Answers to End of Chapter Questions

1. Basic steps in GAP analysis:

a. Develop an interest rate forecast; the objective is to estimate whether specific assets and liabilities
can be expected to reprice and when they will reprice in this rate environment.
b. Select a series of sequential time intervals for determining how many assets and liabilities are rate
sensitive within each interval; the objective is to identify the timing of expected repricings.
c. Classify assets and liabilities as either rate sensitive or fixed-rate within each time interval; from this
information, calculate static GAP by comparing RSAs with RSLs. If a bank has off-balance sheet
commitments, impute the balance sheet impact on cash flow rate sensitivities.
d. Forecast net interest income and net income given the assumed repricing characteristics of the
underlying assets and liabilities; the objective is to assess the amount and variation in earnings.

2. Rate sensitive assets:

a. yes - matures
b. yes - matures daily
c. no - principal is received after 6 months; coupon interest is not a balance sheet item, so is not
included as either a rate sensitive asset or liability
d. yes, a portion is rate sensitive each month - the partial principal payments during the first 6 months
equal to $578are rate sensitive.
e. yes/no depending on whether the prime rate changes within 6 months. If the prime rate changes
within 6 months, the full amount of loan principal is rate sensitive. If the prime rate does not
change, nothing is rate sensitive. Looking forward, the analyst must forecast whether prime will
change to assign the principal amount to a specific time interval.

3. GAP analysis
a. GAP= $400
Expected net interest income = [3,300(.073) + 1,400(.087)] - [2,900(.038)+1,650(.061)]
362.70 - 210.85
151.85

Expected NIM = 151.85/4,700 = .0323

This bank will likely see its net interest income increase if interest rates increase. According the the
GAP model, $400 more in assets than liabilities will reprice at higher rates.

b. Change in net interest income = change in rates x GAP = .02 (400) = +8

NIM would increase to 159.85/4,700 = .0340

c. Change in interest income = .01 (3,300) = +33

Change in interest expense = .0175 (2,900) = +50.75
Change in net interest income = -17.75
New NIM = 134.10/4,700 = .0285

d. Change in interest expense = 300 x .023 = +6.90

Net interest income would fall to 144.95; the decrease reflects greater borrowing at higher current
interest rates (6.1 % versus 3.8%)

4. Given the $3 million in 6-month T-bills financed with $3 million in time deposits:
a. 6-month GAP = $3 - $3 = 0; this seems to indicate no risk
b. 3-month GAP = 0 - $3 = -$1 million; this indicates a negative GAP, which is consistent with the
bank's actual mismatch of rate sensitive assets and liabilities. The issue is to select a time interval
that is short enough to capture a difference in the repricing frequency of assets versus liabilities.

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 5. The GAP ratio = RSAs/RSLs ignores the size of a bank's GAP relative to the size of the bank, and thus
provides no information regarding the potential magnitude of a change in net interest income when interest
rates change. Also, which bank is riskier? Consider a 1-year time frame where Bank A has RSAs of $5 and
RSLs of $4 for a GAP ratio of 1.25. Bank B has RSAs of $500 and RSLs of $400 for a GAP ratio of 1.25.
Both banks are the same size. Bank A has a small GAP and virtually no risk according to this measure.
Bank B has a GAP that is much farther from zero and is thus riskier.

6. When the base rate used to price loans is not tied to a specific index, there is no certainty as to when or
how much the base rate will change over time. Changes are at the discretion of another institution. In GAP
analysis, this makes it difficult to determine or estimate how rate sensitive the loan really is. It cannot be
accurately classified within the rate sensitivity report. For example, a loan priced at Wall Street prime rate
+ 1% will change when Wall Street prime changes. Management does not know when this will happen.

7. GAP comparisons
a. County Bank City Bank
3-month GAP -$10 $0
6-month GAP -$10 -$10
1 -year GAP $0 -$10

b. 3-month: County Bank; 6-month: same; 1-year: City Bank

To best assess risk, one must select time intervals that differentiate the true effective repricing frequency
of assets versus liabilities.

8. First Savings Banks rate sensitivity report

a. If the data accurately reflect sensitivity, that is if base rates change as assumed, MMDAs reprice as
assumed, and the data correctly capture when cash flows will actually reprice, then First Savings Bank will
lose if rates increase because the cumulative GAP is -$15.448 million. As such, more liabilities will reprice
than assets when rates rise.
b. If MMDAs are not repriced within 30 and 90 days while the bank's base rate does increase, then the
$17.3 million in MMDAs is not expected to reprice and First Savings Banks effective cumulative GAP is
+$2.3 million through 90 days. Thus, net interest income will typically rise when rates rise.

9. a. Financing a 1-year T-bill with a 3-month deposit will reduce a bank's positive GAP through one year.
According to the GAP model, this transaction reduces interest rate risk because GAP is closer to zero. With
an inverted yield curve, the 1-year rate may be below the 3-month rate such that the transaction has a
negative spread initially. Whether the bank profits on the transaction depends on what rates the bank
initially contracts for and how short-term rates actually change during the year. If short-term rates
(3-month rates) rise and the bank issues additional 3-month time deposits, the spread will be less than that
expected and probably negative, so a loss will arise. If short-term rates fall more than that expected, the
spread will widen and the bank will profit more than expected. This transaction embodies an implicit
interest rate bet that forward rates are too high.

b. According to GAP, both the deposit and loan are rate sensitive within 3 months assuming the prime
rate changes. Whether this transaction reduces risk depends on the effective rate sensitivity of a prime-
based commercial loan, and whether the bank will continue to fund the loan with short-term deposits. If the
base rate does not change during the first 3 months, the bank has reduced its positive GAP with this
transaction. If the prime rate changes more frequently than 3 months, the GAP is more positive and risk
will be greater.

10. Target GAP = [( 0.10)(.048)/(.02)] $400 = +/- $96

11. Embedded options in contracts

a. Fixed-rate mortgage: the borrower has the option of prepaying the outstanding principal. Borrowers
normally prepay mortgages when they move, when families break-up, and when interest rates decline

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sufficiently to make it financially attractive. Prepayments increase the rate sensitivity of the mortgage to the
lender. Thus, in a falling rate environment the mortgage is more rate sensitive as it may be refinanced.
b. Fixed-rate time deposit: the depositor has the option of withdrawing the funds prior to maturity and
paying the interest penalty. It is financially attractive to withdraw these deposits when interest rates rise
substantially, and the funds can be reinvested at higher rates that cover the withdrawal penalty. Thus, in a
rising rate environment, the deposit will be more rate sensitive than if rates stay constant or fall.
c. Commercial loan with a cap: the borrower has purchased an option with the interest rate cap. If the
banks prime rate rises above 6.5%, the borrower still pays only a 9% rate. If rates rise sufficiently, this
loan is not rate sensitive.

12. Static GAP analysis provides just a snapshot of a banks risk exposure and expected net interest
income given a specific interest rate environment. If interest rates differ from the assumed environment,
then a banks actual interest rate risk will differ from that suggested by GAP. Earnings sensitivity analysis
is more comprehensive because it involves forecasting what will happen to a banks net interest income and
net income over different interest rate environments. The useful output is the potential variation in bank
earnings. It allows for different assumptions regarding the types of interest rate risk faced by a bank and
the value of embedded options.

11. FSB bank will lose in a falling rate environment because of the prepayment risk assumed on-
balance sheet in the form of 30-year fixed-rate mortgages and other loans with maturities beyond 1 year. If
rates fall, loan prepayments and/or refinancings will accelerate and ABC bank will receive principal back
earlier than in other environments. It will, in turn, have to invest these funds at lower rates, which reduces
interest income. In effect, the banks GAP is more positive in a sharply falling rate environment. If rates
rise, the bank has locked in a large amount of long-term assets at below market rates. More liabilities will
reprice over time, such that interest expense will rise more than interest income rises. Over time, the spread
between asset yields and liability costs will narrow as ABC bank will have to increase deposit rates, which
typically lag in a rising rate environment. Thus, the spread will decrease over time in a rising rate
environment.

12. The earnings-at-risk data indicate the percentage change in earnings from some base level if the
general level of interest rates is 1% higher, 1% lower, and if the yield curve inverts by 1% from the base
level. Assume that earnings-at-risk refers to net interest income at risk. In year 1, the bank is asset sensitive
in the sense that its net interest income will increase (decrease) if rates rise (fall). If long-term rates fall
relative to short-term rates, net interest income will rise by 1.1%. In year 2, the bank is similarly asset
sensitive, but the magnitude of risk is greater. Higher risk is indicated by the greater (in absolute value)
percentage change in net interest income across each alternative rate environment.

13. E-Bank Income Statement Gap

Loans $45,198,400
Securities $19,172,050
RSAs $64,370,450

MMDAs $14,157,600
NOWs $33,534,000
CDs > $100,000 $17,828,750
RSLs $65,520,350

Effective GAP - $ 1,149,900

If rates change by an average of 1%, the banks net interest income will rise by:

Change in net interest income = - (0.01) x (- $1,149,900) = $11,499.

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Problem: Synovus Corporation
1. Using data for cumulative GAP, the banks static GAP was positive through 12 months and beyond. In
fact, the GAP was a substantial fraction of total interest sensitive assets ranging from 18.6% at 3
months to 18.3% over 5 years. As such, the bank was positioned to gain if rates rose during 2005 and
thereafter and to lose if rates fell. Falling rates would presumably have a large impact given the
relatively large GAPs. Note that the effect of interest rate swaps was to make the GAP less positive
during the first 3 months and overall during 2005. Thus, the bank appears to have used swaps in the
aggregate to reduce risk. The data for December 31, 2003 indicate much the same profile with a
slightly smaller cumulative GAP across each interval. Swaps had the same basic impact.

The GAP information doesnt indicate how many embedded options exist and when they will be
exercised across different rate environments. The GAP analysis interpretation assumes that the bank
does not have sufficient embedded options to change its overall rate sensitivity profile in different rate
environments.

2. The interest rate swap data for 3 months indicates a negative GAP impact of $977.5 million and lowers
the 3-month GAP from $5.15 billion to $4.174 billion. In making the GAP less positive,
or moving the GAP closer to zero, swaps appear to reduce overall risk. Swap impacts beyond 3 months
appear to make the periodic and cumulative GAPs more positive.

3. The cumulative GAP figures represent a relatively large fraction of total interest sensitive assets. The
greater is the percentage (approximately 16% - 18% for all intervals from 2003-2004) the greater is
interest rate risk, ceteris paribus.