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1、CHAPTER 7ASSET-LIABILITY MANAGEMENT: DETERMINING AND MEASURING INTEREST RATES AND CONTROLLING INTERESTSENSITIVE AND DURATION GAPSGoals of This Chapter： The purpose of this chapter is to explore the options bankers have today for dealing with risk especially the risk of loss due to changing interest
2、rates and to see how a banks management can coordinate the management of its assets with the management of its liabilities in order to achieve the institutions goals。 Key Topic In This Chapter Asset, Liability， and Funds Management Market Rates and Interest Rate Risk The Goals of Interest Rate Hedgi
3、ng Interest Sensitive Gap Management Duration Gap Management Limitations of Hedging TechniquesChapter OutlineI。Introduction： The Necessity for Coordinating Bank Asset and Liability Management DecisionsII。Asset/Liability Management StrategiesA.Asset Management StrategyB。Liability Management StrategyC
4、。Funds Management StrategyIII。Interest Rate Risk： One of the Greatest AssetLiability Management Strategy ChallengesA。Forces Determining Interest RatesB.The Measurement of Interest Rates1.Yield to Maturity2.Bank Discount RateC. The Components of Interest Rates1。Risk Premiums2。Yield Curves3.The Maturi
5、ty Gap and the Yield CurveD.Response to Interest Rate RiskIV。One of the Goals of InterestRate HedgingA。The Net Interest MarginB。InterestSensitive Gap Management1。AssetSensitive Position2.LiabilitySensitive Position3.Dollar InterestSensitive Gap4.Relative Interest Sensitive Gap5。Interest Sensitivity
6、Ratio6。Computer-Based Techniques 7。Cumulative Gap8.Strategies in Gap ManagementC。 Duration Gap ManagementV.The Concept of DurationA. Definition of DurationB. Calculation of DurationC. Net Worth and DurationD. Price Risk and DurationE. Convexity and DurationVI.Using Duration to Hedge Against Interest
7、-Rate RiskA。Duration Gap1。Dollar Weighted Duration of Assets2.Dollar Weighted Duration of Liabilities3。Positive Duration Gap4。Negative Duration GapB.Change in the Banks Net WorthVII。The Limitations of Duration Gap ManagementVIII。Summary of the ChapterConcept Checks71。What do the following terms mean
8、： Asset management？ Liability management？ Funds management?Asset management refers to a banking strategy where management has control over the allocation of bank assets but believes the banks sources of funds (principally deposits) are outside its control。 Liability management is a strategy of contr
9、ol over bank liabilities by varying interest rates offered on borrowed funds。 Funds management combines both asset and liability management approaches into a balanced liquidity management strategy。7-2。What factors have motivated financial institutions to develop funds management techniques in recent
10、 years?The necessity to find new sources of funds in the 1970s and the risk management problems encountered with troubled loans and volatile interest rates in the 1970s and 1980s led to the concept of planning and control over both sides of a banks balance sheet - the essence of funds management.73。
11、What forces cause interest rates to change? What kinds of risk do financial firms face when interest rates change？Interest rates are determined， not by individual banks， but by the collective borrowing and lending decisions of thousands of participants in the money and capital markets。 They are also
12、 impacted by changing perceptions of risk by participants in the money and capital markets, especially the risk of borrower default, liquidity risk， price risk, reinvestment risk， inflation risk， term or maturity risk， marketability risk， and call risk。Financial institutions can lose income or value
13、 no matter which way interest rates go。 Rising interest rates can lead to losses on security instruments and on fixedrate loans as the market values of these instruments fall。 Falling interest rates will usually result in capital gains on fixedrate securities and loans but an institution will lose i
14、ncome if it has more rate-sensitive assets than liabilities。 Rising interest rates will also cause a loss to income if an institution has more rate-sensitive liabilities than rate-sensitive assets.74。What makes it so difficult to correctly forecast interest rate changes？Interest rates cannot be set
15、by an individual bank or even by a group of banks; they are determined by thousands of investors trading in the credit markets。 Moreover， each market rate of interest has multiple components-the risk-free interest rate plus various risk premia。 A change in any of these rate components can cause inte
16、rest rates to change。 To consistently forecast market interest rates correctly would require bankers to correctly anticipate changes in the risk-free interest rate and in all rate components。 Another important factor is the timing of the changes。 To be able to take full advantage of their prediction
17、s, they also need to know when the changes will take place。75。What is the yield curve and why is it important for bankers to know about its shape or slope？The yield curve is a graphical description of the distribution of market interest rates by maturity of financial instrument. The slope of the yie
18、ld curve determines the spread between long-term and shortterm interest rates。 In banking most of the long-term rates apply to loans and securities （i。e.， bank assets） and most of the shortterm interest rates are attached to bank deposits and money market borrowings. Thus， the shape or slope of the
19、yield curve has a profound influence on a banks net interest margin or spread between asset revenues and liability costs.76.What is it that a lending institutions wishes to protect from adverse movements in interest rates?A financial institution wishes to protect both the value of assets and liabili
20、ties and the revenues and costs generated by both assets and liabilities from adverse movements in interest rates.7-7。What is the goal of hedging?The goal of hedging in banking is to freeze the spread between asset returns and liability costs and to offset declining values on certain assets by profi
21、table transactions so that a target rate of return is assured.78。First National Bank of Bannerville has posted interest revenues of 63 million and interest costs of $42 million。 If this bank possesses 700 million in total earning assets， what is First Nationals net interest margin？ Suppose the banks
22、 interest revenues and interest costs double, while its earning assets increase by 50 percent. What will happen ti its net interest margin？Net Interest=63 mill。 42 mill。= 0。03 or 3 percentMargin$700 mill.If interest revenues and interest costs double while earning assets grow by 50 percent， the net
23、interest margin will change as follows:($63 mill. 42 mill.) * 2= 0。04 or 4 percent$700 mill. （1。50)Clearly the net interest margin increases-in this case by one third。79.Can you explain the concept of gap management？Gap management involves determining the maturity distribution and the repricing sche
24、dule for a banks assets and liabilities。 When more assets are subject to repricing or will reach maturity in a given period than liabilities or vice versa， the bank has a GAP between assets and liabilities and is exposed to loss from adverse interest-rate movements based on the gaps size and directi
25、on。710When is a financial institution asset sensitive？ Liability sensitive?A financial institution is asset sensitive when it has more interest-rate sensitive assets maturing or subject to repricing during a specific time period than rate-sensitive liabilities. A liability sensitive position, in con
26、trast, would find the financial institution having more interestrate sensitive deposits and other liabilities than ratesensitive assets for a particular planning period。7-11. Commerce National Bank reports interestsensitive assets of 870 million andinterest sensitive liabilities of $625 million duri
27、ng the coming month. Is the bank asset sensitive or liability sensitive? What is likely to happen to the banks net interest margin if interest rates rise？ If they fall？ Because interest-sensitive assets are larger than liabilities by 245 million the bank is asset sensitive.If interest rates rise， th
28、e banks net interest margin should rise as asset revenues increase by more than the resulting increase in liability costs。 On the other hand, if interest rates fall, the banks net interest margin will fall as asset revenues decline faster than liability costs。712。Peoples Savings Bank, a thrift insti
29、tution, has a cumulative gap for the coming year of + $135 million and interest rates are expected to fall by two and a half percentage points。 Can you calculate the expected change in net interest income that this thrift institution might experience？ What change will occur in net interest income if
30、 interest rates rise by one and a quarter percentage points？For the decrease in interest rates：Expected Change in = 135 million （0.025） = -3。38 million Net Interest IncomeFor the increase in interest rates:Expected Change in Net Interest = 135 million （+0。0125） = +1。69 million Income713How do you me
31、asure the dollar interestsensitive gap？ The relative interestsensitive gap? What is the interestsensitivity ratio?The dollar interestsensitive gap is measured by taking the repriceable （interestsensitive） assets minus the repriceable (interestsensitive) liabilities over some set planning period. Com
32、mon planning periods include 3 months, 6 months and 1 year。 The relative interestsensitive gap is the dollar interestsensitive gap divided by some measure of bank size （often total assets)。 The interestsensitivity ratio is just the ratio of interestsensitive assets to interest sensitive liabilities。
33、 Regardless of which measure you use， the results should be consistent。 If you find a positive (negative） gap for dollar interestsensitive gap, you should also find a positive （negative) relative interestsensitive gap and an interest sensitivity ratio greater (less） than one.714Suppose Carroll Bank
34、and Trust reports interestsensitive assets of 570 million and interestsensitive liabilities of $685 million。 What is the banks dollar interestsensitive gap？ Its relative interestsensitive gap and interestsensitivity ratio?Dollar InterestSensitive Gap = Interest-Sensitive Assets Interest Sensitive Li
35、abilities= $570 $685 = 115Relative Gap= IS Gap=115= 0。2018 or 20。18 percentBank Size570Interest-Sensitivity=Interest-Sensitive Assets=$570= .8321RatioInterest-Sensitive Liabilities6857-15Explain the concept of weighted interestsensitive gap。 How can this concept aid management in measuring a financi
36、al institutions real interestsensitive gap risk exposure?Weighted interest-sensitive gap is based on the idea that not all interest rates change at the same speed。 Some are more sensitive than others。 Interest rates on bank assets may change more slowly than interest rates on liabilities and both of
37、 these may change at a different speed than those interest rates determined in the open market. In the weighted interestsensitive gap methodology， all interestsensitive assets and liabilities are given a weight based on their speed （sensitivity） relative to some market interest rate。 Fed Funds loans
38、， for example, have an interest rate which is determined in the market and which would have a weight of 1. All other loans, investments and deposits would have a weight based on their speed relative to the Fed Funds rate. To determine the interestsensitive gap， the dollar amount of each type of asse
39、t or liability would be multiplied by its weight and added to the rest of the interestsensitive assets or liabilities. Once the weighted total of the assets and liabilities is determined, a weighted interest-sensitive gap can be determined by subtracting the interest-sensitive liabilities from the i
40、nterestsensitive assets。 This weighted interestsensitive gap should be more accurate than the unweighted interestsensitive gap。 The interest-sensitive gap may change from negative to positive or vice versa and may change significantly the interest rate strategy pursued by the bank。7-16。What is durat
41、ion？Duration is the weighted average time at which the cash flows on a security are received. It is a direct measure of price risk.7-17。How is a financial institutions duration gap determined？A banks duration gap is determined by taking the difference between the duration of a banks assets and the d
42、uration of its liabilities。 The duration of the banks assets can be determined by taking a weighted average of the duration of all of the assets in the banks portfolio。 The weight is the dollar amount of a particular type of asset out of the total dollar amount of the assets of the bank. The duratio
43、n of the liabilities can be determined in a similar manner. The duration of the liabilities is then adjusted to reflect that the bank has fewer liabilities than assets。7-18。What are the advantages of using duration as an assetliability management tool as opposed to interest-sensitive gap analysis？In
44、terest-sensitive gap only looks at the impact of changes in interest rates on the banks net income。 It does not take into account the effect of interest rate changes on the market value of the banks equity capital position。 In addition, duration provides a single number which tells the bank their ov
45、erall exposure to interest rate risk。719。How can you tell you are fully hedged using duration gap analysis？You are fully hedged when the dollar weighted duration of the assets portfolio of the bank equals the dollar weighted duration of the liability portfolio. This means that the bank has a zero du
46、ration gap position when it is fully hedged. Of course, because the bank usually has more assets than liabilities the duration of the liabilities needs to be adjusted by the ratio of total liabilities to total assets to be entirely correct。720。What are the principal limitations of duration gap analy
47、sis? Can you think of some ways of reducing the impact of these limitations?There are several limitations with duration gap analysis。 It is often difficult to find assets and liabilities of the same duration to fit into the banks portfolio。 In addition， some accounts such as deposits and others dont have well defined patterns of cash flows which makes it difficult to calculate duration for these accounts。 Duration is also affected by prepayments by customers as well as default。 Finally， duration analysis wor