2-Financial Markets Page 44 Wednesday, February 4, 2004 1:15 PM
44 The Mathematics of Financial Modeling and Investment Managementyears, the spread income will be negative. That is, it will cost the depos-
itory institution more to finance the purchase of the Treasury security
than it will earn on the funds invested in that security.
In our example, the depository institution has “borrowed short” (bor-
rowed for one year) and “lent long” (invested for 15 years). This invest-
ment policy will benefit from a decline in interest rates, but suffer if
interest rates rise. Suppose the institution could have borrowed funds for
15 years at 7% and invested in a U.S. Treasury security maturing in one
year earning 9%—borrowing long (15 years) and lending short (one year).
A rise in interest rates will benefit the depository institution because it can
then reinvest the proceeds from the maturing 1-year government security
in a new 1-year government security offering a higher interest rate. In this
case a decline in interest rates will reduce the spread income. If interest
rates fall below 7%, there will be a negative spread income.
All depository institutions face this interest rate risk problem. Man-
agers of a depository institution who have particular expectations about
the future direction of interest rates will seek to benefit from these expec-
tations. Those who expect interest rates to rise may pursue a policy to
borrow funds long term and lend funds short term. If interest rates are
expected to drop, managers may elect to borrow short and lend long.
The problem of pursuing a strategy of positioning a depository insti-
tution based on expectations is that considerable adverse financial conse-
quences will result if those expectations are not realized. The evidence on
interest rate forecasting suggests that it is a risky business. We doubt if
there are managers of depository institutions who have the ability to
forecast interest rate moves so consistently that the institution can bene-
fit with any regularity. The goal of management should be to lock in a
spread as best as possible, not to wager on interest rate movements.
Some interest rate risk, however, is inherent in any balance sheet of
a depository institution. Managers must be willing to accept some inter-
est rate risk, but they can take various measures to address the interest
rate sensitivity of the institution’s liabilities and its assets. A depository
institution should have an asset/liability committee that is responsible
for monitoring the exposure to interest rate risk. There are several asset/
liability strategies for controlling interest rate risk.
Because of the special role that depository institutions play in the
financial system, they are highly regulated and supervised by either fed-
eral and/or state government entities. Regulators have placed restric-
tions on the types of securities that depository institutions can take a
position in for their investment portfolio. There are risk-based capital
requirements for depository institutions that specify capital require-
ments based on their credit risk and the interest rate risk exposures.