Chapter Seven

Risk Management for Changing

Interest Rates: Asset-Liability
Management and Duration Techniques
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 7-2

Key Topics
• Asset, Liability, and Funds Management
• Market Rates and Interest-Rate Risk
• The Goals of Interest-Rate Hedging
• Interest-Sensitive Gap Management
• Duration Gap Management
• Limitations of Hedging Techniques

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Asset-Liability Management

The Purpose of Asset-Liability

Management is to Control a Bank’s
Sensitivity to Changes in Market
Interest Rates and Limit its Losses in
its Net Income or Equity

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Historical View of Asset-Liability

Management
• Asset Management Strategy (control
over assets, no control over liabilities)
• Liability Management Strategy (control
over liabilities by changing rates and
other terms)
• Funds Management Strategy (work
with both strategies)

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Interest Rate Risk

• Price Risk
▫ When Interest Rates Rise, the Market Value
of the Bond or Asset Falls
• Reinvestment Risk
▫ When Interest Rates Fall, the Coupon
Payments on the Bond are Reinvested at
Lower Rates

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Interest Rate Risk: One of the Main

Challenges
• Forces Determining Interest Rates
▫ Loanable Funds Theory

• The Measurement of Interest Rates

▫ YTM
▫ Bank Discount

• Components of Interest Rates

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Yield to Maturity (YTM)

CFt n
Market Price   t
t 1 (1  YTM)

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Bank Discount Rate (DR)

FV - Purchase Price 360

DR  *
FV # Days to Maturity

Where: FV equals Face Value of a Security,

such as Treasury Bills
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Market Interest Rates

Function of:
• Risk-Free Real Rate of Interest
• Various Risk Premiums
▫ Default Risk
▫ Inflation Risk
▫ Liquidity Risk
▫ Call Risk
▫ Maturity Risk

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Yield Curves
• Graphical Picture of Relationship Between
Yields and Maturities on Securities
• Generally Created With Treasury Securities
to Keep Default Risk Constant
• Shape of the Yield Curve
▫ Upward – Long-Term Rates Higher than Short-
Term Rates
▫ Downward – Short-Term Rates Higher than Long-
Term Rates
▫ Horizontal – Short-Term and Long-Term Rates
the Same
• Shape of the Yield Curve and a Maturity Gap
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Net Interest Margin

Interest Income - Interest Expenses

NIM 
Total Earnings Assets

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Goal of Interest Rate Hedging

One Important Goal of Interest Rate

Hedging is to Insulate the Bank from
the Damaging Effects of Fluctuating
Interest Rates on Profits

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Quick Quiz
• What forces cause interest rates to change?
• What makes it so difficult to correctly forecast
interest rate changes?
• What is the yield curve, and why is it important
to know about its shape and slope?
• What is the goal of hedging?
• First National Bank of Bannerville has posted interest
revenues of $63 million and interest costs from all of its
borrowings of $42 million. If this bank possesses $700
million in total earning assets, what is First National’s
net interest margin? Suppose the bank’s interest
revenues and interest costs double, while its earning
assets increase by 50%. What will happen to its net
interest margin?
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Interest-Sensitive Gap Measurements

Dollar Interest- Interest-Sensitive Assets –

Sensitive Gap = Interest Sensitive Liabilities

Relative
Dollar IS Gap
Interest- 
Sensitive Gap Bank Size

Interest Interest Sensitive Assets

Sensitivity 
Interest Sensitive Liabilities
Ratio
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Examples of Repriceable (Interest

Sensitive) Assets and Liabilities

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Asset-Sensitive Bank Has:

• Positive Dollar Interest-Sensitive Gap

• Positive Relative Interest-Sensitive Gap

• Interest Sensitivity Ratio Greater Than

One

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Liability Sensitive Bank Has:

• Negative Dollar Interest-Sensitive Gap

• Negative Relative Interest-Sensitive

Gap

• Interest Sensitivity Ratio Less Than

One
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Computer-Based Techniques and

Maturity Buckets

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Gap Positions and the Effect of

Interest Rate Changes on the Bank

• Asset-Sensitive • Liability-
Bank Sensitive Bank
▫ Interest Rates Rise ▫ Interest Rates Rise
 NIM Rises  NIM Falls
▫ Interest Rates Fall ▫ Interest Rates Fall
 NIM Falls  NIM Rises

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Zero Interest-Sensitive Gap

• Dollar Interest-Sensitive Gap is Zero

• Relative Interest-Sensitive Gap is Zero
• Interest Sensitivity Ratio is One
▫ When Interest Rates Change in Either
Direction - NIM is Protected and Will Not
Change

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Important Decision Regarding IS Gap

• Management Must Choose the Time Period

Over Which NIM is to be Managed
• Management Must Choose a Target NIM
• To Increase NIM Management Must Either:
▫ Develop Correct Interest Rate Forecast
▫ Reallocate Assets and Liabilities to Increase
Spread
• Management Must Choose Volume of
Interest-Sensitive Assets and Liabilities

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NIM Influenced By:

• Changes in Interest Rates Up or Down

• Changes in the Spread Between Assets and
Liabilities
• Changes in the Volume of Interest-Sensitive
Assets and Liabilities
• Changes in the Mix of Assets and Liabilities

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Cumulative Gap

The Total Difference in Dollars

Between Those Bank Assets and
Liabilities Which Can be Repriced over
a Designated Time Period

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Aggressive Interest-Sensitive Gap

Management

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Problems with Interest-Sensitive Gap

Management
• Interest Paid on Liabilities Tend to Move Faster
than Interest Rates Earned on Assets

• Interest Rate Attached to Bank Assets and

Liabilities Do Not Move at the Same Speed as
Market Interest Rates

• Point at Which Some Assets and Liabilities are

Repriced is Not Easy to Identify

• Interest-Sensitive Gap Does Not Consider the

Impact of Changing Interest Rates on Equity
Position
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Quick Quiz
• 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?

• 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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 7-27

The Concept of Duration

Duration is the Weighted Average

Maturity of a Promised Stream of
Future Cash Flows

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To Calculate the Instrument’s Duration

n n

 (1  YTM) t * CFt
t  (1  YTM) t * CFt
t
D  t 1  t 1
n Current Market Value or Price
 (1  YTM)
t 1
CFt
t

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Price Sensitivity of a Security

P i
 -D*
P (1  i)

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Convexity

The Rate of Change in an Asset’s Price

or Value Varies with the Level of
Interest Rates or Yields

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Dollar-Weighted Duration of Asset

Portfolio
n
D A   w i * D Ai
i 1

Where:
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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Dollar-Weighted Duration of a Liability

Portfolio
n
D L   w i * D Li
i 1

Where:
wi = the dollar amount of the ith liability divided by total liabilities
DLi = the duration of the ith liability in the portfolio
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Duration Gap

TL
D  DA - DL *
TA

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Change in the Value of a Bank’s Net

Worth

 i   i 
NW  - D A * * A  - - D L * * L
 (1  i)   (1  i) 

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Impact of Changing Interest Rates on a

Bank’s Net Worth

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Limitations of Duration Gap Management

• Finding Assets and Liabilities of the Same
Duration Can be Difficult
• Some Assets and Liabilities May Have
Patterns of Cash Flows that are Not Well
Defined
• Customer Prepayments May Distort the
Expected Cash Flows in Duration
• Customer Defaults May Distort the Expected
Cash Flows in Duration
• Convexity Can Cause Problems

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Quick Quiz
• What is duration? How is a financial
institution’s duration gap determined?
• What are the advantages of using duration as
opposed to interest-sensitive gap analysis?
• Suppose that a thrift institution has an average
asset duration of 2.5 years and an average
liability duration of 3.0 years. If the thrift holds
total assets of $560 million and total liabilities
of $467 million, does it have a significant
leverage-adjusted duration gap? If interest
rates rise, what will happen to the value of its
net worth?
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