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Asset - Liability MGT

The document discusses asset-liability management techniques used by banks to control interest rate risk. It defines key concepts like interest rate sensitivity, yield curves, net interest margin, and interest rate gaps. It also introduces the concepts of duration and convexity as improved measures of interest rate risk and explains how duration gaps can impact a bank's net worth under different interest rate scenarios.

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Muhammad Umar Farooq
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45 views32 pages

Asset - Liability MGT

The document discusses asset-liability management techniques used by banks to control interest rate risk. It defines key concepts like interest rate sensitivity, yield curves, net interest margin, and interest rate gaps. It also introduces the concepts of duration and convexity as improved measures of interest rate risk and explains how duration gaps can impact a bank's net worth under different interest rate scenarios.

Uploaded by

Muhammad Umar Farooq
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Chapter Seven

Asset-Liability Management:
Determining and Measuring
Interest Rates and Duration
Gaps
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
Historical View of Asset-Liability
Management

• Asset Management Strategy


• Liability Management Strategy
• Funds Management Strategy
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
Yield to Maturity (YTM)

n
CFt
Market Price  
t 1 (1  YTM)
t
Bank Discount Rate (DR)

FV - Purchase Price 360


DR  *
FV # Days to Maturity

Where: FV equals Face Value


Market Interest Rates

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

Interest Income - Interest Expenses


NIM 
Total Earnings Assets
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
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 
Ratio
Interest Sensitive Liabilities
Interest-Sensitive Assets

• Short-Term Securities Issued by the


Government and Private Borrowers
• Short-Term Loans Made by the Bank
to Borrowing Customers
• Variable-Rate Loans Made by the
Bank to Borrowing Customers
Interest-Sensitive Liabilities

• Borrowings from Money Markets


• Short-Term Savings Accounts
• Money-Market Deposits
• Variable-Rate Deposits
Asset-Sensitive Bank Has:

• Positive Dollar Interest-Sensitive Gap


• Positive Relative Interest-Sensitive
Gap
• Interest Sensitivity Ratio Greater
Than One
Liability Sensitive Bank Has:

• Negative Dollar Interest-Sensitive


Gap
• Negative Relative Interest-Sensitive
Gap
• Interest Sensitivity Ratio Less Than
One
Gap Positions and the Effect of
Interest Rate Changes on the Bank

• Asset-Sensitive • Liability-Sensitive
Bank Bank
– Interest Rates Rise – Interest Rates Rise
• NIM Rises • NIM Falls
– Interest Rates Fall – Interest Rates Fall
• NIM Falls • NIM Rises
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
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
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
Cumulative Gap

The Total Difference in Dollars


Between Those Bank Assets and
Liabilities Which Can be Repriced
over a Designated Time Period
Aggressive Interest-Sensitive Gap
Management
Expected Change Best Interest- Aggressive
in Interest Rates Sensitive Gap Management’s
Position Likely Action
Rising Market Positive IS Gap Increase in IS
Interest Rates Assets
Decrease in IS
Liabilities
Falling Market Negative IS Gap Decrease in IS
Interest Rates Assets
Increase in IS
Liabilities
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
The Concept of Duration

Duration is the Weighted Average


Maturity of a Promised Stream of
Future Cash Flows
To Calculate Duration

n
t * CFt
t 1 (1  YTM)
t
D n
CFt
t 1 (1  YTM)
t
Price Sensitivity of a Security

P i
 -D*
P (1  i)
Convexity

The Rate of Change in an Asset’s


Price or Value Varies with the Level
of Interest Rates or Yields
Duration of an 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
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
Duration Gap

TL
D  DA - DL *
TA
Change in the Value of a Bank’s
Net Worth

 i   i 
NW  - D A * * A  - - D L * * L
 (1  i)   (1  i) 
Impact of Changing Interest Rates
on a Bank’s Net Worth
Positive Interest Rate Rise NW Decrease
Gap Interest Rate Fall NW Increase
Negative Interest Rate Rise NW Increase
Gap Interest Rate Fall NW Decrease
Zero Interest Rate Rise No Change
Gap Interest Rate Fall No Change
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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