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 bank¶s profitability and market value of equity.

Interest Rate (Percent)
20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1980 1981 1982

Figure 8-1
Fed Funds 10-Year Treasury

1983

1984

1985

1986 1987 1988 1989 Monthly Average Rates

1990

1991

1992

1993

1994

Longer maturity (duration) -. impact on market value of equity. => Duration GAP. .> larger change in value for a given change in interest rates. => Funding GAP. Price Risk Change in interest rates will cause a change in the value (price) of assets and liabilities.Interest Rate Risk   Reinvestment rate risk . impact on NII.Cost of funds vrs return on assets.

.Funding GAP: Focus on managing NII in the short run. 0-3 months..$ Value or RSLt where t = time bucket.g.  Method € Group assets and liabilities into time "buckets" according to when they mature or re-price. € Calculate GAP for each time bucket € Funding GAPt = $ Value RSAt . e.

 Changes in the level of i-rates. Change in the composition of assets and liab.)    Changes in the volume of assets and liab.Factors Affecting NII. . Changes in the relationship between asset yields and liab. cost of funds.  (NII = (GAP) * ((iexp.

3 / 850 GAP = 500 (0.3 Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities Cost Rate sensitive 500 8.3 = 4.08x500+0.5 NIM = 41.04x600+0.06x220) 37.0% Fixed rate 350 11.11x350) 78.0% 220 6.2 = 41.0% 600 4.Exhibit 8.86% 600 = -100 .0% Non earning 150 100 920 Equity 80 Total 1000 1000 NII = (0.

Increase in RSAs and decrease in RSL¶s   RSA = 540.5%   Proportionate doubling in size.Exhibit 8. .   RSA increase to 8.4   1% increase in the level of all short-term rates. fixed rate = 260. 1% decrease in spread between assets yields and interest cost.5% RSL increase to 5. fixed rate = 310 RSL = 560.

09x500+0.06x220) 43.0% Fixed rate 350 11.0% 220 6.3 = 4.11x350) 83.0% 600 5.0% Non earning 150 100 920 Equity 80 Total 1000 1000 NII = (0.2 = 40.5 NIM = 40.74% 600 = -100 .3 / 850 GAP = 500 (0.1% Increase in Short-Term Rates Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities Cost Rate sensitive 500 9.05x600+0.

0% 220 6.8 / 850 GAP = 500 (0.09% 600 = -100 .085x500+0.1% Decrease in Spread Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities Cost Rate sensitive 500 8.5% 600 5.06x220) 46.0% Non earning 150 100 920 Equity 80 Total 1000 1000 NII = (0.2 = 34.11x350) 81 NIM = 34.8 = 4.5% Fixed rate 350 11.055x600+0.

4 = 82.Proportionate Doubling in Size Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities Cost Rate sensitive 1000 8.6 / 1700 GAP = 1000 (0.86% 1200 = -200 .0% 1200 4.04x1200+0.0% Fixed rate 700 11.08x1000+0.6 = 4.0% Non earning 300 200 1840 Equity 160 Total 2000 2000 NII = (0.11x700) 157 NIM = 82.0% 440 6.06x440) 74.

0% Fixed rate 310 11.04x560+0.0% 260 6.0% 560 4.3 NIM = 39.Increase in RSAs and Decrease in RSLs Expected Balance Sheet for Hypothetical Bank Assets Yield Liabilities Cost Rate sensitive 540 8.11x310) 77.08x540+0.3 = 4.62% 560 = -20 .0% Non earning 150 100 920 Equity 80 Total 1000 1000 NII = (0.06x260) 38 = 39.3 / 850 GAP = 540 (0.

Measures the timing of potential income effects from interest rate changes. Measures aggregate interest rate risk over the entire period.5: .Rate Sensitivity Reports  Periodic GAP   Gap for each time bucket. Sum of periodic GAP's.  Cumulative GAP    Examine Exhibit 8.

9 9.8 1.5 1.5 0.2 13.4 -14.7 5.4 4.7 1 2.5 1 7 21.9 7.4 3 6 -23.2 6.8 .9 13.9 13.S.9 6.3 3.8 9 9 5.7 15 10 10 9 35 14.6 27.3 Time Frame for Rate Sensitivity 8-30 31-90 91-180 181-365 > 1 yr Not RS Total 0.4 -29.2 0.2 7.000 0.7 4.3 6.9 1.3 GAP Periodic GAP -16 Cumulative GAP -16 2 4 5.9 FF purchased NOW Savings DD Other liabilities Equity Total Liab & Eq.9 8. Treasury MM Inv Municipals FF & Repo's Comm loans Install loans Cash Other assets Total Assets 1-7 5 1 0.3 Super NOW 2.7 9.6 15.Assets U.9 4.9 CD's > 100.5 6 9 -7 18 -8 -15 24.5 1 7 100 Liabilities and Equity MMDA 17.8 30.1 12.6 11.8 2.8 3 0.6 1.2 2.5 5 13.6 1.5 42.3 1.7 100 17. 22.6 1.6 1.5 1.000 1.2 19.2 CD's < 100.2 1.3 2.7 3.9 0 9.

2. Calculate interest income for the period Int Inc. Method: 1.Break Even Analysis   Focus on repriceable assets and calculate a break-even yield required to maintain stable NII after a rate change. Calculate funding GAP for the period. Calculate NII. 3. Calculate repriceable assets and liab. = rRSA x (n/365) x $RSA 4. 5. for the desired period. . Calculate interest expense for the period.

Calculate required interest income = 5. 6. Calculate NII. Int exp. = rRSL forcasted x (n/365) x $RSL 7. Calculate new interest expense on RSL that rolled over.) + 6. on new money = rnew money x (n/365) x $amt of new money 8.) 9.) + 7.Break Even Analysis (Cont. . Calculate interest expense on "new money" Int exp. Calculate break even asset yield for the use of new money.) Forecast Break-Even yield on assets 5.

000) 246.10% 28.141x(30/360) 220.) Annualized Average Rate $ amount 21.321 9.30% 8.000 9.3mx0.973 =28.70% 250.742x(30/365) = 21300000+1000000(1-0.874 250.Calculate Break Even Asset Yield Rollover of RSA and RSL's Rates Unchanged Repriceable assets Repriceable liabilities GAP Interest income (next 30 days) Interest expense (next 30days) Net interest return Break Even Analysis (Cont.300.742 13.000.3mx0. on existing RSL -2.548 10.000 14.50% (7.00% Int exp on new money 1.00 mill Target net spread on repriceables Required interest income Break even asset yield (annualied) 216.874 Forecasted Break-even Yield on Assets "New" Int exp.300.03) .40% 25.095x(30/360) 25.847 =21.

Speculating on the GAP. Only limited flexibility in adjusting the GAP. Requires accurate interest rate forecast on a consistent basis. .   (NII = (GAP) * (( iexp) Speculating on the GAP 1. Usually only look short term. 4. No adjustment for timing of cash flows or dynamics of the changing GAP position. customers and depositors. 3. 5. 2. Difficult to vary the GAP and win.

Duration GAP    Focus on managing NII or the market value of equity. Asset duration > Liability duration ointerest rates pMarket value of equity falls . recognizing the timing of cash flows Interest rate risk is measured by comparing the weighted average duration of assets with liab.

years. 1000 + int |------------------------------|---------------------------| 0 10 20 900+int 100 + int |---|--------------------------|---------------------------| 900 principal in 1 year.) 1000 loan. 2.) 1000 loan. principal + interest paid in 20 years. 100 principal in 20 .  Duration vrs maturity 1.

Larger coupon smaller change in price for a given change in i-rates. .Duration Approximate measure of the market value of interest elasticity « (V » ¬ V ¼ %(V DUR $ ¬ $ (i ¼ (i ¬ ¼ ­1+i ½  Price (value) changes   Longer maturity/duration larger changes in price for a given change in i-rates.

10% coupon. § (1 + r) t t =1 n Examples: 1000 face value. 3 year. 12% YTM .Calculate Duration n C t (t) C t (t) § (1 + r) t § (1 + r) t DUR = t =1 ! t =1 n Ct PV of theSec.

12) = 2. 3 year. 1 2 3 1 2 3 3 2597.12) (1.Calculate Duration D n n Ctt(t) Ctt(t) § (1 + r)tt § (1 + r)tt t=1 t=1 = t=1 ! t=1 n n Ctt P of the Sec.12)3 (1.12) t=1 t=1 t t + 3 (1.12)3 .73 years D ! 12% YTM ! 3 3 100 1000 951. § (1 + r)tt t=1 t=1 n n Examples: 1000 * 3 100 * 3 100 * 1 100 * 2 + + 1000 face+value. 10% coupon.6 (1.12) (1.96 § (1.

05)3 (1.05)3 (1.31 D! 1136.16 2. 10% coupon.16 3127.05)2 D! 1136. 5% YTM 1000 * 3 100 * 3 100 * 1 100 * 2 + + + 1 2 3 3 (1. 3 year.05)1 (1.If YTM = 5% 1000 face value.75 years .

20% YTM 2131.68 years .95 D! 789. 3 year.35 2.If YTM = 20% 1000 face value. 10% coupon.

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

12)3 D! 1000 3 (1. 0% coupon. 3 year.If YTM = 12% and Coupon = 0 1000 face value.12)3 = 3 by definition . 12% YTM 1000 |-------|-------|-------| 0 1000 * 3 2 1 3 3 (1.

  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. hence HPR falls. . If you sell the security prior to maturity then the price or value falls . 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.Relate Two Types of Interest Rate Risk   Reinvestment rate risk Price risk.   If i-rate oYTM from reinvestment of the cash flows o and holding period return (HPR) increases.

but not both. .u x DL. whereDA = weighted average duration of assets.Duration GAP at the Bank   The bank can protect either the market value of equity (MVE) or the book value of NII. To protect the MVE the bank would set DGAP to zero: DGAP = DA . DL = weighted average duration of liabs.

00% Treasury bond 200 12.56% 12. YTM Market Value 100 Dur.65 5.43% 520 400 920 0 920 80 1000 1. Assets Cash 100 Earning assets Commercial loan 700 14.05 520 9.00% 10.49 2. Tot.00% 13.00% 400 10.8 click for ot er examples Par Years $1.00% 9.20% 700 200 900 0 1000 2.00 3.43% 9.1 Exhibit 8. Time deposit Certificate of deposit Tot.000 % Coup Mat.00% 12. bearing Total liabilities Total equity Total liabs & equity 3 9 14. Int Bearing Liabs.00% Total Earning Assets 900 Non-cash earning assets 0 Total assets 1000 Liabilities Interest bearing liabs.00% 920 0 920 80 1000 1 4 9.08 .97 3. non-int.

14)3 12.20% 700 200 900 0 1000 2.00% 12.00% 9 Total Earning Assets 98900 98 v 1 v 1 98 v 3  Non-cash earning assets 02  1 (1.56% 700 v 3 (1. bearing Total liabilities Total equity Total liabs & equity  14. Time deposit Certificate of deposit Tot.08 . non-int.14) (11000 (1.43% 520 400 920 0 920 80 1000 1.97 3. Int Bearing Liabs.14) Total dur ! assets Liabilities Interest bearing liabs.8 Par Years $1.05 700 520 9. Tot.000 % Coup Mat.49 2.1 Exhibit 8.00% 13.00% 10.65 5.00% 920 0 920 80 1000 1 4 9. YTM Market Value 100 Dur. Assets Cash 100 Earning assets Commercial loan 700 14.00% 9.00% 400 10.43% 9.00 3.14)3 .00% 3 Treasury bond 200 12.

.Calculating DGAP   In exhibit 8.48 = 2.00 + (400 / 920) * 3.65 + (200 / 1000) * 5.(920 / 1000) * 2.8: DA = (700 / 1000) * 2.97 = 3.06 = 1.14 mean? The average duration of assets > liabilities.00 . hence asset values change by more than liability values.05 DA = (520 / 920) * 1.08 DGAP = 3.14 years What does 1.

24 .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.

00% 400 10. YTM Market Value 100 Dur. Time deposit Certificate of deposit Tot.00% 14.89 3.43% 515.86 70.64 5.9 Par Years $1.02 189.06 .43% 10. Tot.891 973.00% 10.00% Total Earning Assets 900 Non-cash earning assets 0 Total assets 1000 Liabilities Interest bearing liabs. bearing Total liabilities Total equity Total liabs & equity Exhibit 8.75 0 973.27 387.57% 13.59 902.86 0 902.00% 13. Int Bearing Liabs.1 Assets Cash 100 Earning assets Commercial loan 700 14.48 2.75 1.00% Treasury bond 200 12.07% 684. 3 9 15.74 873.00 520 9.000 % Coup Mat.75 2.00 3.00% 920 0 920 80 1000 1 4 10.00% 11. non-int.

00 (1.00% 400 10.00% 14.1 Assets Cash 100 Earning assets Commercial loan 700 14.02 189.06 . 3 9 15.15)3 1 4 10. YTM Market Value 100 Dur.43% 515.64 5.15)t t!1  684.07% PV ! § Liabilities Interest bearing liabs.75 0 973.9 Par Years $1.75 2.00 3.00% Total Earning Assets 900 Non-cash earning assets 0 3 98 1000 700 Total assets Exhibit 8.891 973.00% 11.000 % Coup Mat.00% 13.48 520 9.74 873.86 70.00% Treasury bond 200 12.59 902.27 387. bearing Total liabilities Total equity Total liabs & equity (1. Tot.00% 10. Int Bearing Liabs.43% 10.89 3. Time deposit Certificate of deposit Tot.75 1.00% 920 0 920 80 1000 2. non-int.86 0 902.57% 13.

06 = 1.09 years What does 1.09 mean? The average duration of assets > liabilities.48 = 2.9: DA = (684 / 974) * 2. hence asset values change by more than liability values.00 + (387 / 903) * 3.(903 / 974) * 2.89 = 3.Calculating DGAP   In exhibit 8.00 DA = (515 / 903) * 1.64 + (189 / 974) * 5. .00 .06 DGAP = 3.

Change in the Market Value of Equity  Using the relationship: « (V » ¬ V ¼ %(V DUR $ ¬ $ (i ¼ (i ¬ ¼ 1+i ½ ­ .

000 = -$10.04 .1356)] x 1.14) x [+0.01 / (1.Change in the Market Value of Equity  Using the relationship: « (V » ¬ V ¼ %(V DUR $ ¬ $ (i ¼ (i ¬ ¼ ­1+i ½  We can define the change in (i MVE as: the » « (MVE $ ( DGAP ) v ¬ ­ (1  iear ¼ v TA assets ) ½  In our case: (MVE = (-1.

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