AFW 3651 Treasury Management

Question 1
Part (i) Periodic GAP = Individual bucket rate sensitive assets Individual bucket rate sensitive liabilities It is the GAP for each time bucket and measures the timing if potential income effects from interest rate changes.

Part (ii) Cumulative GAP = Period Gap + Previous cumulative GAP It is the sum of the periodic GAPs and measures the aggregate interest rate risk over the entire period. It is important since it directly measures a banks net interest sensitivity throughout the time interval.

Table 1: Summarizes the calculation of periodic gap and cumulative gap

Description Up to 1 mth Total Assets Total Liabilities (i) Periodic GAP (ii)Cumulative GAP 276.95 515.02 -238.07 -238.07 >1 mth3mths 1401.13 601.56 799.57 561.5 >3 mth6mth 51.4 197.96 -146.56 414.94 >6 mth1yr 95.57 495.21 -399.64 15.3 >1yr2yr 169.22 27.67 141.55 156.85 469.3 4.04 465.26 622.11 428.44 15.01 413.43 1035.54 >2yr3yr >3yr5yr >10yr15yr 133.74 0 133.74 1169.28 0.05 0 0.05 1169.33 >15 yr

(Refer to Appendix 1.0)

AFW 3651 Treasury Management

Part (iii) Ratio of GAP to 1 year earning assets:

= = 0.00506

(Refer to Appendix 1.1)

Therefore the ratio of GAP to 1 year earning assets is 0.00506

Part (iv) One year cumulative GAP to Earning Asset Ratio: ( )( )

( (

)(

) )

37.5 %

Thus, the one year cumulative GAP to earnings ratio will be 37.5%

AFW 3651 Treasury Management

Part (v) Periodic GAP figures simply indicate whether more assets or liabilities can be re priced within a specific time interval. RSLs exceed RSAs for the time interval up to 1 month while RSAs exceed RSLs for the time interval greater than 1 month. However, since periodic GAP ignores whether assets and liabilities in other periods can be re priced, it is hardly significant. Cumulative gap on the other hand is a direct measure of the banks net interest sensitivity through the last day of the time bucket. Thus, the cumulative GAP of RM 156.85 indicates that bank AZ can re price RM 156.85m or more of rate-sensitive assets than rate-sensitive liabilities during the next one year.

The bank has a negative cumulative for just the first period with the remainder being positive through 15 years. In other words, there is just RSL for the first period of one month and from that point onwards they are more RSA than RSL. This suggests that the bank has positioned itself to gain in the long term if interest rates fall over the next 15 years. Specifically, if rates falls uniformly during the 15 years, the banks net interest income would increase unless offset by changes in portfolio mix or bank size because interest income should fall less than interest expense.

AFW 3651 Treasury Management

According to the frame work, commercial bank needs to have the following time bucket:

Table 1 Maturity buckets for commercial banks

Commercial banks Up to 1 week 1 week to 1 month 1 to 3 months 3 to 6 months 6 months to 1 year More than 1 year The banks assets and liabilities bucket is not in compliance with the framework. The compliance requirement for specific Islamic banking institutions and commercial bank is that their net compliance surplus should be positive for the first two maturity buckets specified as follows: Maturity bucket Up to 1 week 1 week to 1 month 3% 5% Compliance requirement

The first bucket is already in negative so it does not fit the requirement. The cumulative gap through 1 month is 5.2%. / of total assets. Hence, suggesting that it is slightly

out of the required rate of 5% stated by the Bank Negara Malaysia Maturity bucket Up to 1 week 1 week to 1 month Compliance requirement 3% 5%

AFW 3651 Treasury Management

Part (vi) The ALCO should make sure their balance sheet is in compliance with the framework to avoid legal difficulties. It needs to allocate another bucket for assets and liabilities up to one week and change the up to one month time bucket to a between one we ek to one month time bucket.

After this, the ALCO must ensure that the cumulative GAP for the first two periods is positive. In order to do this, the ALCO can increase the amount of RSA, reduce the amount of RSL or apply both approaches together.

If the bank is expecting the interest rate to increase in the future in certain period, they should position their gap in that period to be positive. This will leads to more volume of RSA reprising upwards (which means more profitable) than the volume of RSL reprising upwards (which means more expensive liabilities). If the bank if expecting a decrease in future interest rate, then they should adopt the negative gap strategy.

AFW 3651 Treasury Management

Question 2
Part (i) Weighted average duration of rate sensitive assets a) Floating rate loan cash flow is 1380 * 0.08 = 110.4 Duration =

/ 1380

= 2.78 years b) Fixed rate loan cash flow is 134 * 0.06 = 8.04 Duration =

/ 134

= 4.47 years c) Corporate bond cash flow is 1159 * 0.05 = 57.95 Duration =

/ 1159

= 4.55 years d) Malaysian Government Securities cash flow is 76 * 0.04 = 3.04 Duration =

/ 76

= 2.89 years e) Commercial paper cash flow is 16 * 0.045 = 0.72 Duration =

/ 16

= 2.87 years f) Placements cash flow is 261 * 0.035 = 9.135 Duration =

/ 261

= 1 year

AFW 3651 Treasury Management

DA = DA = ($1380/$4518) x 2.78 years + ($134/$4518) x 4.47 years + ($1159/$4518) x 4.55 years + ($76/$4518) x 2.89 years + ($16/$4518) x 2.87 years + ($261/$4518) x 1 year DA = 2.27 years Part (ii) Weighted average duration of rate sensitive liabilities a) Money market instrument cash flow is 802 * 0.0325 = 26.07 Duration =

/ 802

= 1 year b) Fixed deposit cash flow is 1054 * 0.041 = 43.214 Duration =

/ 1054

= 1.96 years DL = DL = ($802/$3840) x 1 year + ($1054/$3840) x 1.96 years DL = 0.75 year

Part (iii) Expected economic net interest income = ($1380 x 0.08) + (134 x 0.06) + (1159 x 0.05) + (76 x 0.04) + (16 x 0.045) + (261 x 0.035) (802 x 0.0325) + (1054 x 0.041) + (1086 x 0.0175) = RM 101.01m

AFW 3651 Treasury Management

Part (iv) DGAP = DGAP = 2.27 years ($3840/$4518) 0.75 year DGAP = 1.633 years

Part (v) The above calculations give us an overview of the banks sensitivity towards interest rate risk. Interest rate risk is evidenced by the mismatch in average duration of assets and liabilities and the duration gap of 1.633 years. The weighted average duration of assets 2.27 years exceeds the weighted average duration of liabilities 0.75 year by more than one year. This replicates that the market value of assets will change more than the market value of liabilities if interest rates change by comparable amounts. The positive DGAP reflects the fact that value of assets will fall more than the value of liabilities if interest rates increase. Expected net interest income will also fall since bank will pay higher rates on liabilities.

Part (vi) Bank management can use duration measures to evaluate interest rate risk. The greater the value of DGAP, greater is the interest rate risk. So the ALCO should try to reduce the value of DGAP as much as possible because a perfectly hedged bank has a DGAP value of zero. The bank can reduce its average duration of assets by increasing their rate sensitivity either by purchasing assets of shorter maturity or by converting fixed rate loans into adjustable rate loans. To eliminate the interest rate risk, the ALCO can either shorten its asset duration by 1.633 years or by increasing the duration of the liabilities. With these adjustments made, the bank would be less affected by interest rate swings.

AFW 3651 Treasury Management

QUESTION 3:

Assets

Maturity years

Amount

Rate %

Liability and Capital

Money Market Inst Fixed Deposits Savings deposit Borrowings Government Grants Other liabilities Equity

Maturity years
1

Amount

Rate %

Floating Rate loan Fixed rate loan Corporate bonds Malaysian Govt Sec Commercial papers Placements Other investments Cash Fixed assets Non- rate sensitive Total

$1344.4361

794.2324

4.25

5 5 3 3 1

128.3554 1108.8214 73.8909 15.5602 258.4783 593

7 6 5 5.5 4.5

1,034.1490 1,086.00

5.1 2.75

307 112 479 609.1609

87 417

395 4,421.5423

4,421.5423

(i) Calculation of each Rate Sensitive Asset Duration:

ASSETS Floating Rate Loan Fixed Rate Loan Corporate Bonds Malaysian Govt.Sec. Commercial Papers Placements

Amount ($)
1344.4361

Rate 0.09 0.07 0.06 0.05 0.055

Cash Flow ($) [Amount x Rate] 120.9996 8.9849 66.5293 3.6945 0.8558 11.6315

128.3554 1108.8214 73.8909

15.5602

258.4783 0.045 Table 3.2: New Cash Flow of RSAs 9

AFW 3651 Treasury Management

(Refer to Appendix 3.0) Using Macaulays Duration Formula:

D=

( (

( ) ) )

( ) )

) ( )

Fixed Rate Loan =

= 4.387211256 yrs = 4.3872 yrs

. . /

Corporate Bond =

= 4.3711 yrs

ASSETS Floating Rate Loan Fixed Rate Loan Corporate Bonds Malaysian Govt.Sec. Commercial Papers Placements

Duration (years) 2.76 4.39 4.37 2.86 2.85 1

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AFW 3651 Treasury Management

Weighted Average Duration of Rate Sensitive Assets:

DA=

DA= {

++{ + 2 3

+ *

* +

++{

= 2.1787 yrs Therefore Changes in DA = 2.1787 yrs 2.2652 yrs = - 0.0865 yrs

(ii) Calculation of each Rate Sensitive Liabilities Duration: LIABILITIES Money Market Instr. Fixed Deposits Amount ($) Rate Cash Flow ($) [Amount x Rate] 33.754877 52.741599

794.2324 1034.149

0.0425 0.051

Using Macaulays Duration Formula:

D=

( (

( ) ) )

( ) )

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AFW 3651 Treasury Management

( ) ( ) ( )

Fixed Deposits =

= 1.951474786 yrs = 1.951475 yrs

LIABILITIES

Duration (years)

Money Market Instr. 1 Fixed Deposits 1.96 Table 3.5: Durations of RSLs following 1% increase in interest rates

Weighted Average Duration Liabilities:

DL=
DL= { = 0.737688081 yrs = 0.73769 yrs Therefore, Changes in DL = 0.73769 yrs 0.74700 yrs = -0.00931 yrs

(iii) Expected Economic Net Interest Income =, ( ( ) ), ( ( ) ) ( ( ) ) ( ( ) )( )

=RM 212.695291m RM 116.361476m = RM 96.333815m Therefore Changes in Expected Economic Net Interest Income= RM 96.334m RM 101.001m = -RM 4.667m

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AFW 3651 Treasury Management

(iv) Duration GAP = DA (MVL/MVA) DL = 2.1787 (3812.3814/4421.5423) (0.7377) = 1.566233766 yrs = 1.5426 yrs

Therefore, Changes in Duration GAP = 1.5426 yrs 1.6302 yrs = -0.0876 yrs

(v)

in Market Value of Assets = RM 4421.5423m RM 4518m = -RM 96.4577m = -RM 96.46m in Market Value of Liabilities = RM 3812.3814m RM 3840m = -RM 27.6186m = -RM 27.62m in Equity ( EVE) = MVA - MVL = -RM 96.46m - RM 27.62M = -RM 68.84m

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AFW 3651 Treasury Management

Alternatively: We can use the following formula to calculate the change in equity

EVE = -DGAP 0

Average Earning Asset Yield = 0. . / ( )1 = 0.04189575 = 4.1896%

Therefore,

EVE = -1.6333 0

1(

= -RM 70.812m

(vi) The average duration of assets exceeded the weighted average duration of liabilities and hence, causing a positive GAP. Following a rise in market rates by 1%, the result was that the fall in the market value of assets was greater than the fall in the market value of liabilities. It caused a fall in the market value of equity by RM 68.84m. Consequently, the Expected Economic Net Interest Income also decreased by RM 4.667m which means that bank will pay higher rates on liabilities as compared to the higher yields it receives on reinvested cash inflows over the lifetime of the securities. Thus, this shows deterioration in banks operating position.

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AFW 3651 Treasury Management

Question 4

The GAP and Duration GAP analysis have numerous motives as to why they are used and both are tools that help companies compare actual performance with potential performance. Nevertheless, both the models have certain shortcomings which are illustrated in the following parts. The major attraction of GAP analysis is that it is easy to compute and comprehend. Nonetheless, this model has several inadequacies. The first weakness of the GAP procedure is the ex post measurement errors (MacDonald & Koch, 2006). This error arises because of the instability of base rates or indexes which banks use as benchmark to determine their loan rate. It does not reflect the historical frequency of base rate changes. Therefore, GAP analysis portrays errors in allocating loans differently than actual rate changes would require if there is uncertainty over the changes in base rates. Furthermore, GAP analysis ignores time value of money. Even though assets are allocated into different maturity buckets, it does not distinguish the cash flow received at the beginning of the period and at the end of the period. Thirdly, simple gap analysis which is based on contractual term to maturity assumes that the timing and amount of assets and liabilities maturing within a specific period gap are fixed and determined. It ignores the effects of principal and interest cash flows arising from honouring customer withdrawals on credit commitments, deposit redemptions, and prepayments, either on mortgages or term loans, as well as the timing of maturities within the gap period. Depending on the interest rate environment, the mix of assets and liabilities (both on- and offbalance sheet), and the exercise of credit and deposit options by customers, these deficiencies may represent a significant interest rate risk to an institution. Duration Gap analysis relates the price sensitivity of a banks total assets with the price sensitivity of its total liabilities to assess the impact of potential changes in interest rates on the economic value of equity. Duration is the weighted average of the time until the expected cash flows from a security will be received relative to the securit ys price. The greater the duration of a given security in a bank balance sheet, the greater is the price sensitivity to changes in interest rates. One of the disadvantages of this analysis is that unlike the GAP analysis, it is difficult to compute and requires subjective assumptions, sophisticated data and also needs to be updated on a timely basis. Thus, in order for the Duration GAP (DGAP) to be meaningful, the forecast must be accurate. Another disadvantage is the complexity of calculations for DGAP analysis. This is part due to the reason that the future rates do not accurately predict future interest rate. However, when calculating DGAP the future cash flow is used thus making it harder to compute as the nonparallel shifts in yield curve have to also be considered. Furthermore, because the duration changes with the interest rates, a bank must continuously monitor and adjust the duration. The duration also changes as the time factor decreases, hence, it requires constant rebalancing. Also, due to the fact that duration of nonearning or non-rate-sensitive assets and liabilities is difficult to estimate, the bank must estimate the true rate sensitivity of demand deposits to estimate its duration.
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AFW 3651 Treasury Management

In short, calculation of duration is too subjective. It requires constant adjustment with the banks portfolio in order to adjust the duration gap. This is sometimes not practical for firms with simple balance sheet where the amount affected is not significant.

Limitations in using duration analysis arise from the fact that matching the average term or duration of asset and liability cash flows does not eliminate all interest rate risk. Thus, this duration analysis should be used along with additional interest rate risk measures of cash flow mismatch and cash flow dispersion. These additional measurement techniques are essential if the institution is to control interest rate risks that cannot be summarised adequately in a single risk measure.

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AFW 3651 Treasury Management

Reference List
MacDonald, S., & Koch, T. (2006). Management of Banking. South-Western.

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AFW 3651 Treasury Management

Appendix 1.0

Table 1: AZ Bank Assets and Liabilities in Buckets (RM Million)

Descriptions ASSETS Loans and Financing Commercial Floating rate Fixed rate Non Performing loan Concessionary loan Performing loan Non- performing loan Investment Corporate bond Malaysian Govt Securities Commercial papers Share in CIMB Placement Other Investment Cash Fixed assets Total Assets LIABILITIES Money market instruments Fixed deposits Savings Borrowings Government Grant Shareholder's fund Other liabilities Total liabilities Periodic Gap 515.02 - 238.07 601.56 799.57 197.96 -146.56 495.21 -399.64 27.67 141.55 4.04 465.26 15.01 413.43 0 133.74 0 0.05 276.95 1,401.13 51.4 95.57 169.22 469.3 428.44 133.74 0.05 260.82 15.02 5 50.02 90.36 130.63 10.11 14.95 416 351.91 36.6 100.23 29.78 0 1.11 1,380.20 0.98 1.38 5.21 28.48 53.3 39.93 3.73 0.05 Up to 1 mth > 1 mth 3 mths > 3 mth 6 mth >6 mth 1 yr > 1 yr - 2 yr > 2yr 3yr > 3yr 5 yr > 10 yr - 15 yr > 15 yr

283.21 231.81

332.61 268.95

51.98 145.98

134.51 360.7 27.67 4.04 15.01

Periodic Gap Cumulative Gap

- 238.07

799.57

-146.56

-399.64

141.55

465.26

413.43

133.74

0.05

-238.07

561.5

414.94

15.3

156.85

622.11

1035.54

1169.28

1169.33

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AFW 3651 Treasury Management

Appendix 1.1 Total Earning Assets = 1380.2 + 134.17+1159.17+76.49+14.95+260.82 = RM3025.80m

Appendix 2.0 ( The other type of calculation)

Assets Floating Rate Loan Calculation ( ) ( ) ( ) ( ) ) ( ( Corporate Bonds ( ) ( ) ) ( ( ) ) ( Commercial Papers ( ( ( ( ( ( ) ) ( ) ) ) ) ( ( ( ( ) ( ( ( ) ) ( Fixed Rate Loan ( ( ) ( ) ) ( ) ( ( ) ) ( ( ) ( ) ( ) ( ) ( ) ) )( ) ) ) ( ( ( ) 1.00year Placement ( ( ) ) ( ( ( ( ) ) ) ( ) ) ) ) ( ( ( ) ( ) ) ) ( ) ) ( Malaysian Government Securities ( ) )( ) ) )( ) ) 2.87 years ( ) 2.89 years ( ( ( ( ( ( ) ) ) )( ) 4.55 years ) ) ( ( ) ) )( ) 4.47 years )( ) Duration 2.78 years

Liabilities Money Market Instrument

Fixed Deposit

Calculation ( )( ) ( ) ( ) ( ) ( ) ( ( ) ( ( ( ) (

Duration 1 year

) )

)( ) )

1.96 years

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AFW 3651 Treasury Management

Appendix 3.0
Assets Floating Rate Loan Calculation ( ( Fixed Rate Loan ( ) ( Corporate Bonds ( ) ( Malaysian Government Securities Commercial Papers ( ( ( ( ( ( ( ( ) ) ) ) ) ) ) ( ( ) ( ( ) ) ) ( ) ( ) ) ( ( ( ) 1 year ) ) ( ( ) ) ( ( ( ) ) ( ) ) 2.85 years ( ( ) ) ) ) ( ( ( ( ) ( ( ( ) ) ) ) ( ) ) ( ( ( ( ) ) ) ) ( ) ( ) 2.86 years ( ( ) ( ( ) ) ( ) ) 4.47 years ( ) ) 4.38 years ) ( ) ) Duration 2.76 years

Placement

Liabilities Money Market Instrument

Calculation ( ) ( ) ( ) ( ) ( ( ) ) ( ( ( ) ) ( ) )

Duration 1 year

Fixed Deposit

1.95years

20