Annals of “Dunarea de Jos” University of Galati Fascicle I. Economics and Applied Informatics
Years XXII – no3/2016
ISSN-L 1584-0409 ISSN-Online 2344-441X www.eia.feaa.ugal.ro
Remarks on Interest Rate Risk Management
Elena-Violeta DRĂGOI, Oana-Mihaela ILIE
A R T I C L E I N F O A B S T R A C T
Article history: Accepted November Available online December JEL Classification G , G , G
Keywords:
APR, Commission, Interest margin,
)nterest rate, )nterest rate risk management
Bank interest and interest rate risk management is a contemporary subject and for socio-economic environment of Romania cause serious consequences in the level of socio-economic development. The purpose of this research is to highlight the main indicator that measures the total cost of a loan, namely the annual percentage rate APR , because if we refer to an interest rate lower, at first glance that loan seems more advantageous, but at a closer look, taking into account the commissions charged by the bank, we see that the loan is more expensive compared to another, whose interest rate is higher.
© EA). All rights reserved.
1.Introduction
The interest rate represents the amount of money or the price that a person must pay for a loan over a certain period of time up to maturity of creditor. )f the loan has a quality primary the interest is the condition of opportunity.
Representing the price of credit, interest doesn`t a a fixed value but a variable, variable interest that each country have a different one. The overall value of interest rate is fixed by liquidity degree of the capital market. )n case on the market is a highly liquid capital, interest is low and and if on the market availability of capital is low, and interest increases automatically.
The interest rate is also an important element in terms of international competition. When bank interest is low in a country that will encourage economic activity which will reduce the production cost. Through this the country with low interest rate will be more advantageous in terms of international economic exchanges.
Many economists, philosophers and schools have attempted to formulate and develop concepts of loan and interest and relationships between those concepts to demonstrate the need and emergence of interest.
)nterest has been present in people's lives since antiquity and the Middle Ages, even sometimes were need some regulations to combat usury.
Many economists have approached the cause and need for interest rate in their work and the need for interest rate, but if the interest is seen from different situations, demonstrating that its existence is necessary from several points of view.
Physiocrats view was that interest couldn`t be achieved from economic activity, but it`s found in nature. According to them, interest is the incumbent tenants from the contract as an agricultural surplus and a prerequisite for reproduction.
From a microeconomic perspective, interest is seen as an asset that will be worth more in the future than today. The more time passes, a good loses its value. )nterest is the amount that is paid for use of the property now compared to the future use of the asset.
)nterest paid by bank customers who make deposits are differentiated depending on the storage limits. Usually the interest rate subsidy is higher, as the deposits are made for a longer period.
This situation is advantageous for bank as achieving long-term deposits will allow the granting of loans for a longer period. But customers prefer to constitute short-term deposits up to one year for which the bank pays an interest rate lower than that provided for the establishment of long-term deposits, due to the uncertainty that characterizes the entire market and economic activity.
2. Techniques for managing interest rate risk
)n order to protect against the risks, businesses and the banks resort to the following methods:
• Determining the type of interest rate, fixed or variable. When on the market is an increase in the
interest rate, the most appropriate will be to use liquidity sales with a variable rate and a fixed rate with loan
contraction. When the rate will decrease, liquidity will be sold at a fixed rate and the loans will be purchased at a variable rate. Companies seek to obtain substantial gains as a result of developments in market interest rates.
• The choice of placement is conditional on the evolution of interest rate anticipation. )n case of
occurrence of a decrease in the interest rate, the best is opting for long-term investments, and if the forecasts show that the rate will fall, the most convenient is to opt for short-term placements.
• The conclusion of contracts which allow advance payment. )f the interest rate increases, the creditor
is entitled to contract another loan more convenient, and if the rate will decrease the the borrower is entitled to contract another advantageous loan, prepayment installments for the loan current.
• Dividing the loan in equal installments. Whether the interest rate will increase or decrease, loss
registered at one of the installments will indemnify earnings next installment.
3. Correlation of bank assets and liabilities through credit cost
For the prevention of risk due to the instability of interest rates, any bank has a variety of methods and operations for the most effective management of bank assets and liabilities.
The instability of interest rates affect bank earnings because of the vulnerability to the risks that are reflected in their financial situation.
All banks have implemented certain limits in terms of interest rate movements to be prepared to face the risks that will arise from its instability.
The interest margin
To register a substantial profit, managers of banking institutions trying to better supervision of interest rate trends.
The interest margin is one of the most important indicators of bank profitability. Margin is established based on inconsistency of income from interest and interest payment expenses.
Another method of interest is the examination of the imbalance that is based on the balance sheet. By using the imbalance of bank, we can determine the place of bank due to the discrepancy between assets and liabilities with fixed interest rates. For recording some increased revenues the most appropiate activity is the imbalance management. For banks to record revenue potential, they must take many risks.
4. The manner to fix prices (APR calculation)
Given that in most cases in the comparison of financing offers frequent mistake is to choose the offer according to the monthly rate or interest rate, so ) wanted to highlight the main indicator that measures the total cost of a loan, namely the annual percentage rate.
Analyzing a monthly rate only taking loan can get at a very expensive loan because the monthly rate is negatively correlated with the repayment period, making it possible to decrease the monthly installment by the wider repayment period.
Therefore, a loan may have a lower monthly rate in comparison to another, but for an longer period, it becomes more expensive than the one whose monthly rate is higher. For example, a loan of , lei, for a fixed interest rate of % has a monthly rate of . lei if it`s contracted for a period of two years. The same loan, but contracted at a fixed interest rate of %, but over a period of years, has a monthly rate of . lei. Therefore, a loan whose cost is double may seem to be more advantageous in terms of the monthly because it doesn`t take into account any interest rate or fees where applicable .
Also no interest rate can`t be considered a relevant indicator comparing prices for certain loans because it doesn`t account for commissions charged by the bank, and these values increasingly higher because some interest was converted into fees, due to the limitations of the central bank on extending loans to the population. An indicator that is relevant in choosing a great credit can be refunded the full amount because it covers all costs of this credit, but doesn`t take account of inflation, which, over time, changing value of money. Consequently, the only relevant indicator, which expresses the total cost of a loan as an annual percentage of the total amount of credit and makes it possible to compare tenders for funding is the annual percentage rate Annual percentage rate of charge , hereinafter referred to as APR.
According to regulations, basic equation expressing the equivalence of drawdowns on the one hand and repayments and charges on the other hand is as follows:
∑
k=1
m C
k
(1+X)tk=
∑
l=1
m D
l
(1+X)Sl,
where: X = APR;
Ck = Amount of drawdown k;
tk =)nterval, expressed in years and fractions of a year, between the date of the first drawdown and the date
of each subsequent drawdown, thus t1 = ,
m' = number of the last repayment or payment of charges; l = number of a repayment or costs incurred;
Dl = Recoverable value or cost incurred;
Sl = )nterval, expressed in years and fractions of a year, between the date of the first drawdown and the date of each refunds or costs incurred.
This simple equation can be rewritten in the following form:
S=
∑
k=1
n A
k
(1+X)tk
To highlight the correct way to compare three loans taken from various banking institutions have taken an example from the following table:
Table 1. Conditions of the three offers of different banks' credit
Offer 1 Offer 2 Offer 3
Loan amount . € . € . €
Repayment period months months months
Interest rate (fixed) 15.0% 16.0% 17.0%
Analysis commission
Monthly administration commission . % . %
APR 21,77 % 19,69 % 18,92 %
Source: Processing of data randomly chosen
At first glance, the first offer seems more advantageous if we consider the interest rate that is lower, but taking into account the commissions charged by those banks, the most advantageous customer turns out to be the third offer because APR take the lowest. To better understand this example, if the first offer if you turn in the interest rate charges, it would be . %, much higher than the Offer .
The way to fix prices within Raiffeisen Bank credit "Your House"
"Your (ouse" is a housing loan granted by Raiffeisen Bank under a secured by mortgage rank imposed on the purchased property or immovable property owned by the applicant or third parties. This type of loan can be contracted in Lei and Euro for a period of years and years, and its valu€e is between
, € and , € for loans in RON or between , and € , for loans in Euro .
Example:
)f the loan was "Your (ouse" in Lei standard offer , the annual percentage rate is calculated using the following formula:
S=
∑
k=1
n
Ak
(
1+X)
tk,
were:
S = €
n = years = months
Ak = , €
Formula for calculating variable interest rate is ROBOR Months . % + Margin , % . )nterest rate = , %
So,
= , → = → = ,
→ +X = → +X = , → X = , %
(owever, taking into account analysis commission of € / Lei tax assessment and collateral . € . % , the annual percentage rate will be . %.
)n terms of contracting the loan "Your (ouse" in Euro standard offer , the annual percentage rate is calculated using the following formula:
(
+
X
)
,
A
=
S
n
=
k k
t k
∑
1
1
were:
S = €
n = years = months
Ak = , €
Formula for calculating variable interest rate is EUR)BOR Months . % + margin % . )nterest rate = , %
The granting of this type of loan requires a commission analysis of € / Lei and a tax assessment of . € guarantee.
So,
= , → = → = ,
→ +X = → +X = , → X = , %
Taking into account analysis commission of € / Lei tax assessment and collateral . € . % , the annual percentage rate will be . %.
)n terms of contracting the loan "Your (ouse" in Euro offer for house customer , the annual percentage rate is calculated using the following formula:
were:
S = €
n = years = months
= , €
Formula for calculating variable interest rate is EUR)BOR Months , % + Margin , % . )nterest rate = , %
The granting of this type of loan requires a commission analysis of €/ Lei and a tax assessment of , € guarantee.
So,
= , → = → = ,
→ +X = → +X = , → X = , %
Taking into account analysis commission of €/ Lei tax assessment and collateral , €
, % , the annual percentage rate will be , %.
Chart 1. The annual percentage rate for credit "Your House"
Source: Processing of data available on http://www.raiffeisen.ro/persoane-fizice/credite/casa-ta
Analyzing the chart above we can see that the annual percentage rate is positively correlated with floating interest rate, because when the interest rate changes on the upside and the annual percentage change in the same direction.
Given this, for credit "Your (ouse" in Lei, floating interest rate is calculated by adding the index ROBOR months currently . % with a margin determined by the quality of Raiffeisen Bank customers: ¾ Standard offer (any client intended) - the margin is fixed at . %;
¾ Offer for house customers designed for customers who have or will open their salary accounts or pension at Raiffeisen Bank - the margin is fixed at . %.
For three months the index ROBOR interest rate is updated four times a year, namely the last day of March, June, September and December.
)n the case of credit "Your (ouse" in euro floating interest rate takes into account the EUR)BOR months currently . % and Raiffeisen Bank margin determined by the quality of customer:
1. Standard offer (any client intended) - the margin is fixed at 6.00%;
. Offer for house customers (designed for customers who have or will open their salary accounts or pension at Raiffeisen Bank) - the margin is fixed at 5.40%.
For six months EUR)BOR rate is updated twice a year, namely the last day of June and December. So, customers who account at Raiffeisen Bank and request a credit "Your (ouse" benefit from a reduction in the annual percentage rate, derived from the rate reduction variable interest loans in RON and Euro.
According to the schedule described above, the difference between the effective annual interest rate for an offer standard and designed to offer customers home is . % for a loan "Your (ouse" in Lei and
. % for a loan "Your (ouse" in Euro.
5. Conclusion
Despite the difficult economic climate, lending to all customer segments can be an advantage for the bank, which facilitates maintaining market share in lending to individuals.
)n conclusion, in order to contract a loan with variable interest it`s important to note that the APR expresses the total cost of the loan at that time, given the level of interest charged by the bank. )n this way, a change in interest rate leads to increase or decrease the level of annual percentage rate. This will calculate APR in choosing the cheapest loan, regardless of the level it will reach the benchmark index corresponding to that type of loan.
(owever, given that all credit institutions use the same indexes ROBOR, EUR)BOR , this doesn`t affect the analysis of prices for all loans contracted at a variable interest rate. )n such circumstances, it will be able to calculate APR in choosing the cheapest loan, regardless of the level it will reach the benchmark index corresponding to that type of loan.
)n case of loans with fixed interest rate, the APR calculation provides accurate results, knowing that the interest rate remains constant from the day of signing the contract until the day of payment of the last installment. )t`s difficult to compare a fixed rate with variable rate one, since in this case, the choice must consider and estimates about the evolution of interbank rates during the period.
References
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13. *** Annex No. 1 of Law no. 289/2004 regarding the legal regime of consumer credit to consumers, individuals. 14. *** Law no. 33/1991 regarding the banking activity in Romania, art.3.
