RISK MANAGEMENT FOR

CHANGING INTEREST RATE:

ASSET-LIABILITY
MANAGEMENT DURATION

Chapter 5

William Chittenden edited and updated the PowerPoint slides for this edition.

7-2

Key topics

1. Asset, Liability, and Funds management

2. Market rates and interest-rate risk

3. The goals of interest-rate hedging

4. Interest-sensitive gap management

5. Duration gap management

6. Limitations of hedging techniques

1
 7-3

Asset-Liability Management

The purpose of Asset-Liability management is to

control a bank’s sensitivity to changes in market
interest rates and limit its losses in its net
income or equity.

Asset and Liability Management

Committee (ALCO)

▪ The ALCO’s primary responsibility is interest

rate risk management.

▪ The ALCO coordinates the bank’s strategies to

achieve the optimal risk/reward trade-off.

2
 7-5

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 (work with both

strategies)

7-6

Interest rate risk:

one of the main challenges
▪ Forces determining interest rates
▪ Loanable funds theory

▪ The measurement of interest rates

▪ YTM
▪ Bank discount

▪ Components of interest rates

3
 7-7

Yield to maturity (YTM)

n
CFt
Market Price = 
t =1 (1 + YTM)
t

7-8

Bank discount rate (DR)

FV - Purchase Price 360

DR = *
FV # Days to Maturity

Where: FV equals Face Value of a Security,

such as Treasury Bills
8

4
 7-9

Market interest rates

Function of:

▪ Risk-free real rate of interest

▪ Various risk premiums

➢Default risk

➢Inflation risk

➢Liquidity risk

➢Call risk

➢Maturity risk 9

7-10

Yield curves
▪ Graphical picture of relationship between yields
and maturities on securities
▪ Generally created with treasury securities to
keep default risk constant
▪ Shape of the yield curve
➢ Upward – long-term rates higher than short-term
rates
➢ Downward – short-term rates higher than long-
term rates
➢ Horizontal – short-term and long-term rates the
same
▪ Shape of the yield curve and a maturity gap
10

10

5
 7-11

Goal of interest rate hedging

One important goal of interest rate hedging is to

insulate the bank from the damaging effects of
fluctuating interest rates on profits.

11

11

7-12

Net interest margin

Interest Income - Interest Expenses

NIM =
Total Earnings Assets

12

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6
 7-13

Quick quiz

1. What forces cause interest rates to change?

2. What makes it so difficult to correctly forecast
interest rate changes?
3. What is the yield curve, and why is it important
to know about its shape and slope?
4. What is the goal of hedging?
• First National Bank of Bannerville has posted interest
revenues of $63 million and interest costs from all of its
borrowings of $42 million. If this bank possesses $700 million
in total earning assets, what is First National’s net interest
margin? Suppose the bank’s interest revenues and interest
costs double, while its earning assets increase by 50%. What
will happen to its net interest margin? 13

13

Interest rate risk

▪ Interest rate risk

➢ The potential loss from unexpected changes in

interest rates which can significantly alter a

bank’s profitability and market value of equity.

14

14

7
 7-15

Interest rate risk

▪ Reinvestment risk

➢ When interest rates fall, the coupon payments

on the bond are reinvested at lower rates

▪ Price risk

➢ When interest rates rise, the market value of the

bond or asset falls

15

15

Interest rate risk:

Re-investment rate (spread) risk
▪ If interest rates change, the bank will have to
reinvest the cash flows from assets or refinance
rolled-over liabilities at a different interest rate
in the future.
➢ An increase in rates, ceteris paribus,
increases a bank’s interest income but also
increases the bank’s interest expense.
▪ Static GAP Analysis considers the impact of
changing rates on the bank’s net interest
income. 16

16

8
 Interest rate risk:
Price risk
▪ If interest rates change, the market values of
assets and liabilities also change.

➢ The longer is duration, the larger is the

change in value for a given change in
interest rates.

▪ Duration GAP considers the impact of changing

rates on the market value of equity.
17

17

Measuring interest rate risk with GAP

▪ Example:
➢ A bank makes a $10,000 four-year car loan to a
customer at fixed rate of 8.5%. The bank initially
funds the car loan with a one-year $10,000 CD at
a cost of 4.5%. The bank’s initial spread is 4%.

4 year Car Loan 8.50%

1 Year CD 4.50%
4.00%
➢ What is the bank’s risk?

18

18

9
 What determines rate sensitivity (ignoring
embedded options)?
▪ An asset or liability is considered rate sensitivity
if during the time interval:
➢ It matures
➢ It represents and interim, or partial, principal
payment
➢ It can be repriced
❖ The interest rate applied to the outstanding
principal changes contractually during the interval
❖ The outstanding principal can be repriced when
some base rate of index changes and
management expects the base rate / index to
change during the interval 19

19

What are ISAs and ISLs?

▪ Considering a 0-90 day “time bucket,” ISAs and ISLs
include:
➢ Maturing instruments or principal payments
❖ If an asset or liability matures within 90 days, the
principal amount will be re-priced
❖ Any full or partial principal payments within 90
days will be re-priced
➢ Floating and variable rate instruments
❖ If the index will contractually change within 90
days, the asset or liability is rate sensitive
❖ The rate may change daily if their base rate
changes.
Issue: do you expect the base rate to change? 20

20

10
 7-21

Examples of re-priceable (interest sensitive)

Assets and Liabilities

21

21

Factors affecting net interest income (NII)

▪ Changes in the level of interest rates

▪ Changes in the spread between assets and
liabilities
▪ Changes in the rate sensitive gap (=ISA – ISL),
caused by
➢ Changes in the composition of assets and
liabilities
➢ Changes in the volume of earning assets and
22
interest-bearing liabilities outstanding
22

11
 Factors affecting net interest income:
An example
▪ Consider the following balance sheet:
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 500 8.0% $ 600 4.0%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)

NII = 78.5 - 37.2 = 41.3
NIM = 41.3 / 850 = 4.86%
23
GAP = 500 - 600 = -100

23

Examine the impact of the following changes

▪ A 1% increase in the level of all short-term

rates?
▪ A 1% decrease in the spread between assets
yields and interest costs such that the rate on
ISAs increases to 8.5% and the rate on ISLs
increase to 5.5%?
▪ A proportionate doubling in size of the bank?
▪ A change in the composition of both assets and
liabilities
24

24

12
 1% increase in short-term rates
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 500 9.0% $ 600 5.0%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)

NII = 83.5 - 43.2 = 40.3
NIM = 40.3 / 850 = 4.74% With a negative GAP, more
GAP = 500 - 600 = -100 liabilities than assets reprice
higher; hence NII and NIM fall
25

25

1% decrease in the spread

Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 500 8.5% $ 600 5.5%
Fixed rate $ 350 11.0% $ 220 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

NII = (0.085 x 500 + 0.11 x 350) - (0.055 x 600 + 0.06 x 220)

NII = 81 - 46.2 = 34.8
NIM = 34.8 / 850 = 4.09% NII and NIM fall (rise) with a
GAP = 500 - 600 = -100 decrease (increase) in the
spread.
Why the larger change? 26

26

13
 Changes in the slope of the yield curve

▪ If liabilities are short-term and assets are long-

term, the spread will

➢ widen as the yield curve increases in slope

➢ narrow when the yield curve decreases in

slope and/or inverts

27

27

Changes in the volume of earning assets and

interest-bearing liabilities

▪ Net interest income varies directly with changes

in the volume of earning assets and interest-

bearing liabilities, regardless of the level of

interest rates

28

28

14
 Proportionate doubling in size
Expected Balance Sheet for Hypothetical Bank
Assets Yield Liabilities Cost
Rate sensitive $ 1,000 8.0% $ 1,200 4.0%
Fixed rate $ 700 11.0% $ 440 6.0%
Non earning $ 300 $ 200
$ 1,840
Equity
$ 160
Total $ 2,000 $ 2,000

NII = (0.08 x 1000 + 0.11 x 700) - (0.04 x 1200 + 0.06 x 440)

NII = 157 - 74.4 = 82.6
NIM = 82.6 / 1700 = 4.86% NII and GAP double, but NIM
GAP = 1000 - 1200 = -200 stays the same.
What has happened to risk?
29

29

ISAs increase to $540 while fixed-rate assets

decrease to $310 and ISLs decrease to $560 while
fixed-rate liabilities increase to $260

Expected Balance Sheet for Hypothetical Bank

Assets Yield Liabilities Cost
Rate sensitive $ 540 8.0% $ 560 4.0%
Fixed rate $ 310 11.0% $ 260 6.0%
Non earning $ 150 $ 100
$ 920
Equity
$ 80
Total $ 1,000 $ 1,000

NII = (0.08 x 540 + 0.11 x 310) - (0.04 x 560 + 0.06 x 260)

NII = 77.3 - 38 = 39.3
NIM = 39.3 / 850 = 4.62%
GAP = 540 - 560 = -20
30
Although the bank’s GAP
(and hence risk) is lower, 30
NII is also lower.

15
 Changes in portfolio composition and risk

▪ To reduce risk, a bank with a negative GAP

would try to increase ISAs (variable rate loans
or shorter maturities on loans and investments)
and decrease ISLs (issue relatively more
longer-term CDs and fewer FED funds
purchased)
▪ Changes in portfolio composition also raise or
lower interest income and expense based on
the type of change 31

31

7-32

Interest-sensitive gap measurements

Dollar Interest- Interest-Sensitive Assets –

Sensitive Gap = Interest Sensitive Liabilities

Relative
Dollar IS Gap
Interest- =
Sensitive Gap Bank Size

Interest Interest Sensitive Assets

Sensitivity =
Interest Sensitive Liabilitie s
Ratio
32

32

16
 Changes in Net Interest Income are directly
proportional to the size of the GAP
▪ If there is a parallel shift in the yield curve:

ΔNII exp = GAP  iexp

▪ It is rare, however, when the yield curve shifts
parallel

➢ If rates do not change by the same amount

and at the same time, then net interest
income may change by more or less.
33

33

Traditional static GAP analysis

Steps in GAP analysis
▪ Develop an interest rate forecast
▪ Select a series of “time buckets” or intervals for
determining when assets and liabilities will re-
price
▪ Group assets and liabilities into these “buckets
”
▪ Calculate the GAP for each “bucket ”
▪ Forecast the change in net interest income
given an assumed change in interest rates
34

34

17
 7-35

Computer-based techniques and maturity

buckets

35

35

7-36

Asset-sensitive bank has:

▪ Positive dollar interest-sensitive gap

▪ Positive relative interest-sensitive gap

▪ Interest sensitivity ratio greater than one

36

36

18
 7-37

Liability sensitive bank has:

▪ Negative dollar interest-sensitive gap

▪ Negative relative interest-sensitive gap

▪ Interest sensitivity ratio less than one

37

37

7-38

Gap positions and the effect of interest rate

changes on the bank

▪ Asset-sensitive bank ▪ Liability-sensitive bank

➢ Interest rates rise ➢ Interest rates rise
❖ NIM rises ❖ NIM falls

➢ Interest rates fall ➢ Interest rates fall

❖ NIM falls ❖ NIM rises

38

38

19
 7-39

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

39

39

7-40

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 interest-
sensitive assets and liabilities
40

40

20
 7-41

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

41

41

7-42

Cumulative gap

The total difference in dollars between those

bank assets and liabilities which can be re-priced
over a designated time period.

42

42

21
 7-43

Aggressive interest-sensitive gap management

43

Interest rate-sensitivity reports

Classifies a bank’s assets and liabilities into time intervals
according to the minimum number of days until each
instrument is expected to be repriced.

▪ GAP values are reported a periodic and

cumulative basis for each time interval.
➢ Periodic GAP
❖ Is the Gap for each time bucket and measures
the timing of potential income effects from
interest rate changes
◼ Cumulative GAP
❖ It is the sum of periodic GAP's and measures
aggregate interest rate risk over the entire
period
❖ Cumulative GAP is important since it directly
measures a bank’s net interest sensitivity 44

throughout the time interval.

44

22
 Measuring interest rate risk with GAP
1-7 8-30 31-90 91-180 181-365 Over Not Rate
Days Days Days Days Days 1 year Sensitive Total
Assets
U.S. Treas & ag 0.7 3.6 1.2 0.3 3.7 9.5
MM Inv 1.2 1.8 3.0
Municipals 0.7 1.0 2.2 7.6 11.5
FF & Repo's 5.0 5.0
Comm loans 1.0 13.8 2.9 4.7 4.6 15.5 42.5
Install loans 0.3 0.5 1.6 1.3 1.9 8.2 13.8
Cash 9.0 9.0
Other assets 5.7 5.7
Total Assets 6.3 15.0 10.0 10.0 9.0 35.0 14.7 100.0
Liabilities and Equity
MMDA 5.0 12.3 17.3
Super NOW 2.2 2.2
CD's < 100,000 0.9 2.0 5.1 6.9 1.8 2.9 19.6
CD's > 100,000 1.9 4.0 12.9 7.9 1.2 27.9
FF purchased -
NOW 9.6 9.6
Savings 1.9 1.9
DD 13.5 13.5
Other liabilities 1.0 1.0
Equity 7.0 7.0
Total Liab & Eq. 5.0 11.0 30.3 24.4 3.0 4.8 21.5 100.0
45
Periodic GAP 1.3 4.0 -20.3 -14.4 6.0 30.2
Cumulative GAP 1.3 5.3 -15.0 -29.4 -23.4 6.8
45

Example

◼ Table 7.1. – p.231-232

46

46

23
 Advantages and disadvantages of
static GAP analysis
▪ Advantages
➢ Easy to understand
➢ Works well with small changes in interest rates
▪ Disadvantages
➢ Ex-post measurement errors
➢ Ignores the time value of money
➢ Ignores the cumulative impact of interest rate
changes
➢ Typically considers demand deposits to be non-
rate sensitive
➢ Ignores embedded options in the bank’s assets
and liabilities
47

47

Measuring interest rate risk with GAP Ratio

◼ GAP Ratio = ISAs/ISLs

◼ A GAP ratio greater than 1 indicates a

positive GAP

◼ A GAP ratio less than 1 indicates a negative

GAP

48

48

24
 What is the ‘Optimal GAP’

▪ There is no general optimal value for a bank's

GAP in all environments.

▪ Generally, the farther a bank's GAP is from

zero, the greater is the bank's risk.

▪ A bank must evaluate its overall risk and return

profile and objectives to determine its optimal
GAP
49

49

GAP and variability in earnings

▪ Neither the GAP nor GAP ratio provide direct
information on the potential variability in
earnings when rates change.
➢ Consider two banks, both with $500 million in
total assets.
❖ Bank A: $3 mil in ISAs and $2 mil in ISLs.
GAP = $1 mil and GAP ratio = 1.5 mil
❖ Bank B: $300 mil in ISAs and $200 mil ISLs.
GAP equals $100 mill and 1.5 GAP ratio.
❖ Clearly, the second bank assumes greater
interest rate risk because its net interest income
will change more when interest rates change.
50

50

25
 Link between GAP and Net interest margin

▪ Many banks will specify a target GAP to

earning asset ratio in the ALCO policy
statements

Target Gap (Allowable % Change in NIM)(Expec ted NIM)

=
Earning assets Expected % change in interest rates

51

51

Establishing a target GAP: an example

▪ Consider a bank with $50 million in earning

assets that expects to generate a 5% NIM.

▪ The bank will risk changes in NIM equal to plus

or minus 20% during the year

➢ Hence, NIM should fall between 4% and 6%.

52

52

26
 Establishing a target GAP: an example (cont.)

▪ If management expects interest rates to vary up

to 4 percent during the upcoming year, the
bank’s ratio of its 1-year cumulative GAP
(absolute value) to earning assets should not
exceed 25 percent.
◼ Target GAP/Earning assets

= (.20)(0.05) / 0.04 = 0.25

▪ Management’s willingness to allow only a 20
percent variation in NIM sets limits on the GAP,
which would be allowed to vary from $12.5
million to $12.5 million, based on $50 million in
earning assets. 53

53

Speculating on the GAP

▪ Many bank managers attempt to adjust the

interest rate risk exposure of a bank in
anticipation of changes in interest rates.

▪ This is speculative because it assumes that

management can forecast rates better than the
market.

54

54

27
 Can a bank effectively speculate on the GAP?

▪ Difficult to vary the GAP and win as this

requires consistently accurate interest rate
forecasts

▪ A bank has limited flexibility in adjusting its

GAP; e.g., loan and deposit terms

▪ There is no adjustment for the timing of cash

flows or dynamics of the changing GAP position
55

55

7-56

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 re-
priced is not easy to identify
▪ Interest-sensitive gap does not consider the
impact of changing interest rates on equity
position
56

56

28
 7-57

Quick quiz
1. Commerce National Bank reports interest-sensitive assets
of $870 million and interest-sensitive liabilities of $625
million during the coming month. Is the bank asset
sensitive or liability sensitive? What is likely to happen to
the bank’s net interest margin if interest rates rise? If they
fall?

2. People’s Savings Bank , a thrift institutions, 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. Calculate the expected change in net
interest income that this thrift institution might experience.
What will occur in net interest income if interest rates rise
by one and a quarter percentage points? 57

57

7-58

Duration for managing the net worth

- From the problem of interest GAP in interest

rate management

- Affects of interest rate changes to net worth

(value of stockholders’ investment in the FI)

- Duration gap management

58

58

29
 7-59

The concept of duration

Duration is the weighted average maturity of a

promised stream of future cash flows.

59

59

7-60

To calculate the instrument’s duration

n n

 (1 + YTM)
t * CFt
t  (1 +t *YTM)
CFt
t
D = t =1 = t =1
n Current Market Value or Price
 (1 + YTM)
t =1
CFt
t

60

60

30
 Specific example of duration calculation:

P. 237-238

61

61

7-62

Price sensitivity of a security

P i
 -D*
P (1 + i)

62

62

31
 7-63

Convexity

The non-linear relationship between change in

an asset’s price or value varies and the change

in level of interest rates or yields.

63

63

7-64

Dollar-weighted duration of asset portfolio

n
D A =  w i * D Ai
i =1

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

64

64

32
 7-65

Dollar-weighted 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
65

65

7-66

Duration gap

TL
D = DA - DL *
TA

66

66

33
 7-67

Change in the value of a bank’s net worth

 i   i 
NW = - D A * * A  - - D L * * L
 (1 + i)   (1 + i) 

67

67

7-68

Impact of changing interest rates on a bank’s

net worth

68

34
 Example: Table 7.4. pages 244 - 246

69

7-70

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
70

70

35
 7-71

Quick quiz
1. What is duration? How is a financial institution’s
duration gap determined?
2. What are the advantages of using duration as
opposed to interest-sensitive gap analysis?
3. Suppose that a thrift institution has an average
asset duration of 2.5 years and an average liability
duration of 3.0 years. If the thrift holds total assets
of $560 million and total liabilities of $467 million,
does it have a significant leverage-adjusted
duration gap? If interest rates rise, what will
happen to the value of its net worth? 71

71

Questions & Problems

1. Can you explain the concept of gap management?
2. Explain the concept of weighted interest-sensitive gap.
How can this concept aid management in measuring a
financial institution’s real interest-sensitive gap risk
exposure?
3. What are the advantages of using duration as an asset-
liability management tool as opposed to interest-sensitive
gap analysis?
4. What are the principal limitations of duration gap analysis?
Can you think of some way of reducing the impact of
these limitations?
5. Problem 8, 9, 11 and 13 (page 249-250) 72

72

36
 Answers
1. Can you explain the concept of gap management?
- Gap management requires the management to perform
analysis of the maturities and repricing opportunities
associated with interest-bearing assets and with
interest-bearing 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 gap's size and direction.
73

Answers
2. Explain the concept of weighted interest-sensitive gap.
How can this concept aid management in measuring a
bank’s real interest-sensitive 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 these may change at a different speed than
those interest rates determined in the open market.

74

37
 Answers
2. Explain the concept of weighted interest-sensitive gap.
How can this concept aid management in measuring a
bank’s real interest-sensitive gap risk exposure?
❖ In the weighted interest-sensitive gap methodology, all
interest-sensitive assets and liabilities are given a weight
based on their speed (sensitivity) relative to some market
interest rate.
❖ Fed Funds loans 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.

75

Answers
2. Explain the concept of weighted interest-sensitive gap.
How can this concept aid management in measuring a
bank’s real interest-sensitive gap risk exposure?
❖ To determine the interest-sensitive gap, the dollar amount of
each type of asset or liability would be multiplied by its
weight and added to the rest of the interest-sensitive 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 interest-sensitive assets.

76

38
 Answers
2. Explain the concept of weighted interest-sensitive gap.
How can this concept aid management in measuring a
bank’s real interest-sensitive gap risk exposure?
❖ This weighted interest-sensitive gap should be more
accurate than the unweighted interest-sensitive 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.

77

Answers
3. What are the advantages of using duration as an asset-
liability management tool as opposed to interest-sensitive
gap analysis?
❖ Interest-sensitive gap only looks at the impact of changes
in interest rates on the bank’s net income. It does not take
into account the effect of interest rate changes on the
market value of the bank’s equity capital position. In
addition, duration provides a single number which tells the
bank their overall exposure to interest rate risk.

78

39
 Answers
4. What are the principal limitations of duration gap analysis?
Can you think of some way 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 financial-service institution’s portfolio

✓ Some accounts such as deposits and others don’t have well

defined patterns of cash flows which make it difficult to
calculate duration for these accounts.

79

Answers
4. What are the principal limitations of duration gap analysis?
Can you think of some way of reducing the impact of
these limitations?
❖ There are several limitations with duration gap analysis:
✓ Duration is also affected by prepayments by customers as well as
default. Duration gap models assume that a linear relationship
exists between the market values (prices) of assets and liabilities
and interest rates, which is not strictly true.

✓ Duration analysis works best when interest rate changes are small
and short and long term interest rates change by the same
amount. If this is not true, duration analysis is not as accurate.

80

40
 Answers
5. Problem 8 (page 249)
Coming Next Next More Than
Week 30 Days 31-90 Days 90 Days
Loans $200 $300 $475 $525
Securities +21 +26 40 70
Total IS Assets $221 $326 $515 $595

Transaction Dep. $320 $ --- $ --- $ ---

Time Accts. 100 290 196 100
Money Mkt. Borr. 136 140 100 65
Total IS Liab. $556 $430 $296 $165

GAP - $335 - $104 $219 + $430

Cumulative GAP - $335 - $439 - $220 $210

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5. Problem 8 (page 241-3)
❖ First National has a negative gap in the nearest period
and therefore would benefit if interest rates fell.
❖ In the next period it has a slightly negative gap and would
therefore benefit of interest rate rose. However, its
cumulative gap is still negative.
❖ The third period is positive gap and hence the bank would
benefit if interest rates rises.
❖ In the final period the gap is positive and the bank would
benefit if interest rates rose. Its cumulative gap is slightly
positive and also shows that rising interest rates would be
beneficial to the bank overall.
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5. Problem 9 (page 249)
Dollar IS Gap = ISA – ISL = (50 + 50 + 350) – (250 + 90)
= 450 – 340
= 110

Weighted IS Gap = [(1)x(50) + (1.2) x (50) + (1.45) x (350)]

- [(0.75) x (250) + (0.95) x (90)]
= (50 + 60 + 507.5) – (187.5 + 85.5)
= 617.5 – 273
= 344.5

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5. Problem 9 (page 249)
a) Change in Bank’s Income
= IS Gap * Change in interest rates
= ($110) (.005) = $.55 million
Using the regular IS Gap; net income will change by (+/-)
$550,000

b) Change in Bank’s Income

= Weighted IS Gap * Change in interest rates
= ($344.5) (.005) = $1.7225 million
Using the weighted IS Gap; net income will change by (+/-)
$1,722,500

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5. Problem 11 (page 250)
Richman has asset duration (DA) of:

$1,275,600*1 + $746,872 * 2 + $341,555 * 3 + $62,482 * 4 + $9,871 * 5

(1 + 0.0425)1 (1 + 0.0425)2 (1 + 0.0425)3 (1 + 0.0425)4 (1 + 0.0425)5

$1,275,600 + $746,872 + $341,555 + $62,482 + $9,871

(1 + 0.0425)1 (1 + 0.0425)2 (1 + 0.0425)3 (1 + 0.0425)4 (1 + 0.0425)5

= $3,754,097 / $2,273,192 = 1.65 years

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5. Problem 11 (page 250)
Richman has a liability duration (DL) of:

$1,295,500 * 1 + $831,454 * 2 + $123,897 * 3 + $1,005 * 4

(1 + 0.0425)1 (1 + 0.0425) (1 + 0.0425)3 (1 + 0.0425)4

$1,295,500 + $831,454 + $123,897 + $1,005

(1 + 0.0425)1 (1 + 0.0425)2 (1 + 0.0425)3 (1 + 0.0425)4

= $3,104,237 / $2,117,934 = 1.47 years

Richman's Duration Gap = Asset Duration - Liability Duration

= 1.65 - 1.47 = 0.18 years

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5. Problem 11 (page 250)
❖ With a positive duration gap
✓ the bank's total returns will decrease if interest rates rise
because the value of the liabilities will decline by less than
the value of the assets.

✓ if interest rates were to fall, this positive duration gap will

result in the bank's total returns increasing. In this case, the
value of the assets will rise by a greater amount than the
value of the liabilities.

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5. Problem 11 (page 250)
❖ With a positive duration gap, the bank management needs
to close its duration gap between assets and liabilities.
✓ shorten asset duration, lengthen liability duration, and use
financial futures or options to deal with whatever asset-
liability gap exists at the moment.
✓ consider securitization or selling some of its assets,
reinvesting the cash flows in maturities that will more closely
match its liabilities' maturities.
✓ consider negotiating some interest-rate swaps to change the
cash flow patterns of its liabilities to more closely match its
asset maturities.

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5. Problem 13 (page 250)
Change in net worth = [-DA * ∆r * A] - [- DL * Dr * L]
(1+ r) (1+ r)

✓ If interest rates from 5% to 6%, Watson's net worth will

change to:
Change in net worth = -$120,000 million + $57,143 million
= -$62.,857 million

✓ If interest rates decline from 5% to 4.5%, we have:

Change in net worth = + $60,000 mil - $34,286 mil
= + $25,714 million

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RISK MANAGEMENT FOR

CHANGING INTEREST RATE:
ASSET-LIABILITY
MANAGEMENT DURATION

Chapter 5

William Chittenden edited and updated the PowerPoint slides for this edition.

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