Risk Management Manual of Examination Policies - FDIC

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SENSITIVITY TO MARKET RISK Section 7.1 ∆% = Modified Duration x ∆ Yield x 100 = 2.59% x 50bp x 100 = 2.59% x .5 = 1.295% The formula for the dollar change in price: ∆$ = minus Price x Modified Duration x ∆ Yield x 100 If the price of the bond had been $875.66, then its approximate change in value (price) if rates change by 50bp would be = -$875.66 x 1.295% = -$11.34 If rates fell, the estimated value would be $887.00, while if rates rose the estimated value would fall to $864.32. For very small changes (1 to 5 basis points) the duration based price forecast will be precise. For larger changes (100bp or more) the result will only approximate the change in price. The larger the change, the larger the approximation error. The reason for the error is the nonlinear price/yield relationship, or convexity. Convexity Convexity describes the nonlinear price/yield relationship. Option-free instruments display positive convexity. When rates decline, a positively convex instrument’s price increases at an increasing rate. When rates rise, a positively convex instrument’s price decreases at a decreasing rate. Negative convexity causes the duration of a security to lengthen when a rates rise and shorten when rates fall. Instruments that contain embedded options demonstrate negative convexity. When rates decline, a negatively convex instrument’s price increases at a decreasing rate. When rates rise, the price of a negatively convex instrument will decline at an increasing rate. As the following chart illustrates in the +200 to +300bp range, the value of the treasury security changes relatively less in value in comparison to the sample mortgage security, which declines more significantly. However, as yields decrease, the treasury security gains value at an increasing rate, while the mortgage security gains only modestly. As interest rates decline, the likelihood that borrowers will refinance (exercise prepayment option) increases. Therefore, the value of a mortgage security does not increase at the same rate or magnitude as a decline in interest rates. 130 120 110 100 90 80 70 Effective Duration and Effective Convexity are used to calculate bonds with embedded options. The calculation provides an approximate price change of a bond given a parallel yield curve shift. Measures of modified duration and convexity do not provide accurate calculations of price sensitivity for bonds with embedded options. Effective duration and convexity provide a more accurate view of price sensitivity since the measures allow for cash flows to change due to a change in yield. Formula: Effective Duration =Vֵ - V+ ÷ 2VO (Change Y ) Effective Convexity =V+ + Vֵ- 2VO ÷ 2VO (Change Y) ² Where, Negative Convexity (Mortgage) Convexity Positive Convexity (Treasury) Change Y = Change in market interest rate used to calculate new values V+ = Price if yield is increased by Change Y Vֵ= Price if yield is decreased by Change Y VO= Initial price per $100 of par value Assume: a three-year callable bond’s current market value is $98.60 (VO); that interest rates are projected to change by 100 basis points (Y); that the price of this bond given a 100 basis point increase in rates is $96.75 (V+); and that the price of this bond given a 100 basis point decrease in rates is $99.98 (Vֵ). To calculate effective duration and convexity: Effective Duration =99.98 – 96.75÷2(98.60)(.01) = 1.64 Effective Convexity=96.75 + 99.98 – 2(98.60)÷2(98.60)(.01)² = -23.83 Sensitivity to Market Risk (12-04) 7.1-18 DSC Risk Management Manual of Examination Policies Federal Deposit Insurance Corporation
SENSITIVITY TO MARKET RISK Section 7.1 If we assume interest rates increase 100 bps, the approximate price change due to effective duration is the following: Percentage Price Change = -Effective Duration x Yield Change Percentage Change in Price = -1.64 x .01 = -1.64% The approximate price change due to effective convexity is the following: ½ x Effective Convexity x (Yield Change)² ½ x -23.83 x (0.01)² x 100 = -0.12% Thus this bond’s price would be expected to decrease by about 1.76% given a 100 bps rise in rates: Effective Duration = -1.64% Effective Convexity = -0.12% -1.76% DSC Risk Management Manual of Examination Policies 7.1-19 Sensitivity to Market Risk (12-04) Federal Deposit Insurance Corporation
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DSC Risk Management Manual of Exami
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INDEX Section 0.1 Policies, Procedu
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INDEX Section 0.1 Liquidity Managem
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INDEX Section 0.1 Introduction 14.1
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BASIC EXAMINATION CONCEPTS AND GUID
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CAPITAL Section 2.1 INTRODUCTION Pu
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CAPITAL Section 2.1 Interests in As
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CAPITAL Section 2.1 the holder prio
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CAPITAL Section 2.1 • Qualifying
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CAPITAL Section 2.1 application sub
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CAPITAL Section 2.1 may leave the b
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CAPITAL Section 2.1 procedures empl
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CAPITAL Section 2.1 growth and rema
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ASSET QUALITY Section 3.1 INTRODUCT
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LOANS Section 3.2 INTRODUCTION The
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LOANS Section 3.2 Qualifications of
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LOANS Section 3.2 to the ALLL), an
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LOANS Section 3.2 PORTFOLIO COMPOSI
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LOANS Section 3.2 • Require reaso
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LOANS Section 3.2 Internal Controls
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LOANS Section 3.2 continue to suppo
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LOANS Section 3.2 board of director
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LOANS Section 3.2 the institution's
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LOANS Section 3.2 such as for lives
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LOANS Section 3.2 Classification Gu
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LOANS Section 3.2 checks; terms in
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LOANS Section 3.2 • Sublicensee B
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LOANS Section 3.2 similar propertie
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LOANS Section 3.2 Problems in this
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LOANS Section 3.2 Other loans of qu
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LOANS Section 3.2 be determined whe
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LOANS Section 3.2 security interest
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LOANS Section 3.2 unambiguous terms
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LOANS Section 3.2 Trustees are sele
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LOANS Section 3.2 Although some ins
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LOANS Section 3.2 • Portfolio gro
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LOANS Section 3.2 pricing decisions
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LOANS Section 3.2 trends, condition
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LOANS Section 3.2 provide additiona
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SECURITIES AND DERIVATIVES Section
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CASH AND DUE FROM BANKS Section 3.4
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CASH AND DUE FROM BANKS Section 3.4
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PREMISES AND EQUIPMENT Section 3.5
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PREMISES AND EQUIPMENT Section 3.5
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OTHER REAL ESTATE Section 3.6 Under
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OTHER ASSETS AND LIABILITIES Sectio
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OFF-BALANCE SHEET ACTIVITIES Sectio
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MANAGEMENT Section 4.1 INTRODUCTION
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MANAGEMENT Section 4.1 consequently
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MANAGEMENT Section 4.1 overdue, ren
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MANAGEMENT Section 4.1 money launde
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MANAGEMENT Section 4.1 management l
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MANAGEMENT Section 4.1 • An adequ
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MANAGEMENT Section 4.1 • Troubled
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MANAGEMENT Section 4.1 management i
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INTERNAL ROUTINE AND CONTROLS Secti
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RELATED ORGANIZATIONS Section 4.3
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RELATED ORGANIZATIONS Section 4.3 A
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RELATED ORGANIZATIONS Section 4.3 A
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FIDELITY AND OTHER INDEMNITY PROTEC
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FIDELITY AND OTHER INDEMNITY PROTEC
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BANK SECRECY ACT, ANTI-MONEY LAUNDE
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BANK FRAUD AND INSIDER ABUSE Sectio
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SUSPICIOUS ACTIVITY AND CRIMINAL VI
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INTERNATIONAL BANKING Section 11.1
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APPLICATIONS Section 12.1 Effective
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APPLICATIONS Section 12.1 for compa
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APPLICATIONS Section 12.1 be tantam
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APPLICATIONS Section 12.1 accept sh
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APPLICATIONS Section 12.1 consideri
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APPLICATIONS Section 12.1 accepted
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APPLICATIONS Section 12.1 The FDIC
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APPLICATIONS Section 12.1 employee
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APPLICATIONS Section 12.1 including
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APPLICATIONS Section 12.1 Branch cl
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APPLICATIONS Section 12.1 its accep
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APPLICATIONS Section 12.1 examinati
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MEMORANDUMS OF UNDERSTANDING Sectio
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CIVIL MONEY PENALTIES Section 14.1
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CMP MATRIX (Continued) Points Sugge
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FORMAL ADMINISTRATIVE ACTIONS Secti
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REPORT OF EXAMINATION INSTRUCTIONS
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BANK OF ANYTOWN ANYTOWN ANY COUNTY
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Examination Conclusions and Comment
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Risk Management Assessment 99999 1.
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Violations of Laws and Regulations
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Information Technology Assessment (
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Fiduciary Activities Assessment (Co
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Recapitulation of Securities 99999
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Items Subject to Adverse Classifica
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Analysis of Loans Subject to Advers
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Capital Calculations 99999 Tier 1 C
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Extensions of Credit to Directors/T
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Confidential - Supervisory Section
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In-House Information Technology 999
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INTERNATIONAL REPORT PAGES AND WORK
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Analysis of the Country Exposure Ma
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International Loans, Acceptances, a
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International Loans, Acceptances, a
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Foreign Exchange Activities 99999 N
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Position Analysis - Other Currencie
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Policy and Procedures 99999 1. (a)
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Policy and Procedures (Continued) 9
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Audit and Internal Controls - Inter
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REPORT OF INVESTIGATION INSTRUCTION
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Description of the Transaction INVE
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FINANCIAL HISTORY AND CONDITION Ass
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FINANCIAL HISTORY AND CONDITION (Co
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ADEQUACY OF THE CAPITAL STRUCTURE G
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ADEQUACY OF THE CAPITAL STRUCTURE (
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FUTURE EARNINGS PROSPECTS Assess th
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FUTURE EARNINGS PROSPECTS (Continue
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GENERAL CHARACTER OF THE MANAGEMENT
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IV. GENERAL CHARACTER OF THE MANAGE
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Interview Comments IV. GENERAL CHAR
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RISK TO THE FUNDS As a general matt
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VI. CONVENIENCE AND NEEDS OF THE CO
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OTHER PERTINENT INFORMATION If appl
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Source: Application for Federal Dep
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Service Continuity & Monitoring OTH
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