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Chapter. 7. Asset-Liability Management: The Concept of Duration and Managing a Bank’s Duration Gap. This chapter introduces us to yet another way to measure a bank’s exposure to loss from changes in interest rates – the concept of

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  1. Chapter 7 Asset-Liability Management: The Concept of Duration and Managing a Bank’s Duration Gap This chapter introduces us to yet another way to measure a bank’s exposure to loss from changes in interest rates – the concept of duration. We also see how bankers use duration analysis as a management weapon, offsetting the potentially damaging effects of rising or falling market interest rates.

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

  3. To Calculate Duration

  4. Price Sensitivity of a Security

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

  6. 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

  7. 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

  8. Duration Gap

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

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

  11. 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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