Executive Summary
The solves the problem of the need to have viable strategies for managing the investment rate risk confronting the NBC and advice the management team appropriately. The task was accomplished through investigating the cash flow ladder, zero coupon equivalent rate, PVBP, and assessment of the market conditions. The investigation found that the cash flow rate sensitive for assets and liabilities were equal for the standing different buckets. Also, the analysis using Zero Coupon market rate gave the following results. First, the zero coupon rate was 1.93 and the FRA rate was 0.01960004. The original net cash flow was 2272450 and the net cash flow was 1692302.43. The four years SWAP was -580148 while the discount interest rate was 1.01949409. In addition, in the one-year duration, the PV was 1660107.76 and the PV+0.01% was 1,659,943.35 from the original PVBP of -220.774814.
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VAR was found to measure the worst for the expected loss over a specific horizon under the normal conditions of the market. Also, the NBC is highly exposed to long interest rate risk considering its duration for year 4. It was found that the future may change to have a zero mean for the yield curve, which means the changes follows the normal distribution trend. The bonds were used to hedge and the effect was found to mitigate the exposure to high interest rate risk. The hedging method was used because it the best strategy to better manage the interest rate risk confronting NBC.
Introduction
A fluctuation in the interest rates in the investment portfolios poses risk to the value of investment due to its significant changes. The stated risks are known as the interest rate risk (Arshanapalli & Nelson, 2011). Interest rate risk can be defined as the risk that the value of an investment will change because of the dynamics of the interest rates’ absolute level. Usually, it is the responsibility of interest rate management personnel to device effective strategies to manage the interest rate risk (Thao & Tsanthaiwo, 2017). One of the strategies to manage the interest risk is diversification on investment securities in the investment portfolio Ledenyov & Ledenyov, 2015). Also, the manager may decide to adopt hedging strategy to manage the interest rate risk such as interest rate swap (Omran, 2011). It is essential for interest rate managers to analyze the investment portfolio for trends and forecasted dynamics and advice the management team of the institution to consider a proper investment alternative.
For the case of National Banking Company of Australia Limited (NBC) and as the head of interest rate management, the interest rate as of 31st August 2018 reveals the bank is exposed to interest rate risk, which calls for urgent management strategies (Arshanapalli & Nelson, 2011). Based on the revelation, this report aims at investigating the possible strategies to manage the interest rate risk confronting the NBC. The bank intends to improve its profitability through investments in the trading portfolio, which is only possible through reduced interest rate risk. The reduced interest rate risk keep the value of the investment to minimize the possible loses (Ledenyov & Ledenyov, 2015). Therefore, the purpose of this report is to explore the viable strategies for managing the investment rate risk confronting the NBC and advice the management team appropriately. The status of the interest rate risk for NBC is of interest in this report and the presentation of recommendations based on the findings of the analysis.
What was Investigated
The report investigates the interest rate risk for NBC as of 31st August 2018. First, the Cash flow Ladder for interest rate sensitive to assets and liabilities was investigated in the report. Secondly, the report investigates the Zero-Coupon equivalent interest rate, which was used in calculating the market interest rates. Also, in the report, PVBP was calculated for each of the “time bucket” in the cash flow. The report also investigated the calculation regarding the total PVBP for all the interest rate sensitive assets and liabilities of the NBC. Another issue, which was under investigation in the report, is the assessment of the past daily changes in the interest rate for each of the time buckets set out in the cash flow ladder independently. The report also investigated the best approaches and assumptions about the interest rate exposure of the NBC. Lastly, the report investigated the current environment for monetary policies to present the dynamics, which could affect the interest rates and related risks in the investment portfolio.
Findings
The investigation of earlier stated issues presented the following findings. First, the cash flow rate sensitive for assets and liabilities were equal for the standing different buckets. Similarly, the market interest rate is equal to the Zero Coupon equivalent interest rate. For duration of one year, which was the second term, the analysis using Zero Coupon market rate gave the following results. First, the zero coupon rate was 1.93 and the FRA rate was 0.01960004. The original net cash flow was 2272450 and the net cash flow was 1692302.43. The four years SWAP was -580148 while the discount interest rate was 1.01949409. In addition, in the one-year duration, the PV was 1660107.76 and the PV+0.01% was 1,659,943.35 from the original PVBP of -220.774814.
For the past daily changes in the interest rate risk, VAR was found to measure the worst for the expected loss over a specific horizon under the normal conditions of the market. The investigation found the NBC is highly exposed to long interest rate risk considering its duration for year 4. The finding is based on the fact that year 4 of the NBC presented the largest negative VAR. Also, from the investigations, it is notable that the future may change to have a zero mean for the yield curve, which means the changes follows the normal distribution trend.
Interpretation and Judgment
The presented findings in the report reveal that NBC is exposed to high interest rate risk in its investment portfolio. The cash flow rate sensitive to assets and liabilities is equivalent to the standing different markets, which means that the NBC is at high interest rate risk. Therefore, NBC should adopt strategies to increase its cash flow. Additionally, the NBC should ensure that its interest rate is lower than the market rates to attract potential borrowers with a consequential boost of its earnings from the interest rates (Thao & Tsanthaiwo, 2017). The findings state that the market is experiencing dynamics, which requires the NBC to assess the conditions and consider effective mitigation measures. When the market interest rate is fluctuating in short durations, it means the investors are at high interest rate risk and may incur losses if the interest rates become lower (Lebdaoui & Wild, 2016). On the other hand, if the interest rates in the market are high, investors are likely to get high profits (Omran, 2011). It is notable that the shorter the time of investment, the higher the interest rate risk associated with it.
From the findings, their interpretation is that the PV of NBC is decreasing as a sign of poor financial performance in the market. Another indicator that NBC is not doing well in its investment portfolio is the reducing PVBP (Heo, Grable & O’Neill, 2016). Therefore, it is upon the management of the stated institution to explore the strategies to manage the current high exposure to interest rate risk.
Conclusion
The task succeeded in the investigation the viable strategies for managing the investment rate risk confronting the NBC and advice the management team appropriately. In the investigation, it is notable that the cash flow rate sensitive for assets and liabilities is equal for the standing different buckets. The standing different buckets are similar to the market interest rate, which is equal to the Zero Coupon equivalent interest rate. Also, in the investigation, it is remarkable that in a duration of one year, which was the second term for NBC, the analysis using Zero Coupon market rate gave the different results. First, the zero coupon rate was 1.93 and the FRA rate was 0.01960004. The original net cash flow was 2272450 and the net cash flow was 1692302.43. The four years SWAP was -580148 while the discount interest rate was 1.01949409. In addition, in the one-year duration, the PV was 1660107.76 and the PV+0.01% was 1,659,943.35 from the original PVBP of -220.774814. It is essential for interest rate managers to analyze the investment portfolio for trends and forecasted dynamics and advice the management team of the institution to consider a proper investment alternative.
The findings have great significance towards the aim of increasing the profitability of the firm through viable strategies to manage the noted high interest rate risk. First, the findings are useful in decision-making on critical issues affecting the investment portfolio. Secondly, the findings highlight the necessary adjustments, which can help in reducing the noted high risk of interest rates. From the stated findings, it is possible for the management of the firm to explore other alternatives to keep their investment value positive because they now understand the conditions of the market. Another significance of the findings is that they are critical in forecasting the market trends for proper investment durations. The understanding of the investment durations help the firm avoid high risk of losing its investment value in the market.
It is remarkable that the aim of the task was accomplished because the presented findings justify their significance towards reducing the high interest rate risk. The task was subject to certain limitations, which compromised the achievement of the aim and purpose. One of the limitations is the unlikeliest to normalize the actual market data in the distribution (Heracleous, 2013). The method used in the investigation is also a limitation to the findings because it used population data instead of using samples. However, sample data may not represent the population accordingly in the investigation because the sample data can be compromised by several extreme values and biasness in selection. Another notable limitation for the findings is the impossibility of the pat data to predict the future of the market regarding its efficiency and effectiveness (Heracleous, 2013). The last limitation is the possible misleading or false sense of VAR as security during the investigations. From the findings, it is remarkable that the occurrence of VAR requires further analysis for accuracy and reliability of the findings to achieve the aim of reducing the interest rate risk.
Recommendation
A part from the findings, the investigation of the strategies to manage the interest rate risk in the investment portfolio of NBC and the analysis of the findings initiates certain recommendations. The goal to have an effective management for the interest rate risk requires the firm to adopt some thee investment strategies including buying future, purchasing high yield bonds, and selling long-term bonds (Lebdaoui & Wild, 2016).
Buying Future
For the investors and stakeholders the trading business, the future is the bread and butter of the investment market (Budnikas, 2011). Also, the future is one of the sophisticated tools for potential investors in the trading market. The NBC needs to adopt the buying the future strategy, which is the purchase of bonds at a give interest rate that is set without the consideration of the market fluctuations (Latif, Jaskani, Ilyas, Babar & Gulzar, 2014). Although there is usually a cost incurred in using the buying the future strategy, but is one of the common strategy for hedging because it has a great degree of probability in the transactions (Omran, 2003).
Purchasing High Yield Bonds
The strategy is complicated, but it can save investors from the possible losses in their investments. It is recommended for NBC to purchase bonds with high yield because of their inconsistency in the market. The strategy make the firm attractive in the market for more investors even if it defaults settling some of its debts (Budnikas, 2011). Meaning the investors will get higher returns for their investments (Omran, 2003). It is essential to note that the strategy is also prone to risks, but the investors can position their portfolio to avoid the risks trough transition to include high yield bonds, which also have short-term variety (Latif, Jaskani, Ilyas, Babar & Gulzar, 2014). Meaning the portfolio will be diversified to cater for the hedging risks.
Selling Long-term Bonds
It is advised for NBC to sell long-term bonds when their prices are high as a mitigation measure to the interest rate risk (Heo, Grable & O’Neill, 2016). The firm may trade by acquiring the bonds during downtime in the market when the bonds are selling at lower prices and sell them when the prices increase to realize profits (Heracleous, 2013).
The stated strategies are the best recommendations in line with the findings of the investigation to help NBC manage its interest rate risk and realize profitability in the trading market. It is essential for interest rate managers to analyze the investment portfolio for trends and forecasted dynamics and advice the management team of the institution to consider a proper investment alternative.
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