COMMERCIAL

BANK MANAGEMENT

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 Commercial Bank Management

CHAPTER 3
TOOLS FOR MANAGING AND HEDGING AGAINST RISK

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Learning Objectives

• Asset, Liability, and Funds management

• Market rates and interest-rate risk

• Interest-sensitive gap management

• Duration gap management

• The Use of Derivatives: Financial Futures, Options, Swaps, and Other Hedging Tools

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Chapter 3: Tools for managing and hedging against risk

Risk management for changing interest rates: asset-liability management and

3.1
duration techniques
3.1.1 Asset, Liability, and Funds Management
3.1.2. Market Rates and Interest Rate Risk
3.1.3. Interest-Sensitive Gap Management
3.1.4. Duration Gap Management
Risk management: Financial Futures, Options, Swaps, and Other Hedging
3.2 Tools
3.2.1 Financial Futures Contracts
3.2.2. Interest-Rate Options
3.2.3. Interest-Rate Swaps
3.2.4. Caps, Floors, and Collars
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3.1 Risk management for changing interest
rates: asset-liability management and
duration techniques

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3.1.1 Asset-Liability Management Strategies

• Asset-Liability Management:
o Definition: coordinated and integrated decision making in managing asset and liability
portfolios
o Purpose: controlling a bank’s sensitivity to changes in market interest rates and limit its
losses in its net income or net worth.

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3.1.1 Asset-Liability Management Strategies

• Historical strategies of asset-liability management:

o Asset management strategy (control assets – allocating funds in loans and investments;
no control over liabilities – taking the funds as solely determined by the public)
o Liability management strategy (control liabilities by changing rates and other terms)

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3.1.1 Asset-Liability Management Strategies

• Funds management strategy:

o Control over the volume, mix, and return or cost of both assets and liabilities
o Control over assets coordinated with control over liabilities to maximize the spread
between revenues and costs and control risk exposure
o Revenues and costs arising from both sides of the balance sheet (i.e., from both asset and
liability accounts)

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3.1.1 Asset-Liability Management Strategies

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3.1.1 Asset-Liability Management Strategies

• Asset and Liability Management Committee (ALCO):

o Composing of key officers representing different departments
o Primary responsibility: interest rate risk management
o Coordinating the bank’s strategies to achieve the optimal risk/reward trade-off.

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3.1.2. Market Rates and Interest Rate Risk

• Forces Determining Interest Rates

• Banks - both supply and

demand for loanable funds
• Interest rates are
determined by the supply
& demand of the market
for loanable funds
• Interest rate risk: including
price risk & reinvestment
risk

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3.1.2. Market Rates and Interest Rate Risk

• The measurement of interest rates

o Yield to maturity

n
CFt
Market Price = å
t =1 (1 + YTM)
t

o Bank discount rate (DR)

𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 − 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑛 𝑙𝑜𝑎𝑛 𝑜𝑟 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 360

𝐷𝑅 = 𝑥
𝐹𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 𝑁𝑜 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦

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3.1.2. Market Rates and Interest Rate Risk

• The Components of Interest Rates:

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3.1.2. Market Rates and Interest Rate Risk

• Yield curves:
o Definition: Graphical picture of relationship between yields and maturities on securities
(at a single point in time, assuming ceteris paribus)

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3.1.2. Market Rates and Interest Rate Risk

• Yield curves:
o Shape of the yield curve
ü Upward – long-term rates higher than short-term rates (economic expansion)
ü Downward – short-term rates higher than long-term rates (economic recession)
ü Horizontal – short-term and long-term rates the same
o Shape of the yield curve and the maturity gap
ü Typical maturity gap of a bank: longer maturities of assets (loans & securities) than
liabilities (deposits)
ü Upward sloping yield curve benefits banks, generating positive net interest margin
ü Downward and horizontal yield curve put negative pressure in bank earnings

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3.1.2. Market Rates and Interest Rate Risk

• Interest rate risk: is the potential loss from unexpected changes in interest rates which
can significantly alter a bank’s profitability and market value of equity, including:
o Reinvestment risk: If interest rates change, the bank will have to reinvest the cash flows
from assets or refinance rolled-over liabilities at a different interest rate in the future.
o Price risk: If interest rates change, the market values of assets and liabilities also change.

è What is the risk for banks when interest increases/decreases?

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3.1.2. Market Rates and Interest Rate Risk

• Interest rate risk:

o Example:
A bank makes a $10,000 four-year car loan to a customer at fixed rate of 8.5%. The bank
initially funds the car loan with a one-year $10,000 CD at a cost of 4.5%. The bank’s initial
spread is 4%. What is the bank’s risk?

4 year Car Loan 8.50%

1 Year CD 4.50%
4.00%

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3.1.3 Interest-Sensitive Gap Management

• Goal of interest rate hedging: to insulate the bank from the damaging effects of
fluctuating interest rates on profits.
o Must concentrate on those interest-sensitive assets and liabilities
o To protect profits against adverse interest rate changes, management seeks to hold fixed
the net interest margin (NIM)

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3.1.3 Interest-Sensitive Gap Management

• Factors affecting NIM:

o Changes in the level of interest rates
o Changes in the spread between assets and liabilities
o Changes in the volume of interest-sensitive assets and liabilities
o Changes in the mix of interest-sensitive assets and liabilities

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3.1.3 Interest-Sensitive Gap Management

• Dollar interest-sensitive gap:

o Analysis of the maturities and repricing opportunities associated with interest-bearing
assets & interest-bearing liabilities
o Zero gap:

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3.1.3 Interest-Sensitive Gap Management

• Dollar interest-sensitive gap :

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3.1.3 Interest-Sensitive Gap Management

• Dollar interest-sensitive gap:

o A gap exits: the amount of repriceable assets is different from that of repriceable liabilities

Dollar
Interest-Sensitive Assets –
Interest-Sensitive Gap =
Interest Sensitive Liabilities
(IS Gap)

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3.1.3 Interest-Sensitive Gap Management

• Dollar interest-sensitive gap:

o Asset-sensitive bank: having positive gap

Ø If interest increases: NIM increases; if interest decreases: NIM decreases

Ø To reduce risk: increase RSL and decrease RSA

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3.1.3 Interest-Sensitive Gap Management

• Dollar interest-sensitive gap:

o Liability-sensitive bank: having negative gap

Ø If interest increases/decreases: how will NIM change?

Ø How to reduce risk?

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3.1.3 Interest-Sensitive Gap Management

• Dollar interest-sensitive gap:

Gap positions and the effect of interest rate changes on the bank:

o Asset-sensitive bank o Liability-sensitive bank

Ø Interest rates rise: NIM rises Ø Interest rates rise: NIM falls
Ø Interest rates fall: NIM falls Ø Interest rates fall: NIM rises

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3.1.3 Interest-Sensitive Gap Management

• Relative IS GAP ratio

Ø Relative IS GAP > 0: asset-sensitive bank

Ø Relative IS GAP < 0: liability-sensitive bank

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3.1.3 Interest-Sensitive Gap Management

• Interest Sensitivity Ratio (ISR): to compare the ratio of ISA to ISL

Ø ISR > 1: asset-sensitive bank

Ø ISR < 1: liability-sensitive bank

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3.1.3 Interest-Sensitive Gap Management

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3.1.3 Interest-Sensitive Gap Management

• Example:
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 1,000 8.0% $ 1,200 4.0%
Fixed rate $ 700 11.0% $ 440 6.0%
Non earning $ 300 $ 200
$ 1,840
Equity
$ 160
Total $ 2,000 $ 2,000

NII = (0.08 x 1000 + 0.11 x 700) - (0.04 x 1200 + 0.06 x 440)

NII = 157 - 74.4 = 82.6
NIM = 82.6 / 1700 = 4.86%
GAP = 1000 - 1200 = -200
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3.1.3 Interest-Sensitive Gap Management

• Can a bank with zero gap completely hedge its NIM?

o No as practically the interest rates attached to assets and liabilities are not perfectly
correlated in the real world
Ø E.g: Loan interest rates tend to lag behind interest rates on many money market
borrowings.
Ø So interest revenues often tend to grow more slowly than interest expenses during
economic expansions, while interest expenses tend to fall more rapidly than interest
revenues during economic downturns.

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3.1.3 Interest-Sensitive Gap Management

• Important decisions under gap management:

o Choose the time period during which NIM is to be managed
o Choose a target level, i.e. freezing or increasing NIM.
o If management wishes to increase the NIM, it must either develop a correct interest rate
forecast or find ways to reallocate earning assets and liabilities
o Determine the volume of interest-sensitive assets and liabilities it wants the financial firm to
hold

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3.1.3 Interest-Sensitive Gap Management

• Steps in gap analysis:

o Develop an interest rate forecast
o Select a series of “time buckets” or intervals for determining when assets and liabilities will
re-price
o Group assets and liabilities into these “buckets”
o Calculate the GAP for each “bucket ”
o Forecast the change in net interest income given an assumed change in interest rates

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3.1.3 Interest-Sensitive Gap Management

• Cumulative gap: The total difference in dollars RSA & RSL over a designated time period.
o E.g: RSA = $100m; RSL = $200m; subject to change each month over the next six months.
Cumulative gap =($100 million in RSA per month x 6) - ($200 million in RSL per month x 6)
= -$600 million.
o Suppose market interest rates suddenly rise by 1%, net interest income loss equals (+0.01) X
(-$600 million) = -$6 million

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3.1.3 Interest-Sensitive Gap Management

• Cumulative gap: Based on cumulative gap concept, we can calculate approximately how NII
will be affected by an interest rate change.

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3.1.3 Interest-Sensitive Gap Management

• Computer-based techniques and maturity buckets:

(Read textbook Example in Table 7-1 for more details)

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3.1.3 Interest-Sensitive Gap Management

• Aggressive interest-sensitive gap management:

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3.1.3 Interest-Sensitive Gap Management

• Aggressive interest-sensitive gap management:

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3.1.3 Interest-Sensitive Gap Management

• Defensive interest-sensitive gap management:

Set interest-sensitive GAP as close to zero as possible to reduce the expected volatility of NII

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3.1.3 Interest-Sensitive Gap Management

• Problems with interest-sensitive gap management:

o Interest paid on liabilities tend to move faster than interest earned on assets
o Interest rate attached to bank assets and liabilities do not move at the same speed as market
interest rates
o Point at which some assets and liabilities are re-priced is not easy to identify
o Not considering the impact of changing interest rates on equity position

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3.1.3 Interest-Sensitive Gap Management

Exercises:
1. Commerce National Bank reports interest-sensitive assets of $870 million and interest-
sensitive liabilities of $625 million during the coming month. Is the bank asset sensitive or
liability sensitive? What is likely to happen to the bank’s net interest margin if interest
rates rise? If they fall?
1. People’s Savings Bank , a thrift institutions, has a cumulative gap for the coming year of
+$135 million, and interest rates are expected to fall by two and a half percentage points.
Calculate the expected change in net interest income that this thrift institution might
experience. What will occur in net interest income if interest rates rise by one and a
quarter percentage points?

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3.1.4 Duration Gap Management

• Goal of interest rate hedging: protecting the bank from the damaging effects of
fluctuating interest rates on net worth (NW).

• As market interest rates change, the value of both assets and its liabilities will change,
resulting in a change in its NW:
o A rise in market rates of interest will cause the market value (price) of both fixed-rate
assets and liabilities to decline.
o The longer the maturity, the more the declination

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3.1.4 Duration Gap Management

• Duration (D):
o a value- and time-weighted measure of maturity that considers the timing of all cash
inflows & outflows
o In effect, duration measures the average time needed to recover the funds committed to
an investment
n n

t =
å (1 + YTM)
1
t * CFt
t å (1 + YTM)
t =1
t * CFt
t
D= =
n Current Market Value or Price
å (1 + YTM)
t =1
CFt
t

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3.1.4 Duration Gap Management

• Duration (D):
o Example: Suppose that a bank grants a loan to one of its customers for a term of five
years. The customer promises the bank an annual interest payment of 10 percent. The
face (par) value of the loan is $1,000, which is also its current market value (price). What
is this loan duration?

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3.1.4 Duration Gap Management

• Duration (D):
o Example:

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3.1.4 Duration Gap Management

• Duration (D):
o A bank with longer-duration assets than liabilities will suffer a greater decline in NW
when market interest rates rise (than a bank with short-term asset duration or matching
the duration of liabilities with assets)
o Equating asset and liability durations à immunize NW from interest rate risk.

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3.1.4 Duration Gap Management

• Price Sensitivity to Changes in Interest Rates and Duration:

o The % change in the market price of an asset/liability is equal to its duration times the
relative change in interest rates attached to that particular asset or liability:

DP Di
» -D*
P (1 + i)
o the interest-rate risk of financial instruments is directly proportional to their durations.
A financial instrument whose duration is 2 will be twice as risky (in terms of price
volatility) as one with a duration of 1.

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3.1.4 Duration Gap Management

• Price Sensitivity to Changes in Interest Rates and Duration:

o Example: a bond held by a savings institution with a duration of four years and a current
market value (price) of $1,000. Market interest rates attached to comparable bonds are
about 10% currently, but recent forecasts suggest that market rates may rise to 11
percent. If this forecast turns out to be correct, what percentage change will occur in the
bond’s market value?

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3.1.4 Duration Gap Management

• Dollar-weighted duration of asset portfolio:

n
D A = å w i * D Ai
i =1

wi = the dollar amount of the ith asset divided by total assets

DAi = the duration of the ith asset in the portfolio

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3.1.4 Duration Gap Management

• Dollar-weighted duration of liability portfolio:

n
D L = å w i * D Li
i =1
wi = the dollar amount of the ith liability divided by total assets
DAi = the duration of the ith liability in the portfolio

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3.1.4 Duration Gap Management

• Leverage adjusted duration gap:

TL
D = DA - DL *
TA
o TL = the total liabilities divided
o TA = the total assets
o The larger the leverage-adjusted duration gap, the more sensitive will be the net worth
to a change in interest rates

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3.1.4 Duration Gap Management

• Change in the value of a bank’s net worth:

é Di ù é Di ù
DNW = ê- D A * * Aú - ê- D L * * Lú
ë (1 + i) û ë (1 + i) û

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3.1.4 Duration Gap Management

• Change in the value of a bank’s net worth:

Example: A financial firm has an average duration in its assets of three years, an average
liability duration of two years, total liabilities of $100 million, and total assets of $120 million.
Interest rates were originally 10 percent, but suddenly they rise to 12 percent. What is the
impact on the bank’s NW?

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3.1.4 Duration Gap Management

• Change in the value of a bank’s net worth:

• Example: A financial firm has an average duration in its assets of three years, an average
liability duration of two years, total liabilities of $100 million, and total assets of $120
million. Interest rates were originally 10 percent, but suddenly they rise to 12 percent.
What is the impact on the bank’s NW?

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3.1.4 Duration Gap Management

• Impact of changing interest rates on a bank’s net worth:

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3.1.4 Duration Gap Management

• Aggressive duration gap management strategy:

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3.1.4 Duration Gap Management

• Defensive duration gap management strategy: zero leverage-adjusted duration gap

(portfolio immunization)

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3.1.4 Duration Gap Management

• Limitations of duration gap management

o Finding assets and liabilities of the same duration can be difficult
o Some assets and liabilities may have patterns of cash flows that are not well defined
o Customer prepayments may distort the expected cash flows in duration
o Customer defaults may distort the expected cash flows in duration
o Convexity can cause problems

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3.2. Risk management: Financial Futures,
Options, Swaps, and Other Hedging Tools

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3.2.1. Financial Futures Contracts

• Financial futures contract:

o Definition: an agreement reached today between a buyer and a seller that calls for
delivery of a particular security in exchange for cash at some future date.
o Purpose: shift the risk of interest-rate fluctuations from risk-averse investors, such as
banks and insurance companies, to speculators willing to accept and possibly profit from
such risks.

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3.2.1. Financial Futures Contracts

• The Short Hedge in Futures:

o Used when market interest rates are expected to rise à increased cost of borrowings
o Structured to create profits from futures transactions in order to offset losses
experienced on a bank’s balance sheet if interest rates do rise.
o The asset-liability manager will sell futures contracts calling for the future delivery of the
underlying securities, choosing contracts expiring around the time new borrowings will
occur (if the bank holds a fixed-rate loan or a bond).
o Later, as borrowings and loans approach maturity or securities are sold and before the
first futures contract matures, a like amount of futures contracts will be purchased on a
futures exchange.

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3.2.1. Financial Futures Contracts

• The Short Hedge in Futures:

o For instance, suppose the securities portfolio of a bank contains $10 million in 6 percent,
15-year bonds and market yields increase from 6 percent to 6.5 percent.
o The market value of these bonds decreases from $10 million to $9,525,452.07-a loss in
the cash market of $474,547.73.
o However, this loss will be approximately offset by a price gain on the futures contracts.
o Moreover, if the bank makes an offsetting sale and purchase of the same futures
contracts on a futures exchange, it then has no obligation either to deliver or to take
delivery of the securities named in the contracts (The clearinghouse that keeps records
for each futures exchange will simply cancel the two offsetting transactions)

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3.2.1. Financial Futures Contracts

• The Long Hedge in Futures:

o Used when market interest rates are expected to decline & cash inflow (e.g: new deposit)
is expected in the near future
o If management takes no action and the forecast turns out to be true, the financial
institution will suffer an opportunity loss (i.e., reduced potential earnings).
o Management can use a long hedge: Futures contracts can be purchased today and then
sold in like amount at approximately the same time deposits come flowing in.
o The result will be a profit on the futures contracts if interest rates do decline because
those contracts will rise in value.

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3.2.1. Financial Futures Contracts

• Using Long and Short Hedges to Protect Income and Value:

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3.2.1. Financial Futures Contracts

• Number of Futures Contracts Needed to cover risk exposure:

o The objective is to offset the loss in NW due to changes in market interest rates with
gains from trades in the futures market.

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3.2.1. Financial Futures Contracts

• Number of Futures Contracts Needed to cover risk exposure:

o Setting the change in NW equal to the change in the futures position value, we have:

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3.2.1. Financial Futures Contracts

• Number of Futures Contracts Needed to cover risk exposure:

o Example: a financial-services provider has an average asset duration of four years, an
average liability duration of two years, total assets of $500 million, and total liabilities of
$460 million at a given point in time. Suppose, too, that the firm plans to trade in
Treasury bond futures contracts. The T-bonds named in the futures contracts have a
duration of nine years, and the T-bonds' current price is $99,700 per $100,000 contract.
What is the number of futures contracts needed to cover risk exposure?

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3.2.1. Financial Futures Contracts

• Number of Futures Contracts Needed to cover risk exposure:

o Example: a financial-services provider has an average asset duration of four years, an
average liability duration of two years, total assets of $500 million, and total liabilities of
$460 million at a given point in time. Suppose, too, that the firm plans to trade in
Treasury bond futures contracts. The T-bonds named in the futures contracts have a
duration of nine years, and the T-bonds' current price is $99,700 per $100,000 contract.
What is the number of futures contracts needed to cover risk exposure?

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3.2.2. Interest-Rate Options

• The interest-rate options: grant a holder of securities the right to either

(1) place (put) those instruments with another investor at a prespecified exercise price
before the option expires; or
(2) take delivery of securities (call) from another investor at a prespecified price before
the option's expiration date.
• Option premium: the fee that the buyer must pay for the privilege of being able to put
securities to or call securities away from the option writer
• Exercise (strike) price: the price to put/call the security in the future, stated clearly in the
option contract

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3.2.2. Interest-Rate Options

• Using Options to Protect Income:

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3.2.2. Interest-Rate Options

• Using Options to Protect Income:

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3.2.2. Interest-Rate Options

• Using Options to Protect Income:

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3.2.2. Interest-Rate Options

• Using Options to Protect Income:

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3.2.3. Interest-Rate Swaps

• An interest-rate swap: a way to change a bank’s exposure to interest-rate fluctuations and

achieve lower borrowing costs
o E.g: converting from fixed to floating interest rates or from floating to fixed interest rates
and more closely match the maturities of their liabilities to the maturities of their assets.
o A bank can earns fee income (usually amounting to 0.25-0.5% of the amount involved)
for arranging a swap for a customer

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3.2.3. Interest-Rate Swaps

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3.2.3. Interest-Rate Swaps

• Using interest-rate swaps for asset-liability management:

Firm A: Firm B:

Short-term assets with Long-term assets with fixed

flexible yields SWAP rates of return

Long-term liabilities carrying Shorter-term liabilities

fixed interest rates

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3.2.3. Interest-Rate Swaps

• Why use interest-rate swaps?

o Retiring old debt and issuing new securities with more favorable characteristics can be
expensive and risky. New borrowing may have to take place in an environment of higher
interest rates.
o Underwriting costs, registration fees, time delays, and regulations often severely limit
how far any business firm can go in attempting to restructure its balance sheet.
o Swaps can be negotiated to cover virtually any period of time desired, though most fall
into the 3-year to 10-year range. They are also easy to carry out, usually negotiated and
agreed to over the telephone or via e-mail through a broker or dealer.

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3.2.4. Caps, Floors, and Collars

• Interest-rate caps:
o Protecting its holder against rising market interest rates.
o Borrowers are assured that lenders cannot increase loan rate above the cap interest rate
by paying an upfront premium/fee.
o Alternatively, the borrower may purchase an interest-rate cap from a third party who
promises to reimburse borrowers for any additional interest beyond the cap.

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3.2.4. Caps, Floors, and Collars

• Interest-rate caps:
o Typical conditions when a bank buy interest-rate caps:
Ø When it has fixed-rate assets with floating-rate liabilities
Ø When it possesses longer-term assets than liabilities
Ø When it holds a large portfolio of bonds that will drop in value when market interest
rates rise.

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3.2.4. Caps, Floors, and Collars

• Interest-rate floors:
o Guaranteeing minimum rate of return for lenders/investors, used in periods of falling
interest rates
o Banks use interest-rate floors most often when their liabilities have longer maturities
than their assets or when they are funding floating-rate assets with fixed-rate debts.

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3.2.4. Caps, Floors, and Collars

• Interest-rate collars:
o An agreement combining a rate floor and a rate cap
o E.g: a customer who has just received a $100 million loan may ask the lender for a collar
on the loan's prime rate between 11 percent and 7 percent. In this instance, the lender
will pay its customer's added interest cost if prime rises above 11 percent, while the
customer reimburses the lender if prime drops below 7 percent.
o In effect, the collar's purchaser pays a premium for a rate cap while receiving a premium
for accepting a rate floor.

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 Q&A session
Thank you for listening!

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