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Transcript of Chapter07
Chapter Seven
Risk Management for Changing Interest Rates: Asset-Liability Management and Duration
TechniquesCopyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Yield to Maturity (YTM)
n
1tt
t
YTM) (1
CF PriceMarket
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Discount Rate (DR)
Maturity toDays #
360*
FV
Price Purchase- FV DR
Where: FV equals Face Value of a Security, such as Treasury Bills
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Net Interest Margin
Assets Earnings Total
ExpensesInterest - IncomeInterest NIM
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Interest-Sensitive Gap Measurements
Dollar Interest-Sensitive Gap
Interest-Sensitive Assets – Interest Sensitive Liabilities=
Relative Interest-
Sensitive Gap SizeBank
Gap ISDollar
Interest Sensitivity
RatiosLiabilitie SensitiveInterest
Assets SensitiveInterest
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
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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 Bank▫Interest Rates
Rise NIM Rises
▫Interest Rates Fall NIM Falls
•Liability-Sensitive Bank▫Interest Rates
Rise NIM Falls
▫Interest Rates Fall NIM Rises
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
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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
7-20
McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
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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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
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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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The Concept of Duration
Duration is the Weighted Average Maturity of a Promised Stream of Future Cash Flows
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
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To Calculate the Instrument’s Duration
Priceor ValueMarket Current
YTM) (1
CF *t
YTM) (1
CF
YTM) (1
CF *t
D
n
1tt
t
n
1tt
t
n
1tt
t
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Price Sensitivity of a Security
i) (1
i * D-
P
P
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
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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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
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Dollar-Weighted Duration of Asset Portfolio
n
1 iAiA i
D *w D
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
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Dollar-Weighted Duration of a Liability Portfolio
n
1iLiL i
D * w D
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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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
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Duration Gap
TA
TL * D - D D LA
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
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Change in the Value of a Bank’s Net Worth
L * i) (1
i * D- - A *
i) (1
i * D- NW LA
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Impact of Changing Interest Rates on a Bank’s Net Worth
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McGraw-Hill/IrwinBank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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