Chapter Seven

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

2. 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

3. Historical View of Asset-Liability Management • Asset Management Strategy • Liability Management Strategy • Funds Management Strategy

4. 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

5. Yield to Maturity (YTM)

6. Bank Discount Rate (DR) Where: FV equals Face Value

7. Market Interest Rates Function of: • Risk-Free Real Rate of Interest • Various Risk Premiums • Default Risk • Inflation Risk • Liquidity Risk • Call Risk • Maturity Risk

8. Yield Curves • Graphical Picture of Relationship Between Yields and Maturities on Securities • Generally Created With Treasury Securities to Keep Default Risk Constant • Shape of the Yield Curve • Upward – Long-Term Rates Higher than Short-Term Rates • Downward – Short-Term Rates Higher than Long-Term Rates • Horizontal – Short-Term and Long-Term Rates the Same

9. Net Interest Margin

10. 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 on Profits

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

12. 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

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

14. Asset-Sensitive Bank Has: • Positive Dollar Interest-Sensitive Gap • Positive Relative Interest-Sensitive Gap • Interest Sensitivity Ratio Greater Than One

15. Liability Sensitive Bank Has: • Negative Dollar Interest-Sensitive Gap • Negative Relative Interest-Sensitive Gap • Interest Sensitivity Ratio Less Than One

16. 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

17. 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

18. 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 Volume of Interest-Sensitive Assets and Liabilities

19. 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

20. Cumulative Gap The Total Difference in Dollars Between Those Bank Assets and Liabilities Which Can be Repriced over a Designated Time Period

21. Aggressive Interest-Sensitive Gap Management

22. 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

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

24. To Calculate Duration

25. Price Sensitivity of a Security

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

27. 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

28. 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

29. Duration Gap

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

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

32. 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