Interest/Maturity Gap and Sensitivity

Interest/Maturity Gap

G & K Chp. 5

Why Gap? Manage on- or off-balance sheet

Off-Balance Sheet (Futures, Options, later.)

Economic Environment Maturity Gap Duration Gap

Why Gap?

Maturity Pattern and Interest Rate Sensitivity of Assets and Liabilities differ. Fixed Rate Investment funded by Floating Rates can create Spread Squeezes. Want to create stable Spread, and force maximum funds through Changes in interest rates compound spread management by imparting value management in addition.

Business Cycle and Interest Rates

Trough: Low economic activity; low demand for funds, high demand for safe, liquid investments Low relative rates, + - curve Growth to Peak: Increasing economic activity; high demand for funds, low demand for interest-rate investments Higher relative rates, + - to flattening curve SlowdownTrough; Slowing economic activity, early high demand for funds gives rise to drop off High rates drop, with inverted-curve returning to positive slope

Maturity Gap

Repricing of Book Values of Assets vs. Liabilities in common time periods Pg. 5 of any output
Rate Sensitive Assets (RSAs) and Rate Sensitive Liabilities (RSLs) 3, 6, 9 mo., 1 yr., 1-3 yrs., Over 3 yrs.

Idea is: (Gap = RSA RSL) NII = Gap * R

Maturity Gap

Rates Go Up
Positive Gap Increase NII Negative Gap Decrease NII

Rates Go Down
Positive Gap Decrease NII Negative Gap Increase NII

Problems:
Ignores Market Value Changes Ignores variation in intra-bucket value changes Concentrates on single-period CF, not MV

Maturity Gap

Y1Q4:
3 month Assets: 3596.96 3 month Liabilities: 2617.51 RSA RSL = 3 month Gap = 979.45

3 month Interest Rates go up .25%

NII should jump (0.0025*979.45) $2.45 mill

Duration Gap

Duration Weighted Assets and Liabilities Managing the Change in Equity (Value) from a change in interest rates and their effect on Assets and Liabilities Remember: Price = - D * r / (1 + YTM) * Price Applied to Assets and Liabilities: A = - DA * R / (1 + R) * A L = - DL * R / (1 + R) * L

Duration Gap

Then: E =

A -

E = -[ DA - DL (L/A)] * [R/(1+R)] * A

Change in Equity is negative of difference in durations multiplied by interest rate change multiplied by asset base

Duration Gap

Rates Go Up
Positive Duration Gap Decrease Value Negative Duration Gap Increase Value

Rates Go Down
Positive Duration Gap Increase Value Negative Duration Gap Decrease Value

Duration Gap

From 1.4 Output: Assets: Duration = 0.427 , Value = $4.897 bill Liabs: Duration = 1.103, Value = $4.609 bill

NoticeNegatively Gapped! Assume R=7% 7.05% E = -[ DA - DL (L/A)] * (R/(1+R) * A

= -[.427 1.103 (4.609/4.897)]*(+.0005/1.07)*4.897

= +0.00139846 = +$ 1.39846 million