Duration GAP Analysis

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Duration GAP analysis

• Rupee GAP analysis focuses on net interest income rather than equity value. Duration GAP is an
alternative approach of interest rate risk management. Duration simply refers to the weighted
average time period required to realize all cash flows from an investment.

• Duration GAP is the difference between the duration of bank's assets and its liabilities. It is used
to measure of interest sensitivity that explains how a change in market interest rate affects the
market value of a bank's assets, liabilities and its net worth or equity.

• It is calculated as

a. Duration =
∑ PV ( CFt ) Xt or
TPV

1+ Y ( 1+Y )+ n(C−Y )
Duration = −
Y c [ ( 1+ Y ) n−1 ] +Y

Where, y= Yield to maturity

n = Number of period

c= coupon interest rate.

Dur ation
b. Modified Duration =
1+r / c
Modified duration is the price elasticity of an instrument with respect to changes in interest rate. It
represents the percentage changes in the present value of financial instruments for a given percentage
points change in market yield.

Basis point change∈ yield


c. % change in price =−MDX
100
d. Duration GAP (DGAP) =DA-WDL
∆i
e. % Change in Net worth = -DGAP X
1+ i
f. Change in net worth = % change in net worth X Total assets.
g. Duration of equity = DA X A/E –DL X L/E
Where,
DA = Duration of assets
DL = Duration of liabilities
DE = Duration of equity
W = liabilities to assets ratio.
Example
A bank has invested in a 5 year loan of Rs 1000,000. The loan pays annual 10 percent in interest each
year until maturity. What is the duration of loan? What is its modified duration? If interest rates increase
by 150 basis points (that is, 1.5%), what is the percentage changes in its price? Assume required return
of 12 percent.

Solution,

Annual interest = 10% of 1000,000 = Rs 100,000

Calculation of duration

Year (t) CFS PVIF@12% PV PVXt


1 100,000 0.8929 89,290 89,290
2 100,000 0.7972 79,720 159,440
3 100,000 0.7118 71,180 213,540
4 100,000 0.6355 63,550 254,200
5 1100,000 0.5674 624,140 3120,700
TPV=Rs.927,880 ∑ PV ( CFt ) Xt =
Rs. 3837,170

Duration =
∑ PV ( CFt ) Xt =
3,837,170
= 4.14 yrs.
TPV 927,880

Alternatively,

1+ Y ( 1+Y )+ n(C−Y ) 1+ 0.12 ( 1+0.12 ) +5 (0.10−0.12)


Liabilities and equality Duration = − = − =
Y c [ ( 1+ Y ) n−1 ] +Y 0.12 0.10 [ ( 1+0.12 ) 5−1 ] +0.12
4.14 yrs.

Modified duration of loan is given by,

Duration 4.14
Modified Duration = = = 3.70 yrs.
1+r /c 1+ 0.12/1

If interest rate is increase by 150 basis point, the percentage change in loan price is:

Basis point change∈ yield 150


a. % change in price =−MDX = −3.70 X = -5.55%
100 100
Numerical Problems
1. The following is simplified FI balance sheet
Assets Amount Liabilities and equality Amount
4 -year loans 1,000 2-years deposits 850
Equity 150
Total assets 1,000 Total liabilities and 1,000
equity
a. Assuming that interest rates on both loans and deposits are 9 percent. What is the market
value of equity?
b. What is the Maturity Gap for FI
c. What does the Maturity gap in part (b) indicate about the interest rate risk exposure?
(Ans: a. –Rs 7.00, b. 2yrs )
2. Consider a Rs 1,000 bond with three years to maturity and a 9 percent coupon rate.
Currently, the rate of interest on comparable bonds is 12 percent.
a. Calculate the duration of the bond
b. Assume bond had used semiannual compounding, what is the duration of the bond?
(Ans: a. 2.75yrs b. 2.68 yrs)
3. From the information below calculate; funding GAP, Relative GAP and Interest sensitive
ratio.
Assets Amount Liabilities Amount
Vault cash (NRSA) 200 Demand deposit (NRSL) 50
Short term securities (RSA) 150 New accounts (NRSL) 50
long term securities (NRSA) 300 Money market deposits (RSL) 200
Variable rate loans (RSA) 400 Short term saving (RSL) 400
Short term loans(RSA) 200 Long term saving (NRSL) 600
Short term loans(NRSA) 600 Central bank funds (RSL) 550
borrowing
Other assets (NRSA) 100 Equity (NRSL) 100
1,950 1,950
Note: RSA = Rate sensitive assets, RSL= Rate sensitive liabilities, NSRL= Non rate
sensitive liabilities and NRSA = Non rate sensitive assets.
(Ans: -Rs 400, -0.2051 and 0.6522
4. Consider the following liability structure of a commercial bank (Rs in Millions):
Assets Amount Duratio Liabilities and Amount Duration
n equity
Treasury bonds 25 6.25 Negotiable CDs 40 1.75
Municipal Bonds 15 3.45 Time deposits 80 3.15
Commercial 70 0.75 Subordinated notes 25 4.65
loans 50 1.25 equity 55
Consumer loans 40 3.10
Real estate loans
Total 200 Total 200
a. What is the duration of bank assets?
b. What is the duration of bank liability
c. Calculate the duration GAP? What does it imply?
d. Suppose current interest rate is 9 percent. The interest rate in general is expected to rise
9.5 percent. What will happen to the bank's liabilities and net worth?
e. What should be the duration GAP to immunize interest rate risk? explain
(Ans: a. 2.235 yrs, b. 3.0216 yrs, c. 0.04434, d. –Rs 0.04 Million)
5. The National bank has rate-sensitive assets equal Rs 5 million on securities with
maturities less than one year plus Rs 50 million of consumer loans with maturities less
than one year. Its rate-sensitive liabilities equal to Rs 40 million of commercial paper
plus Rs 3 million of bank loans both of which have maturity of less than one year.
a. What is the funding gap of the bank?
b. What effect does a 1 percent rise in interest rate have on the next interest income?
(Ans: a. Rs 12 million b. Rs 0.12 Million)
6. Given the following information (In million)
Assets Amount Rate Liabilities and Amount Duration
equity
Rate sensitive 200 11% Rate sensitive 300 6%
Non rate sensitive 400 12% Non rate sensitive 300 5%
Non earning 100 Equity 100
Total 700 Total 700
a. What is the GAP? Net interest income? Net interest margin? How much net interest
income changes if interest rates fall by 100 basis points?
b. What changes in portfolio composition would you recommend to management if you
expected interest rates to increases? (Ans: a. –Rs 100 million, 5.83%, Rs 37 million)
7. As a management trainee assigned to the bank's assets and liability management
committee, you have been asked to calculate the duration of following loan:
a. Rs. 20,000 principal, Rs 4,500 payment per year for 5 years. Assume that the bank's
current required rate of return on this type of loan is 8 percent. (Ans: 2.85 yrs)
8. Consider the Following Balance Sheet (Probable long question)
Assets Amount Liabilities Amount
3- Year Treasury Bond 275 1- Year CD 155
10- Year Municipal Bond 185 5- Year Note 180
Assume that the three-year Treasury bond has 6 percent coupon, the ten –years municipal
bond has 4 percent coupon, the one –year CD pays 4.5 percent, and the five-year note
pays 6 percent. Assume that all instruments have annual coupon payments and required
rate of return is 8 percent.
a. What is the weighted average maturity of the assets? Liabilities?
b. Assuming a one-year time horizon, what is the rupee gap?
c. What is the interest rate risk exposure of the bank?
d. Calculate the value of all four securities on the banks balance sheet if interest rates
increase by 2 percent. What is the effect on the value of the equity of the bank?
(Ans: a. DA =4.96 years, DL = 2.85 Years, b. –Rs 155, d. Value of T-bond =Rs 261, Value of Municipal Bond
= Rs157, Value of CD= Rs 152, Value of Note = Rs 165, Value of Net worth decline by Rs 24)

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