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# CHAPTER 7 Part 2_A212 (1).ppt

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# CHAPTER 7 Part 2_A212 (1).ppt

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### CHAPTER 7 Part 2_A212 (1).ppt

1. 1. 1 CHAPTER 7 ASSET-LIABILITY MANAGEMENT PART 2
2. 2. INTEREST SENSITIVE GAP MANAGEMENT - SUMMARY Gap Change in interest rate Change in net interest income Positive ISA > ISL Increase Increase Decrease Decrease Negative ISA < ISL Increase Decrease Decrease Increase Zero ISA = ISL Increase No change Decrease No change
3. 3. How to Measure Interest Rate Risk Exposure 1. Cumulative gap 2. Aggressive gap management 3. Weighted interest-sensitive gap
4. 4. Cumulative gap  The total difference in dollars between those assets and liabilities that can be repriced over a designated period of time.  Example: The bank has RM100 million in earning assets and RM200 million in liabilities subject to an interest rate change each month over the next 6 months. The cumulative gap: (RM100 million per month x 6) – (RM200 million per month x 6) = - RM600 million.
5. 5.  The cumulative gap is useful because, given any specific change in market interest rates, we can calculate approximately how net interest income will be affected by an interest rate change.  Change in net interest income = Overall change in interest rate (in percentage points) x size of the cumulative gap (in dollars).  Example: Suppose market interest rate rises by 1 percentage point. The loss of net interest income will be:  0.01 x –RM600 million = -RM6 million
6. 6. Aggressive Gap Management  Some banks shade their interest-sensitive gaps toward either asset sensitivity or liability sensitivity, depending on their degree of confidence in their own interest rate forecast.  Example: If management believes interest rates are going to fall over the current situation, it will probably allow interest-sensitive liabilities to climb above interest-sensitive assets.  If interest rates do fall as predicted, liability costs will drop by more than revenues and the NIM will increase.
7. 7. Weighted Interest-Sensitive Gap  This approach takes into account the tendency of interest rates to vary in speed and magnitude relative to each other and with the up and down cycle of business activity.  The interest rates on assets often change by different amounts and by different speeds than interest rates on liabilities.  Under this approach, all interest-sensitive assets and liabilities are given weight based on their speed (sensitivity) relative to some market interest rate.
8. 8. Weighted Interest-Sensitive Gap  For example, federal funds loans generally carry interest rates set in the open market, so these loans have an interest rate sensitivity weight of 1.0.  On the other way, loans and leases are the most rate-volatile so its weight is estimated to be 1.5.  On the liability side, the bank can assume deposits have a rate- sensitive weight of 0.86 because deposits rate may change more slowly than market interest rates.
9. 9. Weighted Interest-Sensitive Gap  To determine the interest-sensitive gap, the dollar amount of each type of assets or liability would be multiplied by its weight and added to the rest of the interest-sensitive assets or liabilities.  More rate-volatile assets and liabilities will weigh more heavily in the refigured balance sheet.  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
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11. 11. INTEREST SENSITIVE GAP MANAGEMENT Optimal value for a bank’s gap?  There is NO general optimal value for a bank’s gap in all environment.  Gap is a measure of interest rate risk.  The best gap for a bank can be determined only by evaluating a bank’s overall risk and return profile and objectives.  The farther the bank’s gap from zero, the greater the bank’s risk.
12. 12.  Bank managers try to adjust the interest rate exposure in anticipation of changes in interest rates.  Speculating on the gap: * Difficult to vary the gap and win (requires accurate interest rate forecast on a consistent basis). * Usually only look short term. * Limited flexibility in adjusting the gap, customers and depositors. * No adjustment for timing of cash flows or dynamics of the changing gap position.
13. 13. INTEREST SENSITIVE GAP MANAGEMENT With positive gap The risk Possible management responses Asset sensitive ISA > ISL If interest rate rises, banks are fine. BUT, Losses if interest rate fall because bank net interest margin will be reduced Do nothing (maybe interest rate will rise or stable) Extend asset maturities or shorten liability maturities Increase ISL or decrease ISA
14. 14. With negative gap The risk Possible management responses Liability sensitive ISA < ISL If interest rate falls, banks are fine. BUT, Losses if interest rate rise because the bank’s net interest margin will be reduced Do nothing (maybe interest rate will fall or stable) Shorten asset maturities or lengthen liability maturities Decrease ISL or increase ISA INTEREST SENSITIVE GAP MANAGEMENT
15. 15. Problems with IS gap management: i. Interest paid on liabilities tend to move faster than interest rates earned on assets. ii. Interest rate attached to bank assets and liabilities do not move at the same speed as market interest rates. iii. Point at which some assets and liabilities are repriced is not easy to identify. iv. Interest sensitive gap does not consider the impact of changing interest rates in equity position.
16. 16. DURATION GAP MANAGEMENT  Duration is a value and time-weighted measure of maturity that considers the timing of all cash inflows from earning assets and all cash outflows associated with liabilities.  It measures the average maturity of a promised stream of future cash payments.  In effect, duration measures the average time needed to recover the funds committed to an investment.
17. 17. CONCEPT OF DURATION:  How to calculate duration.  How to calculate change in net worth if interest rate rises.  How to calculate dollar-weighted asset portfolio duration.  How to calculate dollar-weighted liability portfolio duration.  How to calculate duration gap.
18. 18. How to Calculate Duration 18 D= instrument’s duration in year t= period of time in which flow of cash to be received CF= expected cash flow for each time period YTM= instrument’s current yield to maturity Abbreviated formula
19. 19. How to Calculate Duration Example: Suppose a commercial bank grants a loan to one of its customers for a term of 5 years. The customer promises the bank an annual interest payment of 10%. The par value of the loan is RM1,000, which is also its current market value (price) because the loan’s current yield to maturity is 10%. What is this loan’s duration? years 4.17 RM1,000 RM4,169.87 000 , 1 ) 10 . 0 1 /( 5 000 , 1 ) 10 . 1 /( 100 D 5 1 t 5           RM RM t RM t
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21. 21. How to Calculate Change in Net Worth if Interest Rate Rises Example: Suppose a commercial bank has an average duration in its assets of 3 years, an average liability duration of 2 years, total liabilities of RM100 million, and total assets of RM120 million. Interest rate was originally 10%, but suddenly they rise to 12%. Find the change in the value of net worth.
22. 22.                   L * i) (1 i * D - - A * i) (1 i * D - NW L A 22 How to Calculate Change in Net Worth if Interest Rate Rises
23. 23. million RM 91 . 2 100 * 0.10) (1 02 . 0 * 2 - - 120 * ) 10 . 0 (1 02 . 0 * 3 - NW                  23 How to Calculate Change in Net Worth if Interest Rate Rises
24. 24. How to Calculate Ringgit-Weighted Asset Portfolio Duration Example: Assets Held Market value (RM) Asset Durations Treasury Bonds 90 mil 7.49 years Commercial Loans 100 mil 0.60 years Consumer Loans 50 mil 1.2 years Real Estate Loans 40 mil 2.25 years Municipal Bonds 20 mil 1.5 years
25. 25.    n 1 i A i A i D * w D 25 Where: wi = the dollar amount of the ith asset divided by total assets DAi = the duration of the ith asset in the portfolio How to Calculate Ringgit- Weighted Asset Portfolio Duration
26. 26. years 3.05 300 914.10 20 40 50 100 90 20) (1.5 40) (2.25 50) (1.20 100) (0.60 90) (7.49 assets all of ue market val Total asset each of ue Market val asset each of Duration D n 1 t A                     26 How to Calculate Ringgit- Weighted Asset Portfolio Duration
27. 27. How to Calculate Ringgit-Weighted Liability Portfolio Duration Example: Liabilities Held Market value (RM) Asset Durations Deposit 78 mil 2.5 years Other Non-deposit borrowings 60 mil 3.0 years
28. 28. How to Calculate Ringgit- Weighted Liability Portfolio Duration    n 1 i L i L i D * w D 28 Where: wi = the dollar amount of the ith liability divided by total liabilities DLi = the duration of the ith liability in the portfolio
29. 29. years 2.72 138 375 60 78 60) (3.0 78) (2.5 DL        29 How to Calculate Ringgit- Weighted Liability Portfolio Duration
30. 30. How to Calculate Leverage- Adjusted Duration Gap
31. 31. How to Calculate Leverage- Adjusted Duration Gap TA TL * D - D D L A  31
32. 32. How to Calculate Leverage- Adjusted Duration Gap years 1.80 300 138 72 . 2 - 3.05 D          32
33. 33. Limitations of Duration Gap Management 33 1. Finding assets and liabilities of the same duration can be difficult 2. Some assets and liabilities may have patterns of cash flows that are not well defined 3. Customer prepayments may distort the expected cash flows in duration 4. Customer defaults may distort the expected cash flows in duration