Assets and liabilities management

Mismatching
A bank with mismatched assets and liabilities can be badly hurt by
unexpected interest rate changes. In the 80s, many Savings & Loan
associations went bankrupt owing to rates increases: since they had
borrowed short and lent long, both their income and their net worth had
become negative.
Banks use the gap and the duration analyses to respectively evaluate
(not necessarily to eliminate) their exposure to income and to capital
risks.
Gap analysis estimates the net effect on income of interest rate changes
(parallel shifts). Income risk is two forged: there is a reinvestment risk
when assets mature before liabilities (ex. when a bank has financed a 6
months T-bill by issuing a 1 year fixed rate CD: when, after 6 months, it
cashes the T-bill, it may be unable to reinvest the proceeds at a
profitable rate. Please note that it is not unusual for a bank to finance a
5-years floating rate loan by issuing a 3-years fixed rate bond: also in
this case it is exposed to a reinvestment risk). There is also a
refinancing risk when liabilities mature before assets (ex. when a bank
has financed a 1 year fixed rate asset by issuing a 6 months CD: when
the liability will mature, the bank has to refinance its position by issuing
another 6 months CD. But, if interest rates have increased, the bank will
have to pay a higher rate).
For the Gap analysis all items, on both sides of the balance sheet, are
classified into two categories: rate-sensitive and fixed-rate (nonsensitive).
1

ASSETS
Rate-sensitive: RSA
(variable-rate

loans

LIABILITIES
Rate-sensitive:RSL
and

bonds; bills and short-term

(variable-rate deposits;
40 short-term or variable-rate

securities)
Fixed-rate: NSA

securities)
Fixed-rate: NSL

(fixed-rate loans; fixed-rate

(fixed-rate loans; fixed-rate

long-term bonds; reserves)

60 long-term bonds; net worth)

30

70

Gap = RSA RSL = 40 30 = 10 million

The (annual) income will change by the size of the gap multiplied by the
size of the interest rates change: if the rates increase by 2% (200 basis
points), the annual income will increase by: 2%(10 million) = 200,000
euro.
GAP>0 The bank is asset sensitive: it benefits from interest rate
increases and suffers from decreases.
GAP<0 The bank is liability sensitive: it gains when rates decrease
and loses when they increase.

A positive gap (asset sensitive bank) is an implicit bet that interest rates
will increase; a negative one (liability sensitive bank) that they will fall.
When the gap is zero, the bank has no exposure to income risk: a
change in interest rates will not change the banks income. The relation
for the expected change in interest margin is given by:
E IM GapE i
2

 Gap ratio: defined as RSA/RSL is frequently utilised to evaluate the

time-path of a bank Gap or to make comparisons with the Gap of other
banks.
To reduce the gap to zero, the bank of the ex. can sell 10 mln of shortterm assets and buy 10 mln of long-term assets. Alternatively, it can
operate in derivatives , both symmetric and asymmetric. In the first case,
it can buy futures or it can sell interest rate swaps or FRAs in order to
transform 10 mln of its floating rate assets into fixed rate assets, as we
shall show later on. The case of asymmetric instruments will be
considered at the end of the course.

Duration analysis
Estimates the effect on the banks net worth (capital gains and losses) of
an interest rate change (parallel shifts).
ASSETS
Rate-sensitive
Fixed-rate

LIABILITIES
40 Rate-sensitive
Fixed-rate
*Zero coupon 5 years (83

*Reserves
*Zero coupon 20 years (233

10 mln, market value at 6%)

mln, market value at 8%)

Total

50 *Net worth
100 Total

30

62
8
100

After a 200 bp increase in interest rates, we have:

ASSETS
Rate-sensitive
Fixed-rate

LIABILITIES
Rate-sensitive
Fixed-rate
*Zero coupon 5 years (83

40

mln, market value at 8%) 56,46

*Reserves
10
*Zero coupon 20 years (233
mln, market value at 10%)
Total

30

34,64 *Net worth

84,64 Total

-1,82
84,64

 The bank is bankrupt, notwithstanding its advantage of 0.2 mln in

interest income. The cause is a very large mismatching between assets
and liabilities duration:
DA
DL

Assets average duration 0 40 / 100 0 10 / 100 20 50 / 100 10

Liabilities average duration 0 30 / 92 5 62 / 92 3.4
DG

Duration gap

DA

L
92
D L 10
3.4 6.87
A
100

1st approximation:Duration gap

L

NW1 D A DL Ai DG Ai

For an increase of 200 bp, DG gives an estimation of NW1 = 13.74 mln:

a poor approximation since the actual fall is 9.82 mln.
2nd approximation: Modified duration gap
DA
L DL

Ai MDG Ai
1 iA A 1 iL

NW2

For MDG = 6.30, we have: NW2 = 12.6 mln.

3rd approximation: Modified duration gap and convexity gap

with:

CA

50
C 20
100

1
L
2
NW3 MDA Ai C A C L A i

2
A
1
2
MDG Ai C G A i
2
10% 180.04 ;

CL

62
C 5
92

8% 17.93 ,

we have: NW3 =

9.45 mln: a not too bad approximation.

Of course, all the approximations are better for smaller changes in
interest rates. For i= 0.01, we obtain: NW1 = 6.87, NW2 = 6.30,
NW3 = 5.51 as against an actual fall of 5.61 mln.
A positive DG is an implicit bet that interest rates will fall; a negative
one that they will rise. To obtain DG = 0, in order to cover much of the
capital risk, the bank can:

1. sell 34.35 mln of its zeros and buy short-term bills, so as to have DA =
20(15.65) = 0.92DL;
2. sell futures as we shall show later on;
3. buy swaps, becoming a fixed rate payer and floating rate receiver, as we
shall show later on;
4. buy FRAs, as we shall show later on.
5. take positions in asymmetric derivatives (options) as we shall see
towards the end of the course.

Hedging the interest margin with futures

To fully protect the interest margin (i.e. to reduce the Gap

to zero), the following relation should hold:
IM F

where
Now:

is the cash flow generated by the futures position.

F DF N F PF Fn i

where D is the modified duration of the underlying of the

futures. For parallel shifts the hedging relation is:
F

Gapi DF N F PF Fn i

Hence we have:
NF

Gap
DF PF F n

as we have already seen. Note that the numerator is Gap,

while before we had: DS PS Sn . But now the amount to cover is
Gap instead of PS Sn and DS 1 because we are considering
the annual change in the banks income.

Banks hedging against capital risk with futures

A positive DG is an implicit bet that interest rates will fall;

a negative one that they will rise. A bank can protect its
net worth by using futures, i.e. selling futures when it has
a DG>0 and buying futures when it has a DG<0 for a
number of contracts as indicated by the following
formula:
DG A
D F PF Fn

NF

as can be proved in this way: there is a full cover of the

capital risk if NW F i.e. if the change in the net worth of
the banks balance sheet is equal to the change of the
futures value with the sign changed. If we consider NW
(the same applies also to the other approximations), in the
case of parallel shifts, we can write:
1

DG Ai DF N F PF Fn i

from which the result follows.