Managing Interest Rate

Risk: Economic Value

of Equity

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Managing Interest Rate Risk:
Economic Value of Equity
 Economic Value of Equity (EVE)
Analysis
 Focuses on changes in stockholders’
equity given potential changes in
interest rates

2
Managing Interest Rate Risk:
Economic Value of Equity
 Duration GAP Analysis
 Compares the price sensitivity of a
bank’s total assets with the price
sensitivity of its total liabilities to
assess the impact of potential changes
in interest rates on stockholders’
equity

3
Managing Interest Rate Risk:
Economic Value of Equity
 GAP and Earnings Sensitivity versus
Duration GAP and EVE Sensitivity

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Managing Interest Rate Risk:
Economic Value of Equity
 Recall from Chapter 6
 Duration is a measure of the effective
maturity of a security
 Duration incorporates the timing and

size of a security’s cash flows

 Duration measures how price sensitive

a security is to changes in interest

rates
 The greater (shorter) the duration, the
greater (lesser) the price sensitivity
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Managing Interest Rate Risk:
Economic Value of Equity
 Market Value Accounting Issues
 EVEsensitivity analysis is linked with the debate
concerning whether market value accounting is
appropriate for financial institutions
 Recently many large commercial and investment
banks reported large write-downs of mortgage-
related assets, which depleted their capital
 Some managers argued that the write-downs far

exceeded the true decline in value of the assets

and because banks did not need to sell the assets
they should not be forced to recognize the “paper”
losses

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7
Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Analysis
 Compares the price sensitivity of a
bank’s total assets with the price
sensitivity of its total liabilities to
assess whether the market value of
assets or liabilities changes more
when rates change

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Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Macaulay’s Duration (D)
 Cashflow t 
 t 
(1  i ) t
D  t 
n

 P* 
 

where P* is the initial price, i is the

market interest rate, and t is equal to
the time until the cash payment is made
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Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Macaulay’s Duration (D)
 Macaulay’s duration is a measure of
price sensitivity where P refers to the
price of the underlying security:
ΔP D
  Δi
P (1  i)

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Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Modified Duration
 Indicates how much the price of a
security will change in percentage
terms for a given change in interest
rates
Modified Duration = D/(1+i)

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Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Example
 Assume that a ten-year zero coupon
bond has a par value of $10,000,
current price of $7,835.26, and a market
rate of interest of 5%. What is the
expected change in the bond’s price if
interest rates fall by 25 basis points?

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Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Example
 Since the bond is a zero-coupon bond,
Macaulay’s Duration equals the time to
maturity, 10 years. With a market rate
of interest, the Modified Duration is
10/(1.05) = 9.524 years. If rates change
by 0.25% (.0025), the bond’s price will
change by approximately 9.524 × .0025
× $7,835.26 = $186.56 13
Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Effective Duration
 Used to estimate a security’s price
sensitivity when the security contains
embedded options
 Compares a security’s estimated price

in a falling and rising rate environment

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Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and Effective Duration
 Effective Duration

Pi- - Pi
Effective Duration 
P0 (i  - i - )

where: Pi- = Price if rates fall

Pi+ = Price if rates rise
P0 = Initial (current) price
i+ = Initial market rate plus the increase in the rate
i- = Initial market rate minus the decrease in the rate
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Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and Effective
Duration
 Effective Duration
 Example
 Consider a 3-year, 9.4 percent semi-annual
coupon bond selling for $10,000 par to yield 9.4
percent to maturity
 Macaulay’s Duration for the option-free version
of this bond is 5.36 semiannual periods, or 2.68
years
 The Modified Duration of this bond is 5.12
semiannual periods or 2.56 years
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Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Effective Duration
 Example
 Assume that the bond is callable at par in
the near-term .
 If rates fall, the price will not rise much
above the par value since it will likely
be called
 If rates rise, the bond is unlikely to be
called and the price will fall
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Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Effective Duration
 Example
 If rates rise 30 basis points to 5%
semiannually, the price will fall to
$9,847.72.
 If rates fall 30 basis points to 4.4%
semiannually, the price will remain at par

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Measuring Interest Rate Risk with
Duration GAP
 Duration, Modified Duration, and
Effective Duration
 Effective Duration
 Example

$10,000 - $9,847.72
Effective Duration   2.54
$10,000(0.05 - 0.044)

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Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model
 Focuses on managing the market value
of stockholders’ equity
 The bank can protect EITHER the

market value of equity or net interest

income, but not both
 Duration GAP analysis emphasizes the

impact on equity and focuses on price

sensitivity

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Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model
 Steps in Duration GAP Analysis
 Forecast interest rates

 Estimate the market values of bank assets,

liabilities and stockholders’ equity

 Estimate the weighted average duration of assets

and the weighted average duration of liabilities

 Incorporate the effects of both on- and off-balance sheet
items. These estimates are used to calculate duration
gap
 Forecasts changes in the market value of
stockholders’ equity across different interest rate
environments
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Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model
 Weighted Average Duration of Bank
Assets (DA):
n
DA   w i Da i
i
where
 wi = Market value of asset i divided by
the market value of all bank assets
 Da = Macaulay’s duration of asset i
i
 n = number of different bank assets
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Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model
 Weighted Average Duration of Bank
Liabilities (DL):
m
DL   z jDl j
j
where
 zj = Market value of liability j divided by
the market value of all bank liabilities
 Dl = Macaulay’s duration of liability j
j
 m = number of different bank liabilities
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Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model
 Let MVA and MVL equal the market values
of assets and liabilities, respectively
 If ΔEVE = ΔMVA – ΔMVL
and
 Duration GAP = DGAP = DA –
(MVL/MVA)DL
then
 ΔEVE = -DGAP[Δy/(1+y)]MVA
where y is the interest rate
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Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model
 To protect the economic value of
equity against any change when rates
change , the bank could set the
duration gap to zero:
 y 
ΔEVE  - DGAP   MVA
 (1  y) 

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Measuring Interest Rate Risk with
Duration GAP
 Duration GAP Model
 DGAP as a Measure of Risk
 The sign and size of DGAP provide information
about whether rising or falling rates are
beneficial or harmful and how much risk the
bank is taking
 If DGAP is positive, an increase in rates will lower
EVE, while a decrease in rates will increase EVE
 If DGAP is negative, an increase in rates will
increase EVE, while a decrease in rates will lower
EVE
 The closer DGAP is to zero, the smaller is the
potential change in EVE for any change in rates
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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks

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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 Implications of DGAP
 The value of DGAP at 1.42 years indicates

that the bank has a substantial mismatch in

average durations of assets and liabilities
 Since the DGAP is positive, the market value

of assets will change more than the market

value of liabilities if all rates change by
comparable amounts
 In this example, an increase in rates will cause a
decrease in EVE, while a decrease in rates will
cause an increase in EVE
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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 Implications of DGAP > 0
 A positive DGAP indicates that assets are more price
sensitive than liabilities
 When interest rates rise (fall), assets will fall
proportionately more (less) in value than liabilities
and EVE will fall (rise) accordingly.
 Implications of DGAP < 0
 A negative DGAP indicates that liabilities are
more price sensitive than assets
 When interest rates rise (fall), assets will fall
proportionately less (more) in value that liabilities
and the EVE will rise (fall)
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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks

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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 Duration GAP Summary

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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 DGAP As a Measure of Risk
 DGAP measures can be used to

approximate the expected change in

economic value of equity for a given
change in interest rates
y
ΔEVE  - DGAP[ ]MVA
(1  y)

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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 DGAP As a Measure of Risk
 In this case:

.01
ΔEVE  - 1.42[ ]$1,000  $12.91
1.10

 The actual decrease, as shown in

Exhibit 8.3, was $12

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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 An Immunized Portfolio
 To immunize the EVE from rate changes in the

example, the bank would need to:

 decrease the asset duration by 1.42 years
or
 increase the duration of liabilities by 1.54 years
DA/( MVA/MVL)
= 1.42/($920/$1,000)
= 1.54 years
or
 a combination of both
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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks

35
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 An Immunized Portfolio
 With a 1% increase in rates, the EVE

did not change with the immunized

portfolio versus $12.0 when the
portfolio was not immunized

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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 An Immunized Portfolio
 If DGAP > 0, reduce interest rate risk by:

 shortening asset durations

 Buy short-term securities and sell long-term
securities
 Make floating-rate loans and sell fixed-rate loans
 lengthening liability durations
 Issue longer-term CDs
 Borrow via longer-term FHLB advances
 Obtain more core transactions accounts from
stable sources

37
Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 An Immunized Portfolio
 If DGAP < 0, reduce interest rate risk by:
 lengthening asset durations
 Sell short-term securities and buy long-term
securities
 Sell floating-rate loans and make fixed-rate loans
 Buy securities without call options
 shortening liability durations
 Issue shorter-term CDs
 Borrow via shorter-term FHLB advances
 Use short-term purchased liability funding from
federal funds and repurchase agreements
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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 Banks may choose to target variables
other than the market value of equity in
managing interest rate risk
 Many banks are interested in
stabilizing the book value of net
interest income
 This can be done for a one-year time

horizon, with the appropriate duration

gap measure
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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 DGAP* = MVRSA(1 − DRSA) − MVRSL(1 − DRSL)
 where
 MVRSA = cumulative market value of rate-
sensitive assets (RSAs)
 MVRSL = cumulative market value of rate-

sensitive liabilities (RSLs)

 DRSA = composite duration of RSAs for the

given time horizon

 DRSL = composite duration of RSLs for the given

time horizon

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Measuring Interest Rate Risk with
Duration GAP
 A Duration Application for Banks
 DGAP* > 0
 Net interest income will decrease (increase)

when interest rates decrease (increase)

 DGAP* < 0
 Net interest income will decrease (increase)

when interest rates increase (decrease)

 DGAP* = 0
 Interest rate risk eliminated

 A major point is that duration analysis can be used to

stabilize a number of different variables reflecting
bank performance
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Economic Value of Equity
Sensitivity Analysis
 Involves the comparison of changes in
the Economic Value of Equity (EVE)
across different interest rate
environments
 An important component of EVE
sensitivity analysis is allowing different
rates to change by different amounts
and incorporating projections of when
embedded customer options will be
exercised and what their values will be
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Economic Value of Equity
Sensitivity Analysis
 Estimating the timing of cash flows
and subsequent durations of assets
and liabilities is complicated by:
 Prepayments that exceed (fall short of)
those expected
 A bond being
 A deposit that is withdrawn early or a
deposit that is not withdrawn as
expected
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Economic Value of Equity
Sensitivity Analysis
 EVE Sensitivity Analysis: An Example
 First Savings Bank
 Average duration of assets equals 2.6

years
 Market value of assets equals

$1,001,963,000
 Average duration of liabilities equals 2

years
 Market value of liabilities equals

$919,400,000
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45
Economic Value of Equity
Sensitivity Analysis
 EVE Sensitivity Analysis: An Example
 First Savings Bank
 Duration Gap
 2.6 – ($919,400,000/$1,001,963,000) × 2.0 = 0.765 years
 Example:
 A 1% increase in rates would reduce EVE by $7.2
million
 ΔMVE = -DGAP[Δy/(1+y)]MVA
 ΔMVE = -0.765 (0.01/1.0693) × $1,001,963,000
= -$7,168,257
 Recall that the average rate on assets is 6.93%
 The estimate of -$7,168,257 ignores the impact of
interest rates on embedded options and the effective
duration of assets and liabilities 46
Economic Value of Equity
Sensitivity Analysis
 EVE Sensitivity Analysis: An Example

47
Economic Value of Equity
Sensitivity Analysis
 EVE Sensitivity Analysis: An Example
 First Savings Bank
 The previous slide shows that FSB’s EVE

will fall by $8.2 million if rates are rise by

1%
 This differs from the estimate of -$7,168,257
because this sensitivity analysis takes into
account the embedded options on loans and
deposits
 For example, with an increase in interest rates,
depositors may withdraw a CD before maturity
to reinvest the funds at a higher interest rate
48
Economic Value of Equity
Sensitivity Analysis
 EVE Sensitivity Analysis: An Example
 First Savings Bank
 Effective “Duration” of Equity

 Recall, duration measures the percentage

change in market value for a given change
in interest rates
 A bank’s duration of equity measures
the percentage change in EVE that will
occur with a 1 percent change in rates:
 Effective duration of equity = $8,200 /
$82,563 = 9.9 years
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Earnings Sensitivity Analysis
versus EVE Sensitivity Analysis
 Strengths and Weaknesses: DGAP and
EVE-Sensitivity Analysis
 Strengths
 Duration analysis provides a
comprehensive measure of interest rate risk
 Duration measures are additive

 This allows for the matching of total assets with

total liabilities rather than the matching of
individual accounts
 Duration analysis takes a longer term view
than static gap analysis
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Earnings Sensitivity Analysis
versus EVE Sensitivity Analysis
 Strengths and Weaknesses: DGAP and EVE-
Sensitivity Analysis
 Weaknesses
 It is difficult to compute duration accurately
 “Correct” duration analysis requires that each

future cash flow be discounted by a distinct

discount rate
 A bank must continuously monitor and adjust the

duration of its portfolio

 It is difficult to estimate the duration on assets

and liabilities that do not earn or pay interest

 Duration measures are highly subjective

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A Critique of Strategies for Managing
Earnings and EVE Sensitivity
 GAP and DGAP Management
Strategies
 Itis difficult to actively vary GAP or
DGAP and consistently win
 Interest rates forecasts are frequently
wrong
 Even if rates change as predicted,
banks have limited flexibility in
changing GAP and DGAP
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A Critique of Strategies for Managing
Earnings and EVE Sensitivity
 Interest Rate Risk: An Example
 Consider the case where a bank has
two alternatives for funding $1,000 for
two years
 A 2-year security yielding 6 percent

 Two consecutive 1-year securities, with

the current 1-year yield equal to 5.5

percent
 It is not known today what a 1-year
security will yield in one year
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A Critique of Strategies for Managing
Earnings and EVE Sensitivity
 Interest Rate Risk: An Example
 Consider the case where a bank has
two alternative for funding $1,000 for
two years
0 1 2
Two-Year Security

$60 $60
0 1 2
One-Year Security & then
another One-Year Security

$55 ?

54
A Critique of Strategies for Managing
Earnings and EVE Sensitivity
 Interest Rate Risk: An Example
 Consider the case where a bank has two
alternative for funding $1,000 for two
years
 For the two consecutive 1-year securities

to generate the same $120 in interest,

ignoring compounding, the 1-year security
must yield 6.5% one year from the present
 This break-even rate is a 1-year forward rate of
:
 6% + 6% = 5.5% + x so x must = 6.5%
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A Critique of Strategies for Managing
Earnings and EVE Sensitivity
 Interest Rate Risk: An Example
 Consider the case where a bank has two
alternative for investing $1,000 for two years
 By investing in the 1-year security, a

depositor is betting that the 1-year interest

rate in one year will be greater than 6.5%
 By issuing the 2-year security, the bank is

betting that the 1-year interest rate in one year

will be greater than 6.5%
 By choosing one or the other, the depositor and
the bank “place a bet” that the actual rate in one
year will differ from the forward rate of 6.5 percent
56
Yield Curve Strategies
 When the U.S. economy hits its peak, the
yield curve typically inverts, with short-
term rates exceeding long-term rates.
 Only twice since WWII has a recession
not followed an inverted yield curve
 As the economy contracts, the Federal
Reserve typically increases the money
supply, which causes rates to fall and the
yield curve to return to its “normal”
shape.
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Yield Curve Strategies
 To take advantage of this trend, when the
yield curve inverts, banks could:
 Buy long-term non-callable securities
 Prices will rise as rates fall
 Make fixed-rate non-callable loans
 Borrowers are locked into higher rates
 Pricedeposits on a floating-rate basis
 Follow strategies to become more liability
sensitive and/or lengthen the duration of
assets versus the duration of liabilities
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59
Managing Interest Rate
Risk: Economic Value
of Equity

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