Simulation, Repricing and Derivative-Hedging Strategies - Article

Introduction

Measuring Interest Rate Risk is only the first step.

After identifying an unacceptable exposure, a bank must decide how to control it.

The bank can broadly respond in three ways:

1. simulate different interest-rate scenarios to understand possible outcomes;

2. change the repricing structure of assets and liabilities; and

3. use permitted interest-rate derivatives to hedge selected exposures.

The 2026 IIBF BFM syllabus includes measurement techniques and strategies for controlling Interest Rate Risk under Module D. It also covers the use of derivatives in risk management and ALM.

Under RBI’s current Commercial Banks – Asset Liability Management Directions, 2025, banks must assess Interest Rate Risk from both the earnings and economic-value perspectives. TGA and DGA are regulatory benchmark methods, while banks with more sophisticated systems may continue using advanced internal approaches in addition to these supervisory frameworks. RBI also requires internal limits, scenario assessment, regular updating of material assumptions and periodic model validation.

Learning Objectives

After studying this topic, you should be able to:

• explain how simulation improves Interest Rate Risk analysis;

• distinguish static gap measurement from scenario-based simulation;

• identify asset-side and liability-side repricing strategies;

• understand how swaps, FRAs, futures and options can hedge interest-rate exposures;

• select suitable responses to common balance-sheet IRR situations; and

• recognise basis, option, model and hedge-ineffectiveness risks that remain after hedging.

Measurement Is Not the Same as Management

Traditional Gap Analysis tells the bank about:

• Rate-Sensitive Assets;

• Rate-Sensitive Liabilities;

• repricing gaps; and

• possible NII sensitivity.

Duration Gap Analysis tells the bank about:

• asset and liability duration;

• Modified Duration Gap; and

• possible Market Value of Equity sensitivity.

These measures answer:

Where is the risk?

Management then has to answer:

What should we do about it?

Possible actions include:

• changing asset composition;

• changing liability composition;

• changing repricing frequencies;

• extending or shortening maturities;

• changing the fixed/floating-rate mix;

• using derivatives; or

• accepting the exposure within approved limits.

What Is Simulation in Interest Rate Risk Management?

Simulation is a forward-looking technique.

Instead of examining only the current repricing gap, the bank projects how its:

• NII;

• margins;

• asset values;

• liability values; and

• economic equity

may behave under different assumptions about future interest rates and customer behaviour.

For example, management may ask:

• What happens if all rates rise sharply?

• What if short-term rates rise but long-term rates do not?

• What if lending benchmarks and deposit costs move differently?

• What if housing-loan prepayments increase?

• What if deposit customers move rapidly into higher-yielding products?

RBI requires banks to assess interest-rate scenarios and the resulting volatility of NII and Net Worth, update material assumptions regularly and use appropriate stress analysis.

Static Analysis vs Simulation

Static analysis is easier to understand and monitor.

Simulation is more flexible but depends heavily on assumptions and model quality.

Static Balance-Sheet Simulation

In a static simulation, the bank broadly assumes that its balance-sheet size and structure remain unchanged or that maturing business is replaced on similar terms.

Interest-rate scenarios are then applied to that balance sheet.

This can help isolate the impact of rate movements without introducing large changes in business volumes.

Typical scenarios may include:

• parallel rate increase;

• parallel rate decrease;

• yield-curve steepening;

• yield-curve flattening;

• changes in benchmark spreads; and

• behavioural changes in selected products.

Dynamic Simulation

Dynamic simulation goes further.

It may incorporate assumptions about:

• future loan growth;

• deposit growth;

• new product pricing;

• changed funding mix;

• customer migration;

• prepayments;

• deposit withdrawals;

• derivative transactions; and

• management actions.

Dynamic simulation therefore asks:

What will happen if rates change and the balance sheet also evolves?

This can give ALCO a more realistic view of future exposure, but it also introduces greater model and assumption risk.

Important Simulation Assumptions

A simulation is only as useful as its assumptions.

Important assumptions may relate to:

• future market rates;

• yield-curve shape;

• loan repricing;

• deposit repricing;

• deposit beta;

• loan prepayments;

• premature deposit withdrawals;

• non-maturity-deposit behaviour;

• new business growth;

• benchmark spreads;

• interest-rate floors and caps; and

• derivative positions.

RBI requires banks to update material assumptions regularly, formalise the assumption-development process, review it at least annually and undertake periodic model validation. Assumptions, discount rates, bucketing, behavioural studies and validation processes must also be documented.

Repricing Strategy – Managing IRR through the Balance Sheet

A bank does not always need derivatives to reduce Interest Rate Risk.

It can change the underlying asset-liability structure.

This is sometimes called natural or on-balance-sheet hedging.

The strategy may involve:

• changing repricing dates;

• changing maturity;

• changing fixed/floating mix;

• altering new-business pricing;

• changing the funding mix; or

• offsetting an exposure with another balance-sheet position.

Asset-Side Repricing Strategies

Assume a bank is vulnerable to rising rates because it holds large fixed-rate assets funded through liabilities that reprice quickly.

Possible asset-side responses include:

• increasing floating-rate assets;

• shortening reset periods on new floating-rate business where appropriate;

• reducing concentration in very long-duration fixed-rate assets;

• allowing long-duration investments to run down;

• increasing shorter-duration assets; and

• pricing new business in a way that better matches the funding structure.

The objective is to allow asset income to respond sooner when funding costs change.

If Rates Are Expected to Fall

A bank should not turn IRR management into a speculative interest-rate bet.

However, within approved risk appetite, management may examine whether the existing asset structure creates excessive exposure to falling rates.

For example, a large concentration of quickly repricing floating-rate assets may cause income to fall faster than liability costs.

The appropriate response may involve better repricing balance rather than simply maximising fixed-rate assets.

Liability-Side Repricing Strategies

A bank can also change the liability structure.

If a bank has long-duration fixed-rate assets but short-term repricing liabilities, it may reduce risk by:

• increasing longer-tenor deposits;

• raising longer-term fixed-rate funding;

• reducing excessive dependence on short-term wholesale borrowing;

• spreading liability maturities;

• changing the fixed/floating mix; and

• avoiding excessive concentration at one repricing point.

If liabilities are repricing too slowly compared with assets, a different funding structure may be appropriate.

The main principle is:

Match the sensitivity of funding more closely with the sensitivity of earning assets.

Repricing Strategy Is Not Exact Matching

Perfect matching of every asset and liability is rarely practical.

Banks must also consider:

• liquidity;

• customer requirements;

• profitability;

• competitive pricing;

• credit strategy;

• capital;

• product design; and

• market conditions.

ALCO therefore aims for an acceptable risk-return position, not mechanical equality of every time bucket.

Under the current RBI ALM framework, the Board/RMC sets limits on Earnings at Risk and MVE volatility, while ALCO periodically reviews these limits after considering interest-rate scenarios and the resulting volatility in NII and Net Worth.

Case 1: Fixed-Rate Assets Funded by Floating Liabilities

A bank has:

• large long-term fixed-rate loans; and

• funding that reprices frequently.

Rates begin to rise.

Problem

Funding cost increases quickly.

Income on the fixed-rate loans does not.

Therefore:

• NII comes under pressure; and

• if the fixed-rate assets have high duration, their economic value may also decline.

Balance-Sheet Response

ALCO may consider:

• increasing floating-rate assets in future business;

• obtaining longer-term fixed-rate funding;

• shortening asset duration; or

• reducing the mismatch through other approved balance-sheet actions.

Derivative Response

A bank seeking protection against rising rates on this structure may use an interest-rate swap that economically receives floating and pays fixed.

As rates rise, the floating receipt increases, helping offset the higher floating funding cost.

The hedge should be selected according to the bank’s actual exposure, benchmark, tenor and regulatory permissions.

Interest Rate Swaps

An Interest Rate Swap (IRS) is an OTC derivative in which two counterparties exchange streams of future interest payments on a notional principal amount.

RBI’s OTC-derivative framework recognises interest-rate swaps, while the Rupee Interest Rate Derivatives framework governs permitted rupee IRD activity. RBI also requires derivative businesses to operate within approved risk limits, stress testing, model-risk controls and internal-control arrangements.

An IRS can change the economic interest-rate character of a position without requiring the underlying loan, investment or borrowing to be sold.

Pay Fixed, Receive Floating

This structure generally gains relative value when floating rates rise.

It may help hedge a bank that has:

• fixed-rate asset income; but

• floating-rate funding cost.

Receive Fixed, Pay Floating

This structure can help protect fixed income where the bank is economically exposed to declining floating-rate receipts.

For example, a bank with large floating-rate assets and relatively fixed funding may use such a structure to convert part of its floating receipt into a more stable fixed receipt.

Case 2: Large Floating-Rate Asset Book and Falling Rates

A bank has:

• floating-rate corporate loans;

• fixed-rate term deposits; and

• a positive short-term repricing gap.

Rates decline sharply.

Effect

Loan yields reset downward.

Fixed deposit costs remain unchanged until maturity.

NII can therefore decline.

Possible Responses

Management may consider:

• increasing appropriately priced fixed-rate assets;

• modifying future liability composition;

• extending repricing periods on suitable assets; or

• using permitted derivative hedges.

A receive-fixed/pay-floating swap may offset part of the fall in floating asset income.

The important case-study point is:

Hedge the actual exposure, not simply the expected direction of rates.

Forward Rate Agreements

A Forward Rate Agreement (FRA) is an OTC derivative based on the difference between an agreed rate and a future reference interest rate for a specified forward period. RBI’s OTC derivative framework recognises FRA as a generic interest-rate derivative.

An FRA can be useful when the bank is concerned about a specific future borrowing or lending period.

For example, it may help:

• protect against a future rise in borrowing rates; or

• lock a future lending/investment rate.

An FRA is therefore particularly useful for a known future repricing exposure rather than an entire long-term balance sheet.

Interest Rate Futures

Interest Rate Futures are exchange-traded derivatives whose value changes with the underlying interest-rate instrument or benchmark.

They can be used to manage exposures such as:

• fixed-income security price risk;

• expected future rate movements; and

• selected duration exposures.

Their exchange-traded nature differs from an OTC swap or FRA.

However, a futures hedge can remain imperfect because:

• the futures contract may not exactly match the exposure;

• maturity may differ;

• basis relationships may change; and

• hedge positions require margin management.

Interest Rate Options, Caps and Floors

Options provide asymmetric protection.

Unlike a swap, which creates two-sided obligations, an option can protect against an adverse movement while allowing some benefit from a favourable movement, subject to the premium and contract structure.

RBI’s OTC derivative framework recognises interest-rate options as well as caps and floors. An interest-rate cap is a series of options providing payment when the reference rate rises above an agreed level, while a floor provides payment when the reference rate falls below an agreed level.

Cap

Useful where the exposure suffers if a floating interest rate rises beyond an acceptable level.

Floor

Useful where the exposure suffers if a floating rate falls below an acceptable level.

Swaption

Provides an option relating to entry into an interest-rate swap and can be useful where the future need for a swap itself is uncertain.

Option-based hedges can therefore be useful when management wants protection without fully giving up the benefit of favourable movements.

Case 3: Gap Appears Matched but Benchmarks Differ

A bank has:

• floating-rate assets repricing in three months; and

• floating-rate liabilities also repricing in three months.

RSA and RSL are approximately equal.

The repricing gap appears small.

However:

• assets are linked to Benchmark A;

• liabilities are linked to Benchmark B.

Benchmark B rises substantially more than Benchmark A.

Result

Funding costs increase more than asset yields.

NII declines even though the simple gap was close to zero.

This is basis risk.

A derivative hedge linked to the wrong benchmark may also fail to provide full protection.

Therefore, ALCO must examine:

• notional amount;

• repricing date;

• tenor; and

• benchmark.

Case 4: Prepayment Changes the Hedge

A bank has hedged a portfolio of long-term fixed-rate loans using derivatives.

Market rates fall sharply.

Customers prepay loans faster than expected.

The underlying asset portfolio becomes smaller, but the derivative hedge remains outstanding.

The bank may now be over-hedged.

This can create a new exposure.

The case demonstrates option risk:

• customers changed the timing of the underlying cash flows;

• the original hedge ratio is no longer appropriate.

RBI requires behavioural studies for assets and liabilities with embedded optionality, including mortgage loans, and requires material assumptions to be reviewed regularly.

Case 5: Derivative Hedge Reduces Gap but Creates Other Risks

Suppose a swap successfully reduces the bank’s repricing exposure.

Interest Rate Risk may decline, but the transaction can introduce or retain other risks such as:

• basis risk;

• counterparty credit risk;

• collateral and liquidity risk;

• valuation risk;

• model risk;

• legal risk; and

• operational risk.

RBI’s OTC derivative framework requires market-makers to identify derivative risks, set risk tolerances and limits, conduct stress testing, manage model risk, address legal enforceability and recognise counterparty credit risk.

Therefore:

Hedging IRR does not mean eliminating all risk.

Simulation before and after Hedging

A good hedge should be tested across more than one scenario.

The bank should compare:

Before Hedge

• NII sensitivity;

• MVE sensitivity;

• basis exposure;

• option exposure.

After Hedge

• revised NII sensitivity;

• revised duration;

• residual benchmark mismatch;

• behaviour under adverse scenarios; and

• new derivative-related risks.

The hedge should reduce the targeted exposure without creating an unacceptable new exposure elsewhere.

Simulation Is More Than a Rate Forecast

Simulation should not be treated merely as:

“Management expects rates to rise, so take a position that profits from rising rates.”

That converts risk management into directional speculation.

A proper simulation instead asks:

• What happens if our expectation is wrong?

• How much NII can we lose?

• How much MVE can decline?

• What happens under an opposite rate shock?

• What if the yield curve moves non-parallel?

• What if customers exercise options differently?

• What if the hedge benchmark diverges?

The purpose is resilience across scenarios.

Role of ALCO

ALCO connects measurement with action.

For Interest Rate Risk, management may use analysis to decide:

• asset repricing structure;

• liability repricing structure;

• fixed/floating mix;

• maturity mix;

• pricing strategy;

• appropriate hedging transactions; and

• risk-limit utilisation.

RBI requires Board/RMC-approved limits on Earnings at Risk and MVE volatility and requires periodic review after assessing different interest-rate scenarios.

Model Validation and Governance

Simulation models can become complex.

RBI requires periodic model validation. Where internal models or software packages are used, banks must ensure the integrity of data and assumptions, and the IRR-management system is subject to independent validation/audit arrangements. Material assumptions must be supported by analysis and documentation.

This is important because a model can fail due to:

• poor input data;

• unrealistic deposit assumptions;

• incorrect prepayment estimates;

• stale correlations;

• inappropriate benchmark relationships; or

• programming/model errors.

A simulation result should therefore be viewed as an estimate, not certainty.

Practical Case-Study Framework

When CAIIB presents an IRR management case, use this sequence.

Step 1: Identify the Exposure

Is the bank vulnerable to:

• rate rise;

• rate fall;

• basis movement;

• yield-curve change; or

• customer optionality?

Step 2: Identify the Risk Measure

Check whether the case concerns:

• NII/EaR;

• MVE/EVE; or

• both.

Step 3: Identify the Existing Balance-Sheet Structure

Look at:

• fixed versus floating assets;

• fixed versus floating liabilities;

• repricing dates;

• duration;

• benchmarks; and

• embedded options.

Step 4: Run Alternative Scenarios

Do not rely on only one expected rate path.

Step 5: Consider Natural Repricing

Ask whether the risk can be reduced by altering the balance sheet.

Step 6: Consider a Derivative Hedge

Choose a product suited to the exposure:

The actual transaction must comply with applicable product, risk and internal-policy requirements.

Step 7: Check Hedge Mismatch

Compare:

• notional amount;

• maturity;

• repricing;

• benchmark; and

• optionality.

Step 8: Re-Simulate

Measure the balance sheet after the hedge.

Step 9: Check New Risks

Do not ignore:

• counterparty;

• liquidity;

• basis;

• model;

• legal; and

• operational risks.

Step 10: Monitor Continuously

A hedge that is appropriate today may cease to be appropriate as the underlying balance sheet changes.

CAIIB Exam Focus

1. Simulation Is Forward-Looking

It estimates outcomes under alternative rate and behavioural assumptions.

2. TGA and DGA Remain Benchmark RBI Methods

Sophisticated internal systems can supplement them, but banks still use the benchmark supervisory frameworks.

3. Balance-Sheet Repricing Is a Hedge

Derivatives are not the only way to manage IRR.

4. Match the Hedge to the Exposure

Amount alone is not enough. Tenor, benchmark and repricing characteristics matter.

5. Pay Fixed / Receive Floating Helps against Rising Floating Costs

It can offset a structure with fixed-rate assets and floating-rate liabilities.

6. Receive Fixed / Pay Floating Can Stabilise Falling Floating Receipts

It can help where floating-rate asset income is exposed to declining rates.

7. FRA Targets a Future Rate Period

It is different from a long-running swap.

8. Options Provide Asymmetric Protection

They can protect against adverse movements while retaining some benefit from favourable movements.

9. A Hedge Can Create New Risks

Counterparty, basis, liquidity, legal, operational and model risks remain important.

10. Re-Simulate after Hedging

The objective is to measure the residual exposure, not merely to execute a derivative.

Common Exam Traps

Trap 1: “Simulation Is the Same as Gap Analysis”

Wrong. Gap analysis measures current repricing mismatches; simulation can model future rate paths, customer behaviour and balance-sheet changes.

Trap 2: “A Bank Should Hedge Based Only on Its Interest-Rate Forecast”

Wrong. Risk management should assess adverse and opposite scenarios rather than depend on one directional forecast.

Trap 3: “Derivatives Are the Only IRR-Control Tool”

Wrong. Asset and liability repricing can provide natural balance-sheet hedges.

Trap 4: “Pay Fixed / Receive Floating Is Suitable for Every Rate-Rise Case”

Wrong. It is useful only when it offsets the bank’s underlying exposure.

Trap 5: “Equal Notional Amount Means a Perfect Hedge”

Wrong. Benchmark, tenor, repricing and optionality may differ.

Trap 6: “A Swap Eliminates Interest Rate Risk Completely”

Wrong. Basis and other risks may remain.

Trap 7: “A Hedge Never Needs Adjustment after Execution”

Wrong. Changes in the underlying exposure, such as loan prepayments, can create under- or over-hedging.

Trap 8: “Options and Swaps Have the Same Pay-Off Structure”

Wrong. A swap creates bilateral payment obligations, while an option provides a right subject to its contractual structure.

Trap 9: “Reducing IRR Means Reducing Total Bank Risk”

Not necessarily. A derivative can reduce IRR while introducing counterparty, liquidity or operational risk.

Trap 10: “Complex Simulation Is Automatically More Accurate”

Wrong. Results remain dependent on data quality, assumptions, model design and validation.

Memory Technique

Remember:

S – R – H – T

• S = Simulate

• R = Reprice the balance sheet

• H = Hedge residual exposure

• T = Test again

For a derivative hedge:

Amount – Time – Benchmark – Behaviour

All four should align as closely as practical with the exposure being hedged.