Chapter Seven

Risk Management for Changing Interest

Rates: Asset-Liability Management and
Duration Techniques
 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 Interest Rate Risk Management

Techniques

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 Introduction

• Even as a financial institution takes on risk, it must protect the

value of its net worth from erosion, which could result in
ultimate failure
• Financial-service managers have learned to look at their asset
and liability portfolios as an integrated whole
• They must consider how their institution’s whole portfolio
contributes to the firm’s goals of adequate profitability and
acceptable risk
▫ Known as asset-liability management (ALM)
▫ Can protect against business cycles and seasonal pressures

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 Asset-Liability Management Strategies

• Asset Management Strategy

▫ Control over assets, no control over liabilities
• Liability Management Strategy
▫ Control over liabilities by changing rates and other terms
• Funds Management Strategy
▫ Works with both strategies

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 EXHIBIT 7–1 Asset-Liability Management in Banking and
Financial Services

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 Interest Rate Risk: One of the Greatest
Management Challenges
• Changing interest rates impact both the balance sheet and the
statement of income and expenses of financial firms
• Price Risk
▫ When interest rates rise, the market value of the bond or asset
falls
• Reinvestment Risk
▫ When interest rates fall, the coupon payments on the bond are
reinvested at lower rates

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 Interest Rate Risk: One of the Greatest
Management Challenges (continued)
• Forces Determining Interest Rates
▫ Loanable Funds Theory
• The Measurement of Interest Rates
▫ YTM
▫ Bank Discount
• Components of Interest Rates

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 EXHIBIT 7–2 Determination of the Rate of Interest in the
Financial Marketplace Where the Demand and Supply of
Loanable Funds (Credit) Interact to Set the Price of Credit

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 Interest Rate Risk: One of the Greatest
Management Challenges (continued)
• Interest rates are the price of credit
▫ Demanded by lenders as compensation for the use of borrowed funds
▫ Expressed in percentage points and basis points (1/100 of a percentage
point)
• 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

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 Interest Rate Risk: One of the Greatest
Management Challenges (continued)
• How to Calculate the Yield to Maturity

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 Interest Rate Risk: One of the Greatest
Management Challenges (continued)

• Another popular interest rate measure is the bank discount rate

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

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 Interest Rate Risk: One of the Greatest
Management Challenges (continued)
• The DR measure ignores the effect of compounding and is based
on a 360-day year
▫ Unlike the YTM measure, which assumes a 365-day year and assumes
that interest income is compounded at the calculated YTM
▫ The DR measure uses the face value of a financial instrument to calculate
its yield or rate of return
▫ Makes calculations easier but is theoretically incorrect
▫ The purchase price of a financial instrument is a much better base to use
in calculating the instrument’s true rate of return

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 Interest Rate Risk: One of the Greatest
Management Challenges (continued)

• To convert a DR to the equivalent yield to maturity, we can use the

formula

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 Interest Rate Risk: One of the Greatest
Management Challenges (continued)
• Market interest rates are a function of
▫ Risk-free real rate of interest
▫ Various risk premiums
▫ Default Risk
▫ Inflation Risk
▫ Liquidity Risk
▫ Call Risk
▫ Maturity Risk

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 Interest Rate Risk: One of the Greatest
Management Challenges (continued)
• Market interest rate formula

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 Interest Rate Risk: One of the Greatest
Management Challenges (continued)
• Yield Curves
▫ Graphical picture of the relationship between yields and maturities of
securities
▫ Generally created with treasury securities to keep default risk constant
▫ Shapes of the yield curve
▫ Upward – long-term rates are higher than short-term rates
▫ Downward – short-term rates are higher than long-term rates
▫ Horizontal – short-term and long-term rates are equal

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 EXHIBIT 7–3 Yield Curves for U.S. Treasury Securities in
2009 and 2010

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 Interest Rate Risk: One of the Greatest
Management Challenges (continued)
• Typically managers of financial institutions that focus on
lending fare somewhat better with an upward-sloping 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)
• In contrast, a relatively flat (horizontal) or negatively sloped
yield curve often generates a small or even negative net
interest margin
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 EXHIBIT 7–4 The Spread between Short-Term and Long-
Term Interest Rates on Treasury Securities (October 2010)

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin

• In order to protect profits against adverse interest

rate changes, management seeks to hold fixed the
financial firm’s net interest margin (NIM)

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)
• 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
▫ If management feels its institution is excessively exposed to
interest rate risk, it will try to match as closely as possible the
volume of assets that can be repriced as interest rates change
with the volume of liabilities whose rates can also be adjusted
with market conditions during the same time period

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)
• Examples of Repriceable (Interest-Sensitive) Assets and
(Interest-Sensitive) Liabilities and Nonrepriceable Assets
and Liabilities

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)

• 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 gap is the portion of the balance sheet affected by

interest rate risk

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)

• If interest-sensitive assets exceed the volume of interest-

sensitive liabilities subject to repricing, the financial firm is
said to have a positive gap and to be asset sensitive

• In the opposite situation, suppose an interest-sensitive

bank’s liabilities are larger than its interest-sensitive assets

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)

• There are several ways to measure the interest-sensitive gap

(IS GAP)
▫ One method – Dollar IS GAP
▫ If interest-sensitive assets (ISA) are $150 million and interest-
sensitive liabilities (ISL) are $200 million
▫ The Dollar IS GAP = ISA – ISL = $150 million – $200 million = -
$50 million
▫ An institution whose Dollar IS GAP is positive is asset sensitive,
while a negative Dollar IS GAP describes a liability-sensitive
condition

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)
• Relative IS GAP ratio

▫ A Relative IS GAP greater than zero means the institution is

asset sensitive, while a negative Relative IS GAP describes a
liability-sensitive financial firm

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)

• Interest Sensitivity Ratio (ISR)

▫ An ISR of less than 1 tells us we are looking at a liability-

sensitive institution, while an ISR greater than unity points to
an asset-sensitive institution
▫ Only if interest-sensitive assets and liabilities are equal is a
financial institution relatively insulated from interest rate risk

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)
• 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 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
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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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)
• Many institutions use computer-based techniques in which
their assets and liabilities are classified as due or repriceable
today, during the coming week, in the next 30 days, and so
on

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)
• The net interest margin is influenced by multiple factors:
1. Changes in the level of interest rates
2. Changes in the spread between asset yields and liability costs
3. Changes in the volume of interest-bearing (earning) assets a
financial institution holds as it expands or shrinks the overall scale
of its activities
4. Changes in the volume of interest-bearing liabilities that are used to
fund earning assets as a financial institution grows or shrinks in
size
5. Changes in the mix of assets and liabilities that management draws
upon as it shifts between floating and fixed-rate assets and
liabilities, between shorter and longer maturity assets and liabilities,
and between assets bearing higher versus lower expected yields

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)

• We calculate a firm’s net interest income to see how it will

change if interest rates rise
• Net interest income can be derived from the following formula

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)

• A useful overall measure of interest rate risk exposure is the

cumulative gap
▫ The total difference in dollars between those assets and liabilities
that can be repriced over a designated period of time
• Given any specific change in market interest rates, we can
calculate approximately how net interest income will be
affected by an interest rate change

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 One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)

• Problems with Interest-Sensitive GAP Management

▫ Interest paid on liabilities tend to move faster than interest
rates earned on assets
▫ The interest rate attached to bank assets and liabilities do not
move at the same speed as market interest rates
▫ The point at which some assets and liabilities are repriced is
not easy to identify
▫ The interest-sensitive gap does not consider the impact of
changing interest rates on equity positions

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 TABLE 7–2 Eliminating an Interest-Sensitive Gap

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 The Concept of Duration as a Risk-Management
Tool

• Duration is a value-weighted and time-weighted measure of

maturity that considers the timing of all cash inflows from
earning assets and all cash outflows associated with liabilities
▫ Measures the average maturity of a promised stream of future cash
payments

or

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 The Concept of Duration as a Risk-Management
Tool (continued)

• The net worth (NW) of any business or household is equal

to the value of its assets less the value of its liabilities

• 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

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 The Concept of Duration as a Risk-Management
Tool (continued)
• 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
• 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
• Thus, duration analysis can be used to stabilize, or immunize, the
market value of a financial institution’s net worth

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 The Concept of Duration as a Risk-Management
Tool (continued)
• 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

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 The Concept of Duration as a Risk-Management
Tool (continued)
• The relationship between an asset’s change in price and its change
in yield or interest rate is captured by a key term in finance that is
related to duration – convexity
▫ Convexity refers to the presence of a nonlinear relationship between
changes in an asset’s price and changes in market interest rates
• It is a number designed to aid portfolio managers in measuring and
controlling the market risk in a portfolio of assets
• An asset or portfolio bearing both a low duration and low
convexity normally displays relatively small market risk
• Convexity increases with the duration of an asset
• It tells us that the rate of change in any interest-bearing asset’s
price (market value) for a given change in interest rates varies
according to the prevailing level of interest rates
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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
(continued)
• Because the dollar volume of assets usually exceeds the dollar volume of
liabilities, a financial institution seeking to minimize the effects of interest
rate fluctuations would need to adjust for leverage

• Equation (7-21) states that the value of liabilities must change by slightly
more than the value of assets to eliminate a financial firm’s overall interest-
rate risk exposure
• The larger the leverage-adjusted duration gap, the more sensitive will be
the net worth (equity capital) of a financial institution to a change in
interest rates
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 Using Duration to Hedge against Interest Rate Risk
(continued)

• Expanding the balance sheet relationship of Equation (7–17)

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 Using Duration to Hedge against Interest Rate Risk
(continued)

• Suppose a bank holds the following portfolio of assets and

their corresponding durations

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 Using Duration to Hedge against Interest Rate Risk
(continued)
• Weighting each asset duration by its associated dollar volume, we can
calculate the duration of the asset portfolio as:

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 Using Duration to Hedge against Interest Rate Risk
(continued)
• The impact of changing market interest rates on net worth can be
described as:

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 The 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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 Quick Quiz
• What do the following terms mean: asset management? liability
management? funds management?
• What is the yield curve, and why is it important to know about its
shape or slope?
• Can you explain the concept of gap management?
• When is a financial firm asset sensitive? Liability sensitive?
• Explain the concept of weighted interest-sensitive gap. How can this
concept aid management in measuring a financial institution’s real
interest-sensitive gap risk exposure?
• 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?

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