McGraw-Hill/Irwin

Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
ALM and Duration
1
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Key Topics
Asset, Liability, and Funds Management
Market Rates and Interest-Rate Risk
The Goals of Interest-Rate Hedging
Interest-Sensitive Gap Management
Duration Gap Management
Limitations of Hedging Techniques

7-2
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
7-3
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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)
7-4
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Interest Rate Risk
Price Risk
When Interest Rates Rise, the Market Value
of the Bond or Asset Falls
Reinvestment Risk
When Interest Rates Fall, the Coupon
Payments on the Bond are Reinvested at
Lower Rates
7-5
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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

7-6
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Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Yield to Maturity (YTM)

=
+
=
n
1 t
t
t
YTM) (1
CF
Price Market
7-7
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Discount Rate (DR)
Maturity to Days #
360
*
FV
Price Purchase - FV
DR =
Where: FV equals Face Value of a Security,
such as Treasury Bills
7-8
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Market Interest Rates
Function of:
Risk-Free Real Rate of Interest
Various Risk Premiums
Default Risk
Inflation Risk
Liquidity Risk
Call Risk
Maturity Risk
7-9
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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

7-10
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Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Net Interest Margin
Assets Earnings Total
Expenses Interest - Income Interest
NIM =
7-11
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Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
7-12
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Quick Quiz
What forces cause interest rates to change?
What makes it so difficult to correctly forecast
interest rate changes?
What is the yield curve, and why is it important
to know about its shape and slope?
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 Nationals
net interest margin? Suppose the banks interest
revenues and interest costs double, while its earning
assets increase by 50%. What will happen to its net
interest margin?

7-13
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Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Interest-Sensitive Gap Measurements
Dollar Interest-
Sensitive Gap
Interest-Sensitive Assets
Interest Sensitive Liabilities
=
Relative
Interest-
Sensitive Gap
Size Bank
Gap IS Dollar
=
Interest
Sensitivity
Ratio
s Liabilitie Sensitive Interest
Assets Sensitive Interest
=
7-14
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Examples of Repriceable (Interest
Sensitive) Assets and Liabilities
7-15
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Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Asset-Sensitive Bank Has:
Positive Dollar Interest-Sensitive Gap

Positive Relative Interest-Sensitive Gap

Interest Sensitivity Ratio Greater Than
One
7-16
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Liability Sensitive Bank Has:
Negative Dollar Interest-Sensitive Gap

Negative Relative Interest-Sensitive
Gap

Interest Sensitivity Ratio Less Than
One
7-17
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Computer-Based Techniques and
Maturity Buckets
7-18
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
7-19
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
7-20
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
7-21
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
7-22
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Cumulative Gap

The Total Difference in Dollars
Between Those Bank Assets and
Liabilities Which Can be Repriced over
a Designated Time Period
7-23
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Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Aggressive Interest-Sensitive Gap
Management
7-24
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
7-25
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Quick Quiz
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 banks net
interest margin if interest rates rise? If they fall?

Peoples 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?
7-26
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Concept of Duration


Duration is the Weighted Average
Maturity of a Promised Stream of
Future Cash Flows
7-27
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
To Calculate the Instruments Duration
Price or Value Market Current
YTM) (1
CF * t
YTM) (1
CF
YTM) (1
CF * t
D
n
1 t
t
t
n
1 t
t
t
n
1 t
t
t

=
=
=
+
=
+
+
=
7-28
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Price Sensitivity of a Security
i) (1
i
* D -
P
P
+
A
~
A
7-29
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Convexity


The Rate of Change in an Assets Price
or Value Varies with the Level of
Interest Rates or Yields
7-30
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Dollar-Weighted Duration of Asset
Portfolio

=
=
n
1 i
A i A
i
D * w D
Where:
w
i
= the dollar amount of the ith asset divided by total assets
D
Ai
= the duration of the ith asset in the portfolio
7-31
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Dollar-Weighted Duration of a Liability
Portfolio

=
=
n
1 i
L i L
i
D * w D
Where:
w
i
= the dollar amount of the ith liability divided by total liabilities
D
Li
= the duration of the ith liability in the portfolio
7-32
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Duration Gap
TA
TL
* D - D D
L A
=
7-33
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Change in the Value of a Banks Net
Worth
(

+
A
(

+
A
= A L *
i) (1
i
* D - - A *
i) (1
i
* D - NW
L A
7-34
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Impact of Changing Interest Rates on a
Banks Net Worth
7-35
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
7-36
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Quick Quiz
What is duration? How is a financial
institutions duration gap determined?
What are the advantages of using duration as
opposed to interest-sensitive gap analysis?
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?
7-37