Chapter Eight

Interest Rate Risk I

Chapter Outline
Introduction
The Central Bank and Interest Rate Risk
The Repricing Model
Rate-Sensitive Assets
Rate-Sensitive Liabilities
Equal Changes in Rates on RSAs and RSLs
Unequal Changes in Rates on RSAs and RSLs
Weaknesses of the Repricing Model
Market Value Effects
Overaggregation
he !roble" of Runoffs
Cash #lo$s fro" Off-%alance Sheet Activities
The Maturity Model
he Maturit& Model $ith a !ortfolio of Assets and Liabilities
Maturity Matching and Interest Rate Exposure
Summary
ppendix !" Term Structure of Interest Rates
Unbiased E'(ectations heor&
Liquidit& !re"iu" heor&
Market Seg"entation heor&
))
Solutions for End#of#Chapter $uestions and %ro&lems" Chapter Eight
*+ ,hat is the re(ricing ga(- .n using this "odel to evaluate interest rate risk/ $hat is "eant b&
rate sensitivit&- On $hat financial (erfor"ance variable does the re(ricing "odel focus-
E'(lain+
he re(ricing ga( is a "easure of the difference bet$een the dollar value of assets that $ill
re(rice and the dollar value of liabilities that $ill re(rice $ithin a s(ecific ti"e (eriod/ $here
re(rice "eans the (otential to receive a ne$ interest rate+ Rate sensitivit& re(resents the ti"e
interval $here re(ricing can occur+ he "odel focuses on the (otential changes in the net
interest inco"e variable+ .n effect/ if interest rates change/ interest inco"e and interest e'(ense
$ill change as the various assets and liabilities are re(riced/ that is/ receive ne$ interest rates+
0+ ,hat is a "aturit& bucket in the re(ricing "odel- ,h& is the length of ti"e selected for
re(ricing assets and liabilities i"(ortant $hen using the re(ricing "odel-
he "aturit& bucket is the ti"e $indo$ over $hich the dollar a"ounts of assets and liabilities
are "easured+ he length of the re(ricing (eriod deter"ines $hich of the securities in a (ortfolio
are rate-sensitive+ he longer the re(ricing (eriod/ the "ore securities either "ature or need to
be re(riced/ and/ therefore/ the "ore the interest rate e'(osure+ An e'cessivel& short re(ricing
(eriod o"its consideration of the interest rate risk e'(osure of assets and liabilities are that
re(riced in the (eriod i""ediatel& follo$ing the end of the re(ricing (eriod+ hat is/ it
understates the rate sensitivit& of the balance sheet+ An e'cessivel& long re(ricing (eriod
includes "an& securities that are re(riced at different ti"es $ithin the re(ricing (eriod/ thereb&
overstating the rate sensitivit& of the balance sheet+
1+ Calculate the re(ricing ga( and the i"(act on net interest inco"e of a * (ercent increase in
interest rates for each of the follo$ing (ositions2
Rate-sensitive assets 3 4055 "illion+ Rate-sensitive liabilities 3 4*55 "illion+
Re(ricing ga( 3 RSA - RSL 3 4055 - 4*55 "illion 3 64*55 "illion+
7.. 3 84*55 "illion98+5*9 3 64*+5 "illion/ or 4*/555/555+
Rate-sensitive assets 3 4*55 "illion+ Rate-sensitive liabilities 3 4*:5 "illion+
Re(ricing ga( 3 RSA - RSL 3 4*55 - 4*:5 "illion 3 -4:5 "illion+
7.. 3 8-4:5 "illion98+5*9 3 -45+: "illion/ or -4:55/555+
Rate-sensitive assets 3 4*:5 "illion+ Rate-sensitive liabilities 3 4*;5 "illion+
Re(ricing ga( 3 RSA - RSL 3 4*:5 - 4*;5 "illion 3 64*5 "illion+
7.. 3 84*5 "illion98+5*9 3 645+* "illion/ or 4*55/555+
)<
a+ Calculate the i"(act on net interest inco"e on each of the above situations assu"ing a
* (ercent decrease in interest rates+
7.. 3 84*55 "illion98-+5*9 3 -4*+5 "illion/ or -4*/555/555+
7.. 3 8-4:5 "illion98-+5*9 3 645+: "illion/ or 4:55/555+
7.. 3 84*5 "illion98-+5*9 3 -45+* "illion/ or -4*55/555+
b+ ,hat conclusion can &ou dra$ about the re(ricing "odel fro" these results-
he #.s in (arts 8*9 and 819 are e'(osed to interest rate declines 8(ositive re(ricing ga(9
$hile the #. in (art 809 is e'(osed to interest rate increases+ he #. in (art 819 has the
lo$est interest rate risk e'(osure since the absolute value of the re(ricing ga( is the lo$est/
$hile the o((osite is true for (art 8*9+
;+ ,hat are the reasons for not including de"and de(osits as rate-sensitive liabilities in the
re(ricing anal&sis for a co""ercial bank- ,hat is the subtle/ but (otentiall& strong/ reason
for including de"and de(osits in the total of rate-sensitive liabilities- Can the sa"e
argu"ent be "ade for (assbook savings accounts-
he regulator& rate available on de"and de(osit accounts is =ero+ Although "an& banks are able
to offer 7O, accounts on $hich interest can be (aid/ this interest rate seldo" is changed and
thus the accounts are not reall& sensitive+ >o$ever/ de"and de(osit accounts do (a& i"(licit
interest in the for" of not charging full& for checking and other services+ #urther/ $hen "arket
interest rates rise/ custo"ers dra$ do$n their ??As/ $hich "a& cause the bank to use higher
cost sources of funds+ he sa"e or si"ilar argu"ents can be "ade for (assbook savings
accounts+
:+ ,hat is the ga( ratio- ,hat is the value of this ratio to interest rate risk "anagers and
regulators-
he ga( ratio is the ratio of the cu"ulative ga( (osition to the total assets of the bank+ he
cu"ulative ga( (osition is the su" of the individual ga(s over several ti"e buckets+ he value
of this ratio is that it tells the direction of the interest rate e'(osure and the scale of that e'(osure
relative to the si=e of the bank+
)+ ,hich of the follo$ing assets or liabilities fit the one-&ear rate or re(ricing sensitivit& test-
@*-da& U+S+ reasur& bills Aes
*-&ear U+S+ reasur& notes Aes
05-&ear U+S+ reasur& bonds 7o
05-&ear floating-rate cor(orate bonds $ith annual re(ricing Aes
15-&ear floating-rate "ortgages $ith re(ricing ever& t$o &ears 7o
15-&ear floating-rate "ortgages $ith re(ricing ever& si' "onths Aes
Overnight fed funds Aes
)B
@-"onth fi'ed rate C?s Aes
*-&ear fi'ed-rate C?s Aes
:-&ear floating-rate C?s $ith annual re(ricing Aes
Co""on stock 7o
<+ Consider the follo$ing balance sheet for ,atchoverU Savings/ .nc+ 8in "illions92
Assets Liabilities and Equit&
#loating-rate "ortgages ?e"and de(osits
8currentl& *5C annuall&9 4:5 8currentl& )C annuall&9 4<5
15-&ear fi'ed-rate loans i"e de(osits
8currentl& <C annuall&9 4:5 8currentl& )C annuall& 405
Equit& 4*5
otal Assets 4*55 otal Liabilities D Equit& 4*55
a+ ,hat is ,atchoverUEs e'(ected net interest inco"e at &ear-end-
Current e'(ected interest inco"e2 4:" 6 41+:" 3 4B+:"+
E'(ected interest e'(ense2 4;+0" 6 4*+0" 3 4:+;"+
E'(ected net interest inco"e2 4B+:" - 4:+;" 3 41+*"+
b+ ,hat $ill be the net interest inco"e at &ear-end if interest rates rise b& 0 (ercent-
After the 055 basis (oint interest rate increase/ net interest inco"e declines to2
:585+*09 6 :585+5<9 - <585+5B9 - 058+5)9 3 4@+:" - 4)+B" 3 40+<"/ a decline of 45+;"+
c+ Using the cu"ulative re(ricing ga( "odel/ $hat is the e'(ected net interest inco"e for
a 0 (ercent increase in interest rates-
,achoviaEsF re(ricing or funding ga( is 4:5" - 4<5" 3 -405"+ he change in net interest
inco"e using the funding ga( "odel is 8-405"985+509 3 -4+;"+
d+ ,hat $ill be the net interest inco"e at &ear-end if interest rates increase 055 basis
(oints on assets/ but onl& *55 basis (oints on liabilities- .s it reasonable for changes in
interest rates to affect balance sheet in an uneven "anner- ,h&-
After the unbalanced rate increase/ net interest inco"e $ill be :585+*09 6 :585+5<9 -
<585+5<9 - 058+5)9 3 4@+:" - 4)+*" 3 41+;"/ an increase of 45+1"+ .t is not unco""on for
interest rates to adGust in an uneven "anner over t$o sides of the balance sheet because
interest rates often do not adGust solel& because of "arket (ressures+ .n "an& cases the
changes are affected b& decisions of "anage"ent+ hus &ou can see the difference
bet$een this ans$er and the ans$er for (art a+
B+ ,hat are so"e of the $eakness of the re(ricing "odel- >o$ have large banks solved the
(roble" of choosing the o(ti"al ti"e (eriod for re(ricing- ,hat is runoff cash flo$/ and
ho$ does this a"ount affect the re(ricing "odelEs anal&sis-
)@
he re(ricing "odel has four general $eaknesses2
8*9 .t ignores "arket value effects+
809 .t does not take into account the fact that the dollar value of rate sensitive assets and
liabilities $ithin a bucket are not si"ilar+ hus/ if assets/ on average/ are re(riced earlier in
the bucket than liabilities/ and if interest rates fall/ #.s are subGect to reinvest"ent risks+
819 .t ignores the (roble" of runoffs/ that is/ that so"e assets are (re(aid and so"e liabilities
are $ithdra$n before the "aturit& date+
8;9 .t ignores inco"e generated fro" off-balance-sheet activities+
Large banks are able to re(rice securities ever& da& using their o$n internal "odels so
reinvest"ent and re(ricing risks can be esti"ated for each da& of the &ear+
Runoff cash flo$ reflects the assets that are re(aid before "aturit& and the liabilities that are
$ithdra$n unsus(ectedl&+ o the e'tent that either of these a"ounts is significantl& greater than
e'(ected/ the esti"ated interest rate sensitivit& of the bank $ill be in error+
@+ Use the follo$ing infor"ation about a h&(othetical govern"ent securit& dealer na"ed M+!+
Horgan+ Market &ields are in (arenthesis/ and a"ounts are in "illions+
Assets Liabilities and Equit&
Cash 4*5 Overnight Re(os 4*<5
* "onth -bills 8<+5:C9 <: Subordinated debt
1 "onth -bills 8<+0:C9 <: <-&ear fi'ed rate 8B+::C *:5
0 &ear -notes 8<+:5C9 :5
B &ear -notes 8B+@)C9 *55
: &ear "unis 8floating rate9
8B+05C reset ever& ) "onths9 0: Equit& *:
otal Assets 411: otal Liabilities D Equit& 411:
a+ ,hat is the funding or re(ricing ga( if the (lanning (eriod is 15 da&s- @* da&s- 0
&ears- Recall that cash is a noninterest-earning asset+
#unding or re(ricing ga( using a 15-da& (lanning (eriod 3 <: - *<5 3 -4@: "illion+
#unding ga( using a @*-da& (lanning (eriod 3 8<: 6 <:9 - *<5 3 -405 "illion+
#unding ga( using a t$o-&ear (lanning (eriod 3 8<: 6 <: 6 :5 6 0:9 - *<5 3 64:: "illion+
b+ ,hat is the i"(act over the ne't 15 da&s on net interest inco"e if all interest rates rise
:5 basis (oints- ?ecrease <: basis (oints-
7et interest inco"e $ill decline b& 4;<:/555+ 7.. 3 #I8R9 3 -@:8+55:9 3 45+;<:"+
7et interest inco"e $ill increase b& 4<*0/:55+ 7.. 3 #I8R9 3 -@:8+55<:9 3 45+<*0:"+
<5
c+ he follo$ing one-&ear runoffs are e'(ected2 4*5 "illion for t$o-&ear -notes/ and
405 "illion for eight-&ear -notes+ ,hat is the one-&ear re(ricing ga(-
#unding or re(ricing ga( over the *-&ear (lanning (eriod 3 8<: 6 <: 6 *5 6 05 6 0:9 - *<5
3 641: "illion+
d+ .f runoffs are considered/ $hat is the effect on net interest inco"e at &ear-end if interest
rates rise :5 basis (oints- ?ecrease <: basis (oints-
7et interest inco"e $ill increase b& 4*<:/555+ 7.. 3 #I8R9 3 1:85+55:9 3 45+*<:"+
7et interest inco"e $ill decrease b& 40)0/:55/ 7.. 3 #I8R9 3 1:8-5+55<:9 3
-45+0)0:"+
*5+ ,hat is the difference bet$een book value accounting and "arket value accounting- >o$
do interest rate changes affect the value of bank assets and liabilities under the t$o
"ethods- ,hat is "arking to "arket-
%ook value accounting re(orts assets and liabilities at the original issue values+ Current "arket
values "a& be different fro" book values because the& reflect current "arket conditions/ such as
interest rates or (rices+ his is es(eciall& a (roble" if an asset or liabilit& has to be liquidated
i""ediatel&+ .f the asset or liabilit& is held until "aturit&/ then the re(orting of book values does
not (ose a (roble"+
#or an #./ a "aGor factor affecting asset and liabilit& values is interest rate changes+ .f interest
rates increase/ the value of both loans 8assets9 and de(osits and debt 8liabilities9 fall+ .f assets and
liabilities are held until "aturit&/ it does not affect the book valuation of the #.+ >o$ever/ if
de(osits or loans have to be refinanced/ then "arket value accounting (resents a better (icture of
the condition of the #.+
he (rocess b& $hich changes in the econo"ic value of assets and liabilities are accounted is
called "arking to "arket+ he changes can be beneficial as $ell as detri"ental to the total
econo"ic health of the #.+
**+ ,h& is it i"(ortant to use "arket values as o((osed to book values $hen evaluating the
net $orth of an #.- ,hat are so"e of the advantages of using book values as o((osed to
"arket values-
%ook values re(resent historical costs of securities (urchased/ loans "ade/ and liabilities sold+
he& do not reflect current values as deter"ined b& "arket values+ Effective financial decision-
"aking requires u(-to-date infor"ation that incor(orates current e'(ectations about future
events+ Market values (rovide the best esti"ate of the (resent condition of an #. and serve as an
effective signal to "anagers for future strategies+
%ook values are clearl& "easured and not subGect to valuation errors/ unlike "arket values+
Moreover/ if the #. intends to hold the securit& until "aturit&/ then the securit&Fs current
liquidation value $ill not be relevant+ hat is/ the (a(er gains and losses resulting fro" "arket
<*
value changes $ill never be reali=ed if the #. holds the securit& until "aturit&+ hus/ the changes
in "arket value $ill not i"(act the #.Fs (rofitabilit& unless the securit& is sold (rior to "aturit&+
*0+ Consider a 4*/555 bond $ith a fi'ed-rate *5 (ercent annual cou(on 8C(n C9 and a "aturit&
879 of *5 &ears+ he bond currentl& is trading to a "arket &ield to "aturit& 8AM9 of *5
(ercent+ Co"(lete the follo$ing table+
#ro" !ar/ 4 #ro" !ar/ C
7 C(n C AM !rice Change in !rice Change in !rice
B *5C @C 4*/5::+1: 4::+1: :+:1:C
@ *5C @C 4*/5:@+@: 4:@+@: :+@@:C
*5 *5C @C 4*/5);+*B 4);+*B )+;*BC
*5 *5C *5C 4*/555+55
*5 *5C **C 4@;*+** -4:B+B@ -:+BB@C
** *5C **C 4@1<+@1 -4)0+5< -)+05<C
*0 *5C **C 4@1:+5< -4);+@1 -)+;@1C
Use the infor"ation to verif& the three (rinci(les of interest rate-(rice relationshi(s for
fi'ed-rate financial assets+
Rule One2 .nterest rates and (rices of fi'ed-rate financial assets "ove inversel&+ See the
change in (rice fro" 4*/555 to 4@;*+** for the change in interest rates fro" *5 (ercent to
** (ercent/ or fro" 4*/555 to 4*/5);+*B $hen rates change fro" *5 (ercent to @ (ercent+
Rule $o2 he longer is the "aturit& of a fi'ed-inco"e financial asset/ the greater is the
change in (rice for a given change in interest rates+ A change in rates fro" *5 (ercent to **
(ercent has caused the *5-&ear bond to decrease in value 4:B+B@/ but the **-&ear bond $ill
decrease in value 4)0+5</ and the *0-&ear bond $ill decrease 4);+@1+
Rule hree2 he change in value of longer-ter" fi'ed-rate financial assets increases at a
decreasing rate+ #or the increase in rates fro" *5 (ercent to ** (ercent/ the difference in
the change in (rice bet$een the *5-&ear and **-&ear assets is 41+*B/ $hile the difference in
the change in (rice bet$een the **-&ear and *0-&ear assets is 40+B)+
Rule #our2 Although not "entioned in the te't/ for a given (ercentage 89 change in interest
rates/ the increase in (rice for a decrease in rates is greater than the decrease in value for an
increase in rates+ hus for rates decreasing fro" *5 (ercent to @ (ercent/ the *5-&ear bond
increases 4);+*B+ %ut for rates increasing fro" *5 (ercent to ** (ercent/ the *5-&ear bond
decreases 4:B+B@+
*1+ Consider a *0-&ear/ *0 (ercent annual cou(on bond $ith a required return of *5 (ercent+
he bond has a face value of 4*/555+
a+ ,hat is the (rice of the bond-
<0
!V 3 4*05J!V.#Ai3*5C/n3*0 6 4*/555J!V.#i3*5C/n3*0 3 4*/*1)+0<
b+ .f interest rates rise to ** (ercent/ $hat is the (rice of the bond-
!V 3 4*05J!V.#Ai3**C/n3*0 6 4*/555J!V.#i3**C/n3*0 3 4*/5);+@0
c+ ,hat has been the (ercentage change in (rice-
! 3 84*/5);+@0 - 4*/*1)+0<9K4*/*1)+0< 3 -5+5)0B or L)+0B (ercent+
d+ Re(eat (arts 8a9/ 8b9/ and 8c9 for a *)-&ear bond+
!V 3 4*05J!V.#Ai3*5C/n3*) 6 4*/555J!V.#i3*5C/n3*) 3 4*/*:)+;<
!V 3 4*05J!V.#Ai3**C/n3*) 6 4*/555J!V.#i3**C/n3*) 3 4*/5<1+<@
! 3 84*/5<1+<@ - 4*/*:)+;<9K4*/*:)+;< 3 -5+5<*: or L<+*: (ercent+
e+ ,hat do the res(ective changes in bond (rices indicate-
#or the sa"e change in interest rates/ longer-ter" fi'ed-rate assets have a greater change in
(rice+
*;+ Consider a five-&ear/ *: (ercent annual cou(on bond $ith a face value of 4*/555+ he
bond is trading at a "arket &ield to "aturit& of *0 (ercent+
a+ ,hat is the (rice of the bond-
!V 3 4*:5J!V.#Ai3*0C/n3: 6 4*/555J!V.#i3*0C/n3: 3 4*/*5B+*;
b+ .f the "arket &ield to "aturit& increases * (ercent/ $hat $ill be the bondEs ne$ (rice-
!V 3 4*:5J!V.#Ai3*1C/n3: 6 4*/555J!V.#i3*1C/n3: 3 4*/5<5+1;
c+ Using &our ans$ers to (arts 8a9 and 8b9/ $hat is the (ercentage change in the bondEs
(rice as a result of the * (ercent increase in interest rates-
! 3 84*/5<5+1; - 4*/*5B+*;9K4*/*5B+*; 3 -5+51;* or L1+;* (ercent+
d+ Re(eat (arts 8b9 and 8c9 assu"ing a * (ercent decrease in interest rates+
!V 3 4*:5J!V.#Ai3**C/n3: 6 4*/555J!V.#i3**C/n3: 3 4*/*;<+B;
! 3 84*/*;<+B; - 4*/*5B+*;9K4*/*5B+*; 3 5+51:B or 1+:B (ercent
e+ ,hat do the differences in &our ans$ers indicate about the rate-(rice relationshi(s of
fi'ed-rate assets-
<1
#or a given (ercentage change in interest rates/ the absolute value of the increase in (rice
caused b& a decrease in rates is greater than the absolute value of the decrease in (rice
caused b& an increase in rates+
*:+ ,hat is "aturit& ga(- >o$ can the "aturit& "odel be used to i""uni=e an #.Es (ortfolio-
,hat is the critical require"ent to allo$ "aturit& "atching to have so"e success in
i""uni=ing the balance sheet of an #.-
Maturit& ga( is the difference bet$een the average "aturit& of assets and liabilities+ .f the
"aturit& ga( is =ero/ it is (ossible to i""uni=e the (ortfolio/ so that changes in interest rates $ill
result in equal but offsetting changes in the value of assets and liabilities and net interest inco"e+
hus/ if interest rates increase 8decrease9/ the fall 8rise9 in the value of the assets $ill be offset b&
a (erfect fall 8rise9 in the value of the liabilities+ he critical assu"(tion is that the ti"ing of the
cash flo$s on the assets and liabilities "ust be the sa"e+
*)+ 7earb& %ank has the follo$ing balance sheet 8in "illions92
ssets 'ia&ilities and E(uity
Cash 4)5 ?e"and de(osits 4*;5
:-&ear treasur& notes 4)5 *-&ear Certificates of ?e(osit 4*)5
15-&ear "ortgages 4055 Equit& 405
otal Assets 4105 otal Liabilities and Equit& 4105
,hat is the "aturit& ga( for 7earb& %ank- .s 7earb& %ank "ore e'(osed to an increase or
decrease in interest rates- E'(lain $h&-
MA 3 M5J05 6 :J)5 6 055J15NK105 3 *@+)@ &ears/ and ML 3 M5J*;5 6 *J*)5NK155 3 5+:11+
herefore the "aturit& ga( 3 MIA! 3 *@+)@ L 5+:11 3 *@+*) &ears+ 7earb& bank is e'(osed to
an increase in interest rates+ .f rates rise/ the value of assets $ill decrease "uch "ore than the
value of liabilities+
*<+ Count& %ank has the follo$ing "arket value balance sheet 8in "illions/ annual rates92
ssets 'ia&ilities and E(uity
Cash 405 ?e"and de(osits 4*55
*:-&ear co""ercial loan O *5C :-&ear C?s O )C interest/
interest/ balloon (a&"ent 4*)5 balloon (a&"ent 40*5
15-&ear Mortgages O BC interest/ 05-&ear debentures O <C interest 4*05
"onthl& a"orti=ing 4155 Equit& 4:5
otal Assets 4;B5 otal Liabilities D Equit& 4;B5
a+ ,hat is the "aturit& ga( for Count& %ank-
MA 3 M5J05 6 *:J*)5 6 15J155NK;B5 3 01+<: &ears+
ML 3 M5J*55 6 :J0*5 6 05J*05NK;15 3 B+50 &ears+
MIA! 3 01+<: L B+50 3 *:+<1 &ears+
<;
b+ ,hat $ill be the "aturit& ga( if the interest rates on all assets and liabilities increase b&
* (ercent-
.f interest rates increase one (ercent/ the value and average "aturit& of the assets $ill be2
Cash 3 405
Co""ercial loans 3 4*)J!V.#An3*:/ i3**C 6 4*)5J!V.#n3*:/i3**C 3 4*;B+;@
Mortgages 3 40+05*/0@;J!V.#An31)5/i3@C 3 40<1+:B*
MA 3 M5J05 6 *;B+;@J*: 6 0<1+:B*J15NK805 6 *;B+;@ 6 0<1+:B*9 3 01+)5 &ears
he value and average "aturit& of the liabilities $ill be2
?e"and de(osits 3 4*55
C?s 3 4*0+)5J!V.#An3:/i3<C 6 40*5J!V.#n3:/i3<C 3 405*+1@
?ebentures 3 4B+;J!V.#An305/i3BC 6 4*05J!V.#n305/i3BC 3 4*5B+00
ML 3 M5J*55 6 :J05*+1@ 6 05J*5B+00NK8*55 6 05*+1@ 6 *5B+009 3 <+<; &ears
he "aturit& ga( 3 MIA! 3 01+)5 L <+<; 3 *:+B) &ears+ he "aturit& ga( increased
because the average "aturit& of the liabilities decreased "ore than the average "aturit& of
the assets+ his result occurred (ri"aril& because of the differences in the cash flo$
strea"s for the "ortgages and the debentures+
c+ ,hat $ill ha((ened to the "arket value of the equit&-
he "arket value of the assets has decreased fro" 4;B5 to 4;;0+5<*/ or 41<+@0@+ he
"arket value of the liabilities has decreased fro" 4;15 to 4;5@+)*/ or 405+)@+ herefore
the "arket value of the equit& $ill decrease b& 41<+@0@ - 405+)@ 3 4*<+01@/ or 1;+;B
(ercent+
d+ .f interest rates increased b& 0 (ercent/ $ould the bank be solvent-
he value of the assets $ould decrease to 4;5@+5;/ and the value of the liabilities $ould
decrease to 41@*+10+ herefore the value of the equit& $ould be 4*<+<0+ Although the
bank re"ains solvent/ nearl& ): (ercent of the equit& has eroded because of the increase in
interest rates+
*B+ Iiven that bank balance sheets t&(icall& are accounted in book value ter"s/ $h& should the
regulators or an&one else be concerned about ho$ interest rates affect the "arket values of
assets and liabilities-
he solvenc& of the balance sheet is an i"(ortant variable to creditors of the bank+ .f the ca(ital
(osition of the bank decreases to near =ero/ creditors "a& not be $illing to (rovide funding for
the bank/ and the bank "a& need assistance fro" the regulators/ or "a& even fail+ hus an&
change in the "arket value of assets or liabilities that is caused b& changes in the level of interest
rate changes is of concern to regulators+
*@+ .f a bank "anager is certain that interest rates $ere going to increase $ithin the ne't si'
"onths/ ho$ should the bank "anager adGust the bankEs "aturit& ga( to take advantage of
<:
this antici(ated increase- ,hat if the "anager believed rates $ould fall- ,ould &our
suggested adGust"ents be difficult or eas& to achieve-
,hen rates rise/ the value of the longer-lived assets $ill fall b& "ore the shorter-lived liabilities+
.f the "aturit& ga( 8or duration ga(9 is (ositive/ the bank "anager $ill $ant to shorten the
"aturit& ga(+ .f the re(ricing ga( is negative/ the "anager $ill $ant to "ove it to$ards =ero or
(ositive+ .f rates are e'(ected to decrease/ the "anager should reverse these strategies+
Changing the "aturit&/ duration/ or funding ga(s on the balance sheet often involves changing
the "i' of assets and liabilities+ Atte"(ts to "ake these changes "a& involve changes in
financial strateg& for the bank $hich "a& not be eas& to acco"(lish+ Later in the te't/ "ethods
of achieving the sa"e results using derivatives $ill be e'(lored+
05+ Consu"er %ank has 405 "illion in cash and a 4*B5 "illion loan (ortfolio+ he assets are
funded $ith de"and de(osits of 4*B "illion/ a 4*)0 "illion C? and 405 "illion in equit&+
he loan (ortfolio has a "aturit& of 0 &ears/ earns interest at the annual rate of < (ercent/
and is a"orti=ed "onthl&+ he bank (a&s < (ercent annual interest on the C?/ but the
interest $ill not be (aid until the C? "atures at the end of 0 &ears+
a+ ,hat is the "aturit& ga( for Consu"er %ank-
MA 3 M5J405 6 0J4*B5NK4055 3 *+B5 &ears
ML 3 M5J4*B 6 0J4*)0NK4*B5 3 *+B5 &ears
MIA! 3 *+B5 L *+B5 3 5 &ears+
b+ .s Consu"er %ank i""uni=ed or (rotected against changes in interest rates- ,h& or
$h& not-
.t is te"(ting to conclude that the bank is i""uni=ed because the "aturit& ga( is =ero+
>o$ever/ the cash flo$ strea" for the loan and the cash flo$ strea" for the C? are
different because the loan a"orti=es "onthl& and the C? (a&s annual interest on the C?+
hus an& change in interest rates $ill affect the earning (o$er of the loan "ore than the
interest cost of the C?+
c+ ?oes Consu"er %ank face interest rate risk- hat is/ if "arket interest rates increase or
decrease * (ercent/ $hat ha((ens to the value of the equit&-
he bank does face interest rate risk+ .f "arket rates increase * (ercent/ the value of the
cash and de"and de(osits does not change+ >o$ever/ the value of the loan $ill decrease to
4*<B+*@/ and the value of the C? $ill fall to 4*:@+5*+ hus the value of the equit& $ill be
84*<B+*@ 6 405 - 4*B - 4*:@+5*9 3 40*+*B+ .n this case the increase in interest rates causes
the "arket value of equit& to increase because of the reinvest"ent o((ortunities on the loan
(a&"ents+
.f "arket rates decrease * (ercent/ the value of the loan increases to 4*B*+B;/ and the value
of the C? increases to 4*):+5<+ hus the value of the equit& decreases to 4*B+<<+
<)
d+ >o$ can a decrease in interest rates create interest rate risk-
he a"orti=ed loan (a&"ents $ould be reinvested at lo$er rates+ hus even though
interest rates have decreased/ the different cash flo$ (atterns of the loan and the C? have
caused interest rate risk+
0*+ #. .nternational holds seven-&ear Ac"e .nternational bonds and t$o-&ear %eta Cor(oration
bonds+ he Ac"e bonds are &ielding *0 (ercent and the %eta bonds are &ielding *; (ercent
under current "arket conditions+
a+ ,hat is the $eighted-average "aturit& of #.Es bond (ortfolio if ;5 (ercent is in Ac"e
bonds and )5 (ercent is in %eta bonds-
Average "aturit& 3 5+;5 ' < &ears 6 5+)5 ' 0 &ears 3 ; &ears
b+ ,hat (ro(ortion of Ac"e and %eta bonds should be held to have a $eighted-average
&ield of *1+: (ercent-
Let PJ85+*09 6 8* - P9J85+*;9 3 5+*1:+ Solving for P/ $e get 0: (ercent+ .n order to get an
average &ield of *1+: (ercent/ $e need to hold 0: (ercent of Ac"e and <: (ercent of %eta+
c+ ,hat $ill be the $eighted-average "aturit& of the bond (ortfolio if the $eighted-
average &ield is reali=ed-
he average "aturit& of the (ortfolio $ill decrease to 5+0: ' < 6 5+<: ' 0 3 1+0: &ears+
00+ An insurance co"(an& has invested in the follo$ing fi'ed-inco"e securities2 8a9
4*5/555/555 of :-&ear reasur& notes (a&ing : (ercent interest and selling at (ar value/ 8b9
4:/B55/555 of *5-&ear bonds (a&ing < (ercent interest $ith a (ar value of 4)/555/555/ and
8c9 4)/055/555 of 05-&ear subordinated debentures (a&ing @ (ercent interest $ith a (ar
value of 4)/555/555+
a+ ,hat is the $eighted-average "aturit& of this (ortfolio of assets-
MA 3 M:J4*5 6 *5J4:+B 6 05J4)+0NK400 3 010K00 3 *5+:: &ears
b+ .f interest rates change so that the &ields on all of the securities decrease * (ercent/ ho$
does the $eighted-average "aturit& of the (ortfolio change-
o deter"ine the $eighted-average "aturit& of the (ortfolio for a rate decrease of *
(ercent/ the ne$ value of each securit& "ust be deter"ined+ his calculation $ill require
kno$ing the AM of each securit& before the rate change+
-notes are selling at (ar/ so the AM 3 : (ercent+ herefore/ the ne$ value $ill be
!V 3 4:55/555J!V.#An3:/i3;C 6 4*5/555/555J!V.#n3:/i3;C 3 4*5/;;:/*B0+
<<
*5-&ear bonds2 !ar 3 4)/555/555/ !V 3 4:/B55/555/ C(n 3 < (ercent AM 3 <+;B:C+
he ne$ !V 3 4;05/555J!V.#An3*5/i3)+;B:C 6 4)/555/555J!V.#n3*5/i3)+;B:C 3 4)/000/0@5+
?ebentures2 !ar 3 4)/555/555/ !V 3 4)/055/555/ C(n 3 @ (ercent B+);; (ercent+ he
ne$ !V 3 4:;5/555J!V.#An305/i3<+);;C 6 4)/555/555J!V.#n305/i3<+);; 3 4)/B05/;*B+
he total value of the assets after the change in rates $ill be 401/;B</B@5/ and the
$eighted-average "aturit& $ill be M:J*5/;;:/*B0 6 *5J)/000/0@5 6
05J)/B05/;*BNK01/;B</B@5 3 0:5/B:</*<5K01/;B</B@5 3 *5+)B &ears+
c+ E'(lain the changes in the "aturit& values if the &ields increase b& * (ercent+
,hen interest rates increase * (ercent/ the value of the -note is 4@/:<B/<);/ the value of
the *5-&ear bond is 4:/;*;/@@1/ and the value of the debenture is 4:/))0/BB0/ and the ne$
value of the assets is 405/):)/)1@+ he $eighted-average "aturit& is *5+;0 &ears+
d+ Assu"e that the insurance co"(an& has no other assets+ ,hat $ill be the effect on the
"arket value of the co"(an&Es equit& if the interest rate changes in 8b9 and 8c9 occur-
Assu"ing that the co"(an& is financed entirel& $ith equit&/ the "arket value $ill increase
4*/;B</B@5 $hen interest rates decrease * (ercent/ and the "arket value $ill decrease
4*/1;1/1)* $hen rates increase * (ercent+ 7otice that for the sa"e absolute rate change/
the increase in value is greater than the decrease in value 8rule nu"ber four in (roble" *0+9
01+ he follo$ing is a si"(lified #. balance sheet2
ssets 'ia&ilities and E(uity
Loans 4*/555 ?e(osits 4B:5
5 Equit& 4*:5
otal Assets 4*/555 otal Liabilities D Equit& 4*/555
he average "aturit& of loans is four &ears/ and the average "aturit& of de(osits is t$o
&ears+ Assu"e loan and de(osit balances are re(orted as book value/ =ero-cou(on ite"s+
a+ Assu"e that interest rates on both loans and de(osits are @ (ercent+ ,hat is the "arket
value of equit&-
he value of loans 3 4*/555K8*+5@9
;
3 4<5B+;1/ and the value of de(osits 3 4B:5K8*+5@9
0
3
4<*:+;1+ he net $orth 3 4<5B+;1 - 4<*:+;1 3 -4<+550B+ 8hat is/ net $orth is negative+9
b+ ,hat "ust be the interest rate on de(osits to force the "arket value of equit& to be
=ero- ,hat econo"ic "arket conditions "ust e'ist to "ake this situation (ossible-
.n this case the de(osit value should equal the loan value+ hus/ 4B:5K8* 6 x9
0
3 4<5B+;1+
Solving for '/ $e get @+:1<;C+ hat is/ de(osit rates $ill have to increase "ore because
<B
the& have a shorter "aturit&+ 7ote2 for those using calculators/ &ou need to co"(ute
.KAEAR after entering B:5 3 #V/ -<5B+;1 3 !V/ 5 3 !M/ 0 3 7+
c+ Assu"e that interest rates on both loans and de(osits are @ (ercent+ ,hat "ust be the
average "aturit& of de(osits for the "arket value of equit& to be =ero-
.n this case/ $e need to solve the equation in (art 8b9 for 7+ he result is 0+**;* &ears+ .f
interest rates re"ain at @ (ercent/ then the average "aturit& of de(osits has to be higher in
order to "atch the value of a ;-&ear loan+
0;+ Iunnison .nsurance has re(orted the follo$ing balance sheet 8in thousands92
ssets 'ia&ilities and E(uity
0-&ear reasur& note 4*<: *-&ear co""ercial (a(er 4*1:
*:-&ear "unis 4*): :-&ear note 4*)5
Equit& 4;:
otal Assets 41;5 otal Liabilities D Equit& 41;5
All securities are selling at (ar equal to book value+ he t$o-&ear notes are &ielding :
(ercent/ and the *:-&ear "unis are &ielding @ (ercent+ he one-&ear co""ercial (a(er
(a&s ;+: (ercent/ and the five-&ear notes (a& B (ercent+ All instru"ents (a& interest
annuall&+
a+ ,hat is the $eighted-average "aturit& of the assets for Iunnison-
MA 3 M0J4*<: 6 *:J4*):NK41;5 3 B+1* &ears
b+ ,hat is the $eighted-average "aturit& of the liabilities for Iunnison-
ML 3 M*J4*1: 6 :J4*)5NK40@: 3 1+*< &ears
c+ ,hat is the "aturit& ga( for Iunnison-
MIA! 3 B+1*- 1+*< 3 :+*; &ears
d+ ,hat does &our ans$er to (art 8c9 i"(l& about the interest rate e'(osure of Iunnison
.nsurance-
Iunnison .nsurance is e'(osed to interest rate risk+ .f interest rates rise/ net $orth $ill
decline because the average "aturit& of the assets is higher than the average "aturit& of the
liabilities+ he o((osite holds true if interest rates fall 8hat is/ net $orth $ill increase+9
e+ Calculate the values of all four securities of Iunnison .nsuranceEs balance sheet
assu"ing that all interest rates increase 0 (ercent+ ,hat is the dollar change in the total
asset and total liabilit& values- ,hat is the (ercentage change in these values-
<@
-notes2 !V 3 B+<:J!V.#Ai3<C/n30 6 *<:J!V.#i3<C/n30 3 4*)B+)<
Munis2 !V 3 *;+B:J!V.#Ai3**C/n3*: 6 *):J!V.#i3**C/n3*: 3 4*;*+0<
Co""ercial !a(er2 !V 3 )+5<:J!V.#Ai3)+:C/n3* 6 *1:J!V.#i3)+:C/n3* 3 4*10+;)
7ote2 !V 3 *0+B5J!V.#Ai3*5C/n3: 6 *)5J!V.#i3*5C/n3: 3 4*;<+B<
otal assets 3 4*)B+)< 6 4*;*+0< 3 415@+@; A 3 -415+5) or -B+B; (ercent change
otal liabilities 3 4*10+;) 6 4*;<+B< 3 40B5+11 L 3 -4*;+)< or -;+@< (ercent change
f+ ,hat is the dollar i"(act on the "arket value of equit& for Iunnison- ,hat is the
(ercentage change in the value of the equit&-
E 3 A - L 3 -415+5) L 8-4*;+)<9 3 -4*:+1@ -1;+0 (ercent
g+ ,hat $ould be the i"(act on IunnisonEs "arket value of equit& if the liabilities (aid
interest se"iannuall& instead of annuall&-
he value of liabilities $ill be lo$er $ith se"i-annual co"(ounding/ increasing the value
of net $orth+ he one-&ear C! $ill decline in value to 4*10+;0)+ he five-&ear note $ill
decline in value to 4*;<+);:+ he value of equit& $ill increase to 40@+B)@ 3 84*)B+)< 6
4*;*+0<9 - 84*10+;0) 6 4*;<+);:9+
0:+ Scandia %ank has issued a one-&ear/ 4*"illion C? (a&ing :+<: (ercent to fund a one-&ear
loan (a&ing an interest rate of ) (ercent+ he (rinci(al of the loan $ill be (aid in t$o
install"ents/ 4:55/555 in ) "onths and the balance at the end of the &ear+
a+ ,hat is the "aturit& ga( of Scandia %ank- According to the "aturit& "odel/ $hat
does this "aturit& ga( i"(l& about the interest rate risk e'(osure faced b& Scandia
%ank-
he "aturit& ga( is * &ear L * &ear 3 5+ he "aturit& ga( "odel $ould state that the
(ortfolio is i""uni=ed against changes in interest rates because assets and liabilities are of
equal "aturit&+
b+ ,hat is the e'(ected net interest inco"e at the end of the &ear-
!rinci(al received in si' "onths 4:55/555
.nterest received in si' "onths 8+51 ' 4*/555/5559 415/555
otal 4:15/555
!rinci(al received at the end of the &ear 4:55/555
.nterest received at the end of the &ear 8+51 ' 4:55/5559 4*:/555
#uture value of interest received in si' "onths 84:15/555 ' *+51J9 4:;:/@55
otal (rinci(al and interest received 4*/5)5/@55
!rinci(al and interest (aid on de(osits 84*/555/555 ' 5+5:<:9 4*/5:</:55
7et interest inco"e received 41/;55
B5

J .t is assu"ed that the "one& $ill be reinvested at current loan rates+ 7ote that the
(rinci(al is also included in the anal&sis because interest e'(ense is based on 4*/555/555+
c+ ,hat $ould be the effect on annual net interest inco"e of a 0 (ercent interest rate
increase that occurred i""ediatel& after the loan $as "ade- ,hat $ould be the effect
of a 0 (ercent decrease in rates-
.f interest rates increase 0 (ercent/ then the reinvest"ent benefits of cash flo$s in si'
"onths $ill be higher2
!rinci(al received in si' "onths 4:55/555
.nterest received in si' "onths 8+51 ' 4*/555/5559 415/555
otal 4:15/555
!rinci(al received at the end of the &ear 4:55/555
.nterest received at the end of the &ear 8+51 ' 4:55/5559 4*:/555
#uture value of interest received in si' "onths 84:15/555 ' *+5;9 4::*/055
otal (rinci(al and interest received 4*/5))/055
!rinci(al and interest (aid on de(osits 84*/555/555 ' 5+5:<:9 4*/5:</:55
7et interest inco"e received 4B/<55
.f interest rates decrease b& 0 (ercent/ then reinvest"ent inco"e is reduced+
!rinci(al received in si' "onths 4:55/555
.nterest received in si' "onths 8+51 ' 4*/555/5559 415/555
otal 4:15/555
!rinci(al received at the end of the &ear 4:55/555
.nterest received at the end of the &ear 8+51 ' 4:55/5559 4*:/555
#uture value of interest received in si' "onths 84:15/555 ' *+509 4:;5/)55
otal (rinci(al and interest received 4*/5::/)55
!rinci(al and interest (aid on de(osits 84*/555/555 ' 5+5:<:9 4*/5:</:55
7et inco"e received 4-*/@55
d+ ,hat do these results indicate about the "aturit& "odelEs abilit& to i""uni=e (ortfolios
against interest rate e'(osure-
he results indicate that Gust "atching assets and liabilities b& "aturit& is not sufficient to
i""uni=e a (ortfolio+ .f the ti"ing of the cash flo$s $ithin a (eriod is different for assets
and liabilities/ the effects of interest rate changes are different+ #or a trul& effective
i""uni=ation strateg&/ one also needs to account for the ti"ing of cash flo$s+
B*
0)+ E?# %ank has a ver& si"(le balance sheet+ Assets consist of a t$o-&ear/ 4* "illion loan
that (a&s an interest rate of L.%OR (lus ; (ercent annuall&+ he loan is funded $ith a t$o-
&ear de(osit on $hich the bank (a&s L.%OR (lus 1+: (ercent interest annuall&+ L.%OR
currentl& is at ; (ercent/ and both the loan and de(osit (rinci(al $ill not be (aid until
"aturit&+
a+ ,hat is the "aturit& ga( of this balance sheet-
Maturit& ga( 3 0 - 0 3 5 &ears
b+ ,hat is the e'(ected net interest inco"e in &ear * and &ear 0-
.nterest received in &ear * 4B5/555 .nterest received in &ear 0 4B5/555
.nterest (aid in &ear * 4<:/555 .nterest (aid in &ear 0 4<:/555
7et interest inco"e in &ear * 4:/555 7et interest inco"e in &ear 0 4:/555
c+ .""ediatel& (rior to the beginning of &ear 0/ L.%OR rates increased to ) (ercent+
,hat is the e'(ected net interest inco"e in &ear 0- ,hat $ould be the effect on net
interest inco"e of a 0 (ercent decrease in L.%OR-
)ear *" .f interest rates increase 0 (ercent )ear *" .f interest rates decrease 0 (ercent
.nterest received in &ear 0 4*55/555 .nterest received in &ear 0 4)5/555
.nterest (aid in &ear 0 4@:/555 .nterest (aid in &ear 0 4::/555
7et interest inco"e in &ear 0 4:/555 7et interest inco"e in &ear 0 4:/555
d+ >o$ $ould &our results be affected if the interest (a&"ents on the loan $ere received
se"iannuall&-
With 'IBOR at +," Aear * Aear 0
.nterest received in Q &ear 4;5/555 .nterest received in Q &ear 4;5/555
.nterest received at &ear-end 4;5/555 .nterest received at &ear-end 4;5/555
Reinvested interest 4*/)55 Reinvested interest 4*/)55
.nterest (aid in &ear * 4<:/555 .nterest (aid in &ear 0 4<:/555
7et interest inco"e in &ear * 4 )/)55 7et interest inco"e in &ear 0 4 )/)55
With 'IBOR at -," Aear * Aear 0
.nterest received in Q &ear 4:5/555 .nterest received in Q &ear 4:5/555
.nterest received at &ear-end 4:5/555 .nterest received at &ear-end 4:5/555
Reinvested interest 40/:55 Reinvested interest 40/:55
.nterest (aid in &ear * 4@:/555 .nterest (aid in &ear 0 4@:/555
7et interest inco"e in &ear * 4 </:55 7et interest inco"e in &ear 0 4 </:55
With 'IBOR at *," Aear * Aear 0
.nterest received in Q &ear 415/555 .nterest received in Q &ear2 415/555
.nterest received at &ear-end 415/555 .nterest received at &ear-end 415/555
Reinvested interest 4@55 Reinvested interest 4@55
B0
.nterest (aid in &ear * 4::/555 .nterest (aid in &ear 0 4::/555
7et interest inco"e in &ear * 4 :/@55 7et interest inco"e in &ear 0 4 :/@55
e+ ,hat i"(lications do these results have on the effectiveness of the "aturit& "odel as
an i""uni=ation strateg&-
Even though the "aturit& ga( is =ero/ the (ortfolio is not full& i""uni=ed+ hat is because
the ti"ings of the cash flo$s are not the sa"e for the assets and liabilities+ he onl& $a& to
i""uni=e using the "aturit& "odel is if the ti"ing of the cash flo$s for both assets and
liabilities are the sa"e/ as de"onstrated in !roble" *08c9+
The follo.ing (uestions and pro&lems are &ased on material in the appendix to the chapter/
0<+ he current one-&ear reasur& bill rate is :+0 (ercent/ and the e'(ected one-&ear rate *0
"onths fro" no$ is :+B (ercent+ According to the unbiased e'(ectations theor&/ $hat
should be the current rate for a 0-&ear reasur& securit&-
8*+5:098*+5:B9 3 8* 6 R09
0
3 *+**15*)R 8* 6 R09 3 *+5:;@@) R0 3 +5::5 or :+:5 (ercent
0B+ A recent edition of The Wall Street Journal re(orted interest rates of ) (ercent/ )+1:
(ercent/ )+): (ercent/ and )+<: (ercent for three-&ear/ four-&ear/ five-&ear/ and si'-&ear
reasur& notes/ res(ectivel&+ According to the unbiased e'(ectations theor&/ $hat are the
e'(ected one-&ear rates for &ears ;/ :/ and )-
M* 6 E8ri9N 3 8* 6 Ri9
i
8* 6 Ri-*9
i-*
M* 6 E8r;9N 3 8*+5)1:9
;
8*+5)9
1
3 *+5<;* r; 3 <+;* (ercent for (eriod ;
M* 6 E8r:9N 3 8*+5)):9
:
8*+5)1:9
;
3 *+5<B) r: 3 <+B) (ercent for (eriod :
M* 6 E8r)9N 3 8*+5)<:9
)
8*+5)):9
:
3 *+5<0: r) 3 <+0: (ercent for (eriod )
0@+ >o$ does the liquidit& (re"iu" theor& of the ter" structure of interest rates differ fro" the
unbiased e'(ectations theor&- .n a nor"al econo"ic environ"ent/ that is/ an u($ard
slo(ing &ield curve/ $hat is the relationshi( of liquidit& (re"iu"s for successive &ears into
the future- ,h&-
he unbiased e'(ectations theor& asserts that long-ter" rates are a geo"etric average of current
and e'(ected short-ter" rates+ he liquidit& (re"iu" theor& asserts that long-ter" rates are a
geo"etric average of current and e'(ected short-ter" rates (lus a liquidit& risk (re"iu"+ he
(re"iu" is assu"ed to increase $ith the "aturit& of the securit& because the uncertaint& of
future returns gro$s as "aturit& increases+
B1