Gap Reports: Reporting on Options Related Positions

Many consumer products have embedded options in them because the customer has the right to change the terms of a contract or to act when warranted by market conditions. When a customer exercises the option, the bank loses a valuable asset that will no longer pay interest. Since these products are germane to a bank’s interest rate risk exposure, institutions should incorporate them into their gap reports.

In a product with an embedded option, the cash flows will depend on the path of interest rates; different interest rate paths need to be considered because of the dates of the options exercise will change accordingly, affecting cash flows. A single gap report gives an incomplete picture of products with embedded options because it allows for only repricing date.

Three methods of incorporating options exposures into gap reports are popular with banks. An examiner encountering a bank using another method should analyse the approach to determine whether it properly incorporates the asymmetrical impact of options on future net interest income and economic value.

The first method either recognizes that the cap is in full effect for the remaining life of the product or ignores it for the same period. The following example illustrates this all or nothing approach to a cap on a floating rate loan:

The bank has a 10-year $100,000 floating rate loan that reprices every six months but is subject to a 12 percent lifetime cap (the rate of the loan cannot exceed 12%). The all-or-nothing approach would consider the loan a six-month floating rate loan when rates are below 12%. If rates equal or exceed 12%, the loan becomes a fixed rate loan wit a 10-year repricing maturity.

This approach has several weaknesses. First, the method does not correctly reflect the exposure of net interest income to future changes in interest rates. For example, when the loan is slotted as a six-month repricing asset and funded with a six month CD, the gap report would not indicate any interest rate risk. If interest rates were to rise above 12%, however, the loan could not reprice further but the funding costs on the CD could continue to rise, and interest margins would decline. Second, this treatment does not suggest how this exposure may be hedged. Neither hedging the asset as a six-month floating rate asset nr hedging it as a 10 year fixed rate asset would be appropriate.

A better approach would be for the bank to prepare two gap reports, one for a high rate scenario and the other for a low-rate scenario. Under the high rate scenario the cap would be binding and the gap report would show the capped loans as fixed rate assets. Under the low rate scenario, the gap report would show the loan as a floating rate asset.

A bank could use similar approaches to measure prepayment option risks associated with a fixed residential mortgage loans. Under the high-rate scenario, the weighted average lives of the fixed rate mortgages would be extended in the gap report, reflecting the effect of slower repayments. Under the low-rate scenario, the weighted lives would be shortened, reflecting faster prepayments. Comparing the gaps, between the two schedules provides an indication of the amount of option risk the bank faces.