1 / 50

Chapter 6

Asset-Liability Management: Determining and Measuring Interest Rates and Controlling Interest Sensitive and Duration Gaps. Chapter 6. The Definition of Asset-Liability Management.

minor
Download Presentation

Chapter 6

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Asset-Liability Management:Determining and Measuring Interest Rates and Controlling Interest Sensitive and Duration Gaps Chapter 6

  2. The Definition ofAsset-Liability Management Asset-Liability Management (ALM) broadly defined is the coordinated decision-making process which views the balance sheet as an integrated whole and results in strategies and actions that contribute to the management of risk and the creation of value for the bank’s shareholders. ALM in the broadest sense involves all aspects of bank management.

  3. ALM and Interest Rate Risk • The management of interest rate risk is central to ALM. • Unexpected interest rate changes cause the Net Interest Margin to change if the repricing of assets and liabilities do not match. • Unexpected interest rate changes cause the value of the bank’s equity to change if the duration of assets and liabilities do not match. • ALM defined in a narrow sense is the management of interest rate risk.

  4. Reinvestment Rate Risk The rates at which banks can reinvest cash flows from assets and rates they pay on rolled over or new liabilities are not known with certainty in the future. Cost of Funds vs. Return on Assets Interest Sensitive GAP, impact on NII and NIM Price Risk Change in interest rates will cause a change in the value (price) of assets and liabilities. Duration GAP, impact on market value of equity Interest Rate Risk

  5. The Goals of ALM The Principal Goals of ALM are • Maximize, or stabilize, Net Interest Margin (Manage Reinvestment Risk) • Achieved by Controlling the Bank’s Interest-Sensitive Gap • Maximize, or stabilize, the Market Value of the Owner’s Equity (Manage Price Risk) • Achieved by Controlling the Bank’s Duration Gap The two goals may be incompatible. The bank probably cannot achieve both goals at the same time.

  6. Asset and Liability Management Committee (ALCO) • A bank's asset and liability management committee (ALCO) coordinates all policy decisions and strategies that determine a bank's risk and profit objectives. • Interest rate risk management is the primary responsibility of this committee. • The senior managers of the bank comprise the committee.

  7. Part I. Interest-Sensitive GAP Analysis

  8. A Simple Illustration of Reinvestment Risk

  9. On 1-1-1999, loan officer Mike Redd makes a $1,000 loan due in 5 years (1-1-2004) at a fixed rate of 6% per year. Principal is due at maturity and interest is payable annually.

  10. Charlie Greene, the funding manager, issues a $1,000 CD to acquire the deposits to fund Mike Redd’s loan. Deposit customers did not want long term CD’s so Charlie issues a CD due in one year at a rate of 3%.

  11. Fund the loan with a CD On 1-1-1999 we make $1,000 Loan due in 5 years on 1-1-2004 with a Fixed Rate 6% $1,000 CD due 1 year 1-1-2000 Fixed Rate 3% Notice mismatch of repricing opportunities. We will be required to replace the funding next year. Year 1 (1999) Interest Income $60 Interest Expense$30 NII $30 NIM = 30/1,000 = 3%

  12. $1,000 CD due 1 year 1-1-2001 Fixed Rate 5% $1,000 Loan due in 4 years 1-1-2004 Fixed Rate 6% Year 2000: 1 yr rates go up 2% Interest Income $60 Interest Expense$50 NII $10 NIM = 10/1,000 = 1% The original CD used to fund the loan matures and must be replaced with another 1 year CD but it carries a 5% rate.

  13. $1,000 Loan due in 3 years 1-1-2004 Fixed Rate 6% $1,000 CD due 1 year 1-1-2002 Fixed Rate 2% Year 2001: 1 yr rates go down 3% Interest Income $60 Interest Expense$20 NII $40 NIM = 40/1,000 = 4% The second CD used to fund the loan matures and must be replaced with another 1 year CD but it carries a 2% rate.

  14. “Charlie, why don’t we hedge our bets with a 2 year CD” “President Redd, our NIM has been very volatile.” NIM 3% 1% 4% Rates* 3% 5% 2% * 1 Year CD

  15. $1,000 CD due in 2 years 1-1-2004 Fixed Rate 3.5% $1,000 Loan due in 2 years 1-1-2004 Fixed Rate 6% Year 2002: 1 yr Rates go up 1% Interest Income $60 Interest Expense$35 NII $25 NIM = 25/1,000 = 2.5% The third CD used to fund the loan matures and must be replaced BUT is replaced with a 2 year CD which carries a 3.5% rate.

  16. $1,000 Loan due in 5 years Fixed Rate 6% $1,000 CD due 2 years Fixed Rate 3.5% Year 2003: Rates go up 3% Interest Income $60 Interest Expense $35 NII $25 NIM = 25/1,000 = 2.5% The CD with a two year maturity has not matured yet so our funding costs are still 3.5%, not the current 6% on 1 yr CD’s

  17. Interest-Sensitivity Analysis(for 1-1-1999)

  18. Interest-Sensitivity Analysis(for 1-1-2002)

  19. Interest Sensitivity Analysis:Rate Sensitivity Reports

  20. Rate Sensitivity Reports A rate sensitivity report classifies a bank’s assets and liabilities into time intervals according to the minimum number of days until each instrument can be repriced. It then reports GAP values on a periodic and cumulative basis through each time interval.

  21. Definition of Repriceable Assets and Liabilities • A repriceable asset or liability is any asset or liability on which the bank has the discretion of changing the interest rate during the next time period. • The time period chosen determines if an asset or liability is repriceable. • The legal contract for the item will determine when it can be repriced, for example, at maturity or at various intervals for adjustable rate instruments.

  22. Interest-Sensitive Gap Measurement Interest-Sensitive Gap = Interest-Sensitive Assets MINUS Interest-Sensitive Liabilities Remember Interest-Sensitive is the same as Repriceable.

  23. Periodic GAP vs. Cumulative GAP The periodic GAP indicates whether more assets or liabilities can be repriced within a specific time interval or maturity bucket. The periodic GAP is not very meaningful because it ignores whether assets and liabilities in other periods can be repriced. The cumulative GAP is the most important because it directly measures a bank’s net interest sensitivity from the present to the last day of the time interval. The cumulative GAP measures the sum of the periodic GAPS from time 0, the present, to the end of the time interval under consideration.

  24. Positive Gap: Asset Sensitive • Interest Rates Increase More assets reprice at the higher rates than liabilities. So, interest income goes up more that interest expense causing NII and NIM to go UP. • Interest Rates Fall More assets reprice at the lower rates than liabilities. So, interest incomes decreases more than interest expense causing NII and NIM to go DOWN.

  25. Negative Gap: Liability Sensitive • Interest Rates Increase More liabilities reprice at the higher rates than assets. So, interest expense goes up more than interest income causing NII and NIM to go DOWN. • Interest Rates Fall More liabilities reprice at the lower rates than assets. So, interest expense decreases more than interest income causing NII and NIM to go UP.

  26. Zero Gap When Interest Rates Change in Either Direction, NIM does not change. This happens because interest income and interest expense increase or decrease in the same amount causing NII and NIM to remain constant.

  27. Speculating on the GAP • Many bank managers attempt to adjust the interest rate risk exposure of a bank in anticipation of changes in interest rates. • This activity is speculative because it assumes that management can forecast rates better than forward rates embedded in the yield curve. • Speculating on the GAP • Difficult to vary the GAP and win – requires accurate interest rate forecast on a consistent basis. • Usually only look short term. • Only limited flexibility in adjusting the GAP because customers and depositors preferences..

  28. Advantages and Disadvantages of GAP • The primary advantage of GAP analysis is its simplicity. • The primary weakness is that it ignores the time value of money and the market value of the owner’s equity. • Assumes that interest rate changes on assets occur at the same time as liabilities. This is probably not the case. • GAP ignores the impact of embedded options. • For this reason, most banks conduct earnings sensitivity analysis, or pro forma analysis, to project earnings and the variation in earnings under different interest rate environments.

  29. Part II. The Concept of Duration and Managing a Bank’s Duration Gap

  30. The Definition of Duration Duration is the weighted average number of years until the cash flows from an investment are received. Duration is the “effective” time until maturity. Notice that duration is a more descriptive measure of the repricing opportunities than maturity. Duration is a better description of the structure of the time pattern of the cash flows of a financial instrument than maturity.

  31. Duration versus Maturity 1.) 1,000 loan, principal + interest paid in 20 years. 2.) 1,000 loan, 900 principal in 1 year, 100 principal in 20 years. 1000|-------------------|-----------------|0 10 20 900100|----|--------------|-----------------| 0 1 10 20 What is the maturity of each? 20 years What is the "effective“ or average maturity? 2.) = [(900/1000) x 1]+[(100/1000) x 20] = 2.9 yrs 1 2 Duration, however, uses a weighted average of the present values.

  32. Macaulay’s Duration Formula: Market Price Market Price of the Security = Present Value of all Cash Flows (CF) y = Yield to Maturity t = Time Period

  33. Macaulay’s Duration Example: y = 12% Coupon Rate = 10% Par Value = $1,000 Maturity = 3 Years

  34. Calculation of Macaulay’s Duration

  35. Duration of a Discount Bond or Zero Coupon Bond If YTM = 12%, 1000 face, 0% coupon, 3 year maturity $711.78 1000|-------|-------|-------|0 1 2 3 Duration = Maturity

  36. Modified Duration Modified duration is an indication of the percentage change in the price of a fixed income financial instrument for a given change in interest rates. D* = Modified Duration = D/(1 + i) D = Macaulay’s Duration P/P = -D*( i) or P/P = -D{ i/(1 + i)}

  37. Duration and Risk Management The important feature of duration from a risk management point of view is that it measures the sensitivity of the market value of financial instruments to changes in interest rates. Assume we own a bond with D = 4 years, current market price = $1,000, and a yield to maturity of 10%. What percentage change in the price of our bond will occur if market interest rates increase by 1% to 11%. P/P = -D{ i/(1 + i)} = -4(.01/1.10) = -0.0364 = -3.64% The price of our bond will go down by 3.64% if interest rates go up 1%.

  38. The Purpose of Duration Gap Analysis The purpose of DGAP analysis is to provide a measure of the impact of unexpected interest rate changes on the market value of a bank’s owners’ equity, i.e. net worth. Interest sensitive GAP analysis does not consider the impact of changing interest rates on the market value of a bank’s owners’ equity.

  39. Two Interest Rate TheoremsCentral to DGAP Analysis I. Market yields and market prices move in opposite directions. A rise in market rates of interest will cause the market value of both fixed-rate assets and liabilities to decline. II. The longer the maturity of a fixed rate financial instrument, the greater will be the change in market value for a given change in market interest rates. The longer the duration of a bank’s assets and liabilities, the more they will decline in market value when market interest rates rise.

  40. The Duration Gap DGAP = DA - {DL (TL\TA)} DGAP = Duration Gap DA= Dollar Weighted Duration of theAsset Portfolio DL = Dollar Weighted Duration of the Bank’s Liabilities TL = Total Market Value of the Bank’s Liabilities TA = Total Market Value of the Bank’s Assets DGAP is measured in years and is a measure of the mismatch in the average duration of the assets and the liabilities. The larger the mismatch, the greater the impact of unexpected interest rate changes on the market value of the net worth of the bank.

  41. DGAP = Leverage Adjusted Duration GAP When I refer to the DGAP or Duration GAP I mean the Leverage Adjusted DGAP. DGAP = DA - {DL (TL\TA)} Disregard the concept DGAP = DA - DL(Equation 20 Text)

  42. The Duration of a Portfolio The duration of a portfolio of bank assets or liabilities is the value weighted average of the duration of each instrument in the portfolio.

  43. The Calculation of the Duration of a Portfolio of Assets DA = 3.047 years

  44. Computation of the DGAP

  45. Positive Duration GAP • Interest Rates Increase Assets have a higher duration so they will decrease more in value than liabilities. This causes the Net Worth to decrease. • Interest Rates Fall Assets have a higher duration so they will increase more in value than liabilities. This causes the Net Worth to increase.

  46. Negative Duration GAP • Interest Rates Increase Assets have a lower duration so they will decrease less in value than liabilities. This causes the Net Worth to increase. • Interest Rates Fall Assets have a lower duration so they will increase less in value than liabilities. This causes the Net Worth to decrease.

  47. Zero Duration GAP If the DGAP = 0 over the planning period, the bank is immunized against changes in the value of its net worth. In other words, the market value of the bank’s equity will be stable in the event of unexpected interest rate changes, either up or down.

  48. Change in the $Value of a Bank’s Net Worth NW = TA - TL Using P/P = -D[ i/(1 + i)] = P = -D[ i/(1 + i)] P NW = {-DA[i/(1+i)] TA} - {-DL[i/(1+i)] TL} or NW = {-DGAP [i/(1+i)] TA}

More Related