Learning Outcomes
After studying this article, you will be able to explain gap (repricing) exposure as a form of interest rate risk, describe how to assess and measure such risk using key metrics, and outline approaches and derivative tools used to manage interest rate risk. You will recognise scenarios of interest rate risk in financial statements and be able to apply relevant risk management techniques for ACCA Financial Management (FM) exam questions.
ACCA Financial Management (FM) Syllabus
For ACCA Financial Management (FM), you are required to understand the causes and management of interest rate risk. This article specifically covers:
- The types of interest rate risk, with an emphasis on gap (repricing) exposure
- Risk metrics used to assess interest rate risk positions
- Methods for managing and hedging interest rate risk, including asset and liability management and the use of derivatives such as FRAs, futures, and swaps
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is gap (repricing) exposure in interest rate risk management?
- How does a negative gap position affect a company when interest rates rise?
- Which key metrics are commonly used to assess a company’s exposure to interest rate risk?
- Name two derivative instruments used to hedge interest rate risk and briefly explain their function.
- True or false? Asset and liability management can help reduce a firm's sensitivity to interest rate movements.
Introduction
All businesses face risk from changes in market interest rates. This risk can increase costs, reduce investment income, or disrupt cash flow planning. Gap exposure, also called repricing exposure, is a primary form of interest rate risk and arises when assets and liabilities reset their interest rates at different times. Assessing and managing this risk is essential for financial managers. This article will explain gap exposure, the key metrics used to measure it, and common risk management strategies, including the use of derivatives.
Key Term: Interest rate risk
The risk that changes in market interest rates will adversely affect a company’s cash flows, profitability, or asset values.
Understanding Gap (Repricing) Exposure
Interest rate risk arises when a business has assets, liabilities, or off-balance-sheet positions whose values or interest income and expenses are affected by changes in market interest rates.
Types of Interest Rate Risk
- Gap (repricing) exposure: Occurs when the timing of interest rate resets on assets and liabilities does not match.
- Basis risk: Arises when asset and liability rates are linked to different benchmarks, causing them to move independently.
Key Term: Gap (repricing) exposure
The difference in amount between assets and liabilities that reprice or mature within a specified time period, making the firm sensitive to changes in interest rates.Key Term: Basis risk
The risk that different interest rate benchmarks (e.g., SONIA, LIBOR) do not move in perfect correlation, leading to unexpected gains or losses.
Sources of Gap Exposure
A company holding floating rate assets and fixed rate liabilities, or vice versa, typically has different maturity and repricing patterns. This mismatch means that as market rates change, the company may earn less on its assets while still paying fixed higher rates on liabilities, or vice versa.
The effect of interest rate changes depends on both the size and direction of the gap:
- Positive gap: More assets than liabilities repricing in a given time bucket.
- Negative gap: More liabilities than assets repricing in the same period.
If, for example, a company has a positive gap over the next six months and interest rates rise, it will benefit as more assets re-price to the higher rate than liabilities.
Worked Example 1.1
A bank has £100 million in loans and £80 million in deposits maturing in the next year. Both reprice at the end of 12 months. If market interest rates rise, how does this affect the bank’s net interest income?
Answer:
The bank has a positive gap of £20 million (£100m – £80m). If rates rise, both assets and liabilities will reprice at higher rates, but more assets than liabilities will do so. Therefore, net interest income increases.
Measuring Interest Rate Gap
A typical gap analysis involves grouping assets and liabilities into time buckets according to when they reprice or mature (e.g., 1 month, 3 months, 6 months, 1 year).
Gap in a time bucket = Rate-sensitive assets – Rate-sensitive liabilities
The gap indicates the institution’s exposure to rising or falling rates in a given period.
- Positive gap: Gains if rates rise, loses if rates fall.
- Negative gap: Loses if rates rise, gains if rates fall.
Key Risk Metrics
- Cumulative gap: Sum of all gaps up to a specific time bucket; helps estimate cumulative exposure over time.
- Earnings at risk: Estimates the potential impact on net interest income from movements in interest rates.
- Duration gap: Measures sensitivity of net asset value to changes in interest rates, using duration-weighted assets and liabilities.
Key Term: Earnings at risk (EaR)
A measure estimating the change in net interest income over a specific period, given a defined movement in interest rates.Key Term: Duration gap
The difference between the weighted average durations of assets and liabilities, showing sensitivity of net worth to interest rate changes.
Worked Example 1.2
Company X has the following repricing profile for the next year:
- 3-month assets: £50m
- 3-month liabilities: £80m
- 1-year assets: £30m
- 1-year liabilities: £20m
Calculate the 3-month gap and 1-year cumulative gap.
Answer:
3-month gap = £50m – £80m = –£30m (negative gap; exposed to losses if rates rise in the next 3 months) 1-year cumulative gap = (–£30m) + (£30m – £20m) = –£20m
Risk Management Strategies
Gap exposure can be managed or hedged by several methods.
Asset and Liability Management
One common technique is to match the interest rate sensitivities of assets and liabilities, either by choosing similar repricing terms or by adjusting the composition over time.
Matching maturities or repricing intervals helps reduce net exposure to adverse rate changes.
Use of Derivative Instruments
Where matching is impractical or insufficient, derivative contracts can be used:
- Forward Rate Agreements (FRAs): Contracts to fix the interest rate for a future loan or deposit.
- Interest Rate Swaps: Agreements to exchange fixed rate and floating rate cash flows between parties.
- Interest Rate Futures and Options: Standardised contracts traded on exchanges to hedge against adverse movements in short-term rates.
Key Term: Forward Rate Agreement (FRA)
A contract that locks in an interest rate to be paid or received on a notional amount at a future date, protecting against rate fluctuations.Key Term: Interest rate swap
An agreement between two parties to exchange interest payments on a specified principal, typically swapping fixed and floating rate payments.
Worked Example 1.3
A company expects to borrow $5 million in 3 months’ time for 6 months. Concerned about rising rates, the company buys a 3–9 month FRA. Later, market rates rise by 1%. What effect does the FRA have?
Answer:
The FRA ensures the company pays the agreed rate, not the higher market rate. If actual rates exceed the FRA rate, the bank pays compensation to cover the difference.
Exam Warning
Be careful not to overlook the impact of off-balance-sheet items or variable rate clauses—gap calculations should include all positions that can change with market rates.
Summary
Interest rate gap (repricing) exposure arises from mismatches in timing between when assets and liabilities reset their rates. Risk metrics such as gap analysis, cumulative gap, earnings at risk, and duration gap help measure this exposure. Matching assets and liabilities and using derivatives like FRAs and swaps are key techniques to control interest rate risk.
Key Point Checklist
This article has covered the following key knowledge points:
- Define interest rate risk, gap (repricing) exposure, basis risk, earnings at risk, duration gap, FRA, and interest rate swap
- Calculate and interpret simple interest rate gap positions
- Understand the impact of positive vs negative gaps when rates move
- Identify main risk metrics for measuring interest rate exposure
- Outline methods for managing interest rate risk, including matching and using derivatives
Key Terms and Concepts
- Interest rate risk
- Gap (repricing) exposure
- Basis risk
- Earnings at risk (EaR)
- Duration gap
- Forward Rate Agreement (FRA)
- Interest rate swap