Use of Derivatives for Interest Rate Risk Management
Rationale behind an Interest Rate Swap
This can be understood using the oft quoted and widely used measure of Duration. Duration or the weighted average time to maturity of an asset/liability measures the interest rate sensitivity of the asset or liability.
Duration Gap = Average (dollar weighted) duration of assets
- Average (dollar weighted) duration of liabilities
Here, the bank is in an adverse situation when the D (Assets) is greater than the D (Liabilities) in a scenario where the interest rates are likely to rise i.e we are explaining the top hand corner scenario. This is where the bank needs to take corrective action and it can do so in two ways:
Decrease Asset Duration
The bank can do so such a thing by entering into a swap in which it swaps out a fixed interest rate income for a floating interest rate income stream. This transaction entered into by the bank results in the bank shifting some of its assets from being fixed interest rate to floating interest rate, resulting in a reduction in the duration.
Increase Liabilities Duration
The bank can enable such a case when it has a positive duration gap. It enters a swap where it swaps out a floating interest rate expense for a fixed interest rate expense stream. What results from such a case is that the bank by shifting some of its floating interest rate liabilities to a fixed interest bearing liability increases its liability duration.
The opposite of this case holds for a scenario where the bank expects the interest rates to move down in the future and has a negative duration gap. i.e. the bottom right hand corner in the table above.
Also read about :
Interest Rate Caps
Interest Rate Floors
Interest Rate Collars