ECOBAM- Interest Rate and Market Risk Management

Interest Rate Management

When a bank makes a fixed rate loans for duration longer than the duration of
funding, it is betting on the movement of interest rate
In simplicity, bank will use gap analysis to evaluate the exposure of the
banking book to interest rate changes
Gap analysis provides a measure of overall balance sheet mismatches
Once gap is identified bank deals with interest rate risk by using duration
matching of assets and liabilities (called internal hedging operation)

Concept of Duration and its Application to Banks Interest Rate Management

Duration is the measure of the average time to maturity of a series of cash
flows from a financial asset. It measures effective maturity by taking into
account the timing and the size of the cash flows
Formula for duration is given as:

D= {[(Ct * t)/(1+r)t ]/P0}

or
D= (1/P0)*[(Ct *t)/(1+r)t]

Ct= cash flow at time t

t= time period
r= rate of interest
P0= value of financial asset

Duration can also be an approximate measure of the price sensitivity of the

asset with respect to rate of interest-elasticity of the price of asset with respect
to rate of interest.
Value of loan (P0) is equal to its present value.

P0= [Ct/(1+r)t]

Differentiating this with respect to (1+r) gives:

P0/(1+r)= -[(Ct*t)/(1+r)t+1]

Now multiplying both sides by (1+r)/P0 gives:

[P0/P0]/[(1+r)/(1+r)] = - (1/P0)*[(Ct *t)/(1+r)t]

Elasticity of the price of security -ve of duration

(loan) w.r.t. one plus interest rate

Hence duration provides a measure of the degree of interest rate risk-lower the
measure of duration, the lower price elasticity of the security w.r.t. interest rate
and consequently the smaller the change in price and lower the interest rate
risk.
 Now if bring the discrete change rather than the continuous change as:

P0= -D*[(1+r)/1+r]*P0

Hence smaller the duration, smaller the change in price.

Duration and Change in the Value of Bank

By definition change in the value of a bank is equal to change in the value of
assets and liabilities.
V=PVA PVL (1)

Now by using elasticity component developed above we know that change in

the value of asset is given by

PVA=[-DA/(1+rA)]*rA*PVA (2)

and for liability

PVL=[-DL/(1+rL)]*rL*PVL (3)

Now lets assume simple case where rA=rL. By substituting 2 and 3 in 1 and
rearranging we get

V= -[(DA*PVA)-(DL*PVL)]*[r/(1+r)]

Now duration gap (DG) is given by:

DG= DA-[(PVL/PVA)*DL]
or
V= -DG*[r/(1+r)]*PVA

Conclusion: When duration gap is +ve and interest rate rises, bank value reduces
When duration gap is ve and interest rate rises, bank value increases
The smaller the gap, smaller the effect of interest rate changes on the value of the
bank.
Example:
1) Duration calculation

Commercial Loans: 10000

Loan Term: 5 years
Annual Interest Rate: 6%
Assumption: principal paid at the end of loan term.
Duration is calculated as:
Period
(t) Cash Flow Present Value of Cash Flow*t
1 10000*.06=600 (600/(1+0.06)^1)*1=566.0377
2 10000*.06=600 (600/(1+0.06)^2)*2=1067.996
3 10000*.06=600 (600/(1+0.06)^3)*3=1511.315
4 10000*.06=600 (600/(1+0.06)^4)*4=1901.025
5 10000*.06=600+10000 ((600+10000)/(1+0.06)^5)*5=39604.683
Sum 44651.06
D=44651.06/10000 =4.47< 5 years

Interest Rate Risk and Value of a Bank

Alpha Bank Balance Sheet
Asset Liabilities
Asset value r (%) D Liabilities value r (%) D
Cash 1000 0 0 D Deposits 9000 3 1
Loans 10000 6 4.47 4-years CD's 3000 4.5 3.74
1-year T. Bills 4000 5 1 2-years T. Deposits 2200 4 1.96
14200
represents just
Equity 800 ownership
Total 15000 3.25 15000 1.73

Cash (weight) 0.066667 =0*0.0667+4.47*0.667+1*0.267=3.25

Loans (weight) 0.666667
1-year T. Bills
(weight) 0.266667
Sum 1

Duration Gap (DG) is calculated as:

DG= DA-[(PVL/PVA)*DL] = (3.25-(14200/15000)*(1.73))=1.61 years (+ve)
Now if interest rate is 0.06 and rises by 1% (0.01) then the change in the value of the
bank is:
V= -DG*[r/(1+r)]*PVA = -1.61*(0.01/1+0.06)*15000=-227.8
or 1.5% of its value ((227.8/15000)*100.
Risk Management Strategy:
Risk manager tries to shorten asset duration by 1.61 years
Or
Increase the liability duration by 14200/15000*1.73= 1.64 years
Risk manager can reduce the liability duration by:
1. reducing the dependence on deposits
2. recommend the management to increase capital
 GAP AND DURATION ANALYSIS AND INTEREST RATE MANAGEMENT
IN BANKING

Concept Checks

1 When is a bank asset sensitive? Liability sensitive?

A bank is asset sensitive when it has more interest-rate sensitive assets maturing or
subject to repricing during a specific time period than rate-sensitive liabilities. A
liability sensitive position, in contrast, would find the bank having more interest-rate
sensitive deposits and other liabilities than rate-sensitive assets for a particular
planning period.

2. What do the following terms mean: Asset management? Liability

management? Funds management?

Asset management refers to a banking strategy where management has control over
the allocation of bank assets but believes the bank's sources of funds (principally
deposits) are outside its control. Liability management is a strategy of control over
bank liabilities by varying interest rates offered on borrowed funds. Funds
management combines both asset and liability management approaches into a
balanced liquidity management strategy.

3. What factors have motivated banks to develop funds management techniques

in recent years?

The necessity to find new sources of funds in the 1970s and the risk management
problems encountered with troubled loans and volatile interest rates in the 1970s and
1980s led to the concept of planning and control over both sides of a bank's balance
sheet -- the essence of funds management.

4. What forces cause interest rates to change? What kinds of risk do bankers face
when interest rates change?

Interest rates are determined, not by individual banks, but by the collective borrowing
and lending decisions of thousands of participants in the money and capital markets.
They are also impacted by changing perceptions of risk by participants in the money
and capital markets, especially the risk of borrower default, liquidity risk, price risk,
reinvestment risk, inflation risk, term or maturity risk, marketability risk, and call risk.

Bankers can lose income or value no matter which way interest rates go. Rising
interest rates can lead to losses on bank security instruments and on fixed-rate loans as
the market values of these instruments fall. Falling interest rates will usually result in
capital gains on fixed-rate securities and loans but a bank will lose income if it has
more rate-sensitive assets than liabilities. Rising interest rates will also cause a loss to
bank income if a bank has more rate-sensitive liabilities than rate-sensitive assets.

5. What makes it so difficult for banks to forecast interest rate changes?

Interest rates cannot be set by an individual bank or even by a group of banks; they
are determined by thousands of investors trading in the credit markets. Moreover,
each market rate of interest has multiple components--the risk-free interest rate plus
various risk premia. A change in any of these rate components can cause interest rates
to change. To consistently forecast market interest rates correctly would require
bankers to correctly anticipate changes in the risk-free interest rate and in all rate
components. Another important factor is the timing of the changes. To be able to
take full advantage of their predictions, they also need to know when the changes will
take place.

6. What is the yield curve and why is it important for bankers to know about its
shape or slope?

The yield curve is a graphical description of the distribution of market interest rates
by maturity of financial instrument. The slope of the yield curve determines the
spread between long-term and short-term interest rates. In banking most of the long-
term rates apply to loans and securities (i.e., bank assets) and most of the short-term
interest rates are attached to bank deposits and money market borrowings. Thus, the
shape or slope of the yield curve has a profound influence on a bank's net interest
margin or spread between asset revenues and liability costs.

7. What is it that a bank wishes to protect from adverse movements in interest

rates?

A bank wishes to protect both the value of bank assets and liabilities and the revenues
and costs generated by both assets and liabilities from adverse movements in interest
rates.

8. What is the goal of hedging in banking?

The goal of hedging in banking is to freeze the spread between asset returns and
liability costs and to offset declining values on certain assets by profitable transactions
so that a target rate of return is assured.

9. Can you explain the concept of gap management?

Gap management involves determining the maturity distribution and the repricing
schedule for a bank's assets and liabilities. When more assets are subject to repricing
or will reach maturity in a given period than liabilities or vice versa, the bank has a
GAP and is exposed to loss from adverse interest-rate movements based on the gap's
size.

10. What is duration?

Duration is a value-weighted measure of the maturity of a security or other income-

generating asset that takes into consideration the amount and timing of all cash flows
expected from the asset
11. How is a bank's duration gap determined?

A bank's duration gap is determined by taking the difference between the duration of a
bank's assets and the duration of its liabilities. The duration of the banks assets can
be determined by taking a weighted average of the duration of all of the assets in the
banks portfolio. The weight is the dollar amount of a particular type of asset out of
the total dollar amount of the assets of the bank. The duration of the liabilities can be
determined in a similar manner.

12 What are the advantages of using duration as an asset-liability management

tool as opposed to interest-sensitive gap analysis?

Interest-sensitive gap only looks at the impact of changes in interest rates on the
banks net income. It does not take into account the effect of interest rate changes on
the market value of the banks equity capital position. In addition, duration provides a
single number which tells the bank their overall exposure to interest rate risk.

13. How can you tell you are fully hedged using duration gap analysis?

You are fully hedged when the dollar weighted duration of the assets portfolio of the
bank equals the dollar weighted duration of the liability portfolio. This means that the
bank has a zero duration gap position when it is fully hedged. Of course, because the
bank usually has more assets than liabilities the duration of the liabilities needs to be
adjusted by the ratio of total liabilities to total assets to be entirely correct.

14. What are the principal limitations of duration gap analysis? Can you think of
some ways of reducing the impact of these limitations?

There are several limitations with duration gap analysis. It is often difficult to find
assets and liabilities of the same duration to fit into the banks portfolio. In addition,
some accounts such as deposits and others dont have well defined patterns of cash
flows which makes it difficult to calculate a duration for these accounts. Duration is
also affected by prepayments by customers as well as default. Finally, duration
analysis works best when interest rate changes are small and short and long term
interest rates change by the same amount. If this is not true, duration analysis is not
as accurate.

15 How do you measure a banks dollar interest-sensitive gap? Its relative

interest-sensitive gap? What is the interest-sensitivity ratio?

The dollar interest-sensitive gap is measured by taking the repriceable (interest-

sensitive) assets minus the repriceable (interest-sensitive) liabilitiies over some set
planning period. Common planning periods include 3 months, 6 months and 1 year.
The relative interest-sensitive gap is the dollar interest-sensitive gap divided by some
measure of bank size (often total assets). The interest-sensitivity ratio is just the ratio
of interest-sensitive assets to interest sensitive liabilities. Regardless of which
measure you use, the results should be consistent. If you find a positive (negative)
gap for dollar interest-sensitive gap, you should also find a positive (negative) relative
interest-sensitive gap and a interest sensitivity ratio greater (less) than one.
16 Explain the concept of weighted interest-sensitive gap. How can this concept
aid banks real interest-sensitive gap risk exposure?

Weighted interest-sensitive gap is based on the idea that not all interest rates change at
the same speed. Some are more sensitive than others. Interest rates on bank assets
may change more slowly than interest rates on liabilities and both of these may
change at a different speed than those interest rates determined in the open market.
In, the weighted interest-sensitive gap methodology all interest-sensitive assets and
liabilities are given a weight based on their speed (sensitivity) relative to some market
interest rate. Fed Funds loans, for example, have an interest rate which is determined
in the market and which would have a weight of 1. All other loans, investments and
deposits would have a weight based on their speed relative to the Fed Funds rate. To
determine the interest-sensitive gap, the dollar amount of each type of asset or liability
would be multiplied by its weight and added to the rest of the interest-sensitive assets
or liabilities. Once the weighted total of the assets and liabilities is determined, a
weighted interest-sensitive gap can be determined by subtracting the interest-sensitive
liabilities from the interest-sensitive assets. This weighted interest-sensitive gap
should be more accurate than the unweighted interest-sensitive gap. The interest-
sensitive gap may change from negative to positive or vice versa and may change
significantly the interest rate strategy pursued by the bank.

Numerical Example

1. Commerce National Bank reports interest-sensitive assets of $870 million and

interest-sensitive liabilities of $625 million. Because interest-sensitive assets are
larger than liabilities by $245 million the bank is asset sensitive.

If interest rates rise, the bank's net interest margin should rise as asset revenues
increase by more than the resulting increase in liability costs. On the other hand, if
interest rates fall, the bank's net interest margin will fall as asset revenues decline
faster than liability costs.

2. First National Bank of Bannerville has posted the following financial

statement entries:
Interest revenues $63 million
Interest costs $42 million
Total earning assets $700 million

The bank's net interest margin must be:

Net Interest = $63 mill. - $42 mill. = 0.03 or 3 percent

Margin $700 mill.

If interest revenues and interest costs double while earning assets grow by 50 percent,
the net interest margin will change as follows:

($63 mill. - $42 mill.) * 2 = 0.04 or 4 percent

$700 mill. * (1.50)
Clearly the net interest margin increases--in this case by one third.
3. First National Bank 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.
What is the expected change in First National's net interest income?

Expected
Change in = $135 million * (-0.025) = -$3.38 million
Net Interest Income

What change will occur in net interest income if interest rates rise by one and a
quarter percentage points?

Expected Change
in Net Interest = $135 million * (+0.0125) = +$1.69 million
Income

4 Suppose Carroll Bank and Trust reports interest-sensitive assets of $570

million and interest-sensitive liabilities of $685 million. What is the banks dollar
interest-sensitive gap? Its relative interest-sensitive gap and interest-sensitivity ratio?

Dollar Interest-Sensitive Gap = Interest-Sensitive Assets Interest Sensitive

Liabilities
= $570 - $685 = -$115

Relative Gap = $ IS Gap = -$115 = -0.2018 or -20.18 percent

Bank Size $570

Interest-Sensitivity = Interest-Sensitive Assets = $570 = .8321

Ratio Interest-Sensitive Liabilities $685

5. A government bond is currently selling for $900 and pays $80 per year in
interest for 5 years when it matures. If the redemption value of this bond is $1,000,
what is its yield to maturity if purchased today for $900. The yield to maturity
equation for this bond would be:

$80 $80 $80 $80 $80

$900 = + + + +
(1 YTM)1 (1 YTM) 2 (1 YTM)3 (1 YTM)4 (1 YTM)5
$1,000
+
(1 YTM)5

At an YTM of 10 percent the bond's price is $924.28, while at 12 percent its price
becomes $864.40. Thus, the true YTM lies between 10% and 12%. To find the true
YTM we use:

$924.28 $900
10% + * 2% 10.81%
$924.28 $864.40
6. Suppose the government bond described in problem #1 is held for 3 years and
then the bank acquiring the bond decides to sell it at a price of $950. Can you figure
out the average annual yield the bank will have earned for its 3-year investment in the
bond?

In this instance the yield-to-maturity equation can be modified slightly to find the
correct holding-period yield that the bank would earn. Specifically,

$80 $80 $80 $950

$900 = 1 + 2 + 3 +
(1 HPY) (1 HPY) (1 HPY) (1 HPY)3

At an HPY of 10% the bond's price becomes $912.31, while at 12% the bond's price is
$868.56.

The true holding period yield must be:

912.31 900
10% + x 2% 10.56%.
912.31 868.56

7. U.S. Treasury bills are available for purchase this week at the following prices
(based upon $100 par value) and with the indicated maturities:

a. $97.25, 182 days.

b. $96.50, 270 days.
c. $98.75, 91 days.

The discount rates and equivalent yields to maturity (bond-equivalent or coupon-

equivalent yields) on each of these Treasury bills are:

Discount Rates Equivalent Yields to Maturity

(100 97.25) 360 (365x.0544)

a. * = 5.44% =
100 182 [360 (0.0544x182)]
19.856
= 5.67%
350.1

(100 96.50) 360 (365x.0467)

b. * = 4.67% =
100 270 [360 (.0467x270)]
17.046
= 4.91%
347.39

(100 98.75) 360 (365x.0495) 18.07

c. * = 4.95% =
100 91 [360 (.0495x91)] 355.5
= 5.08%

8. The First State Bank of Ashfork reports a net interest margin of 3.25 percent in
its most recent financial report with total interest revenues of $88 million and total
interest costs of $72 million. What volume of earning assets must the bank hold?
The relevant formula is:

$88 mill. $72 mil.

Net Interest Margin = .0325 = Earning Assets

Then Earning Assets = $492.31 million.

Suppose the bank's interest revenues rise by 8 percent and its interest costs and
earning assets increase 10 percent. What will happen to Ash Fork's net interest
margin?

Substituting in the correct formula we have:

$88 million (1 .08) $72 million(1 .10)

New Net Interest Margin =
$492.3 million(1 .10)

$95.04 million $79.20 million

=
$541.53 million

= 0.0293 or 2.93 percent.

9. If a bank's net interest margin, which was 2.85 percent, doubles and its total
assets, which stood originally at $545 million, rise by 40 percent, what change will
occur in the bank's net interest income?

The correct formula is:

Net Interest Income

.0285 * 2 = $545 million * (1 .4)

or Net Interest Income = 0.057 * $763 million

= $43.49 million.

10. The cumulative interest-rate gap of Snidal State Bank and Trust Company
doubles from an initial figure of -$35 million. If market interest rates fall by 25
percent from an initial level of 6 percent, what change will occur in Snidal Bank's net
interest income?

The key formula here is:

Change in the Bank's = Change in interest rates (in percentage points) * cumulative
gap
Net Interest = 0.06 * -.25 x (-$35 mill.) * 2
Income = 1.05

Thus, the bank's net interest income will rise by 5 percent.

11. Suppose a bank has an average asset duration of 2.5 years and an average
liability duration of 3.0 years. If the bank holds total assets of $560 million and total
liabilities of $467 million, does it have a significant duration gap? If interest rates rise,
what will happen to the value of the bank's net worth?

Liabilities $467 million

Duration Gap = DA DL * = 2.5 yrs. 3.0 yrs.
Assets $560 million
= 2.5 years 2.5018 years
= -0.018 years

This bank has a very slight negative duration gap; so small in fact that we could
consider it insignificant. If interest rates rise, the bank's liabilities will fall slightly
more in value than its assets, resulting in a small increase in net worth.

12. Stilwater Bank and Trust Company has an average asset duration of 3.25 years
and an average liability duration of 1.75 years. Its liabilities amount to $485 million,
while its assets total $512 million. Suppose that interest rates were 7 percent and then
rise to 8 percent. What will happen to the value of the Stilwater Bank's net worth as a
result of a decline in interest rates?

First, we need an estimate of StiIwater's duration gap. This is:

$485 mill.
Duration Gap = 3.25 yrs. 1.75 yrs * = + 1.5923 years
$512 mill.

Then, the change in net worth if interest rates rise from 7 percent to 8 percent will be:

Change in NW =
.01 .01
- 3.25 yrs. x x $512 mill - - 1.75 yrs. x x$485 mill.
(1 .07) (1 .07)

= $7.62 million.

13. Given: Merchants State Bank has recorded the following financial data for the
past three years (dollars in millions):

Current Year Previous Year Two Years Ago

Interest revenues $57 $56 $55
Interest expenses 49 42 34
Loans (Excluding nonperforming) 411 408 406
Investments 239 197 174
Total deposits 487 472 467
Money market borrowings 143 118 96

Solution:

Net interest margin (NIM) = Net Interest Income/Earning Assets, where

Net Interest Income = Net Interest Revenues - Net Interest Expenses
Earning Assets = Loans + Investments
NIM(Current) = ($57-49)/(411 + 239) = 8/650 = 0.0123 or 1.23%
NIM(previous) = ($56-42)/(408 + 197) = 14/605 = 0.0231 or 2.31%
NIM(Two years ago) = ($55-34)/(406 + 174) = 21/580 = 0.0362 or 3.62%

The net interest margin has been declining steadily and significantly. Probable causes
includegreater increases in interest expenses relative to interest income due to shifts in
funding mix with greater dependence on borrowed funds (more expensive sources)
relative to deposits (less expensive sources). Additionally, the mix in earning assets,
with greater growth in lower yielding investment securities than in higher yielding
loans, is another contributor to the steadily declining net interest margin.

Management needs to reevaluate its funding strategies and its loan and investment
strategies. If slower loan growth is related to external forces -- for example, a weaker
economy -- then less borrowing should be considered. If the slower loan growth is
more internal, then more aggressive loan management would be appropriate.

14 The First National Bank of Wedora, California has the following interest-
sensitive gaps:

Coming Next Next More Than

Week 30 Days 31-90 Days 90 Days
Interest - $144 $110 $164 $184
Sensitive +29 +19 29 8
Assets = $173 $129 $193 $192

Interest - $232 $ --- $ --- $ ---

Sensitive 98 84 196 35
Liabilities = 36 6 --- ---
$366 $90 $196 $35

GAP - $193 + $39 - $3 + $157

Cumulative GAP - $193 - $154 - $157 $0

First National has a cumulative zero gap and therefore is not vulnerable to loss if
interest rates rise. It does have a positive gap in two periods--the next 30 days and
more than 90 days. During these particular periods a rise in interest rates would
produce a short-run gain.

15. First National Bank of Barnett currently has the following interest-sensitive
assets and liabilities on its balance sheet:

Interest-Sensitive Assets Interest-Sensitive Liabilities

Federal fund loans $65
Security holdings $42 Interest-bearing deposits $185
Loans and leases $230 Money-market borrowings $78

What is the banks current interest-sensitive gap? Suppose its Federal funds loans
carry an interest-rate sensitivity weight of 1.0 while its investments have a rate-
sensitivity weight of 1.15 and its loans and leases display a rate-sensitivity weight of
1.35. On the liability side First Nationals rate-sensitivity weight is 0.79 for interest-
bearing deposits and 0.98 for its money-market borrowings. Adjusted for these
various interest-rate sensitivity weights, what is the banks weighted interest-sensitive
gap? Suppose the Federal funds interest rate increases or decreases one percentage
point. How will the banks net interest income be affected (a) given its current
balance sheet make up and (b) reflecting its weighted balance sheet adjusted for the
foregoing rate-sensitivity weights?

Solution:

Dollar IS Gap = ISA - ISL = ($65 + $42 + $230) - ($185 + $78) = $337 - $263 = $74

Weighted IS Gap = [(1)($65) + (1.15)(42) + (1.35)(230)] - [(.79)($185) + (.98)($78)]

= $65 + $48.3 + $310.5 - $146.15 + $76.44
= $423.8 - $222.59
= $201.21

a.) Change in Banks Income = IS Gap * Change in interest rates

= ($74)(.01) = $.74 million

Using the regular IS Gap, net income will change by plus or minus $740,000

b.) Change in Banks Income = Weighted IS Gap * Change in interest rates

= ($201.21)(.01) = $2.012

Using the weighted IS Gap, net income will change by plus or minus $2,012,000

16 McGraw Bank and Trust has interest-sensitive assets of $225 million and
interest-sensitive liabilities of $168 million. What is the banks dollar interest-
sensitive gap? What is McGraws relative interest-sensitive gap? What is the value
of its interest-sensitivity ratio? Is the bank asset sensitive or liability sensitive?
Under what scenario for market interest rates will the bank experience a gain in net
interest income? A loss in net interest income?

Dollar Interest-Sensitive Gap = ISA ISL = $225 - $168 = $57

Relative Interest-Sensitive Gap = ISA ISL = $57 = 0.2533

Bank Size $225

Interest-Sensitivity Ratio = ISA = $225 = 1.3393

ISL $168

This bank is asset sensitive. More assets will be repriced during this time period than
liabilities. This means that if interest rates rise, the interest earned on assets will rise
relative to the interest paid on liabilities and net interest margin will rise. However, if
interest rates fall, interest earned on assets will fall more than interest paid on
liabilities and net interest margin will fall.
17. Casio Merchants and Trust Bank, N.A., has a portfolio of loans and securities
expected to generate cash inflows for the bank as follows:

Expected Cash Receipts Period in Which Receipts Are Expected

$1,385,421 Current year

746,872 Two years from today
341,555 Three years from today
62,482 Four years from today
9,871 Five years from today

Deposits and money market borrowings are expected to require the following cash
outflows:

Expected Cash Payments Period in Which Payments Will be Made

$1,427,886 Current year

831,454 Two years from today
123,897 Three years from today
1,005 Four years from today
----- Five years from today

If the discount rate applicable to the above cash flows is 8 percent, what is the
duration of the bank's portfolio of earning assets and of its deposits and money market
borrowings? What will happen to the bank's total returns, assuming all other factors
are held constant, if interest rates rise? If interest rates fall? Given the size of the
duration gap you have calculated, what type of hedging should the bank engage in?
Please be specific about the hedging transactions that are needed and their expected
effects.

Solution:

Casio has an asset duration of:

$1,385,421 *1 + $746,872 * 2 + $341,555 * 3 + $62,482 * 4 + $9,871 * 5

(1 + 0.08)1 (1 + 0.08)2 (1 + 0.08)3 (1 + 0.O8)4 (1 + 0.O8)5
DA = $1,385,421 + $746,872 + $341,555 + $62,482 + $9,871
(1 + 0.08)1 (1 + 0.08)2 (1 + 0.08)3 (1 + 0.08)4 (1 + 0.08)5

= $3,594,1481 / $2,246,912 = 1.5996 years

Casio has a liability duration of:

$1,427,886 * 1 + $831,454 * 2 + $123,897 * 3 + $1,005 * 4

(1 + 0.08)1 (1 + 0.08)2 (1 + 0.08)3 (1 + 0.08)4
DL=
$1,427,886 + $831,454 + $123,897 + $1,005
(1 + 0.08)1 (1 + 0.08)2 (1 + 0.08)3 (1 + 0.08)4

= $3,045,808 / $2,134,047 = 1.4272 years

Casio's Duration Gap = Asset Duration - Liability Duration = 1.5996 - 1.4272 =
0.1724 years.

Because Casio's Asset Duration is greater than its Liability Duration, the bank has a
positive duration gap, which means that the bank's total returns will decrease if
interest rates rise because the value of the liabilities will decline by less than the value
of the assets. On the other hand, if interest rates were to fall, this positive duration
gap will result in the bank's total returns increasing. In this case, the value of the
assets will rise by a greater amount than the value of the liabilities.

Given the magnitude of the duration gap, the management of Casio Merchants and
Trust Bank needs to do a combination of things to close its duration gap between
assets and liabilities. It probably needs to try to shorten asset duration, lengthen
liability duration, and use financial futures or options to deal with whatever asset-
liability gap exists at the moment. The bank may want to consider securitization or
selling some of its assets, reinvesting the cash flows in maturities that will more
closely match its liabilities' maturities. The bank may also consider negotiating some
interest-rate swaps to change the cash flow patterns of its liabilities to more closely
match its asset maturities.

Alternative Scenario 1:

Given: The discount rate applicable to Casio's cash inflows and outflows falls to 6
percent.

How does the duration of its earning assets and liabilities change? How does this
change affect the bank's sensitivity to interest rate movements?

Solution:

Casio now has an asset duration of:

$1,385,421 * 1 + $746,872 * 2 + $341,555 * 3 + $62,482 * 4 + $9,871 * 5

(1 + 0.06)1 (1 + 0.06)2 (1 + 0.06)3 (1 + 0.06)4 (1 + 0.06)5
DA =
$1,385,421 + $746,872 + $341, 555 + $62,482 + $9,871
(1 + 0.06)1 (1 + 0.06)2 (1 + 0.06)3 (1 + 0.06)4 (1 + 0.06)5

= $3,731,603 / $2,315,358 = 1.6117 years

Casio now has a liability duration of:

$1,427,886 * 1 + $831,454 * 2 + $123,897 *3 + $1,005 * 4

(1 + 0,06)1 1 + 0.06)2 (1 + 0.06)3 (1 + 0.06)4
DL =
$1,427,886 + $831,454 + $123,897 + $1,005
(1 + 0.06)1 (1 + 0.06)2 (1 + 0.06)3 (1 + 0.06)4

= $3,142,308 / $2,191,876 = 1.4336 years

Both the Asset Duration and the Liability Duration increase with the decline in the
discount rate, with the Asset Duration increasing by more than the Liability Duration.
The Duration Gap increases from 0.1724 years to 0.1781 years, making Casio more
sensitive to interest rate changes.

Alternative Scenario 2:

Given: The appropriate discount rate climbs to 10 percent.

What happens to the durations of Casio's earning assets and liabilities? How does the
interest rate sensitivity of Casio's total return change as a result of this upward
movement in the discount rate?

Solution:
Casio now has an asset duration of:

$1,385,421 * 1 + $746,872 * 2 + $341,555 X 3 + $62,482 * 4 + $9,871 * 5

(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3 (1 + 0.10)4 (1 + 0.10)5
DA=
$1,385,421 + $746,872 + $341,555 + $62,482 + $9,871
(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3 (1 + 0.10)4 (1 + 0.10)5

= $3,465,169 / $2,182,144 = 1.5880 years

Casio now has a liability duration of:

$1,427,886 * 1 + $831,454 * 2 + $123,897 * 3 + $1,005 * 4

(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3 (1 + 0.10)4
DL = $1,427,886 + $831,454 + $123,897 + $1,005
(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3 (1 + 0.10)4

= $2,954,385 / $2,079,002 = 1.4211 years

The new Duration Gap = 1.5880 1.4211 = 0.1669 years.

With the increase in the discount rate, both the Asset Duration and the Liability
Duration decrease, with the Asset Duration declining by a greater rate than the
Liability Duration.

The interest sensitivity of the two portfolios, and the bank as a whole, declines, due to
the relative degree of change in each portfolio.

18. Given the cash inflow and outflow figures in Problem 1 for Casio Merchants
and Trust Bank, what would happen to the value of Casio's net worth as a result of
this movement in interest rates? If interest rates drop from 8 percent to 7 percent, what
happens to Casio's net worth in this case and by how much in dollars does it change?
From Problem #1 we find that Casio's average asset duration is 1.5996 years and
average liability duration is 1.4272 years. If total assets are $125 million and total
liabilities are $110 million, then Casio has a duration gap of:

$110 mill.
Duration Gap = 1.5996 1.4272 *
$125 mill.
= 1.5996 1.2559

= 0.3437

The change in Casio's net worth would be:

r r
Change in Value of Net Worth = [-DA * * A] [ - DL * * L]
(1 r) (1 r)

If interest rates fall from 8 percent to 7 percent,

(-.01) (-.01)
Change in NW = - 1.5996 x x $125 - 1.4272 x x $110 mill.
(1 .08) (1 .08)

= + 1.8514 1.4536

= + 0.3978 million.

19. Leland National Bank reports an average asset duration of 4.5 years, an average
liability duration of 3.25 years. The bank has total assets of $1.8 billion and liabilities
totaling $1.5 billion. If interest rates rise from 7 percent to 9 percent, how will
Leland's net worth change? What if interest rates fall from 7 to 5 percent?

The key formula is:

r r
Change in net worth = [-DA * * A] - [ - DL * * L]
(1 r) (1 r)

For the change in interest rates from 7 to 9 percent, Leland's net worth will change to:

Change in Net Worth =

(.02) (.02)
- 4.5 years x x$1800 mill. - - 3.25 years x x $1500 mill.
(1 .07) (1 .07)

= -$151.40 million + $91.12 million

= -$60.28 million

On the other hand, if interest rates decline from 7 to 5 percent we have:

Change in Net Worth =

 (-.02) (-.02)
- 4.5 yrs x x$1800 mill. - - 3.25 yrs x x$1500 mill.
(1 .07) (1 .07)

= + $151.40 mill. - $91.l2 mill.

= + $60.28 million.

20. A bank holds a bond in its investment portfolio whose duration is 5.5 years.
Its current market price is $950. While market interest rates are currently at 8 percent
for comparable quality securities, an increase to 10 percent is expected in the coming
weeks. What change (in percentage terms) will the bonds price experience if market
interest rates change as anticipated?

Solution:

P i (.02)
Dx 5.5 x .1019 or - 10.19 percent
P (1 i ) (1.08)

This bonds price will decrease by 10.19 percent or its price will decline to $853.

12. A banks dollar weighted asset duration is 6 years. Its total liabilities amount
to $750 million, while its assets total $900 million. What is the dollar-weighted
duration of the banks liability portfolio if the banks duration gap were zero?

Given the bank has a duration gap equal to zero:

Total Liabilities
Duration Gap = DA - DL x
Total Assets

Total Assets $900

DL (DA - Duration Gap) x (6 - 0) x 7.2 years
Total Liabilities $750

21. Commerce National Bank holds assets and liabilities whose average duration
and dollar amount are shown as below:

Asset and Liability Items Avg. Dollar

Duratio Amount
n
Investment-grade bonds 8.0 yrs. $60 mill.
Commercial loans 3.6 yrs. $320 mill.
Consumer loans 4.5 yrs. $140 mill.
Deposits 1.1 yrs. $490 mill.
Nondeposit borrowings 0.1 yrs $20 mill.

What is the dollar-weighted duration of the banks asset portfolio and liability
portfolio? What is the duration gap?
DA =
$60 mill. $320 mill. $140 mill.
8.0 yrs. x 3.6 yrs.x 4.5 yrs. x 4.35 years
$520 mill. $520 mill. $520 mill.

$490 $20
DL = 1.1 yrs. x 0.1 yrs. x 1.061 years
$510 $510

Total Liabilities $510

Duration Gap DA - DL x 4.35 yrs. - 1.061 yrs. x 3.31 years
Total Assets $520

14. A government bond currently carries a yield to maturity of 12 percent for a

maturity of 5 years and a current market price of $928. The bond pays $100 in annual
interest. If the bond has a par value of $1,000 its duration can be found from:

$100x1 $100x2 $100x3 $100x4 $1100x5

D= / $928
(1 0.12) (1 0.12)
1 2
(1 0.12) 3
(1 0.12) 4
(1 0.12)5

$3837.31
= = 4.14 years
$928

22. Dewey National Bank holds $15 million in government bonds having a
duration of 6 years. If interest rates suddenly rise from 6 percent to 7 percent, what
percentage change should occur in the bonds' market price?

The relevant formula is equation is: ( P/P) = -D * [ i/( 1+i)].

We have: ( P/P) = -6 years * [+ .01/(1 + 0.06)]

= -6 years *(0.009434)

=- 0.0566 or - 5.66 percent.

The market price will decrease by 5.66% or the price will change to $14.151 million.
 Market Risk

Value at Risk (VaR)

Value at risk calculates the likely loss a bank might experience on its whole
trading book
How much I (bank) loss with x% probability over a given time horizon
(period)
In statistical term VaR is an estimate of the value of loss (P) that cannot be
exceeded, with confidence % over a specific time horizon

Pr[tVaR]=

VaR methodology is based on estimation of the statistical distribution of asset

return
Parametric (also called delta normal) VaR is based on the estimation of the
variance covariance matrix of asset returns from historical time series. Returns
are calculated as:
Rt=((Pt-Pt-1)/Pt-1)*100
Where P stands for price of asset

Theory of Normal Distribution and VaR

Underlying assumption in this method is that returns are normally distributed. A
normal distribution is defined in term of first two moments of its distribution (the
mean ( ) in term of expected return and standard distribution () in term of risk.
Hence if the returns are normally distributed then we are 90% sure that actual returns
will lie within 1.65. If we are interested in only downside risk then we would be
95% sure that actual returns will not be less than -1.65. Hence if the net position of
a single asset is 100m and standard deviation of the return on asset () =2%, then
VaR would be 100*1.65*0.02=3.3m. It means asset holder can expect to loss 3.3m in
only 5 out of 100 days.

VaR Portfolio of Assets

We start with portfolio theory. In the case of two assets portfolio, the returns
on portfolio can be written as:
Rp=a1R1+a2R2
a1+a2=1
Riskiness of portfolio is given by:

= sqrt (a1212+ a1212+21,2 a1a212)

Where p1,2 is correlation coefficient between the returns of asset 1 and 2.

The percent VaR can be stated as 1.65 and the value of VaR V01.65,
where V0 is value of portfolio.
When we have the individual value of VaR for each asset like
VarR1=1.651V1 and VaR2=1.652V2, then value of portfolio is calculated such
as:

VaR=sqrt(VaR12+ VaR22+21,2 VaR1VaR2)

Example
Multinational Bank (A) Case:

Portfolio:
100m =T. Bills
50m = Corporate bonds
Daily basis standard deviation of return () of the 10-year bonds= 0.00605
Standard deviation of return () of corporate bonds = 0.00565
Correlation coefficient of two return (1,2 ) = 0.35

Question: calculate a VaR for a one day horizon with 5% chance of understating a
realized loss.
VaR1=100*(1.65)*(0.00605)= 0.99825
VaR2= 50*(1.65)*(0.00565)= 0.466125
VaRp=sqrt [(0.99825^2+0.466125^2+2*(0.35)*0.99825*0.466125)]
=1.240763m
 Web Site Problems

1. If you wanted to uncover a useful definition of what duration is, where on the web
would you likely find such information?

There are several places on the web that have good definitions of finance terms. After
doing a search on duration gap one place that seems to have good definitions is
http://newrisk.ifci.ch/. They have a glossary and define several different duration
concepts. Their definition of Macaulays Duration is the following. The present
value weighted time to maturity of the cash flows of a fixed payment instrument or of
the implicit cash flows of a derivative based on such an instrument. Originally
developed as a market risk measurement for bonds (the greater the duration or
'average' maturity, the greater the risk), duration has proven useful in analyzing equity
securities and fixed income options and futures. The diagram illustrates Macaulay
duration as a balancing of present values of cash flows. What is nice about this web
site is that they also do an example and have accompanying graphs to illustrate the
concept.

2. See if you can find the meaning of Modified duration on the world wide web.

The same web site listed above also has a good definition of modified duration.
http://newrisk.ifci.ch/ has a good glossary for many finance related terms. Their
definition for modified duration is A measurement of the change in the value of an
instrument in response to a change in interest rates. The primary basis for comparing
the effect of interest rate changes on prices of fixed income instruments. The formula
shows the small difference between modified and Macaulay duration. Many
applications are not sensitive to the difference, and modified and Macaulay duration
numbers are often used interchangeably. Also called Adjusted Duration.
Barclay Bank Case Study
Profitability Analysis
2001 2000 1999 1998 1997 1996
Return on Equity Capital (ROE) 16.99 18.75 20.74 16.79 14.99 22.76
Return on Assets (ROA) 0.69 0.78 0.69 0.60 0.48 0.88
Net Interest Margin (NIM) 1.71 1.63 1.82 1.96 1.72 2.12
Net Non-interest Margin (NNIM) 1.46 1.41 1.47 1.38 1.50 1.94
Net Bank Operating Margin (OM) 1.34 1.30 1.27 1.11 1.00 1.32
Earning Per Share (EPS) 1.48 1.63 1.18 0.87 0.75 1.04
Earning Spread (ES) 3.07 3.00 3.58 4.10 3.84 4.06
Breakdown Equity Return for Closer Analysis
Net Profit Margin 0.22 0.26 0.21 0.18 0.15 0.22
X Asset Utilisation 0.03 0.03 0.03 0.03 0.03 0.04
X Equity Multiplier 24.58 23.98 30.04 27.99 31.05 25.82
= ROE 16.99 18.75 20.74 16.79 14.99 22.76
Further Breakdown Equity Return for Closer Analysis
0.7 0.7 0.6 0.7
Tax Management Efficiency 0.68 0.71 2 0 7 1
0.2 0.2 0.2 0.3
X Expense Control Efficiency 0.32 0.36 9 6 2 1
0.0 0.0 0.0 0.0
X Asset Management Efficiency 0.03 0.03 3 3 3 4
24.5 23.9 30.0 27.9 31.0 25.8
X Funds Management Efficiency 8 8 4 9 5 2
16.9 18.7 20.7 16.7 14.9 22.7
= ROE 9 5 4 9 9 6

Breakdown Return on Assets for Closer Analysis

Net Interest Margin 1.71 1.63 1.82 1.96 1.72 2.12
X Net Non-interest Margin 1.46 1.41 1.47 1.38 1.50 1.94
X Special Transaction Efficiency 2.48 2.25 2.60 2.75 2.73 3.18
= Return on Assets (ROA) 0.69 0.78 0.69 0.60 0.48 0.88
Risk Analysis
2001 2000 1999 1998 1997 1996
Credit Risk Analysis
0.83 0.82 0.81 0.82 0.78 0.83
Total lonas/Total deposits 6 5 4 4 9 1
0.01 0.01 0.01 0.01 0.01 0.02
Non-performing loans/Total loans and leases 7 7 7 9 9 2
0.00 0.00 0.00 0.00 0.00 0.00
Annual provision for loan losses/Total loans and leases 5 4 4 4 2 2

Liquidity Risk Analysis

Total loans/Total assets 0.640 0.628 0.613 0.605 0.583 0.637
Cash and due-from deposit balances held at other banks/Total
assets 0.010 0.012 0.014 0.016 0.014 0.020
Cash assets+government securities/Total assets 0.031 0.029 0.043 0.037 0.040 0.044
Purchased funds/Total assets 0.2300 0.2367 0.2336 0.2281 0.2359 0.1838

Solvency Risk
Price earning ratio 12.68 9.65 15.30 20.18 15.47 7.84
Equity capital/Total assets 0.041 0.042 0.033 0.036 0.032 0.039
Equity capital/Risky assets 0.046 0.047 0.037 0.041 0.038 0.045

Interest Rate Risk

Interest sensitive assets/Interest sensitive liabilities 0.836 0.825 0.814 0.824 0.789 0.831

Earning Risk
SD of NPAT 5.657 504.874 312.541 130.108 357.796
SD of ROE 1.246 1.402 2.787 1.274 5.493
SD of ROA 0.064 0.065 0.064 0.083 0.282