1. Chapter Twelve
Asset-Liability Management: Determining and Measuring Interest Rates and Controlling Interest-Sensitive and Duration Gaps

2. 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

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

4. 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

5. Yield to Maturity (YTM)

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

7. Yield to Maturity

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

9. 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

10. The Maturity Gap and the Yield Curve
Maturity Gap between the Average Maturity of Assets and the Average Maturity of Liabilities
Positive Maturity Gap and Upward-Sloping Yield Curve Lead to a Positive Net Interest Margin

11. Net Interest Margin

12. 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

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

14. 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

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

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

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

18. Gap Positions and the Effect of Interest Rate Changes on the Bank
Liability-Sensitive Bank
Interest Rates Rise
NIM Falls
Interest Rates Fall
NIM Rises
Asset-Sensitive Bank
Interest Rates Rise
NIM Rises
Interest Rates Fall
NIM Falls

19. 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

20. 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

21. NIM Influenced By: Changes in Interest Rates Up or Down
Changes in the Spread Between Asset Yields and Liability Costs (Shape of Yield Curve)
Changes in the Volume of Interest-Bearing Assets and Liabilities
Changes in the Mix of Assets and Liabilities

22. Cumulative Gap
The Total Difference in Dollars Between Those Bank Assets and Liabilities Which Can be Repriced over a Designated Time Period
Changes in NIM=Overall Change in Interest Rate * Size of the Cumulative Gap

23. 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

24. 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 and the Choice of Planning Periods is Highly Arbitrary
Interest-Sensitive Gap Does Not Consider the Impact of Changing Interest Rates on Equity Position

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

26. To Calculate Duration

27. Price Sensitivity of a Security

28. Modified Duration

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

30. Factors Influencing Convexity
Duration ( Maturity)
Coupon Rate
Asset Values Change Differently According to Their Duration, Coupon Rates and Market Interest Rates

31. 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

32. 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

33. Duration Gap

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

35. 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