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CHAPTER SIX Asset-Liability Management: Determining and Measuring Interest Rates and Controlling a Bank’s Interest-Sensitive And Duration Gaps.

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## Asset-Liability Management

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**CHAPTER SIXAsset-Liability Management: Determining and**Measuring Interest Rates and Controlling a Bank’s Interest-Sensitive And Duration Gaps The purpose of this chapter is to explore the options bankers have today for dealing with risk – especially the risk of loss due to changing interest rates – and to see how a bank’s management can coordinate the management of its assets with the management of its liabilities in order to achieve the institution’s goals.**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**• Asset Management Strategy • Liability Management Strategy • Funds Management Strategy**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**Bank Discount Rate (DR)**Where: FV equals Face Value**Market Interest Rates**Function of: • Risk-Free Real Rate of Interest • Various Risk Premiums • Default Risk • Inflation Risk • Marketability Risk • Call Risk • Maturity Risk**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**Interest-Sensitive Gap Measurements**Dollar Interest-Sensitive Gap Interest-Sensitive Assets – Interest Sensitive Liabilities = Relative Interest-Sensitive Gap Interest Sensitivity Ratio**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**• Borrowings from Money Markets • Short-Term Savings Accounts • Money-Market Deposits • Variable-Rate Deposits**Asset-Sensitive Bank Has:**• Positive Dollar Interest-Sensitive Gap • Positive Relative Interest-Sensitive Gap • Interest Sensitivity Ratio Greater Than One**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**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**• 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 Dollar Volume of Interest-Sensitive Assets and Liabilities**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**The Total Difference in Dollars Between Those Bank Assets and Liabilities Which Can be Repriced over a Designated Time Period**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**Duration is the Weighted Average Maturity of a Promised Stream of Future Cash Flows**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**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**Where: wi = the dollar amount of the ith liability divided by total liabilities DLi = the duration of the ith liability in the portfolio**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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