Chapter Five

1. Chapter Five Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

2. Key Topics • Asset, Liability, and Funds Management • Market Rates and Interest Rate Risk • The Goals of Interest Rate Hedging • Interest-Sensitive Gap Management

3. Introduction p. 133-134 • Even as a financial institution takes on risk, it must protect the value of its net worth from declining, which could result in ultimate failure • Financial-service managers have learned to look at their asset and liability portfolios (a bunch of different investments) as a group of investments that work together. • They must consider how their institution’s whole portfolio contributes to the firm’s goals of profitability and acceptable risk • Known as asset-liability management (ALM) • Can protect against business cycles and ups and downs.

4. Asset-Liability Management Strategies p.134-135 • Asset Management Strategy • Control over assets, no control over liabilities • Liability Management Strategy • Control over liabilities by changing rates and other terms • Funds Management Strategy • Works with both strategies

5. EXHIBIT 7–1 Asset-Liability Management in Banking and Financial Services p. 135

6. Interest Rate Risk: One of the Greatest Management Challenges p. 135-136 • Changing interest rates impact both the balance sheet and the statement of income and expenses of financial firms • 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

7. EXHIBIT 7–2 Determination of the Rate of Interest in the Financial Marketplace Where the Demand and Supply of Loanable Funds (Credit) Interact to Set the Price of Credit p. 136

8. Interest Rate Risk: One of the Greatest Management Challenges (continued) p.137 • Forces Determining Interest Rates • Loanable Funds Theory • The Measurement of Interest Rates • YTM • Bank Discount • Components of Interest Rates

9. Interest Rate Risk: One of the Greatest Management Challenges (continued) p. 137 • Interest rates are the price of credit • Demanded by lenders as compensation for the use of borrowed funds • Expressed in percentage points and basis points (1/100 of a percentage point) • Yield to Maturity (YTM) • The discount rate that equalizes the current market value of a loan or security with the expected stream of future income payments that the loan or security will generate

10. Interest Rate Risk: One of the Greatest Management Challenges (continued) p. 137 • How to Calculate the Yield to Maturity

11. Interest Rate Risk: One of the Greatest Management Challenges (continued) p. 137 • Another popular interest rate measure is the bank discount rate (DR) • Often quoted on short-term loans and money market securities (such as Treasury bills)

12. Interest Rate Risk: One of the Greatest Management Challenges (continued) p. 137 • The DR measure ignores the effect of compounding and is based on a 360-day year • Unlike the YTM measure, which assumes a 365-day year and assumes that interest income is compounded at the calculated YTM • The DR measure uses the face value of a financial instrument to calculate its yield or rate of return • Makes calculations easier but is theoretically incorrect • The purchase price of a financial instrument is a much better base to use in calculating the instrument’s true rate of return

13. Interest Rate Risk: One of the Greatest Management Challenges (continued) p. 137 • To convert a DR to the equivalent yield to maturity, we can use the formula

14. Interest Rate Risk: One of the Greatest Management Challenges (continued) p. 138 • Market interest rates are a function of • Risk-free real rate of interest • Various risk premiums • Default Risk – risky borrower • Inflation Risk – rising prices • Liquidity Risk – difficult to sell quickly • Call Risk – borrower pays off loan early • Maturity Risk – have higher interest rates due to greater opportunity for loss

15. One of the Goals of Interest Rate Hedging: 躲闪 duǒshǎnProtect the Net Interest Margin p. 141 • In order to protect profits against adverse interest rate changes, management seeks to hold fixed the financial firm’s net interest margin (NIM)

16. One of the Goals of Interest Rate Hedging: Protect the Net Interest Margin (continued) • A financial firm can hedge itself against interest rate changes – no matter which way rates move – by making sure for each time period that • The gap is the portion of the balance sheet affected by interest rate risk

17. One of the Goals of Interest Rate Hedging: Protect the Net Interest Margin (continued) p. 143 • If interest-sensitive assets exceed the volume of interest-sensitive liabilities subject to repricing, the financial firm is said to have a positive gap and to be asset sensitive • In the opposite situation, suppose an interest-sensitive bank’s liabilities are larger than its interest-sensitive assets

18. One of the Goals of Interest Rate Hedging: Protect the Net Interest Margin (continued) p. 145 • The net interest margin is influenced by multiple factors: • Changes in the level of interest rates, up or down • Changes in thespread (difference or margin)between asset yields and liability costs • Changes in the volume of interest-bearing (earning) assets a financial institution holds as it expands or shrinks the overall scale of its activities • Changes in the volume of interest-bearing liabilities that are used to fund earning assets as a financial institution grows or shrinks in size • Changes in the mix of assets and liabilities that management draws upon as it shifts between floating and fixed-rate assets and liabilities, between shorter and longer maturity assets and liabilities, and between assets bearing higher versus lower expected yields

19. One of the Goals of Interest Rate Hedging: Protect the Net Interest Margin (continued) p. 147 • We calculate a firm’s net interest income to see how it will change if interest rates rise • Net interest income can be derived from the following formula

20. Chapter Summary 1. Managers of banks focus on the management of risk – controlling possible loss due to changes in market rates on interest, borrowers not paying their loans, regulation changes. 2. Focus of this chapter was to show you the tools that managers can use. 3. Early banking history focused on asset management because liabilities are controlled by customers. 4. Liability management became popular when managers realized they could have more control by changing interest rates.

21. Chapter Summary (cont) 5. Funds management is using tools from both. 6. Managers have to deal with interest-rate risk every day, since the market is always changing. 7. Protecting the net interest margin, or the SPREADbetween interest revenues and interest costs, managers use interest sensitive gap management tools

22. Chapter Concept Checks 5-1 What do the following terms mean: Asset management? Liability management? Funds management? • Asset management refers to a banking strategy where management has control over the allocation 分配 (fēnpèi) of bank assets but believes the bank's sources of funds (principally deposits) are outside its control. The key decision area for management is not deposits and other borrowings but assets. The financial manager exercises control over the allocation of incoming funds by deciding who is granted loans and what the terms on those loans will be.

23. Chapter Concept Checks • Liability management is a strategy wherein greater control towards bank liabilities is exercised. This is done mainly by opening up new sources of funding and monitoring the volume, mix and cost of their deposits and non-deposit items.   • Funds management combines both asset and liability management approaches into a balanced liquidity management strategy. Effective coordination in managing assets and liabilities will help to maximize the spread (difference or margin) between revenues and costs and control risk exposure.

24. Chapter Concept Checks • 5-3. What forces cause interest rates to change? What kinds of risk do financial firms face when interest rates change? • Interest rates are determined, not by individual banks, but by the collective borrowing and lending decisions of thousands of participants in the money and capital markets. They are also impacted by changing views of risk by participants in the money and capital markets, especially the risk of borrower default, liquidity risk, price risk, reinvestment risk, inflation risk, term or maturity risk, marketability risk, and call risk.

25. Chapter Concept Checks • 5-4 What makes it so difficult to correctly forecast 预测 (yùcè) interest rate changes? Interest rates cannot be set by an individual bank or even by a group of banks. They are determined by thousands of investors (the public, consumers like you and me) trading in the credit markets. Moreover, each market rate of interest has multiple parts—the risk-free real interest rate plus various risk costs. A change in any of these rate parts can cause interest rates to change. This makes it difficult to forecast interest rate changes.

26. Chapter Concept Checks • 5-7. What is the goal of hedging? • The goal of hedging in banking is to freeze (hold), or protect the spread between asset returns and liability costs and to offset declining values on certain assets by profitable transactions so that a target rate of return is assured.

27. Chapter Concept Checks 5-8. First National Bank of Bannerville has posted interest revenues of $63 million and interest costs from all of its borrowings of $42 million. If this bank possesses $700 million in total earning assets, what is First National’s net interest margin? Suppose the bank’s interest revenues and interest costs double, while its earning assets increase by 50 percent. What will happen to its net interest margin? See slide 15 or page 141

28. Chapter Concept Checks The bank’s net interest margin is 3% computed as follows: Net interest margin = = 0.03 (3%) If interest revenues and interest costs double while earning assets grow by 50 percent, the net interest margin will change as follows: Net interest margin= = 0.04 (4%) Clearly the net interest margin increases—in this case by one third.