Chapter Seven

Risk Management for Changing Interest

Rates: Asset-Liability Management and
Duration Techniques
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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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Asset-Liability Management

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Interest Rate Risk

• Price Risk
▫When interest rates rise, the market value of the
bond or asset (fixed-rate loans) falls. If a financial
institution wishes to sell these financial instruments
in a rising rate period, it must be prepared to accept
capital losses.
• Reinvestment Risk
▫When interest rates fall, forcing a financial firm to
invest incoming funds in lower-yielding earning
asset, lowering its expected future income.
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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)

n
CFt
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-Sensitive
Bank 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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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 A i
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 D A - D L *
TA

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Change in the Value of a Bank’s Net Worth

 i   i 
NW  - D A * * A -  - DL * * 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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