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Part B Covers pages 201-205PowerPoint Presentation

Part B Covers pages 201-205

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Part B Covers pages 201-205

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Part B

Covers pages 201-205

AssetsLiabilitiesGapCum. Gap

1-day $ 20 $ 30 $-10 $-10

>1day-3mos. 30 40 -10 -20

>3mos.-6mos. 70 85 -15 -35

>6mos.-12mos. 90 70 +20 -15

>1yr.-5yrs. 40 30 +10 -5

>5 years 10 5 +5 0

- Example II:
If we consider the cumulative 1-year gap,

DNII = (CGAPone year) DR = (-$15 million)(.01)

= -$150,000.

- Example: Suppose rates rise 1% for RSAs and RSLs. Expected annual change in NII,
NII = CGAP × R

= -$15 million × .01

= -$150,000

- With positive CGAP, rates and NII move in the same direction.
- Change proportional to CGAP

- If changes in rates on RSAs and RSLs are not equal, the spread changes. In this case,
NII = (RSA × RRSA ) - (RSL × RRSL )

AssetsLiabilitiesGapCum. Gap

1-day $ 20 $ 30 $-10 $-10

>1day-3mos. 30 40 -10 -20

>3mos.-6mos. 70 85 -15 -35

>6mos.-12mos. 90 70 +20 -15

210225

>1yr.-5yrs. 40 30 +10 -5

>5 years 10 5 +5 0

- Spread effect example:
RSA rate rises by 1.0% and RSL rate rises by 1.0%

NII = interest revenue - interest expense

= ($210 million × 1.0%) - ($225 million × 1.0%)

= $2,100,000 -$2,250,000 = -$150,000

Spread effect example:

RSA rate rises by 1.2% and RSL rate rises by 1.0%

NII = interest revenue - interest expense

= ($210 million × 1.2%) - ($225 million × 1.0%)

= $2,520,000 -$2,250,000 = $270,000

Spread effect example:

RSA rate rises by 1.0% and RSL rate rises by 1.2%

NII = interest revenue - interest expense

= ($210 million × 1.0%) - ($225 million × 1.2%)

= $2,100,000 -$2,700,000 = -$600,000

- Equity/Common Stock O/S
- Ignore for repricing model, duration/maturity = 0

- Demand Deposits
- Treat as 30% repricing over 5 years/duration = 5 years 70% repricing immediately/duration = 0

- Passbook Accounts
- Treat as 20% repricing over 5 years/duration = 5 years 80% repricing immediately/duration = 0

- Amortizing Loans
- We will bucket at final maturity, but really should be spread out in buckets as principal is repaid. Not a problem for duration/market value methods

- Prime-based loans
- Adjustable rate mortgages
- Put in based on adjustment date
- Repricing/maturity/duration models cannot cope with life-time cap

- Assets with options
- Repricing model cannot cope
- Duration model does not account for option
- Only market value approaches have the capability to deal with options
- Mortgages are most important class
- Callable corporate bonds also

- The FI can restructure its assets and liabilities, on or off the balance sheet, to benefit from projected interest rate changes.
- Positive gap: increase in rates increases NII
- Negative gap: decrease in rates increases NII

- The “simple bank” we looked at does not appear to be subject to much interest rate risk.
- Let’s try restructuring for the “Simple S&L”

- Weaknesses:
- Ignores market value effects and off-balance sheet (OBS) cash flows
- Overaggregative
- Distribution of assets & liabilities within individual buckets is not considered. Mismatches within buckets can be substantial.

- Ignores effects of runoffs
- Bank continuously originates and retires consumer and mortgage loans and demand deposits/passbook account balances can vary. Runoffs may be rate-sensitive.

- Text example: Prime-based loans versus CD rates
- What about libor-based loans versus CD rates?
- What about CMT-based loans versus CD rates
- What about each loan type above versus wholesale funding costs?
- This is why the industry spreads all items to Treasury or LIBOR

- Explicitly incorporates market value effects.
- For fixed-income assets and liabilities:
- Rise (fall) in interest rates leads to fall (rise) in market price.
- The longer the maturity, the greater the effect of interest rate changes on market price.
- Fall in value of longer-term securities increases at diminishing rate for given increase in interest rates.

- Maturity of portfolio of assets (liabilities) equals weighted average of maturities of individual components of the portfolio.
- Principles stated on previous slide apply to portfolio as well as to individual assets or liabilities.
- Typically, maturity gap, MA - ML > 0 for most banks and thrifts.

- Size of the gap determines the size of interest rate change that would drive net worth to zero.
- Immunization and effect of setting
MA - ML = 0.

- If MA - ML = 0, is the FI immunized?
- Extreme example: Suppose liabilities consist of 1-year zero coupon bond with face value $100. Assets consist of 1-year loan, which pays back $99.99 shortly after origination, and 1¢ at the end of the year. Both have maturities of 1 year.
- Not immunized, although maturity gap equals zero.
- Reason: Differences in duration**
**(See Chapter 9)

- Leverage also affects ability to eliminate interest rate risk using maturity model
- Example:
Assets: $100 million in one-year 10-percent bonds, funded with $90 million in one-year 10-percent deposits (and equity)

Maturity gap is zero but exposure to interest rate risk is not zero.

- Example:

Correct for leverage

to immunize, change:

MA - ML = 0 to

MA – ML& E = 0 with ME = 0

(not in text)