Repricing and maturity models:

We have seen that not only individuals holding fixed-income securities like bonds, but also banks and firms face the consequences of interest rate risk. In this section we look at some strategies to manage interest rate risks, which can be employed by organisations whose assets and liabilities both involve interest rates. The liabilities may be deposits of banks or borrowings if it is a firm. On the other hand, banks may provide loans to others, which are assets of the banks. So banks are concerned with interest rates affecting both their assets as well as liabilities.

There are two approaches towards understanding the effects of exposure of a bank or company to interest rate risk. One approach focuses on the effects of interest rate changes on future financial flows such as cash flows, net interest incomes, or earnings. The second approach looks at the effect of interest rate changes on market value. In the case, the main concern is not with how rate changes will affect future financial flows, per se. Rather, the emphasis is laid on how changes in interest rates will affect the current value of future cash flows or profits, usually measured as the market value of the firm, or the value of owners' equity.  Here the notion of duration that we studied in the previous section is used to quantify the sensitivity of assets and liabilities to interest rate changes. Clearly, these two approaches to studying the effect of interest rate changes on assets and liabilities are related to each other, since the market value of the firm can be seen as the present value of its future cash flows.

However, there may be differences in these approaches and we have to see what these differences are. Now we come to the important topics of repricing of securities  and GAP analysis with regard to these securities. We understand that interest is the price of loans. Now sometimes these are repriced, that is, their prices are adjusted and revised. For a bank, for example, both its assets and liabilities may come to be repriced. Repricing can occur either after the maturity of the loan, or it may be repriced, if the contract rate is reset prior to maturity. Suppose you have gone in for a home loan on a floating interest rate term. Before you entirely repay the money, the contract for your loan may be repriced.

The interest rate GAP (it is actually gap but usually denoted GAP) is defined by classifying financial assets and liabilities into two types: those that will be reprised within a specified interval called the gap interval or gap maturity and those that will be reprised later. Assets and liabilities that are repriced within the gap interval are called "rate sensitive assets" and "rate sensitive liabilities",  or RSA and RSL respectively. The difference between RSA and RSL, or RSA minus RSL is equal to the GAP.

The GAP is the money amount of assets and liabilities that are mismatched. If there are more RSL than RSA, the GAP will be  negative. Basically, the GAP measures the volume of fixed rate assets that are financed with variable rates liabilities. If rates of interest rise, it will increase the cost of interest on that volume while the interest incomes will not. This will reduce the net interest  margin. The magnitude of these effects will depend on the magnitude of the GAP.

Many a time, companies restructure their balance sheets in order to rearrange or redistribute interest rate risk exposure or to change the timing f interest payments. Companies can do this through cash or spot market transactions.  This usually involves selling off an existing asset, paying off debt and replacing it with some other obligation. But sometimes companies do not take this route; it may be because they want to reduce transaction costs of issuing new securities or retiring existing ones, or because they use off-balance sheet methods to hide the actual nature of the intended changes.

Now we come to a very important concept that has to do with protection against interest rate risk. This is the concept of   immunisation, and this is what we turn to now. The name indicates that it is a process that 'immunises' the value of the fixed- income securities portfolio against interest rate changes. It is a method to protect an investment with a specific time horizon from  interest rate changes. An investor who invests in fixed-income securities may hold these securities with a specific purpose in mind.  For example, suppose a person will retire in 10 years and wants the proceeds from her investment to finance her retirement. She could invest in a zero-coupon bond that will mature after 10 years so that her invested amount is locked in for 10 years. Another way could be to invest in a portfolio non-zero coupon bond but make the portfolio behave as though it were a zero-coupon one. 

Designing a portfolio of coupon bonds so that it behaves like a zero-coupon bond with a maturity equal to the investor's investment horizon is called immunisation. We know that a coupon bond involves two kinds of risks. First, there is the risk of changes in price that will be realised if it is liquidated before maturity. Secondly, it has the risk of changes in the interest rate at which coupon  payments can be reinvested. These risks move in the direction opposite to changes in the market interest rates. The aim of immunisation of a portfolio is to make these risks offsetting so that the bond value plus the accumulation of reinvested coupon  payments will be the same at the end of the investment period, regardless of the level of interest rates. The way to do this is to choose the portfolio's duration to equal the length of the investment horizon. It can be shown that when the duration is equal to the length of the investment horizon, then changes in reinvestment income caused by changes in interest rates will offset changes in the price of the portfolio in a manner such that the total accrual at the end of the investment horizon cannot decrease. Thus  immunisation reduces and can potentially eliminate interest rate risks for portfolios by equating the duration and intended holding period of the portfolio.

Immunisation matches duration as well as present values. Immunisation provides protection against changes in yield. The basic shortcoming of immunisation is that it assumes that all yields are equal.