1. Chapter Seven
Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Key Topics 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 Hedging Techniques

3. Asset-Liability Management
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Asset-Liability Management
The Purpose of Asset-Liability Management is to Control a Bank’s Sensitivity to Changes in Market Interest Rates and Limit its Losses in its Net Income or Equity

4. Historical View of Asset-Liability Management
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Historical View of Asset-Liability Management
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 (work with both strategies)

5. Interest Rate Risk Price Risk Reinvestment Risk
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Interest Rate Risk
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

6. Interest Rate Risk: One of the Main Challenges
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Interest Rate Risk: One of the Main Challenges
Forces Determining Interest Rates
Loanable Funds Theory
The Measurement of Interest Rates
YTM
Bank Discount
Components of Interest Rates

7. Yield to Maturity (YTM)
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Yield to Maturity (YTM)

8. Bank Discount Rate (DR)
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Bank Discount Rate (DR)
Where: FV equals Face Value of a Security, such as Treasury Bills

9. Market Interest Rates Function of: Risk-Free Real Rate of Interest
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Market Interest Rates
Function of:
Risk-Free Real Rate of Interest
Various Risk Premiums
Default Risk
Inflation Risk
Liquidity Risk
Call Risk
Maturity Risk

10. 7-10
Yield Curves
Graphical Picture of Relationship Between Yields and Maturities on Securities
Generally Created With Treasury Securities to Keep Default Risk Constant
Shape of the Yield Curve
Upward – Long-Term Rates Higher than Short- Term Rates
Downward – Short-Term Rates Higher than Long- Term Rates
Horizontal – Short-Term and Long-Term Rates the Same
Shape of the Yield Curve and a Maturity Gap

11. 7-11
Net Interest Margin

12. Goal of Interest Rate Hedging
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Goal of Interest Rate Hedging
One Important Goal of Interest Rate Hedging is to Insulate the Bank from the Damaging Effects of Fluctuating Interest Rates on Profits

13. Quick Quiz What forces cause interest rates to change?
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Quick Quiz
What forces cause interest rates to change?
What makes it so difficult to correctly forecast interest rate changes?
What is the yield curve, and why is it important to know about its shape and slope?
What is the goal of hedging?
First National Bank of Bannerville has posted interest revenues of $63 million and interest costs from all of its borrowings of $42 million. If this bank possesses $700 million in total earning assets, what is First National’s net interest margin? Suppose the bank’s interest revenues and interest costs double, while its earning assets increase by 50%. What will happen to its net interest margin?

14. Interest-Sensitive Gap Measurements
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Interest-Sensitive Gap Measurements
Dollar Interest-Sensitive Gap
Interest-Sensitive Assets – Interest Sensitive Liabilities =
Relative Interest-Sensitive Gap
Interest Sensitivity Ratio

15. Examples of Repriceable (Interest Sensitive) Assets and Liabilities
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Examples of Repriceable (Interest Sensitive) Assets and Liabilities

16. Asset-Sensitive Bank Has:
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Asset-Sensitive Bank Has:
Positive Dollar Interest-Sensitive Gap
Positive Relative Interest-Sensitive Gap
Interest Sensitivity Ratio Greater Than One

17. Liability Sensitive Bank Has:
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Liability Sensitive Bank Has:
Negative Dollar Interest-Sensitive Gap
Negative Relative Interest-Sensitive Gap
Interest Sensitivity Ratio Less Than One

18. Computer-Based Techniques and Maturity Buckets
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Computer-Based Techniques and Maturity Buckets

19. Gap Positions and the Effect of Interest Rate Changes on the Bank
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Gap Positions and the Effect of Interest Rate Changes on the Bank
Liability- Sensitive Bank
Interest Rates Rise
NIM Falls
Interest Rates Fall
NIM Rises
Asset-Sensitive Bank
Interest Rates Rise
NIM Rises
Interest Rates Fall
NIM Falls

20. Zero Interest-Sensitive Gap
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Zero Interest-Sensitive Gap
Dollar Interest-Sensitive Gap is Zero
Relative Interest-Sensitive Gap is Zero
Interest Sensitivity Ratio is One
When Interest Rates Change in Either Direction - NIM is Protected and Will Not Change

21. Important Decision Regarding IS Gap
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Important Decision Regarding IS Gap
Management Must Choose the Time Period Over Which NIM is to be Managed
Management Must Choose a Target NIM
To Increase NIM Management Must Either:
Develop Correct Interest Rate Forecast
Reallocate Assets and Liabilities to Increase Spread
Management Must Choose Volume of Interest-Sensitive Assets and Liabilities

22. NIM Influenced By: Changes in Interest Rates Up or Down
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NIM Influenced By:
Changes in Interest Rates Up or Down
Changes in the Spread Between Assets and Liabilities
Changes in the Volume of Interest-Sensitive Assets and Liabilities
Changes in the Mix of Assets and Liabilities

23. 7-23
Cumulative Gap
The Total Difference in Dollars Between Those Bank Assets and Liabilities Which Can be Repriced over a Designated Time Period

24. Aggressive Interest-Sensitive Gap Management
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Aggressive Interest-Sensitive Gap Management

25. Problems with Interest-Sensitive Gap Management
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Problems with Interest-Sensitive Gap Management
Interest Paid on Liabilities Tend to Move Faster than Interest Rates Earned on Assets
Interest Rate Attached to Bank Assets and Liabilities Do Not Move at the Same Speed as Market Interest Rates
Point at Which Some Assets and Liabilities are Repriced is Not Easy to Identify
Interest-Sensitive Gap Does Not Consider the Impact of Changing Interest Rates on Equity Position

26. 7-26
Quick Quiz
Commerce National Bank reports interest-sensitive assets of $870 million and interest-sensitive liabilities of $625 million during the coming month. Is the bank asset sensitive or liability sensitive? What is likely to happen to the bank’s net interest margin if interest rates rise? If they fall?
People’s Savings Bank , a thrift institutions, has a cumulative gap for the coming year of +$135 million, and interest rates are expected to fall by two and a half percentage points. Calculate the expected change in net interest income that this thrift institution might experience. What will occur in net interest income if interest rates rise by one and a quarter percentage points?

27. The Concept of Duration
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The Concept of Duration
Duration is the Weighted Average Maturity of a Promised Stream of Future Cash Flows

28. To Calculate the Instrument’s Duration
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To Calculate the Instrument’s Duration

29. Price Sensitivity of a Security
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Price Sensitivity of a Security

30. 7-30
Convexity
The Rate of Change in an Asset’s Price or Value Varies with the Level of Interest Rates or Yields

31. Dollar-Weighted Duration of Asset Portfolio
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Dollar-Weighted Duration of Asset Portfolio
Where:
wi = the dollar amount of the ith asset divided by total assets
DAi = the duration of the ith asset in the portfolio

32. Dollar-Weighted Duration of a Liability Portfolio
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Dollar-Weighted Duration of a Liability Portfolio
Where:
wi = the dollar amount of the ith liability divided by total liabilities
DLi = the duration of the ith liability in the portfolio

33. 7-33
Duration Gap

34. Change in the Value of a Bank’s Net Worth
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Change in the Value of a Bank’s Net Worth

35. Impact of Changing Interest Rates on a Bank’s Net Worth
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Impact of Changing Interest Rates on a Bank’s Net Worth

36. Limitations of Duration Gap Management
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Limitations of Duration Gap Management
Finding Assets and Liabilities of the Same Duration Can be Difficult
Some Assets and Liabilities May Have Patterns of Cash Flows that are Not Well Defined
Customer Prepayments May Distort the Expected Cash Flows in Duration
Customer Defaults May Distort the Expected Cash Flows in Duration
Convexity Can Cause Problems

37. 7-37
Quick Quiz
What is duration? How is a financial institution’s duration gap determined?
What are the advantages of using duration as opposed to interest-sensitive gap analysis?
Suppose that a thrift institution has an average asset duration of 2.5 years and an average liability duration of 3.0 years. If the thrift holds total assets of $560 million and total liabilities of $467 million, does it have a significant leverage-adjusted duration gap? If interest rates rise, what will happen to the value of its net worth?