Risk Management

for Changing
Interest Rates:

Asset-Liability
Management and
Duration
Techniques

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 Overview of ALM
• Management decisions are intimately linked to each other.
• For example, decisions on which customer credit requests should be fulfilled are
closely related to the ability of the financial firm to raise funds in order to support
the requested new loans.
• Similarly, the amount of risk that a financial firm accepts in its portfolio is closely
related to the adequacy and composition of its capital (net worth), which protects
its stockholders and creditors against loss.
• Today financial-service managers have learned to look at their asset and liability
portfolios as an integrated whole, considering how their institution's whole
portfolio contributes to the firm's broad goals of adequate profitability and
acceptable risk. This type of coordinated and integrated decision-making is
known as asset-liability management (ALM).

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 Asset Management Strategy
▪ The amount and kinds of deposits a depository institution held, and the
volume of other borrowed funds were largely determined by its customers.
▪ The key decision area for management was not deposits and other borrowings
but assets.
▪ The financial manager could exercise control only over the allocation of
incoming funds by deciding who was to receive the scarce quantity of loans
available and what the terms on those loans would be.

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 Liability Management Strategy
▪ Confronted with fluctuating interest rates and intense competition for funds,
financial firms began to devote greater attention to opening up new sources of
funding and monitoring the mix and cost of their deposit and non-deposit
liabilities. The new strategy is called liability management.
▪ Its goal was simply to gain control over funds sources comparable to the control
financial managers had long exercised over their assets. The key control lever
was price-the interest rate and other terms offered on deposits and other
borrowings to achieve the volume, mix, and cost desired.
▪ For example, a lender faced with heavy loan demand that exceeded its available
funds could simply raise the offer rate on its borrowings relative to its
competitors, and funds would flow in.

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Asset-Liability Management in Banking and Financial
Services

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 Funds Management Strategy
The maturing of liability management techniques, coupled with more volatile interest
rates and greater risk, eventually gave birth to the “Funds management” approach.
key objectives are as follows:
1. Management should exercise as much control as possible over the volume, mix, and
return or cost of both assets and liabilities in order to achieve the financial
institution's goals.
2. Management’s control over assets must be coordinated with control over liabilities.
Effective coordination in managing assets and liabilities will help to maximize the
spread between revenues and costs and control risk exposure.
3. Management policies need to be developed that maximize returns and effectively
control costs from supplying services.

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Funds Management
Strategy (Cont’d)
▪ Income from managing the
liability side of the balance
sheet can help achieve
profitability goals as much as
revenues generated from
managing loans and other
assets.
▪ Many financial firms carry
out daily asset-liability
management (ALM) activities
through asset-liability
committees (ALCO), usually
composed of key officers
representing different
departments of the firm.

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 Interest Rate Risk: One of the Greatest
Management Challenges
▪ No financial manager can completely avoid one of the toughest and potentially
most damaging forms of risk that all financial institutions must face-interest rate
risk.
▪ When interest rates change in the financial marketplace, the sources of revenue
that financial institutions receive-especially interest income on loans and
investment securities-and their most important source of expenses-interest cost
on borrowings-must also change.
▪ Moreover, changing interest rates also change the market value of assets and
liabilities, thereby changing each financial institution's net worth-the value of the
owner's investment in the firm.
▪ Thus, changing interest rates impact both the balance sheet and the statement of
income and expenses of financial firms.

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Forces Determining Interest Rates

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 Risk Financial firms face with the change in
Interest rate
▪ As market interest rates move, financial firms typically face at least two major
kinds of interest rate risk-price risk and reinvestment risk.
▪ Price risk arises when market interest rates rise, causing the market values of
most bonds and fixed-rate loans to fall. If a financial institution wishes to sell
these financial instruments in a rising rate period, it must be prepared to accept
capital losses.
▪ Reinvestment risk rears its head when market interest rates fall, forcing a
financial firm to invest incoming funds in lower-yielding earning assets, lowering
its expected future income. A big part of managing assets and liabilities consists
of finding ways to deal effectively with these two forms of risk.

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 The Measurement of Interest Rates
▪ Interest rates are the price of credit, demanded by lenders as compensation for
the use of borrowed funds. In simplest terms the interest rate is a ratio of the fees
we must pay to obtain credit divided by the amount of credit obtained ( expressed
in percentage points and basis points [i.e., 1/100 of a percentage point])
▪ For example, one of the most popular rate measures is the yield to maturity
(YTM)the discount rate that equalizes the current market value of a loan or
security with the expected stream of future income payments that the loan or
security will generate. In terms of a formula, the yield to maturity may be found
from

where n is the
number of years
that payments
occur.

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 YTM (Cont’d)
▪ For example, 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, will have a promised interest rate, measured by the yield to
maturity, determined by:

This bond's YTM is determined to be 12.10 percent.

(Note: the YTM for bonds is parallel to the APR for loans.)

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 Bank discount rate
▪ Another popular interest rate measure is the bank discount rate, which is often
quoted on short-term loans and money market securities (such as Treasury bills).
The formula for calculating the discount rate (DR) is as follows:

▪ For example, suppose a money market security can be purchased for a price of $96
and has a face value of $100 to be paid at maturity. If the security matures in 90
days, its interest rate measured by the DR must be

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 YTM vs Discount rate
▪ We note that this interest rate measure ignores the effect of compounding of
interest and is based on a 360-day year, unlike the yield to maturity measure,
which assumes a 365-day year and assumes that interest income is compounded
at the calculated YTM.
▪ In addition, the DR uses the face value of a financial instrument to calculate its
yield or rate of return, a simple approach that makes calculations easier but is
theoretically incorrect.
▪ The purchase price of a financial instrument, rather than its face amount, is a
much better base to use in calculating the instrument's true rate of return.
▪ To convert a DR to the equivalent yield to maturity we can use the formula

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 The Maturity Gap and the Yield Curve
▪ Most lending institutions experience a positive maturity gap between the average
maturity of their assets and the average maturity of their liabilities.
▪ If the yield curve is upward sloping, then revenues from longer-term assets will
outstrip expenses from shorter-term liabilities. The result will normally be a
positive net interest margin (interest revenues greater than interest expenses),
which tends to generate higher earnings.
▪ In contrast, a relatively flat (horizontal) or negatively sloped yield curve often
generates a small or even negative net interest margin, putting downward
pressure on the earnings of financial firms that borrow short and lend long.

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 Responses to Interest Rate Risk
▪ Changes in market interest rates can damage a financial firm’s profitability by
increasing its cost of funds, by lowering its returns from earning assets, and by
reducing the value of the owners' investment (net worth or equity capital).

▪ Many banks now conduct their asset-liability management strategies under the
guidance of an asset-liability committee, or ALCO.

▪ A well-run ALCO meets regularly ( quarterly, monthly, or even more frequently) to

manage the financial firm's interest rate risk (IRR) and other risk exposures as well.
The committee is expected to have a firm grasp of the organization's principal goals,
usually centered on the maximization of shareholder wealth, maintaining adequate
profitability, and achieving sufficient capitalization.

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 Responses to Interest Rate Risk(Cont’d)
▪ The committee lays out a plan for how the firm should be funded, the quality of loans that it
should take on, and the proper limits to its off-balance-sheet risk exposure.

▪ The ALCO estimates the firm's risk exposure to its net interest margin and net worth ratios,
develops strategies to keep that risk exposure within well-defined limits and may employ
simulation analysis to test alternative management strategies.

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin
▪ No matter which way interest rates go, managers of financial institutions want
stable profits that achieve the level of profitability desired.
▪ In order to protect profits against adverse interest rate changes, then,
management seeks to hold fixed the financial firm's net interest margin (NIM),
expressed as follows:

▪ If the interest cost of borrowed funds rises faster than income from loans and
securities, a financial firm's NIM will be squeezed, with likely adverse effects on
profits. If interest rates fall and cause income from loans and securities to decline
faster than interest costs on borrowings, the NIM will again be squeezed.

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 Interest-Sensitive Gap Management as a Risk-
Management Tool
▪ Among the most popular interest rate hedging strategies in use today is interest-
sensitive gap management.
▪ Gap management techniques require management to perform an analysis of the
maturities and repricing opportunities associated with interest-bearing assets
and with interest-bearing liabilities.
▪ For example, a financial firm can hedge itself against interest rate changes-no
matter which way rates move-by making sure for each time period that the

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 Interest-Sensitive Gap Management as a Risk-
Management Tool (Cont’d)
▪ What is a repriceable asset?
The most familiar examples of repriceable assets include loans that are about to mature
or will soon to come up for renewal or repricing, such as variable-rate business and
household loans (including credit card accounts and adjustable-rate home mortgages
(ARMs) ).

▪ What is a repriceable liability?

Repriceable liabilities include a depository institution's certificates of deposit (CDs)
about to mature or eligible to be renewed, where the financial firm and its customer
must negotiate new deposit interest rates that capture current market conditions.
▪ Clearly, a gap then exists between these interest-sensitive assets and interest-
sensitive liabilities. The gap is the portion of the balance sheet affected by interest
rate risk:

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Interest-Sensitive Gap Management as a Risk-
Management Tool (Cont’d)

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Interest-Sensitive Gap Management as a Risk-
Management Tool (Cont’d)

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 Interest-Sensitive Gap Management as a Risk-
Management Tool (Cont’d)
▪ Another risk management tool: Cumulative gap
A useful overall measure of interest rate risk exposure is the cumulative gap,
which is the total difference in dollars between those assets and liabilities that can
be repriced over a designated period of time.

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 Interest-Sensitive Gap Management as a Risk-
Management Tool (Cont’d)
▪ For example, 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 must be -$600 million that is: ($100 million in earning assets
per month X 6) - ($200 million in liabilities per month X 6) = -$600 million.
▪ The cumulative gap concept is useful because, given any specific change in market
interest rates, we can calculate approximately how net interest income will be affected
by an interest rate change. The key relationship is this:

For example, suppose market interest rates suddenly rise by 1 full percentage point.
Then the bank in the example given above will suffer a net interest income loss of
approximately
(+0.01) X (-$600 million) = -$6 million
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 Key conclusions for managers from Interest-
Sensitive Gap Management
▪ Gapping methods used today vary greatly in complexity and form. All methods,
however, require financial managers to make some important decisions:
1. Management must choose the time period during which the net interest margin
(NIM) is to be managed (e.g., six months or one year) to achieve some desired value
and the length of subperiods ("maturity buckets") into which the planning period is
to be divided.
2. Management must choose a target level for the net interest margin-that is,
whether to freeze the margin roughly where it is or perhaps increase the NIM.
3. If management wishes to increase the NIM, it must either develop a correct
interest rate forecast or find ways to reallocate earning assets and liabilities to
increase the spread between interest revenues and interest expenses.
4. Management must determine the volume of interest-sensitive assets and
interest-sensitive liabilities it wants the financial firm to hold.

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 The Concept of Duration as a
Risk Management Tool
• Duration is a value- and time-weighted measure of maturity that considers the
timing of all cash inflows from earning assets and all cash outflows associated
with liabilities. In effect, duration measures the average time needed to recover
the funds committed to an investment.

D stands for the instrument's duration in years and fractions of a year; t

represents the period of time in which each flow of cash off the instrument, such
as interest or dividend income, is to be received; CF indicates the volume of each
expected flow of cash in each time period (t); and YTM is the instrument's current
yield to maturity. 26
 The Concept of Duration as a
Risk Management Tool (Cont’d)
• For example, 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.

The duration of the loan is $4,169.87/$1,000.00, or 4.17 years.

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 The Concept of Duration as a
Risk Management Tool (Cont’d)
• As market interest rates change, the value of both a financial institution's assets and
its liabilities will change, resulting in a change in its net worth ( the owner's
investment in the institution):

Portfolio theory teaches us that

1. A rise in market rates of interest will cause the market value (price) of both fixed-
rate assets and liabilities to decline.

2. The longer the maturity of a financial firm's assets and liabilities, the more they
will tend to decline in market value (price) when market interest rates rise.

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 The Concept of Duration as a
Risk Management Tool (Cont’d)

▪ Because duration is a measure of maturity, a financial firm with longer-duration

assets than liabilities will suffer a greater decline in net worth when market interest
rates rise than a financial institution whose asset duration is relatively short term or
one that matches the duration of its liabilities with the duration of its assets.
▪ By equating asset and liability durations, management can balance the average
maturity of expected cash inflows from assets with the average maturity of expected
cash outflows associated with liabilities.

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 Price Sensitivity to Changes in Interest Rates
and Duration
• The important feature of duration from a risk-management point of view is that it
measures the sensitivity of the market value of financial instruments to changes in
interest rates.
• The percentage change in the market price of an asset or a liability is equal to its duration
times the relative change in interest rates attached to that particular asset or liability.
That is,

where Δp ÷ P represents the percentage change in market price and Δ i ÷ ( 1 + i) is the

relative change in interest rates associated with the asset or liability. D represents duration,
and the negative sign attached to it reminds us that market prices and interest rates on
financial instruments move in opposite directions.
• The relationship between an asset's change in price and its change in yield or interest rate
is called convexity. An asset or portfolio bearing both a low duration and low convexity
normally displays relatively small market risk.

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 Using Duration to Hedge against Interest Rate
Risk
• A financial-service provider interested in fully hedging against interest rate
fluctuations wants to choose assets and liabilities such that

so that the duration gap is as close to zero as possible

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 Using Duration to Hedge against Interest Rate
Risk
• Institution faces a substantial decline in the value of its net worth unless it can hedge itself
against the projected loss due to rising interest rates. The impact of changing market interest
rates on net worth is indicated by entries in the following table:

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 Using Duration to Hedge against Interest Rate
Risk
• How much will the value of this bank's net worth change for any given change in
interest rates? The appropriate formula is as follows:

The above formula reminds us that the impact of interest rate changes on the market value of
net worth depends upon three crucial size factors:
A. The size of the duration gap (DA – Dd), with a larger duration gap indicating greater
exposure of a financial firm to interest rate risk.
B. The size of a financial institution (A and L), with larger institutions experiencing a greater
change in net worth for any given change in interest rates.
C. The size of the change in interest rates, with larger rate changes generating greater
interest rate risk exposure.

Management can reduce a financial firm's exposure to interest rate risk by closing up the
firm's duration gap (changing DA, DL, or both) or by changing the relative amounts of assets
and liabilities (A and L)outstanding. 33
Thank you!

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