an FI’s cost of funds and return on assets.
4.4.1. Sources of interest rate risk
Basically sources of interest risk are classified in to four as re pricing risk, yield curve risk,
basis risk and optionality
1. Re pricing risk: As financial intermediaries, banks encounter interest rate risk in
several ways. The primary and most often discussed form of interest rate risk arises
from timing differences in the maturity (for fixed-rate) and re pricing (for floating-
rate) of bank assets, liabilities, and OBS positions. While such re pricing mismatches
are fundamental to the business of banking, they can expose a bank's income and
underlying economic value to unanticipated fluctuations as interest rates vary.
2. Yield curve risk: Re pricing mismatches can also expose a bank to changes in the
slope and shape of the yield curve. Yield curve risk arises when unanticipated shifts
of the yield curve have adverse effects on a bank's income or underlying economic
value.
3. Basis risk: Another important source of interest rate risk, commonly referred to as
basis risk, arises from imperfect correlation in the adjustment of the rates earned and
paid on different instruments with otherwise similar re pricing characteristics. When
interest rates change, these differences can give rise to unexpected changes in the cash
flows and earnings spread between assets, liabilities and OBS instruments of similar
maturities or re pricing frequencies.
4. Optionality: An additional and increasingly important source of interest rate risk
arises from the options embedded in many bank assets, liabilities, and OBS portfolios.
Formally, an option provides the holder the right, but not the obligation, to buy, sell,
or in some manner alter the cash flow of an instrument or financial contract.
There are three methods of interest risk analysis. Those are gap analysis or re pricing model,
duration gap model and simulation model. The re pricing model, sometimes called the
funding gap model, concentrates on the impact of interest rate changes on an FI’s net interest
income (NII), which is the difference between an FI’s interest income and interest expense
and thus the FI’s profits. This contrasts with the market value–based duration gap model,
which incorporates the impact of interest rate changes on the overall market value of an FI’s
balance sheet and ultimately on its owners’ equity or net worth.
I. Re pricing Model

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Fed required quarterly reporting by commercial banks of re pricing gaps for assets and
liabilities with these maturities:
1. One day
2. More than 1 day to 3 months
3. More than 3 months to 6 months
4. More than 6 months to 12 months
5. More than 1 year to 5 years
6. More than 5 years
The gap in each maturity bucket (or bin) is calculated by estimating the difference between
the rate-sensitive assets (RSAs) and rate-sensitive liabilities (RSLs) on the balance sheet.
Rate sensitivity means that the asset or liability is re priced (either because it matures and the
funds will be rolled over into a new asset or liability, or because it is a financial instrument
with a variable interest rate) at or near current market interest rates within the maturity
horizon of the bucket under consideration.
This calculation, GAP, can be written as
∆ NII = (GAP ) ∆ RI =(RSA−RSL)∆ RI
A negative, or liability-sensitive, gap occurs when liabilities exceed assets (including OBS
positions) in a given time band. This means that an increase in market interest rates could
cause a decline in net interest income. Conversely, a positive, or asset-sensitive, gap implies
that the bank's net interest income could decline as a result of a decrease in the level of
interest rates.
The re pricing or funding gap model is essentially a book value accounting cash flow
analysis of the interest income earned on an FI’s assets and the interest expense paid on its
liabilities (or its net interest income) over some particular period.
Although gap analysis is a very commonly used approach to assessing interest rate risk
exposure, it has a number of shortcomings. First, gap analysis does not take account of
variation in the characteristics of different positions within a time band. In particular, all
positions within a given time band are assumed to mature or re price simultaneously, a
simplification that is likely to have greater impact on the precision of the estimates as the
degree of aggregation within a time band increases. Moreover, gap analysis ignores
differences in spreads between interest rates that could arise as the level of market interest
rates changes (basis risk). In addition, it does not take into account any changes in the timing
of payments that might occur as a result of changes in the interest rate environment. Thus, it
fails to account for differences in the sensitivity of income that may arise from option-related
positions. For these reasons, gap analysis provides only a rough approximation of the actual
change in net interest income which would result from the chosen change in the pattern of
interest rates. Finally, most gap analyses fail to capture variability in non-interest revenue and
expenses, a potentially important source of risk to current income.
II. Duration Model
Duration is a measure of the percentage change in the economic value of a position that will
occur given a small change in the level of interest rates. It reflects the timing and size of cash
flows that occur before the instrument's contractual maturity. Generally, the longer the
maturity or next re pricing date of the instrument and the smaller the payments that occur
before maturity (e.g. coupon payments), the higher the duration (in absolute value). Higher

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duration implies that a given change in the level of interest rates will have a larger impact on
economic value.
For FIs, the major relevance of duration is its use as a measure of interest rate risk exposure.
The duration model can be used instead of the re pricing model discussed above to evaluate
an FI’s overall interest rate exposure—to measure the FI’s duration gap.
% ∆∈the market value of a security
DUR=
∆ R(1+ R)
DUR∗∆ i
OR; % ∆ P ≈−
1+i
Where %∆ P=(P t 1−Pt )/Pt = percent change in market value of the security
DUR = duration
i = interest rate
4.4.3. Difficulties in Applying the Duration Model to Real-World FI Balance
Sheets.
 Duration Matching Can Be Costly. Critics charge that although in principle an FI
manager can change D A and D L to immunize the FI against interest rate risk,
restructuring the balance sheet of a large and complex FI can be both time-consuming
and costly.
 Immunization Is a Dynamic Problem. Even though assets and liabilities are duration
matched today, the same assets and liabilities may not be matched tomorrow. This is
because the duration of assets and liabilities changes as they approach maturity, and,
most importantly, the rate at which their durations change through time may not be
the same on the asset and liability sides of the balance sheet. As a result, the manager
has to continuously restructure the balance sheet to remain immunized.
 Large Interest Rate Changes and Convexity. Duration measures the price sensitivity
of fixed-income securities for small changes in interest rates of the order of one basis
point (or one-hundredth of 1 %). But suppose that interest rate shocks are much
larger, of the order of 2 % or 200 basis points. In this case, duration becomes a less
accurate predictor of how much the prices of securities will change and, therefore, a
less accurate measure of the interest rate sensitivity and the interest rate gap of an FI.
C. simulation model
Many banks (especially those using complex financial instruments or otherwise having
complex risk profiles) employ more sophisticated interest rate risk measurement systems than
those based on simple maturity/re pricing schedules. These simulation techniques typically
involve detailed assessments of the potential effects of changes in interest rates on earnings
and economic value by simulating the future path of interest rates and their impact on cash
flows. In some sense, simulation techniques can be seen as an extension and refinement of
the simple analysis based on maturity/re pricing schedules. However, simulation approaches
typically involve a more detailed breakdown of various categories of on- and off balance-
sheet positions, so that specific assumptions about the interest and principal payments and
non-interest income and expense arising from each type of position can be incorporated. In
addition, simulation techniques can incorporate more varied and refined changes in the
interest rate environment, ranging from changes in the slope and shape of the yield curve to
interest rate scenarios derived from Monte Carlo simulations.

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 4.5. Hedging with derivative markets
Financial derivatives are so effective in reducing risk because they enable financial
institutions to hedge, that is, engage in a financial transaction that reduces or eliminates risk.
When a financial institution has bought an asset, it is said to have taken a long position, and
this exposes the institution to risk if the returns on the asset are uncertain. On the other hand,
if it has sold an asset that it has agreed to deliver to another party at a future date, it is said to
have taken a short position, and this can also expose the institution to risk. Financial
derivatives can be used to reduce risk by invoking the following basic principle of hedging:
Hedging risk involves engaging in a financial transaction that offsets a long position by
taking an additional short position, or offsets a short position by taking an additional long
position. In other words, if a financial institution has bought a security and has therefore
taken a long position, it conducts a hedge by contracting to sell that security (take a short
position) at some future date. Alternatively, if it has taken a short position by selling a
security that it needs to deliver at a future date, then it conducts a hedge by contracting to buy
that security (take a long position) at a future date. We first look at how this principle can be
applied using forward contracts.
Derivatives can be either speculators or hedgers. Speculators in derivative contracts buy to
profit from a price increase or sell to profit from a price decrease. Speculators buy derivative
contracts with the hope of later being able to sell them at a higher price. Conversely,
speculators sell derivative contracts with the hope of being able to buy back identical and
offsetting derivative contracts at a lower price. Thus, speculators put their money at risk in
the hope of profiting from an anticipated price change. t derivative securities contracts play
significant role in managing an FI’s interest rate, foreign exchange, and credit risk exposures.
4.5.1. Hedging with Futures Contracts
Even though some hedging of interest rate risk does take place using forward contracts—
such as forward rate agreements commonly used by insurance companies and banks prior to
mortgage loan originations—many FIs hedge interest rate risk either at the micro level (called
micro hedging ) or at the macro level (called macro hedging ) using futures contracts.
A. Micro and macro hedging
FI is micro hedging when it employs a derivative securities contract to hedge a particular
asset or liability risk.
Macro hedging occurs when an FI manager wishes to use futures or other derivative
securities to hedge the entire balance sheet duration gap. This contrasts with micro hedging in
which an FI manager identifies specific assets and liabilities and seeks individual futures and
other derivative contracts to hedge those individual risks. Note that macro hedging and micro
hedging can lead to quite different hedging strategies and results. In particular, a macro hedge
takes a whole portfolio view and allows for individual asset and liability interest sensitivities
or durations to net out each other.
B. Routine Hedging versus Selective Hedging
Routine hedging occurs when an FI reduces its interest rate risk exposure to the lowest
possible level by selling sufficient futures to offset the interest rate risk exposure of its whole
balance sheet or cash positions in each asset and liability. However, since reducing risk also
reduces expected return and thus shareholder wealth, not all FI managers seek to do this.

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Indeed, a manager will follow this strategy only if the direction and size of interest rate
changes are extremely unpredictable to the extent that the manager is willing to forgo return
to hedge this risk.
Rather than a fully hedged position, most FIs choose to bear some interest rate risk as well as
credit and FX risks because of their comparative advantage as FIs One possibility is that an
FI may choose to selectively hedge its portfolio.
4.6. Stock Index Futures
Financial institution managers, particularly those who manage mutual funds, pension funds,
and insurance companies, also worry about stock market risk, the risk that occurs because
stock prices fluctuate. Stock index futures were developed in 1982 to meet the need to
manage stock market risk, and they have become among the most widely traded of all futures
contracts. Stock index futures contracts differ from most other financial futures contracts in
that they are settled with a cash delivery rather than with the delivery of a security. Cash
settlement gives these contracts the advantage of a high degree of liquidity and also rules out
the possibility of anyone’s cornering the market.

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