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Appendix 8A The Maturity Model 1

Appendix 8A

The Maturity Model

As mentioned in the chapter, a weakness of the repricing model is its reliance on
book values rather than market values of assets and liabilities. Indeed, in most
book value countries, FIs report their balance sheets by using book value accounting. This
accounting method records the historic values of securities purchased, loans made, and lia-
Accounting method bilities sold. For example, for U.S. banks, investment assets (i.e., those expected to
in which the assets
be held to maturity) are recorded at book values, while those assets expected to be
and liabilities of the
FI are recorded at used for trading (trading securities or available-for-sale securities) are reported
historic values. according to market value.1 The recording of market values means that assets and
liabilities are revalued to reflect current market conditions. Thus, if a fixed-coupon
bond had been purchased at $100 per $100 of face value in a low-interest rate envi-
ronment, a rise in current market rates reduces the present value of the cash flows
from the bond to the investor. Such a rise also reduces the price—say, to $97—at
market value which the bond could be sold in the secondary market today. That is, the market
accounting value accounting approach reflects economic reality, or the true values of assets
Accounting method and liabilities if the FI’s portfolio were to be liquidated at today’s securities prices
in which the assets
rather than at the prices when the assets and liabilities were originally purchased
and liabilities of the FI
are revalued accord- or sold. This practice of valuing securities at their market value is referred to as
ing to the current marking to market. We discuss book value versus market value accounting and
level of interest rates. the impact that the use of the alternate methods has in measuring the value of an FI
in more detail in Chapter 20. In the maturity and duration model, developed below
marking to market
Valuing securities at and in Chapter 9, the effects of interest rate changes on the market values of assets
their current market and liabilities are explicitly taken into account. This contrasts with the repricing
price. model, discussed in the body of the chapter, in which such effects are ignored.

EXAMPLE 8A–1 Consider the value of a bond held by an FI that has one year to maturity, a face value of $100 (F)
Fixed Income to be paid on maturity, one single annual coupon at a rate of 10 percent of the face value (C)
and a current yield to maturity (R) (reflecting current interest rates) of 10 percent. The fair
Assets and the market price of the one-year bond, P1B , is equal to the present value of the cash flows on the
Maturity Model bond:

F C $100  $10
P1B    $100
(1  R ) 1.1

Suppose the Federal Reserve tightens monetary policy so that the required yield on the bond
rises instantaneously to 11 percent. The market value of the bond falls to:

$100  $10
P1B   $99.10
1.11

1
More accurately, they are reported at the lower of cost or current market value (LOCOM). However,
both the SEC and the Financial Accounting Standards Board (FASB) have strongly advocated that FIs
switch to full market value accounting in the near future. Currently, FASB 115 requires FIs to value certain
bonds at market prices but not loans.

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2 Appendix 8A The Maturity Model

Thus, the market value of the bond is now only $99.10 per $100 of face value, while its original
book value was $100. The FI has suffered a capital loss (∆P1) of $0.90 per $100 of face value
in holding this bond, or:

 P1B  $99.10  $100  $0.90

Also, the percent change in the price is:

$99.10  $100
%  P1B   0.90%
$100

This example simply demonstrates the fact that:

P
 0
R
A rise in the required yield to maturity reduces the price of fixed-income securities
held in FI portfolios. Note that if the bond under consideration were issued as a
liability by the FI (e.g., a fixed-interest deposit such as a CD) rather than being
held as an asset, the effect would be the same—the market value of the FI’s depos-
its would fall. However, the economic interpretation is different. Although rising
interest rates that reduce the market value of assets are bad news, the reduction
in the market value of liabilities is good news for the FI. The economic intuition is
illustrated in the following example.

EXAMPLE 8A–2 Suppose the FI in the example above issued a one-year deposit with a promised interest rate
Fixed Rate of 10 percent and principal or face value of $100.2 When the current level of interest rates is
10 percent, the market value of the liability is 100:
Liabilities and
the Maturity $100  $10
P1D   $100
1.1 0
Model
Should interest rates on new one-year deposits rise instantaneously to 11 percent, the FI
has gained by locking in a promised interest payment to depositors of only 10 percent. The
market value of the FI’s liability to its depositors would fall to $99.10; alternatively, this would
be the price the FI would need to pay the depositor if it repurchased the deposit in the sec-
ondary market:

$100  $10
P1D   $99.10
1.11
That is, the FI gained from paying only 10 percent on its deposits rather than 11 percent if
they were newly issued after the rise in interest rates.

As a result, in a market value accounting framework, rising interest rates gener-

ally lower the market values of both assets and liabilities on an FI’s balance sheet.
Clearly, falling interest rates have the reverse effect: They increase the market val-
ues of both assets and liabilities.
2
In this example we assume for simplicity that the promised interest rate on the deposit is 10 percent.
In reality, for returns to intermediation to prevail, the promised rate on deposits would be less than the
promised rate (coupon) on assets.

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Appendix 8A The Maturity Model 3

EXAMPLE 8A–3 In the preceding examples, both the bond and the deposit were of one-year maturity. We can
Impact of easily show that if the bond or deposit had a two-year maturity with the same annual coupon
rate, the same increase in market interest rates from 10 to 11 percent would have had a more
Maturity on negative effect on the market value of the bond’s (and deposit’s) price. That is, before the rise
Change in Bond in required yield:
Value $10 $10  $100
P2B    $100
1.10 (1.10)2

After the rise in market yields from 10 to 11 percent:

$10 $10  $100

P2B    $98.29
1.11 (1.11)2

and

 P2B  $98.29  $100  $1.71

The resulting percentage change in the bond’s value is:

% P2B  ($98.29  $100)/$100  1.71%

If we extend the analysis one more year, the market value of a bond with three years to
maturity, a face value of $100, and a coupon rate of 10 percent is:

$10 $10 $10  $100

P3B     $100
1.10 (1.10)2 (1.10)3

After the rise in market rates from 10 to 11 percent, market value of the bond is:

$10 $10 $10  $100

P3B     $97.56
1.11 (1.11)2 (1.11)3

This is a change in the market value of:

 P3B  $97.56  $100  $2.44

or

$97.56  $100
% P3B   2.44%
$100

This example demonstrates another general rule of portfolio management for FIs:
The longer the maturity of a fixed income asset or liability, the larger its fall in price
and market value for any given increase in the level of market interest rates.
That is:
P1B P2B P30B
  ... 
R R R
Note that while the two-year bond’s fall in price is larger than the fall of the
one-year bond’s, the difference between the two price falls, %ΔP2B  %ΔP1B, is
1.71%  (0.9%)  0.81%. The fall in the three-year, 10 percent coupon bond’s
price when yield increases to 11 percent is 2.44 percent. Thus, %ΔP3B  %ΔP2B
 2.44%  (1.71%)  0.73%, This establishes an important result: While

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4 Appendix 8A The Maturity Model

FIGURE 8A–1 0 1 2 3
Maturity of
The Relationship the bond
between ΔR,
Maturity, and ΔP 2$0.90
(Capital Loss)

2$1.71
2$2.44

DP
(Capital loss)

P3B falls more than P2B and P2B falls more than P1B, the size of the capital loss increases
at a diminishing rate as we move into the higher maturity ranges. This effect is
graphed in Figure 8A–1.
So far, we have shown that for an FI’s fixed-income assets and liabilities:
1. A rise (fall) in interest rates generally leads to a fall (rise) in the market value of
an asset or liability.
2. The longer the maturity of a fixed-income asset or liability, the larger the fall
(rise) in market value for any given interest rate increase (decrease).
3. The fall in the value of longer-term securities increases at a diminishing rate for
any given increase in interest rates.

The Maturity Model with a Portfolio of Assets and Liabilities

The preceding general rules can be extended beyond an FI holding an individual
asset or liability to a portfolio of assets and liabilities. Let MA be the weighted-
average maturity of an FI’s assets and ML the weighted-average maturity of an FI’s
liabilities such that:
Mi  Wi 1 Mi 1  Wi 2 Mi 2  . . .  Win Min

where
Mi  Weighted-average maturity of an FI’s assets (liabilities), i  A or L
Wij  Importance of each asset (liability) in the asset (liability) portfolio as
measured by the market value of that asset (liability) position relative to
the market value of all the assets (liabilities)
Mij  Maturity of the jth asset (or liability), j  1 . . . n
This equation shows that the maturity of a portfolio of assets or liabilities is a
weighted average of the maturities of the assets or liabilities that constitute that
portfolio. In a portfolio context, the same three principles prevail as for an individ-
ual security:
1. A rise in interest rates generally reduces the market values of an FI’s asset and
liability portfolios.
2. The longer the maturity of the asset or liability portfolio, the larger the fall in
value for any given interest rate increase.
3. The fall in value of the asset or liability portfolio increases with its maturity at a
diminishing rate.

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Appendix 8A The Maturity Model 5

TABLE 8A–1
Assets Liabilities
The Market Value
Balance Sheet of Long-term assets (A) Short-term liabilities (L)
an FI Net worth (E)

TABLE 8A–2
Assets Liabilities
Initial Market
Values of an A  $100 (MA  3 years) $ 90  L (ML  1 year)
FI’s Assets and 10  E
Liabilities (in $100 $100
millions of dollars)

Given the preceding, the net effect of rising or falling interest rates on an FI’s
balance sheet depends on the extent and direction in which the FI mismatches
the maturities of its asset and liability portfolios. That is, the effect depends on
maturity gap whether its maturity gap, MA  ML, is greater than, equal to, or less than zero.
Difference between Consider the case in which MA  ML  0 (as shown in Table 8A–1); that is, the
the weighted-average maturity of assets is longer than the maturity of liabilities. This is the case of most
maturity of the FI’s
assets and liabilities. commercial banks and thrifts. These FIs tend to hold large amounts of relatively
longer-term fixed-income assets such as conventional mortgages, consumer loans,
commercial loans, and bonds,3 while issuing shorter-term liabilities, such as certif-
icates of deposit with fixed interest payments promised to the depositors.
Consider the simplified portfolio of a representative FI in Table 8A–2 and notice
that all assets and liabilities are marked to market; that is, we are using a market
value accounting framework. Note that in the real world, reported balance sheets
differ from Table 8A–2 because historic or book value accounting rules are used.
In Table 8A–2 the difference between the market value of the FI’s assets (A) and
the market value of its liabilities such as deposits (L) is the net worth or true equity
value (E) of the FI. This is the economic value of the FI owners’ stake in the FI. In
other words, it is the money the owners would get if they could liquidate the FI’s
assets and liabilities at today’s prices in the financial markets by selling off loans
and bonds and repurchasing deposits at the best prices. This is also clear from the
balance sheet identity:
E  AL
As was demonstrated earlier, when interest rates rise, the market values of both
assets and liabilities fall. However, in this example, because the maturity on the
asset portfolio is longer than the maturity on the liability portfolio, for any given
change in interest rates, the market value of the asset portfolio (A) falls by more
than the market value of the liability portfolio (L). For the balance sheet identity
to hold, the difference between the changes in the market value of its assets and
liabilities must be made up by the change in the market value of the FI’s equity or
net worth:
E  A  L
(change in FI (change in market (change in market
net worth) value of assets) value of liabilities)
3
These assets generate periodic interest payments such as coupons that are fixed over the asset’s life. In
Chapter 9 we discuss interest payments fluctuating with market interest rates, such as on an adjustable
rate mortgage.

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6 Appendix 8A The Maturity Model

TABLE 8A–3
Assets Liabilities
An FI’s Market
Value Balance A  $97.56 L  $89.19
Sheet after a Rise in E  8.37
Interest Rates of 1 $97.56 $97.56
Percent (in millions or E   A  L
of dollars) $1.63  ($2.44)  ($0.81)

To see the effect on FI net worth of having longer-term assets than liabilities,
suppose that initially the FI’s balance sheet looks like the one in Table 8A–2. The
$100 million of assets is invested in three-year, 10 percent coupon bonds, and the
liabilities consist of $90 million raised with one-year deposits paying a promised
interest rate of 10 percent. We showed earlier that if market interest rates rise
1 percent, from 10 to 11 percent, the value of three-year bonds falls 2.44 percent
while the value of one-year deposits falls 0.9 percent.4 Table 8A–3 depicts this fall
in asset and liability market values and the associated effects on FI net worth.
Because the FI’s assets have a three-year maturity compared with its one-year
maturity liabilities, the value of its assets has fallen by more than has the value of
its liabilities. The FI’s net worth declines from $10 million to $8.37 million, a loss of
$1.63 million, or 16.3 percent! Thus, it is clear that with a maturity gap of two years:
M A  ML  2years
(3)  (1)
a 1 percentage point rise in interest rates can cause the FI’s owners or stockholders
to take a big hit to their net worth. Indeed, if a 1 percent rise in interest rates leads
to a fall of 16.3 percent in the FI’s net worth, it is not unreasonable to ask how large
an interest rate change would need to occur to render the FI economically insolvent
by reducing its owners’ equity stake or net worth to zero. That is, what increase in
interest rates would make E fall by $10 million so that all the owners’ net worth
would be eliminated? For the answer to this question, look at Table 8A–4. If interest
rates were to rise a full 7 percent, from 10 to 17 percent, the FI’s equity (E) would
fall by just over $10 million, rendering the FI economically insolvent.5

4
The market value of deposits (in millions of dollars) is initially:

$9  $90
P1D   $90
1.10

When rates increase to 11 percent, the market value decreases:

$9  $90
P1D   $89.19
1.11

The resulting change is:

$89.19  $90
%  P1D   0.90%
$90
5
Here we are talking about economic insolvency. The legal and regulatory definition may vary, depending
on what type of accounting rules are used. In particular, under the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) (November 1991), a DI is required to be placed in conservatorship by regula-
tors when the book value of its net worth falls below 2 percent. However, the true or market value of net
worth may well be less than this figure at that time.

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Appendix 8A The Maturity Model 7

TABLE 8A–4
Assets Liabilities
An FI Becomes
Insolvent after A  $84.53 L  $84.62
a 7 Percent Rate E  0.09
Increase (in $84.53 $84.53
millions of dollars) or E  A  L
$10.09  $15.47  ($5.38)

TABLE 8A–5
Assets Liabilities
An FI with an
Extreme Maturity A  $100 (MA  30 years) L  $90 (ML  1 year)
Mismatch (in E  10
millions of dollars) $100 $100

TABLE 8A–6
Assets Liabilities
The Effect of a 1.5
Percent Rise in A  $87.45 L  $88.79
Interest Rates on E  1.34
the Net Worth of an $87.45 $87.45
FI with an Extreme or E  A  L
Asset and Liability $11.34  ($12.55)  ($1.21)
Mismatch (in
millions of dollars)

EXAMPLE 8A–4 Suppose the FI had adopted an even more extreme maturity gap by investing all its assets
Extreme in 30-year fixed-rate bonds paying 10 percent coupons while continuing to raise funds by
issuing one-year deposits with promised interest payments of 10 percent, as shown in Table 8A–5.
Maturity Assuming annual compounding and a current level of interest rates of 10 percent, the market
Mismatch price of the bonds (in millions of dollars) is initially:

$10 $10 $10 $10  $100

B
P30   ...    $100
1.10 (1.10)2 (1.10)29 (1.10)30

If interest rates were to rise by 1.5 percent to 11.5 percent, the price (in millions of dollars) of
the 30-year bonds would fall to:

$10 $10 $10 $10  $100

B
P30   ...    $87.45,
1.115 (1.115)2 (1.115)29 (1.115)30

a drop of $12.55, or as a percentage change, % P30

B
 ($87.45  $100)/$100  12.55%.
The market value of the FI’s one-year deposits would fall to:

$9  $90
P1D   $88.79
1.115

a drop of $1.21 or ($88.79 $90)/$90  1.34%.

Look at Table 8A–6 to see the effect on the market value balance sheet and the FI’s net
worth after a rise of 1.5 percent in interest rates. It is clear from Table 8A–6 that when the
mismatch in the maturity of the FI’s assets and liabilities is extreme (29 years), a mere 1.5
percent increase in interest rates completely eliminates the FI’s $10 million in net worth and
renders it completely and massively insolvent (net worth is $1.34 million after the rise in
rates). In contrast, a smaller maturity gap (such as the two years from above) requires a much
larger change in interest rates (i.e., 7 percent) to wipe out the FI’s equity. Thus, interest rate
risk increases as the absolute value of the maturity gap increases.

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8 Appendix 8A The Maturity Model

Given this example, it is not surprising that savings associations with 30-year
fixed-rate mortgages as assets and shorter-term CDs as liabilities suffered
badly during the 1979–82 period, when interest rates rose so dramatically (see
Figure 8–1). At the time, depository institutions measured interest rate risk almost
exclusively according to the repricing model, which captures the impact of interest
rate changes on net interest income only. Regulators monitoring this measure only,
rather than a market value–based measure, were unable to foresee the magnitude
of the impact of rising interest rates on the market values of these FIs’ assets and
thus on their net worth.
From the preceding examples, you might infer that the best way for an FI to
immunize immunize, or protect, itself from interest rate risk is for its managers to match
Fully protect an FI’s the maturities of its assets and liabilities, that is, to construct its balance sheet so
equity against interest that its maturity gap, the difference between the weighted-average maturity of its
rate risk.
assets and liabilities, is zero (MA  ML  0). However, as we discuss next, maturity
matching does not always protect an FI against interest rate risk.

WEAKNESSES OF THE MATURITY MODEL

The maturity model has two major shortcomings: (1) It does not account for the
degree of leverage in the FI’s balance sheet and (2) it ignores the timing of the
cash flows from the FI’s assets and liabilities. As a result of these shortcomings,
a strategy of matching asset and liability maturities moves the FI in the direction
of hedging itself against interest rate risk, but it is easy to show that this strategy
does not always eliminate all interest rate risk for an FI.
To show the effect of leverage on the ability of the FI to eliminate interest rate risk
using the maturity model, assume that the FI is initially set up as shown in Table
8A–7. The $100 million in assets is invested in one-year, 10 percent coupon bonds,
and the $90 million in liabilities are in one-year deposits paying 10 percent. The
maturity gap (MA  ML) is now zero. A 1 percent increase in interest rates results in
the balance sheet in Table 8A–8. In Table 8A–8, even though the maturity gap is zero,
the FI’s equity value falls by $0.10 million. The drop in equity value is due to the
fact that not all the assets (bonds) are financed with deposits. Rather, equity is used
to finance a portion of the FI’s assets. As interest rates increase, only $90 million in
deposits are directly affected, while $100 million in assets are directly affected.

TABLE 8A–7
Assets Liabilities
Initial Market Values
of an FI’s Assets A  $100 (MA  1 year) L  $ 90 (ML  1 year)
and Liabilities with E  10
a Maturity GAP of $100 $100
Zero (in millions of
dollars)

TABLE 8A–8
Assets Liabilities
FI’s Market Value
Balance Sheet after A  $99.09 L  $89.19
a 1 Percent Rise in E  9.90
Interest Rates (in $99.09 $99.09
millions of dollars) or E  A  L
0.10  0.91  (0.81)

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Appendix 8A The Maturity Model 9

FIGURE 8A–2 0 1 year

One-Year CD Cash
Flows

FI borrows FI pays principal

$100 plus interest to
depositor = $115

FIGURE 8A–3 0 6 months 1 year

One-Year Loan Cash
Flows
Loan Receive Receive
$100 $50 principal $50 principal
+ interest ($7.5) + interest ($3.75)
= $57.5 + interest on
reinvestment of cash
flow received in
month 6 = $53.75 plus
interest on cash flows
received in month 6

We show next, using a simple example, that an FI choosing to directly match the
maturities and values of its assets and liabilities (so that MA  ML and $A  $L)
does not necessarily achieve perfect immunization, or protection, against interest
rate risk. Consider the example of an FI that issues a one-year CD to a depositor.
This CD has a face value of $100 and an interest rate promised to depositors of
15 percent. Thus, on maturity at the end of the year, the FI has to repay the bor-
rower $100 plus $15 interest, or $115, as shown in Figure 8A–2.
Suppose the FI lends $100 for one year to a corporate borrower at a 15 percent
annual interest rate (thus, $A  $L). However, the FI contractually requires half of
the loan ($50) to be repaid after six months and the last half to be repaid at the end
of the year. Note that although the maturity of the loan equals the maturity of the
deposit of 1 year and the loan is fully funded by deposit liabilities, the cash flow
earned on the loan may be greater or less than the $115 required to pay off depos-
itors, depending on what happens to interest rates over the one-year period. You
can see this in Figure 8A–3.
At the end of the first six months, the FI receives a $50 repayment in loan prin-
cipal plus $7.5 in interest (100  1/2 year  15 percent), for a total midyear cash
flow of $57.5. At the end of the year, the FI receives $50 as the final repayment
of loan principal plus $3.75 interest ($50  1/2 year  15 percent) plus the rein-
vestment income earned from relending the $57.5 received six months earlier. If
interest rates do not change over the period, the FI’s extra return from its ability to
reinvest part of the cash flow for the last six months will be ($57.5  1/2  15 per-
cent)  4.3125. We summarize the total cash flow on the FI’s one-year loan in
Table 8A–9.
As you can see, by the end of the year, the cash paid in on the loan exceeds the
cash paid out on the deposit by $0.5625. The reason for this is the FI’s ability to rein-
vest part of the principal and interest over the second half of the year at 15 percent.
Suppose that interest rates, instead of staying unchanged at 15 percent throughout
the whole one-year period, had fallen to 12 percent over the last six months in the
year. This fall in rates would affect neither the promised deposit rate of 15 percent

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10 Appendix 8A The Maturity Model

TABLE 8A–9
Cash Flow at 1/2 Year
Cash Flow on a
Loan with a 15 Principal $ 50.00
Percent Interest Interest 7.50
Rate Cash Flow at 1 Year
Principal $ 50.00
Interest 3.75
Reinvestment income 4.3125
$115.5625

TABLE 8A–10
Cash Flow at 1/2 Year
Cash Flow on the
Loan When the Principal $ 50.00
Beginning Rate of Interest 7.50
15 Percent Falls to Cash Flow at 1 Year
12 Percent Principal $ 50.00
Interest 3.75
Reinvestment income 3.45
$114.70

nor the promised loan rate of 15 percent because they are set at time 0 when the
deposit and loan were originated and do not change throughout the year. What is
affected is the FI’s reinvestment income on the $57.5 cash flow received on the loan
at the end of six months. It can be re-lent for the final six months of the year only at
the new, lower interest rate of 12 percent (see Table 8A–10).
The only change to the asset cash flows for the bank comes from the reinvestment
of the $57.50 received at the end of six months at the lower interest rate of 12 percent.
This produces the smaller reinvestment income of $3.45 ($57.5  1/2  12 percent)
rather than $4.3125 when rates stayed at 15 percent throughout the year. Rather
than making a profit of $0.5625 from intermediation, the FI loses $0.3. Note
that this loss occurs as a result of interest rates changing, even when the FI had
matched the maturity of its assets and liabilities (MA  ML  1 year), as well as the
dollar amount of loans (assets) and deposits (liabilities) (i.e., $A  $L).
Despite the matching of maturities, the FI is still exposed to interest rate risk
because the timing of the cash flows on the deposit and loan are not perfectly
matched. In a sense, the cash flows on the loan are received, on average, earlier
than cash flows are paid out on the deposit, where all cash flows occur at the end
of the year. Chapter 9 shows that only by matching the average lives of assets and
liabilities—that is, by considering the precise timing of arrival (or payment) of
cash flows—can an FI immunize itself against interest rate risk.

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