09/02/2018

Chapter Three

Risk Management for Changing

Interest Rates: Asset-Liability
Management and Duration Techniques

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7-2

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 Management
(Quản trị tài sản )

• 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.

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Liabilities management
(Quản trị nợ)
• Is a strategy of control over bank liabilities
by varying interest rates and terms offered
on borrowed funds.

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Fund management
Combines both asset and liability management
approaches into a balanced liquidity management
strategy.
• Objectives:
- Control over the volume, mix and return or
cost of both assets and liabilities
- Maximize the spread between revenues
and cost and control risk exposure
- Revenues and costs arise from both sides
of the balance sheets

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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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INTEREST RATE RISK

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Definition:
• Interest rate risk: is the risk that incurred when
the interest rates change in the financial
marketplace.
• Consequent:
- Change the income and the expense
- Change the market value of assets and
liabilities
- Change the banks’ net worth
=> Impact both the balance sheet and income
statement
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7-9

Major types of Interest Rate Risk

• Price Risk
▫ When Interest Rates Rise, the Market Value of
the Bond or Asset Falls
• Reinvestment Risk
▫ When Interest Rates
invest Fall, Banks
incoming funds in lower-yielding earning assets,
lowering its expected future income

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7-10

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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11

Loanable fund theory

• Financial managers must be price takers,

not price makers, and must
accept interest rates as a given and plan
accordingly.

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Interest rates are determined by the collective borrowing and

lending decisions of thousands of participants in markets.

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7-13

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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7-14

Yield to Maturity (YTM)

(Lợi suất đáo hạn)

is the interest rate that equalizes the current market price of

a bond with the present value of the future cash flows
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• Coupon rate
• YTM
• Face value
• Present value (purchased price)

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• A bond purchased today at a price of $950

and promising an interest payment of $100
each year over the next three years, when it
will be redeemed by the bond’s issuer for
$1,000.
• What is the promised interest rate, measured
by the yield to maturity?

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17

Exercise 1:
• A bond has a face value of $1000 and five years
to maturity. This bond has a coupon rate of 13
percent and is selling in the market today for
$902. Coupon payments are made annually on
this bond. What is the yield to maturity (YTM)
for this bond?
• A) 13%
• B) 12.75%
• C) 16%
• D) 11.45%
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7-18

Bank Discount Rate (DR)

Often quoted on short-term loans and money
market securities (such as Treasury bills)

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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To convert a DR to the
equivalent yield to maturity

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Exercise 2
• A treasury bill currently sells for $9,845,
has a face value of $10,000 and has 46
days to maturity. What is the bank discount
rate on this security?
• A) 12.49%
• B) 12.13%
• C) 12.30%
• D) 2%

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21

Exercise 3
• A treasury bill currently sells for $9,845,
has a face value of $10,000 and has 46
days to maturity. What is the yield to
maturity on this security?
• A) 12.49%
• B) 12.13%
• C) 12.30%
• D) 2%

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7-22

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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23

The Components of Interest rates

• Nominal market interest rate =
Risk-free real interest rate + Risk premiums to
lender
Risk free interest rates: Inflation –adjusted on
Government bonds
 Risk premium:
▫ Default Risk
▫ Inflation Risk
▫ Liquidity Risk
▫ Call Risk
▫ Maturity Risk
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7-24

Yield Curves (đường lãi suất trái phiếu)

• 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
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25

YIELD CURVE IN VIETNAM

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Maturity Gap
• Between the average maturity of their assets
and the average maturity of their liabilities.
• Mostly positive

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Question ?

Suppose the Yield curve is upward:

• If Maturity gap >0 means ……

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7-28

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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29

REVIEW QUICK QUIZ

• 1. The fact that a consumer who purchases
a particular basket of goods for $100 today
has to pay $105 next year for the same
basket of goods is an example of which of
the following risks:
• A) Inflation risk
• B) Default risk
• C) Liquidity risk
• D) Price risk
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2. When is interest rate risk for a bank

greatest?
A. When interest rates are volatile.
B. When interest rates are stable.
C. When inflation is high.
D. When inflation is low

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31

Review exercise
• A treasury bill currently sells for $9,845,
has a face value of $10,000 and has 46
days to maturity. What is the yield to
maturity on this security?

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INTEREST RATE HEDGING

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7-33

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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7-34

Net Interest Margin

(Tỷ lệ thu nhập biên lãi ròng)

Interest Income - Interest Expenses

NIM 
Total Earnings Assets

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• The Third National Bank of Edmond reports a

net interest margin of 5.83%. It has total
interest revenues of $275 million and total
interest expenses of $210 million. What does
this bank's earnings assets have to be?
• A) $4717 million
• B) $3602 million
• C) $1115 million
• D) $3.790 million

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The ideal …

• Repriceable assets: are loans that are about

to mature or are coming up for renewal

• Repriceable liabilities: CDs about to mature

or be renewed / Floating-rate deposit /
Money-market borrowing

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Examples of Repriceable (Interest

Sensitive) Assets and Liabilities

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What happens when they not equal?

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(Khe hở lãi suất)

• Positive gap // Asset sensitive:

• Negative gap // Liabilities sensitive:

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7-40

Interest-Sensitive Gap Measurements

Dollar Interest- Interest-Sensitive Assets –

Sensitive Gap = Interest Sensitive Liabilities

Relative
Dollar IS Gap
Interest- 
Sensitive Gap Bank Size

Interest InterestSensitiveAssets
Sensitivity 
InterestSensitiveLiabilities
Ratio
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7-41

Asset-Sensitive Bank Has:

• Positive Dollar Interest-Sensitive Gap

• Positive Relative Interest-Sensitive Gap

• Interest Sensitivity Ratio Greater Than

One

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7-42

Liability Sensitive Bank Has:

• Negative Dollar Interest-Sensitive Gap

• Negative Relative Interest-Sensitive

Gap

• Interest Sensitivity Ratio Less Than

One
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7-43

Computer-Based Techniques and

Maturity Buckets

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QUIZ
• Suppose the yields on rate-sensitive and fixed assets average 10%
and 11 %, respectively.
• While rate-sensitive and non-rate-sensitive liabilities cost an average
of 8 % and 9 %, respectively.
• During the coming week the bank holds $1,700 million in rate-
sensitive assets (out of an asset total of $4,100 million) and $1,800
million in rate-sensitive liabilities

• What is net interest income?

• If the market interest rate on rate-sensitive assets rises to 12% and

the interest rate on rate-sensitive liabilities rises to 10% during the
first week , what is the new net interest income?

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Group discussion:
In each case, what happens when interest rate
increases and decreases?

• Asset-Sensitive • Liability-
Bank Sensitive Bank

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7-46

Gap Positions and the Effect of

Interest Rate Changes on the Bank

• Asset-Sensitive • Liability-
Bank Sensitive 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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7-47

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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7-48

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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7-49

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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7-50

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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• Suppose that a bank has $100 million in earning

assets and $200 million in liabilities subject to an
interest rate change each month over the next six
months.

>> Then its cumulative gap is:

= 100*6- 200*6 = –$600 million

• Suppose market interest rates suddenly rise by 1 full

percentage point.
• Then the will suffer a net interest income loss of
approximately = 1%*(-600)= -600$

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7-53

Aggressive Interest-Sensitive Gap

Management

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E1
• 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?

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E2
• Peoples’ Savings 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.
• Can you calculate the expected change in net
interest income that this thrift institution
might experience?
• What change will occur in net interest income
if interest rates rise by one and a quarter
percentage points?
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E3
• Suppose Carroll Bank and Trust reports
interest sensitive assets of $570 million and
interest-sensitive liabilities of $685 million.
What is the bank’s dollar interest-sensitive
gap?
• Its relative interest-sensitive gap and
interest-sensitivity ratio?
•

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E4
Given the following information

ABC National Bank

($ Millions)

Assets Liabilities and Equity

Rate Sensitive $200 (12%) Rate Sensitive $300 (6%)

NonRate Sensitive 400(11%) NonRate Sensitive 300 (5%)
Non Earning 100 Equity 100
Total Assets $700 Total Liabilities and Equity $700

a. What is the GAP? Net Interest Income? Net Interest Margin?

How much will net interest income change if interest rates fall by
200 basis points?
b. What changes in portfolio composition would you
recommend to management if you expected interest rates to
increase. Be specific.
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E6
• Suppose Carroll Bank and Trust reports
interest-sensitive assets of $570 million and
interest-sensitive liabilities of $685 million.
• What is the bank’s dollar interest-sensitive
gap?
• Its relative interest-sensitive gap and
interest-sensitivity ratio?

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First National Bank of Fluffy Clouds currently

has the following interest-sensitive assets
and liabilities on its balance sheet with the
interest-rate sensitivity weights noted.

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• What is the bank’s current interest-sensitive gap?

• Adjusting for these various interest rate sensitivity weights what is the
bank’s weighted interest-sensitive gap?
• Suppose the federal funds interest rate increases or decreases one
percentage point.
• How will the bank’s net interest income be affected
(a) given its current balance sheet makeup and
(b) reflecting its weighted balance sheet adjusted for the foregoing rate-
sensitivity indexes?

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7-61

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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62

DURATION

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7-63

The Concept of Duration

Duration is the Weighted Average

Maturity of a Promised Stream of
Future Cash Flows

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Note on duration …
• Is a value
• Time-weighted measure of maturities
• Measures the average maturity of a
promised stream of future cash payments.
• Measures the average time needed to
recover the funds committed to
an investment.

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• Zero coupon Bond: Duration is equal to its

time to maturity
• Plain Vanilla bond: Duration is always les
than its time to maturity
* In general, higher duration, greater interest
risk.

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7-66

To Calculate the Instrument’s Duration

n n

 (1  YTM) t * CF t
t  (1  YTM) t * CF t
t
D  t 1  t 1
n Current Market Value or Price
 (1  YTM)
t 1
CF t
t

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Suppose that a bank grants a loan to one of

its customers for a term of five years.
The customer promises the bank an annual
interest payment of 10 percent (that is,
$100 per year). The face (par) value of the
loan is $1,000, which is also its current
market value (price) because the loan’s
current yield to maturity is 10 percent. What
is this loan’s duration?

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Price Sensitivity of a Security

P i
 - D*
P (1  i)

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7-69

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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7-70

Dollar-Weighted Duration of Asset

Portfolio
n
D A   w i * D Ai
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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7-71

Dollar-Weighted Duration of a Liability

Portfolio
n
DL   wi * DLi
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  DA - DL *
TA

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Change in the Value of a Bank’s Net

Worth

 i   i 
NW  - DA * * 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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7-77

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?
McGraw-Hill/Irwin
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