Risk Management for Changing Interest Rates: Asset-Liability Management and Duration

Techniques: Chapter 7, Rose & Hudgins, 9th Ed., 2013

Changes in interest rates can affect (1) the net interest margin (NIM) or net interest income
(NII) and (2) the value of the net worth. (pp. 218-219) The Asset-Liability Committee
(ALCO) estimates the risks, often with simulation based on the ideas in these lectures, and
develops strategies for dealing with these risks.

LEARNING OBJECTIVES

See current Treasury bill information http://www.treasury.gov/resource-center/data-chart-

center/interest-rates/Pages/TextView.aspx?data=billRatesYear&year=2014. See notes at bottom
of current month on quotes and yields. See 7/11/2006 for example of differences in rates at
higher yields.

1. EXAM: Know how to calculate interest rates using bank discount rate and bond-equivalent
(or coupon-equivalent) yields. See pp. 221-222 and problem 3 on p. 248. Answers: (see
example of solution for 3.a. below): a. 5.44%, 5.67%; b. 5.67%, 6.00%; c. 4.95%, 5.08%.

Problem 3a. $97.25, 182 days:

DR = [(100 - PP)/100] X [360/#DAYS] = [(100-97.25)/100] X [360/182] = 0.0544 = 5.44%

YTMEY = [(100 - PP)/PP] X [365/#DAYS] = [(100-97.25)/97.25] X [365/182] = 0.0567 =

5.67%.

Problem 3b. $95.75, 270 days; answers are DR = 5.67% and YTMEY = 6.00%.

Problem 3c. $98.75, 91 days: answers are DR = 4.95% and YTMEY = 5.08%.

2. Basic interest rate relationships (pp. 219-225)

A. Market interest rates are affected by the risk-free real rate, inflation risk, default
(credit) risk, term (maturity) risk, marketability (liquidity) risk, call risk, tax-
exemption and other characteristics of the issue
B. As interest rates increase (decrease), value decreases (increases)
C. For a given change in interest rates, as maturity increases, the change in value
increases.
D. Short-term rates are more volatile than long-term rates, which means that the yield
curve changes and the net interest income (NII) or spreads change (see p. 224, Ex.
7-4) or link to Treasury rates on Lecture 7 web page.

4. Gap Management (or Repricing) Model deals with managing NIM that usually accounts for
about 62% and 78% of (net interest income + noninterest income) for banks with total assets >
$1B and <$1B, respectively for Q3 2011. (pp. 225-236)

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 Rate-sensitive asset (RSA) or liability (RSL) must mature or be repriced, i.e., the interest
rate may change, within a specific maturity bucket or period.

Gapi = (RSAi - RSLi) for maturity bucket or period i, e.g., 30, 31-90, 91-180, 181-365,
>365 days. (See examples on pp. 230-232)

Relative Gap = (RSA – RSL)/total assets (aka net assets repriceable within a period)

Cumulative Gapi = sum of all gaps up to maturity i

KNOW: ΔNet Interest Incomei = Gapi X (Δi)

A = (RSA + NRSA) and L = (RSL + NRSL)
NII = (A x iA) - (L x iL)
ΔNII = (RSA x ΔiRSA) - (RSL x ΔiRSL) + [(NRSA x 0) - (NRSL x 0)];
Gap assumes ΔiRSA = ΔiRSL = Δi and no change in volume or mix of RSA & RSL
Gap Δi ΔNII Comment
pos + + positioned for increase in rates or asset-sensitive
pos - - positioned for increase in rates or asset-sensitive
neg + - positioned for decrease in rates or liability-sensitive
neg - + positioned for decrease in rates or liability-sensitive
zero +,- 0
Example for neg. GAP and neg. change in i:
NII = (II + ∆II) + (IE + ∆IE) = (20 – 2) – (10 – 3): (18-7=11) vs. 10 with no
changes
As we examine gaps in class we will see that most banks have a positive gap ; however, the
positive gap usually decreases as the asset size decreases.

Gap examples for one year repricing (Net assets repriceable within 1 year/Total assets):
DATE 12/31/03 12/31/02 12/31/01 12/31/00
SunTrust 44.5% 45.7% 41.8% 22.8%
69 BHCs 22.4% 22.8% 18.7% 16.8%
(TA >= $10B)

See problems 5, 6, 8 on pp. 249. KNOW how to do similar problems and relationships
discussed in class and notes.

PROB 7-5. (9th ed.) If the net interest margin (NIM), which was 2.5%, increases 10%, and the
total assets, which was $575M, increases by 20%. What is the change in net interest income
(NII)?
NIM = NII/TA or NII = NIM X TA;

NII0 = .025 X 575M = 14.375M;

NII1 = NIM X TA = (1.10 X .025) X (1.20 X 575M) = 18.975M;

ΔNII = 18.975M - 14.375M = 4.6M

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Alternative problem 7-5 (8th ed.): If the net interest margin (NIM), which was 2.5%, increases
15%, and the total assets, which was $6255M, increases by 20%. What is the change in net
interest income (NII)?
NIM = NII/TA or NII = NIM X TA;

NII0 = .025 X 625M = 15.625M;

NII1 = NIM X TA = (1.15 X .025) X (1.20 X 625M) = 21.5625M;

ΔNII = 21.5625 - 15.625M = 5.9375M

PROB. 7-6. If the interest rate gap increases from $25M by 60% and interest rates increase from
3% by 25% of that initial level, what is the change in net interest income (NII)?
ΔNII = Gapi X (Δi) = (1.60 X 25M) X (.25 X .03) = 300,000;
Note that Δi is change in interest rate in decimal form and which direction, positive or negative.
These are common mistakes.

Alternative problem: If the interest rate gap increases from $22M by 75% and interest rates
decrease from 3% to 2.25%, what is the change in net interest income (NII)?
ΔNII = Gapi X (Δi) = (1.75 X 22M) X (-.0075) = -288,750.

PROB. 7- 8.
Gaps = 1 WEEK = -355, next 30 DAYS = -104, 31-90 DAYS = +219, >90 DAYS = +430
CUM GAPS = -355, -459, -240, +190

Problems with Gap Model:

1. Gap assumes ΔiRSA = ΔiRSL = Δi, i.e., a flat yield curve, and no changes in volume or mix of
RSA & RSL
2. Ignores change in market value due to changes in YTMs
3. Overaggregation - i.e., maturity buckets may be too large
4. Does not consider runoffs, i.e., cash flows that can be reinvested during repricing period, e.g.,
interest and principal payments, mortgage prepayments. Within a one-year bucket, a short-term A
or L could be repriced many times.
5. The effect of interest rates on noninterest revenue (mortgage servicing and origination,
investment banking fees)
6. Some rates may not change in the same way such as LIBOR and Treasury rates in August and
September of 2007.
Due to aforementioned problems banks usually simulate the many factors to determine the effect.

Asset-Liability Management: The Concept of Duration as a Risk Management Tool:

Chapter 7, Rose & Hudgins, 9th ED, (2013), pp. 236-247;
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EXAM: KNOW how to calculate duration, do problems similar to 7-18 and 7-13, calculate
duration of net worth, the negative duration example, and relationships discussed in class
and notes.

Duration (D) Gap Model deals with managing net worth changes.

Duration = time weighted present value/present value (see p.237-239)

EXAM: Know how to calculate the duration for a bond. Problem 7-17 on page 243 (8th
edition):

Calculate Duration (D) of five-year bond which pays annual interest payments of $100 or 10% of
the face value of $1,000 and a current market price of $1,123.02 (1,161.68 in text is incorrect).
The current yield to maturity is 7%. The present value of the cash flows should be equal to the
current market price.
Time (t Cash PVIFt = PV of Time (t) x
Years) Flow 1/(1+i)t , Cash PVCF
i =0 .07 Flow
1 100 0.9346 93.46 93.46
2 100 0.8734 87.34 174.68
3 100 0.8163 81.63 244.89
4 100 0.7629 76.29 305.16
5 100 + 0.7130 784.30 3,921.50
1,000
PVCF = Σ of (t x
1,123.02
PVCF) =
4,739.69
Duration = [Σ of (t x PVCF)]/PVCF = 4,739.69/1,123.02 = 4.2205 years

Alternative Problem 7-17 on page 240 (7th edition):

Calculate Duration (D) of five-year bond which pays annual interest payments of $100 or 10% of
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the face value of $1,000. The current yield to maturity is 8%. The present value of the cash
flows should be equal to the current market price.
Time (t Cash PVIFt = PV of Time (t) x
Years) Flow 1/(1+i)t , Cash PVCF
i =0 .08 Flow
1 100 0.9259 92.59 92.59
2 100 0.8573 85.73 171.46
3 100 0.7938 79.38 238.14
4 100 0.7350 73.50 294.00
5 100 + 0.6806 748.66 3,743.30
1,000
PVCF =
Σ of (t x
1079.86
PVCF) =
4,539.49
Duration = [Σ of (t x PVCF)]/PVCF = 4,539.49/1079.86 = 4.2038 years

MOST COMMON MISTAKES in calculating duration:

1. Mixing up the coupon rate and its effect on the cash flows, e.g., 10% in this problem, and the
YTM or discount rate of 7% in this problem.
2. Ignoring a cash flow, for example, the $1,000 face value at the end of the maturity.
3. Not multiplying the PVCF for each period or time by the correct respective time.

As D increases, the change in value due to interest rate changes increases.

%ΔP = (ΔP/P) = -D x (Δi/(1+i)) = (-D/(1+i)) x Δi,

where (-D/(1+i)) is sometimes referred to as modified duration

Can also be rearranged as (ΔP) = -D x (Δi/(1+i)) x P

Duration gap (Dgap) helps to measure effect of interest rate changes on both
assets and liabilities.

NW = A - L and ΔNW = ΔA – ΔL

ΔNW = ΔA - ΔL = [-DA x (Δi/(1+i)) x A] - [-DL x (Δi/(1+i)) x L]

(Do Prob. 7-18, p. 251)

Dgap = Dollar-weighted Dassets - Dollar-weighted Dliabilities

DNW = D leverage-adjusted = Dassets - [(Dliabilities) x (Total Liab./Total Assets)], where DA & DL are dollar-
weighted
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Examples:
If i increases and if Dgap > 0, then (A) > (L), which means (NW).
If i decreases and if Dgap > 0, then (A) > (L), which means (NW).

If i increases and if Dgap < 0, then (A) < (L), which means (NW).
If i decreases and if Dgap < 0, then (A) < (L), which means (NW).

Six scenarios:
Dgap Δi ΔNW = ΔA - ΔL
zero + 0
zero - 0
pos + -
pos - +
neg + +
neg - -

Problems with duration:

1. Duration changes as maturity of A & L and YTMs change; therefore, need to re-estimate
often.
2. Convexity - for large changes in i, D underestimates P and overestimates P.
3. Difficult to estimate maturity or duration of some liabilities (demand deposits, savings
deposits, NOW accounts, and MMDAs) and assets (prepayment and default on loans). In gap
analysis, the maturity on a deposit may be characterized as short-term, e.g., less than 30 days, but
cash flows may not be well defined. Prepayments and defaults on loans may not be well defined.

Solution to Problem 7-18 (9th ed., p. 251):

Bank holds $15 million in bonds having a duration of 12. If rates suddenly rise from 6% to 7%,
what percentage change in the bond’s price should occur?

%ΔP = (ΔP/P) = -D x (Δi/(1+i)) = -12 x (+.01/1.06) = -0.1132 = -11.32%

Alternative Problem: What will the price change be if rates go from 7% to 6%?

%ΔP = (ΔP/P) = -D x (Δi/(1+i)) = -12 x (-.01/1.07) = +0.1121 = +11.21%

Be sure to use correct signs and base rates.

Solution to Problem 7-13 (9th ed. , p. 250) A bank has total assets of $1.8 billion with a duration
of 7 years and total liabilities of $1.5 billion with a duration of 4 years. If rates increase from 5%
to 6%, what change will occur to the net worth?

ΔNW = ΔA - ΔL = [-DA x (Δi/(1+i)) x A] - [-DL x (Δi/(1+i)) x L]

= [-7 x (.01/(1.05)) x $1.8B] - [-4 x (.01/(1.05)) x $1.5B]

= [-120M] - [-57.143M] = -62.857M

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If interest rates fell from 5% to 4.5% what change will occur to the net worth?

ΔNW = ΔA - ΔL = [-DA x (Δi/(1+i)) x A] - [-DL x (Δi/(1+i)) x L]

= [-7 x (-.005/(1.05)) x $1.8B] - [-4 x (-.005/(1.05)) x $1.5B]

= [+60M] – [+28.571M] = +31.429M

Alternative Problem 7-13 (8th ed., p. 242): A bank has total assets of $1.8 billion with a
duration of 7 years and total liabilities of $1.5 billion with a duration of 3.25 years. If rates
increase from 6% to 7.5%, what change will occur to the net worth?

ΔNW = ΔA - ΔL = [-DA x (Δi/(1+i)) x A] - [-DL x (Δi/(1+i)) x L]

= [-7 x (.015/(1.06)) x $1.8B] - [-3.25 x (.015/(1.06)) x $1.5B]

= [-178.302M] - [-68.986M] = -109.316M

If interest rates fell from 6% to 5% what change will occur to the net worth?

ΔNW = ΔA - ΔL = [-DA x (Δi/(1+i)) x A] - [-DL x (Δi/(1+i)) x L]

= [-7 x (-.01/(1.06)) x $1.8B] - [-3.25 x (-.01/(1.06)) x $1.5B]

= [+118.868M] – [+45.991M] = +72.877M

What is value of the DNW? DNW = DA – (DL X (L/A) = 7 – (3.25 X (1.5/1.8)) = 4.2917 years

ΔNW = -DNW X (Δi/(1+i)) X A = -4.2917 x (-.01/(1.06)) x $1.8B = 72.878M (rounding error)

ΔNW = -DNW X (Δi/(1+i)) X A = -4.2917 x (+.015/(1.06)) x $1.8B = -109.318M (rounding error)

Duration Example: Most depository financial institutions have positive duration gaps. An
example of an institution with a negative duration gap could be a defined benefit pension fund or
a term life insurance policy. Assume the company has an obligation to pay out $1,000 in 40 years
and the current interest rate is 6% compounded annually. The present value of that payment
today is $97.22 = $1,000/[(1.06) 40]. For the pension fund to be fully funded today it would need
to have investments equal to $97.22. Now assume that the current investment portfolio of $97.22
is invested in 10-year zero-coupon bonds with a payment in 10 years of $174.1062 with a yield of
6% or $97.22 = $174.1062/[(1.06) 10]. The duration gap for this situation would be

DNW = Dassets - [(Dliabilities) x (Total Liab./Total Assets)] = 10 - [40 X (97.22/97.22)] = -30 years.

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Assume that interest rates decrease to 4%. The value of both the assets and liabilities will
increase.

ΔNW = ΔA - ΔL = [-DA x (Δi/(1+i)) x A] - [-DL x (Δi/(1+i)) x L]

= [-10 x (-.02/(1.06)) x $97.22] - [-40 x (-.02/(1.06)) x $97.22]

= [+18.34] - [+73.37] = - 55.03

Remember that duration is accurate for very small changes in interest rates but not as accurate for
large changes, such as 2%; therefore, we should examine the actual changes in value.

The present value of the 10 year, zero-coupon bonds will increase from $97.22 at 6% to $117.62
at 4% (or $174.1062/[(1.04) 10]), about 21% increase in value. The present value of the $1,000
payment in 40 years will increase from $97.22 at 6% to $208.29 at 4% (or $1,000/[(1.04) 40]),
about 114% increase in value. The difference between the assets and liabilities is now $117.62 -
208.29 = -$90.67. The pension fund or policy is now underfunded.

Comparison of GAP and Dgap –

KNOW relationships reflected in
tables below.

Gap = RSA -RSL and we examine the interest rate effect on change in Net Interest
Income (NII); GAP sign affects (> or <) and change in I affects changes in IR and IE.
Example for neg. GAP and neg. change in i:
NII = (II + ∆II) + (IE + ∆IE) = (20 – 2) – (10 – 3): (18-7=11) vs. 10 with no
changes

Dgap = DA -(DL X (L/A)) and we examine interest rate effect on Change in

NW; Dgap sign affects (> or<) and change in I affects changes in A and L.

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 Sig Change in Change in
Measure n Change in i Change in IR > or < IE NII
GAP + + + > + +
GAP + - - > - -
GAP - + + < + -
GAP - - - < - +

Sig Change in
Measure n Change in i Change in A > or < Change in L NW
Dgap + + - > - -
Dgap + - + > + +
Dgap - + - < - +
Dgap - - + < + -