Asset and Liability Management

Interest Rate Risk Management

Asset and Liability Management
Managing Interest Rate Risk
Unexpected changes in interest rates can
significantly alter a banks profitability and
market value of equity.
Figure 8-1
Interest Rate (Percent)
Monthly Average Rates
Fed Funds
10-Year Treasury
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
20
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
Interest Rate Risk
Reinvestment rate risk
- Cost of funds vrs return on assets.
=> Funding GAP, impact on NII.
Price Risk
- Change in interest rates will cause a
change in the value (price) of assets
and liabilities.
- Longer maturity (duration) -- > larger
change in value for a given change in
interest rates.
=> Duration GAP, impact on market value
of equity.
Funding GAP:
Focus on managing NII in the short
run.
Method
Group assets and liabilities into time
"buckets" according to when they
mature or re-price.
Calculate GAP for each time bucket
Funding GAP
t
= $ Value RSA
t
- $ Value or
RSL
t

where t = time bucket; e.g., 0-3
months.
Factors Affecting NII.
Changes in the level of i-rates.
ANII = (GAP) * (Ai
exp.
)
Changes in the volume of assets and liab.
Change in the composition of assets and
liab.
Changes in the relationship between asset
yields and liab. cost of funds.
Exhibit 8.3
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 8.0% 600 4.0%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000
NII = (0.08x500+0.11x350) - (0.04x600+0.06x220)
78.5 - 37.2 = 41.3
NIM = 41.3 / 850 = 4.86%
GAP = 500 - 600 = -100
Exhibit 8.4
1% increase in the level of all short-term rates.
1% decrease in spread between assets yields
and interest cost.
RSA increase to 8.5%
RSL increase to 5.5%
Proportionate doubling in size.
Increase in RSAs and decrease in RSLs
RSA = 540, fixed rate = 310
RSL = 560, fixed rate = 260.
1% Increase in Short-Term Rates
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 9.0% 600 5.0%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000
NII = (0.09x500+0.11x350) - (0.05x600+0.06x220)
83.5 - 43.2 = 40.3
NIM = 40.3 / 850 = 4.74%
GAP = 500 - 600 = -100
1% Decrease in Spread
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 500 8.5% 600 5.5%
Fixed rate 350 11.0% 220 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000
NII = (0.085x500+0.11x350) - (0.055x600+0.06x220)
81 - 46.2 = 34.8
NIM = 34.8 / 850 = 4.09%
GAP = 500 - 600 = -100
Proportionate Doubling in Size
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 1000 8.0% 1200 4.0%
Fixed rate 700 11.0% 440 6.0%
Non earning 300 200
1840
Equity
160
Total 2000 2000
NII = (0.08x1000+0.11x700) - (0.04x1200+0.06x440)
157 - 74.4 = 82.6
NIM = 82.6 / 1700 = 4.86%
GAP = 1000 - 1200 = -200
Increase in RSAs and Decrease
in RSLs
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive 540 8.0% 560 4.0%
Fixed rate 310 11.0% 260 6.0%
Non earning 150 100
920
Equity
80
Total 1000 1000
NII = (0.08x540+0.11x310) - (0.04x560+0.06x260)
77.3 - 38 = 39.3
NIM = 39.3 / 850 = 4.62%
GAP = 540 - 560 = -20
Rate Sensitivity Reports
Periodic GAP
Gap for each time bucket.
Measures the timing of potential income effects from
interest rate changes.
Cumulative GAP
Sum of periodic GAP's.
Measures aggregate interest rate risk over the entire
period.
Examine Exhibit 8.5:
Time Frame for Rate Sensitivity
Assets 1-7 8-30 31-90 91-180 181-365 > 1 yr Not RS Total
U.S. Treasury 0.7 3.6 1.2 0.3 3.7 9.5
MM Inv 1.2 1.8 3
Municipals 0.7 1 2.2 7.6 11.5
FF & Repo's 5 5
Comm loans 1 13.8 2.9 4.7 4.6 15.5 42.5
Install loans 0.3 0.5 1.6 1.3 1.9 8.2 13.8
Cash 9 9
Other assets 5.7 5.7
Total Assets 6.3 15 10 10 9 35 14.7 100
Liabilities and Equity
MMDA 17.3 17.3
Super NOW 2.2 2.2
CD's < 100,000 0.9 2 5.1 6.9 1.8 2.9 19.6
CD's > 100,000 1.9 4 12.9 7.9 1.2 27.9
FF purchased 0
NOW 9.6 9.6
Savings 1.9 1.9
DD 13.5 13.5
Other liabilities 1 1
Equity 7 7
Total Liab & Eq. 22.3 6 18 24.4 3 4.8 21.5 100
GAP
Periodic GAP -16 9 -8 -14.4 6 30.2
Cumulative GAP -16 -7 -15 -29.4 -23.4 6.8
Break Even Analysis
Focus on repriceable assets and calculate a
break-even yield required to maintain stable NII
after a rate change.
Method:
1. Calculate repriceable assets and liab. for the
desired period.
2. Calculate funding GAP for the period.
3. Calculate interest income for the period
Int Inc. = r
RSA
x (n/365) x $RSA
4. Calculate interest expense for the period.
5. Calculate NII.
Break Even Analysis (Cont.)
Forecast Break-Even yield on assets
5. Calculate NII.
6. Calculate new interest expense on RSL that
rolled over.
Int exp. = r
RSL forcasted
x (n/365) x $RSL
7. Calculate interest expense on "new money"
Int exp. on new money = r
new money
x (n/365)
x $amt of new money
8. Calculate required interest income = 5.) + 6.)
+ 7.)
9. Calculate break even asset yield for the use
of new money.
Break even rate = [8.) net new money] x
(365/n)
Break Even Analysis (Cont.)
Calculate Break Even Asset Yield Annualized
Average Rate
Rollover of RSA and RSL's $ amount
Rates Unchanged
Repriceable assets 21,300,000 14.10%
Repriceable liabilities 28,300,000 9.50%
GAP (7,000,000)
Interest income (next 30 days) 246,847 =21.3mx0.141x(30/360)
Interest expense (next 30days) 220,973 =28.3mx0.095x(30/360)
Net interest return 25,874
Forecasted Break-even Yield on Assets
"New" Int exp. on existing RSL -2.00% 216,321 9.30%
Int exp on new money 1.00 mill 8,548 10.40%
Target net spread on repriceables 25,874
Required interest income 250,742
Break even asset yield (annualied) 250,742x(30/365) = 13.70%
21300000+1000000(1-0.03)
Speculating on the GAP.
ANII = (GAP) * (A i
exp
)
Speculating on the GAP
1. Difficult to vary the GAP and win.
2. Requires accurate interest rate forecast on a
consistent basis.
3. Usually only look short term.
4. Only limited flexibility in adjusting the GAP,
customers and depositors.
5. No adjustment for timing of cash flows or
dynamics of the changing GAP position.
Duration GAP
Focus on managing NII or the market value of
equity, recognizing the timing of cash flows
Interest rate risk is measured by comparing the
weighted average duration of assets with liab.
Asset duration > Liability duration
interest rates
Market value of equity falls
Duration vrs maturity
1.) 1000 loan, principal + interest paid in
20 years.
2.) 1000 loan, 900 principal in 1 year,
100 principal in 20
years.

1000 + int
|------------------------------|---------------------------
-|
0 10
20
900+int
100 + int
|---|--------------------------|---------------------------
-|
0 10
20
What is the maturity of each?
What is the "effective" maturity?
1.) = 20 years
2.) = [(900/100) x 1]+[(100/1000) x 20] = 2.9
yrs
Duration, however, uses a weighted
average of the present values.
Duration
Approximate measure of the market value of
interest elasticity






Price (value) changes
Longer maturity/duration larger changes in price for a
given change in i-rates.
Larger coupon smaller change in price for a given
change in i-rates.
DUR
V
i
~

(
(
(
~

A
A
A
A
V
V
i
1+i
%
DUR
V
i
~

(
(
(
~

A
A
A
A
V
V
i
1+i
%
Calculate Duration





Examples:
1000 face value, 10% coupon, 3 year,
12% YTM
DUR =
C (t)
(1+r)
C
(1+r)
C (t)
(1+r)
t
t
t=1
n
t
t
t=1
n
t
t
t=1
n

=
PVof the Sec.
DUR =
C (t)
(1+r)
C
(1+r)
C (t)
(1+r)
t
t
t=1
n
t
t
t=1
n
t
t
t=1
n

=
PVof the Sec.
Calculate Duration





Examples:
1000 face value, 10% coupon, 3 year,
12% YTM
D = =

100*1
(1.12)
+
100*2
(1.12)
+
100*3
(1.12)
+
1000*3
(1.12)
100
(1.12)
+
1000
(1.12)

2597.6
951.96
= 2.73 years
1

2 3 3
t 3
t=1
3
D = =

100*1
(1.12)
+
100*2
(1.12)
+
100*3
(1.12)
+
1000*3
(1.12)
100
(1.12)
+
1000
(1.12)

2597.6
951.96
= 2.73 years
1

2 3 3
t 3
t=1
3
DUR =
C (t)
(1+r)
C
(1+r)
C (t)
(1+r)
t
t
t=1
n
t
t
t=1
n
t
t
t=1
n

=
PVof the Sec.
DUR =
C (t)
(1+r)
C
(1+r)
C (t)
(1+r)
t
t
t=1
n
t
t
t=1
n
t
t
t=1
n

=
PVof the Sec.
If YTM = 5%
1000 face value, 10% coupon, 3 year, 5%
YTM
D =
100*1
(1.05)
+
100* 2
(1.05)
+
100*3
(1.05)
+
1000*3
(1.05)
1136.16
1

2 3 3
D =
100*1
(1.05)
+
100*2
(1.05)
+
100*3
(1.05)
+
1000*3
(1.05)
1136.16
1

2 3 3
D =
3127.31
1136.16
= 2.75 years D =
3127.31
1136.16
= 2.75 years
If YTM = 20%
1000 face value, 10% coupon, 3 year, 20%
YTM





D =
2131.95
789.35
= 2.68 years D =
2131.95
789.35
= 2.68 years
If YTM = 12% and Coupon = 0
1000 face value, 0% coupon, 3 year, 12%
YTM
1000
|-------|-------|-------|
0 1 2 3

If YTM = 12% and Coupon = 0
1000 face value, 0% coupon, 3 year, 12%
YTM
1000
|-------|-------|-------|
0 1 2 3


= 3 by definition
D =
1000*3
(1.12)
1000
(1.12)
3
3
D =
1000*3
(1.12)
1000
(1.12)
3
3
Relate Two Types of Interest
Rate Risk
Reinvestment rate risk
Price risk.
If i-rate


, YTM from reinvestment of the cash flows and
holding period return (HPR) increases.
If you sell the security prior to maturity then the price or
value falls , hence HPR falls.
Increases in i-rates will improve HPR from a higher
reinvestment rate but reduce HPR from capital
losses if the security is sold prior to maturity.
An immunized security is one in which the gain from
the higher reinvestment rate is just offset by the
capital loss. This point is where your holding period
equals the duration of the security.
Duration GAP at the Bank
The bank can protect either the market value
of equity (MVE) or the book value of NII, but
not both.
To protect the MVE the bank would set DGAP
to zero:
DGAP = DA - u
x
DL.
whereDA = weighted average
duration of assets,
DL = weighted average
duration of liabs,

Exhibit 8.8
click for other
examples
1 Par Years Market
$1,000 % Coup Mat. YTM Value Dur.
Assets
Cash 100 100
Earning assets
Commercial loan 700 14.00% 3 14.00% 700 2.65
Treasury bond 200 12.00% 9 12.00% 200 5.97
Total Earning Assets 900 13.56% 900
Non-cash earning assets 0 0
Total assets 1000 12.20% 1000 3.05
Liabilities
Interest bearing liabs.
Time deposit 520 9.00% 1 9.00% 520 1.00
Certificate of deposit 400 10.00% 4 10.00% 400 3.49
Tot. Int Bearing Liabs. 920 9.43% 920
Tot. non-int. bearing 0 0
Total liabilities 920 9.43% 920 2.08
Total equity 80 80
Total liabs & equity 1000 1000
Exhibit 8.8
1 Par Years Market
$1,000 % Coup Mat. YTM Value Dur.
Assets
Cash 100 100
Earning assets
Commercial loan 700 14.00% 3 14.00% 700 2.65
Treasury bond 200 12.00% 9 12.00% 200 5.97
Total Earning Assets 900 13.56% 900
Non-cash earning assets 0 0
Total assets 1000 12.20% 1000 3.05
Liabilities
Interest bearing liabs.
Time deposit 520 9.00% 1 9.00% 520 1.00
Certificate of deposit 400 10.00% 4 10.00% 400 3.49
Tot. Int Bearing Liabs. 920 9.43% 920
Tot. non-int. bearing 0 0
Total liabilities 920 9.43% 920 2.08
Total equity 80 80
Total liabs & equity 1000 1000
dur =

+
98 1
1 14
98 1
1 14
98 3
1 14
700 3
1 14
700
1 2 3 3
( . ) ( . ) ( . ) ( . )
Calculating DGAP
In exhibit 8.8:
DA = (700 / 1000) * 2.65 + (200 / 1000) *
5.97 = 3.05
DA = (520 / 920) * 1.00 + (400 / 920) * 3.48
= 2.08
DGAP = 3.00 - (920 / 1000) * 2.06 = 1.14
years
What does 1.14 mean?
The average duration of assets > liabilities,
hence asset values change by more than liability
values.
What is the minimum risk
position?
To eliminate the risk of changes in the
MVE, what do they have to change DA or
DL by?
Change DA = -1.14
Change DL = +1.14/u = 1.24
Exhibit 8.9
1 Par Years Market
$1,000 % Coup Mat. YTM Value Dur.
Assets
Cash 100 100
Earning assets
Commercial loan 700 14.00% 3 15.00% 684.02 2.64
Treasury bond 200 12.00% 9 13.00% 189.74 5.89
Total Earning Assets 900 14.57% 873.75
Non-cash earning assets 0 0
Total assets 1000 13.07% 973.75 3.00
Liabilities
Interest bearing liabs.
Time deposit 520 9.00% 1 10.00% 515.27 1.00
Certificate of deposit 400 10.00% 4 11.00% 387.59 3.48
Tot. Int Bearing Liabs. 920 10.43% 902.86
Tot. non-int. bearing 0 0
Total liabilities 920 10.43% 902.86 2.06
Total equity 80 70.891
Total liabs & equity 1000 973.75
Exhibit 8.9
1 Par Years Market
$1,000 % Coup Mat. YTM Value Dur.
Assets
Cash 100 100
Earning assets
Commercial loan 700 14.00% 3 15.00% 684.02 2.64
Treasury bond 200 12.00% 9 13.00% 189.74 5.89
Total Earning Assets 900 14.57% 873.75
Non-cash earning assets 0 0
Total assets 1000 13.07% 973.75 3.00
Liabilities
Interest bearing liabs.
Time deposit 520 9.00% 1 10.00% 515.27 1.00
Certificate of deposit 400 10.00% 4 11.00% 387.59 3.48
Tot. Int Bearing Liabs. 920 10.43% 902.86
Tot. non-int. bearing 0 0
Total liabilities 920 10.43% 902.86 2.06
Total equity 80 70.891
Total liabs & equity 1000 973.75
PV
t
t
= +
=

98
1 15
700
1 15
1
3
3
( . ) ( . )
Calculating DGAP
In exhibit 8.9:
DA = (684 / 974) * 2.64 + (189 / 974) * 5.89
= 3.00
DA = (515 / 903) * 1.00 + (387 / 903) * 3.48
= 2.06
DGAP = 3.00 - (903 / 974) * 2.06 = 1.09
years
What does 1.09 mean?
The average duration of assets > liabilities,
hence asset values change by more than liability
values.
Change in the Market Value of
Equity
Using the relationship:





DUR
V
i
~

(
(
(
~

A
A
A
A
V
V
i
1+i
%
DUR
V
i
~

(
(
(
~

A
A
A
A
V
V
i
1+i
%
Change in the Market Value of
Equity
Using the relationship:




We can define the change in the MVE as:



In our case:
AMVE = (-1.14) x [+0.01 / (1.1356)] x 1,000
= -$10.04
DUR
V
i
~

(
(
(
~

A
A
A
A
V
V
i
1+i
%
DUR
V
i
~

(
(
(
~

A
A
A
A
V
V
i
1+i
%
A
A
MVE DGAP
i
i
TA
earnassets
~
+

(
( )
( ) 1