1. Chapter Seven
Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques
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2. 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
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3. 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
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4. 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
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5. 7-5
EXHIBIT 7–1 Asset-Liability Management in Banking and Financial Services
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6. 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
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7. 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
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8. 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
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9. 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
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10. 7-10
Interest Rate Risk: One of the Greatest Management Challenges (continued)
How to Calculate the Yield to Maturity
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11. 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)
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12. 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
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13. 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
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14. 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
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15. 7-15
Interest Rate Risk: One of the Greatest Management Challenges (continued)
Market interest rate formula
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