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Chapter Seven

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Chapter Seven

Asset-Liability Management: Determining and Measuring Interest Rates and Controlling Interest-Sensitive and Duration Gaps

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

- Asset Management Strategy
- Liability Management Strategy
- Funds Management Strategy

- 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

Where: FV equals Face Value

Function of:

- Risk-Free Real Rate of Interest
- Various Risk Premiums
- Default Risk
- Inflation Risk
- Liquidity Risk
- Call Risk
- Maturity Risk

- 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

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

Interest-Sensitive Assets – Interest Sensitive Liabilities

Dollar Interest-Sensitive Gap

=

Relative Interest-Sensitive Gap

Interest Sensitivity Ratio

- Short-Term Securities Issued by the Government and Private Borrowers
- Short-Term Loans Made by the Bank to Borrowing Customers
- Variable-Rate Loans Made by the Bank to Borrowing Customers

- Borrowings from Money Markets
- Short-Term Savings Accounts
- Money-Market Deposits
- Variable-Rate Deposits

- Positive Dollar Interest-Sensitive Gap
- Positive Relative Interest-Sensitive Gap
- Interest Sensitivity Ratio Greater Than One

- Negative Dollar Interest-Sensitive Gap
- Negative Relative Interest-Sensitive Gap
- Interest Sensitivity Ratio Less Than One

Asset-Sensitive Bank

Interest Rates Rise

NIM Rises

Interest Rates Fall

NIM Falls

Liability-Sensitive Bank

Interest Rates Rise

NIM Falls

Interest Rates Fall

NIM Rises

- 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

- 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

- 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

The Total Difference in Dollars Between Those Bank Assets and Liabilities Which Can be Repriced over a Designated Time Period

- 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

Duration is the Weighted Average Maturity of a Promised Stream of Future Cash Flows

The Rate of Change in an Asset’s Price or Value Varies with the Level of Interest Rates or Yields

Where:

wi = the dollar amount of the ith asset divided by total assets

DAi = the duration of the ith asset in the portfolio

Where:

wi = the dollar amount of the ith liability divided by total liabilities

DLi = the duration of the ith liability in the portfolio

- 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