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Chapter Seven

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

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Chapter Seven

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

  2. Goals of This Chapter • 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.

  3. Key Topics in This Chapter • Asset, Liability, and Funds Management • Market Rates and Interest Rate Risk • The Goals of Interest Rate Hedging • Interest Sensitive Gap Management • Duration Gap Management • Limitations of Hedging Techniques

  4. RMB, millions/ %

  5. 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

  6. Asset-Liability Management • Historical View of Asset-Liability Management: • Asset Management Strategy • Liability Management Strategy • Funds Management Strategy

  7. Interest Rate Risk • The Measurement of Interest Rate: • 1. YTM (Yield to Maturity)

  8. Measurement of Interest Rate • Example 7-1: • A government bond is currently selling for $900 and pays $80 per year in interest for nine years when it matures. If the redemption value of this bond is $1,000, what is its yield to maturity if purchased today for $900? • The yield to maturity equation for this bond would be: • Using a financial calculator the YTM = 9.72%

  9. Measurement of Interest Rate • 2. HPR (Holding Period Rate of Return) • Example 7-2: • Suppose the government bond described in example 1 above is held for three years and then the thrift institution acquiring the bond decides to sell it at a price of $950. Can you figure out the average annual yield? • Using a financial calculator, the HPY is 10.56%

  10. Interest Rate Risk • Kinds of 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

  11. The Component of Interest Rates Function of: • Risk-Free Real Rate of Interest • Various Risk Premiums • Default Risk • Inflation Risk • Liquidity Risk • Maturity Risk

  12. The Goals of Interest-Rate Hedging • The Net Interest Margin (NIM): to freeze the spread between asset revenues and liability expenditures • The equity: to insulate the equity (net worth) from the damaging effects of interest rate changes

  13. Interest Rate Sensitive Gap Management • 1. Interest-Sensitive Assets • 2. Interest-Sensitive Liabilities • 3. Interest-Sensitive Gap Measurements Dollar Interest-Sensitive Gap Interest Sensitivity Ratio • 4. Gap Positions and the Effect of Interest Rate Changes • 5. Strategies in Gap Management

  14. 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

  15. Interest-Sensitive Liabilities • Borrowings from Money Markets • Short-Term Savings Accounts • Money-Market Deposits • Variable-Rate Deposits

  16. Interest-Sensitive Gap Measurements Interest-Sensitive Assets – Interest Sensitive Liabilities Dollar Interest-Sensitive Gap = Interest Sensitivity Ratio

  17. 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

  18. Zero Interest-Sensitive Gap • Dollar Interest-Sensitive Gap is Zero • Interest Sensitivity Ratio is One • When Interest Rates Change in Either Direction - NIM is Protected and Will Not Change

  19. Example of IS GAP Management • Example 7-3:

  20. NIM Influenced By: • Changes in Interest Rates Up or Down • The Spread Between Interest-Sensitive Assets and Liabilities • Important Decision Regarding IS Gap: • Management Must Choose the Time Period Over Which NIM is to be Managed • Reallocate Assets and Liabilities to change the Spread • Develop Correct Interest Rate Forecast

  21. Aggressive Interest-Sensitive Gap Management

  22. Limits of Interest-Sensitive Gap Management • Interest-Sensitive Gap Does Not Consider the Impact of Changing Interest Rates on Equity Position • It’s difficult to make sure the amount of interest-sensitive assets and the amount of interest-sensitive liabilities. • Correct interest forecasting is very important.

  23. Duration Gap Management • The Conception of Duration • Using Duration to Hedge Against Interest-Rate Risk

  24. Duration Gap Management • The Conception of Duration • Definition of Duration • Calculation of Duration • Price Risk and Duration

  25. Duration Gap Management • Using Duration to Hedge Against Interest-Rate Risk • A. Duration Gap • Dollar Weighted Duration of Assets • Dollar Weighted Duration of Liabilities • Positive Duration Gap • Negative Duration Gap • B. Change in the Bank’s Net Worth

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

  27. To Calculate Duration

  28. Duration and the Price of Bond • The pricing formula of bonds: • First derivative：

  29. Duration and the Price of Bond • The relationship between the price change of a bond and duration, YTM is as follows: • Price Sensitivity of a Security

  30. Duration Gap Management • 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

  31. 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

  32. Duration Gap

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

  34. Example of Duration Management • Examples 7-4: • New Phase National Bank holds assets and liabilities whose average duration and dollar amount are as shown in this table: • What is the weighted average duration of New Phase’s asset portfolio and liability portfolio. What is the leverage-adjusted duration gap?

  35. Example of Duration Management

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

  37. 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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