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

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Chapter Seven

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Chapter seven

Chapter Seven

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


Asset liability management

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


Historical view of asset liability management

Historical View of Asset-Liability Management

  • Asset Management Strategy

  • Liability Management Strategy

  • Funds Management Strategy


Interest rate risk

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


Yield to maturity ytm

Yield to Maturity (YTM)


Bank discount rate dr

Bank Discount Rate (DR)

Where: FV equals Face Value


Market interest rates

Market Interest Rates

Function of:

  • Risk-Free Real Rate of Interest

  • Various Risk Premiums

    • Default Risk

    • Inflation Risk

    • Liquidity Risk

    • Call Risk

    • Maturity Risk


Yield curves

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


Net interest margin

Net Interest Margin


Goal of interest rate hedging

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


Interest sensitive gap measurements

Interest-Sensitive Gap Measurements

Interest-Sensitive Assets – Interest Sensitive Liabilities

Dollar Interest-Sensitive Gap

=

Relative Interest-Sensitive Gap

Interest Sensitivity Ratio


Interest sensitive assets

Interest-Sensitive Assets

  • 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


Interest sensitive liabilities

Interest-Sensitive Liabilities

  • Borrowings from Money Markets

  • Short-Term Savings Accounts

  • Money-Market Deposits

  • Variable-Rate Deposits


Asset sensitive bank has

Asset-Sensitive Bank Has:

  • Positive Dollar Interest-Sensitive Gap

  • Positive Relative Interest-Sensitive Gap

  • Interest Sensitivity Ratio Greater Than One


Liability sensitive bank has

Liability Sensitive Bank Has:

  • Negative Dollar Interest-Sensitive Gap

  • Negative Relative Interest-Sensitive Gap

  • Interest Sensitivity Ratio Less Than One


Gap positions and the effect of interest rate changes on the bank

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

Gap Positions and the Effect of Interest Rate Changes on the Bank


Zero interest sensitive gap

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


Important decision regarding is gap

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


Nim influenced by

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


Cumulative gap

Cumulative Gap

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


Aggressive interest sensitive gap management

Aggressive Interest-Sensitive Gap Management


Problems with interest sensitive gap management

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


The concept of duration

The Concept of Duration

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


To calculate duration

To Calculate Duration


Price sensitivity of a security

Price Sensitivity of a Security


Convexity

Convexity

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


Duration of an asset portfolio

Duration of an 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


Duration of a liability portfolio

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


Duration gap

Duration Gap


Change in the value of a bank s net worth

Change in the Value of a Bank’s Net Worth


Impact of changing interest rates on a bank s net worth

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


Limitations of duration gap management

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


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