2. CHAPTER SIX Asset-Liability Management: Determining and Measuring Interest Rates and Controlling a Bank’s Interest-Sensitive And Duration Gaps
The purpose of this chapter is to explore the options bankers have today for dealing with risk – especially the risk of loss due to changing interest rates – and to see how a bank’s management can
coordinate the management of its assets with the management of its liabilities in order to achieve the institution’s goals.

3. 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

4. Historical View of Asset-Liability Management
Asset Management Strategy
Liability Management Strategy
Funds Management Strategy

5. Interest Rate Risk Price Risk Reinvestment 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

6. Yield to Maturity (YTM)

7. Bank Discount Rate (DR)
Where: FV equals Face Value

8. Market Interest Rates Function of: Risk-Free Real Rate of Interest
Various Risk Premiums
Default Risk
Inflation Risk
Marketability Risk
Call Risk
Maturity Risk

9. Net Interest Margin

10. 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

11. Interest-Sensitive Gap Measurements
Dollar Interest-Sensitive Gap
Interest-Sensitive Assets – Interest Sensitive Liabilities =
Relative Interest-Sensitive Gap
Interest Sensitivity Ratio

12. 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

13. Interest-Sensitive Liabilities
Borrowings from Money Markets
Short-Term Savings Accounts
Money-Market Deposits
Variable-Rate Deposits

14. Asset-Sensitive Bank Has:
Positive Dollar Interest-Sensitive Gap
Positive Relative Interest-Sensitive Gap
Interest Sensitivity Ratio Greater Than One

15. Liability Sensitive Bank Has:
Negative Dollar Interest-Sensitive Gap
Negative Relative Interest-Sensitive Gap
Interest Sensitivity Ratio Less Than One

16. 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

17. 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

18. 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 Dollar Volume of Interest-Sensitive Assets and Liabilities

19. 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

20. Cumulative Gap
The Total Difference in Dollars Between Those Bank Assets and Liabilities Which Can be Repriced over a Designated Time Period

21. Aggressive Interest-Sensitive Gap Management
Expected Change in Interest Rates
Best Interest-Sensitive Gap Position
Aggressive Management’s Likely Action
Rising Market Interest Rates
Positive IS Gap
Increase in IS Assets
Decrease in IS Liabilities
Falling Market Interest Rates
Negative IS Gap
Decrease in IS Assets
Increase in IS Liabilities

22. 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

23. The Concept of Duration
Duration is the Weighted Average Maturity of a Promised Stream of Future Cash Flows

24. To Calculate Duration

25. Price Sensitivity of a Security

26. Convexity
The Rate of Change in an Asset’s Price or Value Varies with the Level of Interest Rates or Yields

27. Duration of an Asset portfolio
Where:
wi = the dollar amount of the ith asset divided by total assets
DAi = the duration of the ith asset in the portfolio

28. Duration of a Liability Portfolio
Where:
wi = the dollar amount of the ith liability divided by total liabilities
DLi = the duration of the ith liability in the portfolio

29. Duration Gap

30. Change in the Value of a Bank’s Net Worth

31. Impact of Changing Interest Rates on a Bank’s Net Worth
Positive
Rise
Decrease
Gap
Fall
Increase
Negative
Zero
No Change

32. 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