Chapter Seven Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Asset, Liability, and Funds Management 7-2 Key Topics Asset, Liability, and Funds Management Market Rates and Interest Rate Risk The Goals of Interest Rate Hedging Interest-Sensitive Gap Management Duration Gap Management Limitations of Interest Rate Risk Management Techniques Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7-3 Introduction Even as a financial institution takes on risk, it must protect the value of its net worth from erosion, which could result in ultimate failure Financial-service managers have learned to look at their asset and liability portfolios as an integrated whole They must consider how their institution’s whole portfolio contributes to the firm’s goals of adequate profitability and acceptable risk Known as asset-liability management (ALM) Can protect against business cycles and seasonal pressures Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Asset-Liability Management Strategies 7-4 Asset-Liability Management Strategies Asset Management Strategy Control over assets, no control over liabilities Liability Management Strategy Control over liabilities by changing rates and other terms Funds Management Strategy Works with both strategies Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7-5 EXHIBIT 7–1 Asset-Liability Management in Banking and Financial Services Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Interest Rate Risk: One of the Greatest Management Challenges 7-6 Interest Rate Risk: One of the Greatest Management Challenges Changing interest rates impact both the balance sheet and the statement of income and expenses of financial firms Price Risk When interest rates rise, the market value of the bond or asset falls Reinvestment Risk When interest rates fall, the coupon payments on the bond are reinvested at lower rates Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7-7 Interest Rate Risk: One of the Greatest Management Challenges (continued) Forces Determining Interest Rates Loanable Funds Theory The Measurement of Interest Rates YTM Bank Discount Components of Interest Rates Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7-8 EXHIBIT 7–2 Determination of the Rate of Interest in the Financial Marketplace Where the Demand and Supply of Loanable Funds (Credit) Interact to Set the Price of Credit Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7-9 Interest Rate Risk: One of the Greatest Management Challenges (continued) Interest rates are the price of credit Demanded by lenders as compensation for the use of borrowed funds Expressed in percentage points and basis points (1/100 of a percentage point) Yield to Maturity (YTM) The discount rate that equalizes the current market value of a loan or security with the expected stream of future income payments that the loan or security will generate Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7-10 Interest Rate Risk: One of the Greatest Management Challenges (continued) How to Calculate the Yield to Maturity Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7-11 Interest Rate Risk: One of the Greatest Management Challenges (continued) Another popular interest rate measure is the bank discount rate (DR) Often quoted on short-term loans and money market securities (such as Treasury bills) Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7-12 Interest Rate Risk: One of the Greatest Management Challenges (continued) The DR measure ignores the effect of compounding and is based on a 360-day year Unlike the YTM measure, which assumes a 365-day year and assumes that interest income is compounded at the calculated YTM The DR measure uses the face value of a financial instrument to calculate its yield or rate of return Makes calculations easier but is theoretically incorrect The purchase price of a financial instrument is a much better base to use in calculating the instrument’s true rate of return Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7-13 Interest Rate Risk: One of the Greatest Management Challenges (continued) To convert a DR to the equivalent yield to maturity, we can use the formula Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7-14 Interest Rate Risk: One of the Greatest Management Challenges (continued) Market interest rates are a function of Risk-free real rate of interest Various risk premiums Default Risk Inflation Risk Liquidity Risk Call Risk Maturity Risk Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7-15 Interest Rate Risk: One of the Greatest Management Challenges (continued) Market interest rate formula Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.