ECON3610

Money and Banking

Lecture Topic 10

Asset-Liability Management
Readings: Rose and Hudgins: Ch. 7
(Exclude pages: 212-216)

Summary
Asset Management strategies
Liability Management Strategies
The Goals of Interest Rate Hedging
Interest-Sensitive Gap Management
Duration Gap Management
Limitations of Interest Rate Risk
Examples

Asset-Liability Management
The Purpose of Asset-Liability
Management is to Control a Banks
Sensitivity to Changes in Market Interest
Rates and Limit its Losses in its Net
Income or Equity

Historical View of Asset-Liability

Management
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

7-6

EXHIBIT 71 Asset-Liability Management in Banking and

Financial Services

7-7

Interest Rate Risk: One of the Greatest

Management Challenges (continued)
Typically managers of financial institutions that focus
on lending fare somewhat better with an upwardsloping 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 shorterterm 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

Net Interest Margin

Interest Income - Interest Expenses

NIM
Total Earnings Assets

7-9

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

7-10

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

7-11

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

7-12

One of the Goals of Interest Rate Hedging:

Protect the Net Interest Margin (continued)
If interest-sensitive assets exceed the volume of interestsensitive 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

banks liabilities are larger than its interest-sensitive
assets

7-13

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

Interest-Sensitive Gap Measurements

Interest-Sensitive Assets
Dollar InterestSensitive Gap = Interest Sensitive Liabilities
Relative
Dollar IS Gap
Interest
Bank Size
Sensitive Gap
Interest
Interest Sensitive Assets
Sensitivity
Interest
Sensitive
Liabilitie
s
Ratio

Interest-Sensitive Assets
Short-Term Securities Issued by the
Government and Private Borrowers
Short-Term Loans Made by the Bank
to Borrowing Customers
Variable-Rate Loans Made by the
Bank to Borrowing Customers

Gap Positions and the Effect of Interest

Rate Changes on the Bank
Asset-Sensitive
Bank
Interest Rates Rise
NIM Rises
Interest Rates Fall
NIM Falls

Liability-Sensitive
Bank
Interest Rates Rise
NIM Falls
Interest Rates Fall
NIM Rises

Zero Interest-Sensitive Gap

Dollar Interest-Sensitive Gap is Zero
Relative Interest-Sensitive Gap is Zero
Interest Sensitivity Ratio is One
When Interest Rates Change in Either
Direction - NIM is Protected and Will Not
Change

Important Decision Regarding IS

Gap
Management Must Choose the Time Period
Over Which NIM is to be Managed
Management Must Choose a Target NIM
To Increase NIM Management Must Either:
Develop Correct Interest Rate Forecast
Reallocate Assets and Liabilities to Increase
Spread

Management Must Choose Volume of InterestSensitive Assets and Liabilities

NIM Influenced By:

Changes in Interest Rates Up or Down
Changes in the Spread Between Assets and
Liabilities
Changes in the Volume of Interest-Sensitive
Assets and Liabilities
Changes in the Mix of Assets and Liabilities

Cumulative Gap
The Total Difference in Dollars
Between Those Bank Assets and
Liabilities Which Can be Repriced
over a Designated Time Period

Aggressive Interest-Sensitive Gap

Management
Expected Change
in Interest Rates

Best InterestSensitive Gap

Position

Aggressive
Managements
Likely Action

Rising Market
Interest Rates

Positive IS Gap

Increase in IS
Assets
Decrease in IS
Liabilities

Falling Market
Interest Rates

Negative IS Gap

Decrease in IS
Assets
Increase in IS
Liabilities

Problems with Interest-Sensitive Gap

Management
Interest Paid on Liabilities Tend to Move Faster
than Interest Rates Earned on Assets
Interest Rate Attached to Bank Assets and
Liabilities Do Not Move at the Same Speed as
Market Interest Rates
Point at Which Some Assets and Liabilities are
Repriced is Not Easy to Identify
Interest-Sensitive Gap Does Not Consider the
Impact of Changing Interest Rates on Equity
Position

The Concept of Duration

Duration is the Weighted Average
Maturity of a Promised Stream of
Future Cash Flows

7-24

To Calculate the Instruments Duration

(1 YTM)
t * CFt

D t 1
n

(1 YTM)
t 1

CFt

(1 YTM)
t 1

t * CFt

Current Market Value or Price

7-25

The Concept of Duration as a RiskManagement 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 institutions assets and its liabilities will
change, resulting in a change in its net worth

7-26

The Concept of Duration as a RiskManagement 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 firms 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 institutions net worth

Price Sensitivity of a Security

P
i
-D*
P
(1 i)

7-28

The Concept of Duration as a RiskManagement Tool (continued)

The relationship between an assets 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 assets 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 assets
price (market value) for a given change in interest rates varies
according to the prevailing level of interest rates

7-29

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

7-30

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 firms 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

Duration of an Asset portfolio

n

D A w i * D Ai
i 1

Where:
wi = the dollar amount of the ith asset divided by total assets
DLi = the duration of the ith asset in the portfolio

Duration of a Liability Portfolio

n

D L w i * D Li
i 1

Where:
wi = the dollar amount of the ith liability divided by total liabilities
DLi = the duration of the ith liability in the portfolio

Duration Gap

TL
D DA - DL *
TA

Change in the Value of a Banks

Net Worth

i
i
NW - D A *
* A - - D L *
* L
(1 i)
(1 i)

7-35

Using Duration to Hedge against Interest Rate

Risk (continued)
Suppose a bank holds the following portfolio of assets and
their corresponding durations

7-36

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:

7-37

Impact of Changing Interest Rates on a Banks

Net Worth

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