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Chapter Eight
Interest Rate Risk I

Chapter Outline

Introduction

The Central Bank and Interest Rate Risk

The Repricing Model • Rate-Sensitive Assets • Rate-Sensitive Liabilities • Equal Changes in Rates on RSAs and RSLs • Unequal Changes in Rates on RSAs and RSLs

Weaknesses of the Repricing Model • Market Value Effects • Overaggregation • The Problem of Runoffs • Cash Flows from Off-Balance Sheet Activities

The Maturity Model

• The Maturity Model with a Portfolio of Assets and Liabilities

Weakness of the Maturity Model

Summary

Appendix 8A: Term Structure of Interest Rates

• Unbiased Expectations Theory • Liquidity Premium Theory

Market Segmentation Theory

Solutions for End-of-Chapter Questions and Problems: Chapter Eight

1. What was the impact on interest rates of the borrowed reserves targeting regime used by the Federal Reserve from 1982 to 1993?

The volatility of interest rates was significantly lower than under the nonborrowed reserves target regime used in the three years immediately prior to 1982. Figure 8-1 indicates that both the level and volatility of interest rates declined even further after 1993 when the Fed decided that it would target primarily the fed funds rate as a guide for monetary policy.

2. How has the increased level of financial market integration affected interest rates?

Increased financial market integration, or globalization, increases the speed with which interest rate changes and volatility are transmitted among countries. The result of this quickening of global economic adjustment is to increase the difficulty and uncertainty faced by the Federal Reserve as it attempts to manage economic activity within the U.S. Further, because FIs have become increasingly more global in their activities, any

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