Managing Interest Rate Risk(II):
Duration GAP and Economic Value
of Equity
Measuring Interest Rate Risk with Duration
GAP
Economic Value of Equity Analysis
Focuses on changes in stockholders’
equity given potential changes in
interest rates
Duration GAP Analysis
Compares the price sensitivity of a
bank’s total assets with the price
sensitivity of its total liabilities to
assess the impact of potential changes
in interest rates on stockholders’
equity.
Duration GAP
Duration GAP Model
Focuses on either managing the market value of
stockholders’ equity
The bank can protect EITHER the market value of
equity or net interest income, but not both
Duration GAP analysis emphasizes the impact on
equity
Compares the duration of a bank’s assets with the
duration of the bank’s liabilities and examines how the
economic value stockholders’ equity will change when
interest rates change.
Steps in Duration GAP Analysis
Forecast interest rates.
Estimate the market values of bank assets,
liabilities and stockholders’ equity.
Estimate the weighted average duration of
assets and the weighted average duration of
liabilities.
Incorporate the effects of both on- and off-
balance sheet items. These estimates are
used to calculate duration gap.
Forecasts changes in the market value of
stockholders’ equity across different
interest rate environments.
Weighted Average Duration of Bank Assets
Weighted Average Duration of Bank
Assets (DA)
n
DA w iDai
i
Where
wi = Market value of asset i divided by
the market value of all bank assets
Dai = Macaulay’s duration of asset i
n = number of different bank assets
Weighted Average Duration of Bank Liabilities
Weighted Average Duration of Bank
Liabilities (DL)
m
DL z jDlj
j
Where
zj = Market value of liability j divided by
the market value of all bank liabilities
Dlj= Macaulay’s duration of liability j
m = number of different bank liabilities
Duration GAP and Economic Value of Equity
Let MVA and MVL equal the market values of
assets and liabilities, respectively.
If: ΔEVE ΔMVA ΔMVL
and
Duration GAP
DGAP DA - (MVL/MVA)D L
y
Then: ΔEVE - DGAP MVA
(1 y)
where y = the general level of interest
rates
To protect the economic value of equity
against any change when rates change , the
bank could set the duration gap to zero:
Hypothetical Bank Balance Sheet
1 Par Years Market
$1,000 % Coup Mat. YTM Value Dur.
Assets
Cash $100 $ 100
Earning assets
3-yr Commercial loan $ 700 12.00% 3 12.00% $ 700 2.69
6-yr Treasury bond $ 200 8.00% 6 8.00% $ 200 4.99
84 1 84 2 84 3 700 3$ 900
Total Earning Assets
-
$ 900
11.11%
(1.12)1
Non-cash earning assets $ (1 .12) (1.12)3
2
(1.12)3$ -
Total assets D $ 1,000 10.00% $ 1,000 2.88
700
Liabilities
Interest bearing liabs.
1-yr Time deposit $ 620 5.00% 1 5.00% $ 620 1.00
3-yr Certificate of deposit $ 300 7.00% 3 7.00% $ 300 2.81
Tot. Int Bearing Liabs. $ 920 5.65% $ 920
Tot. non-int. bearing $ - $ -
Total liabilities $ 920 5.65% $ 920 1.59
Total equity $ 80 $ 80
Total liabs & equity $ 1,000 $ 1,000
Calculating DGAP
DA
($700/$1000)*2.69 + ($200/$1000)*4.99 = 2.88
DL
($620/$920)*1.00 + ($300/$920)*2.81 = 1.59
DGAP
2.88 - (920/1000)*1.59 = 1.42 years
What does this tell us?
The average duration of assets is greater than the
average duration of liabilities; thus asset values
change by more than liability values.
1 percent increase in all rates.
1 Par Years Market
$1,000 % Coup Mat. YTM Value Dur.
Assets
Cash $ 100 $ 100
Earning assets
3-yr Commercial loan $ 700 12.00% 3 13.00% $ 683 2.69
6-yr Treasury bond $ 200 8.00% 6 9.00% $ 191 4.97
Total Earning Assets $ 900 12.13% $ 875
84 700 $
3
PV
Non-cash earning assets $ -
t
-
Total assets $ 1,000 t 1
1.13 10.88%3 $
1.13 975 2.86
Liabilities
Interest bearing liabs.
1-yr Time deposit $ 620 5.00% 1 6.00% $ 614 1.00
3-yr Certificate of deposit $ 300 7.00% 3 8.00% $ 292 2.81
Tot. Int Bearing Liabs. $ 920 6.64% $ 906
Tot. non-int. bearing $ - $ -
Total liabilities $ 920 6.64% $ 906 1.58
Total equity $ 80 $ 68
Total liabs & equity $ 1,000 $ 975
Calculating DGAP
DA
($683/$974)*2.68 + ($191/$974)*4.97 = 2.86
DA
($614/$906)*1.00 + ($292/$906)*2.80 = 1.58
DGAP
2.86 - ($906/$974) * 1.58 = 1.36 years
What does 1.36 mean?
The average duration of assets is greater than the
average duration of liabilities, thus asset values
change by more than liability values.
Change in the Market Value of Equity
y
ΔEVE - DGAP[ ]MVA
(1 y)
In this case:
.01
ΔEVE - 1.42[ ]$1,000 $12.91
1.10
Positive and Negative Duration GAPs
Positive DGAP
Indicates that assets are more price sensitive
than liabilities, on average.
Thus, when interest rates rise (fall), assets will
fall proportionately more (less) in value than
liabilities and EVE will fall (rise) accordingly.
Negative DGAP
Indicates that weighted liabilities are more
price sensitive than weighted assets.
Thus, when interest rates rise (fall), assets will
fall proportionately less (more) in value that
liabilities and the EVE will rise (fall).
DGAP Summary
DGAP Summary
Change in
DGAP Interest
Assets Liabilities Equity
Rates
Positive Increase Decrease > Decrease → Decrease
Positive Decrease Increase > Increase → Increase
Negative Increase Decrease < Decrease → Increase
Negative Decrease Increase < Increase → Decrease
Zero Increase Decrease = Decrease → None
Zero Decrease Increase = Increase → None
An Immunized Portfolio
To immunize the EVE from rate
changes in the example, the bank
would need to:
decrease the asset duration by 1.42
years or
increase the duration of liabilities by
1.54 years
DA / ( MVA/MVL)
= 1.42 / ($920 / $1,000)
= 1.54 years
Immunized Portfolio
1 Par Years Market
$1,000 % Coup Mat. YTM Value Dur.
Assets
Cash $ 100 $ 100
Earning assets
3-yr Commercial loan $ 700 12.00% 3 12.00% $ 700 2.69
6-yr Treasury bond $ 200 8.00% 6 8.00% $ 200 4.99
Total Earning Assets $ 900 11.11% $ 900
Non-cash earning assets$ - $ -
Total assets $ 1,000 10.00% $ 1,000 2.88
Liabilities
Interest bearing liabs.
1-yr Time deposit $ 340 5.00% 1 5.00% $ 340 1.00
3-yr Certificate of deposit$ 300 7.00% 3 7.00% $ 300 2.81
6-yr Zero-coupon CD* $ 444 0.00% 6 8.00% $ 280 6.00
Tot. Int Bearing Liabs. $ 1,084 6.57% $ 920
Tot. non-int. bearing $ - $ -
Total liabilities $ 1,084 6.57% $ 920 3.11
Total equity $ 80 $ 80
DGAP = 2.88 – 0.92 (3.11) ≈ 0
Immunized Portfolio with a 1% increase in rates
1 Par Years Market
$1,000 % Coup Mat. YTM Value Dur.
Assets
Cash $ 100.0 $ 100.0
Earning assets
3-yr Commercial loan $ 700.0 12.00% 3 13.00% $ 683.5 2.69
6-yr Treasury bond $ 200.0 8.00% 6 9.00% $ 191.0 4.97
Total Earning Assets $ 900.0 12.13% $ 874.5
Non-cash earning assets$ - $ -
Total assets $ 1,000.0 10.88% $ 974.5 2.86
Liabilities
Interest bearing liabs.
1-yr Time deposit $ 340.0 5.00% 1 6.00% $ 336.8 1.00
3-yr Certificate of deposit$ 300.0 7.00% 3 8.00% $ 292.3 2.81
6-yr Zero-coupon CD* $ 444.3 0.00% 6 9.00% $ 264.9 6.00
Tot. Int Bearing Liabs. $ 1,084.3 7.54% $ 894.0
Tot. non-int. bearing $ - $ -
Total liabilities $ 1,084.3 7.54% $ 894.0 3.07
Total equity $ 80.0 $ 80.5
Immunized Portfolio with a 1% increase in rates
EVE changed by only $0.5 with the
immunized portfolio versus $25.0
when the portfolio was not immunized.
Economic Value of Equity Sensitivity Analysis
Effectively involves the same steps as
earnings sensitivity analysis.
In EVE analysis, however, the bank
focuses on:
The relative durations of assets and
liabilities
How much the durations change in
different interest rate environments
What happens to the economic value of
equity across different rate environments
Embedded Options
Embedded options sharply influence the
estimated volatility in EVE
Prepayments that exceed (fall short of)
that expected will shorten (lengthen)
duration.
A bond being called will shorten duration.
A deposit that is withdrawn early will
shorten duration.
A deposit that is not withdrawn as
expected will lengthen duration.
First Savings Bank Economic Value of Equity
Market Value/Duration Report as of 12/31/04
Most Likely Rate Scenario-Base Strategy
Assets
Book Value Market Value Book Yield Duration*
Loans
Prime Based Ln $ 100,000 $ 102,000 9.00%
Equity Credit Lines $ 25,000 $ 25,500 8.75% -
Fixed Rate > I yr $ 170,000 $ 170,850 7.50% 1.1
Var Rate Mtg 1 Yr $ 55,000 $ 54,725 6.90% 0.5
30-Year Mortgage $ 250,000 $ 245,000 7.60% 6.0
Consumer Ln $ 100,000 $ 100,500 8.00% 1.9
Credit Card $ 25,000 $ 25,000 14.00% 1.0
Total Loans $ 725,000 $ 723,575 8.03% 2.6
Loan Loss Reserve $ (15,000) $ 11,250 0.00% 8.0
Net Loans $ 710,000 $ 712,325 8.03% 2.5
Investments
Eurodollars $ 80,000 $ 80,000 5.50% 0.1
CMO Fix Rate $ 35,000 $ 34,825 6.25% 2.0
US Treasury $ 75,000 $ 74,813 5.80% 1.8
Total Investments $ 190,000 $ 189,638 5.76% 1.1
Fed Funds Sold $ 25,000 $ 25,000 5.25% -
Cash & Due From $ 15,000 $ 15,000 0.00% 6.5
Non-int Rel Assets $ 60,000 $ 60,000 0.00% 8.0
Total Assets $ 100,000 $ 100,000 6.93% 2.6
First Savings Bank Economic Value of Equity
Market Value/Duration Report as of 12/31/04
Most Likely Rate Scenario-Base Strategy
Liabilities
Book Value Market Value Book Yield Duration*
Deposits
MMDA $ 240,000 $ 232,800 2.25% -
Retail CDs $ 400,000 $ 400,000 5.40% 1.1
Savings $ 35,000 $ 33,600 4.00% 1.9
NOW $ 40,000 $ 38,800 2.00% 1.9
DDA Personal $ 55,000 $ 52,250 8.0
Comm'l DDA $ 60,000 $ 58,200 4.8
Total Deposits $ 830,000 $ 815,650 1.6
TT&L $ 25,000 $ 25,000 5.00% -
L-T Notes Fixed $ 50,000 $ 50,250 8.00% 5.9
Fed Funds Purch - - 5.25% -
NIR Liabilities $ 30,000 $ 28,500 8.0
Total Liabilities $ 935,000 $ 919,400 2.0
Equity $ 65,000 $ 82,563 9.9
Total Liab & Equity $ 1,000,000 $ 1,001,963 2.6
Off Balance Sheet Notional
lnt Rate Swaps - $ 1,250 6.00% 2.8 50,000
Adjusted Equity $ 65,000 $ 83,813 7.9
Duration Gap for First Savings Bank EVE
Market Value of Assets
$1,001,963
Duration of Assets
2.6 years
Market Value of Liabilities
$919,400
Duration of Liabilities
2.0 years
Duration Gap for First Savings Bank EVE
Duration Gap
= 2.6 – ($919,400/$1,001,963)*2.0
= 0.765 years
Example:
A 1% increase in rates would reduce
EVE by $7.2 million
= 0.765 (0.01 / 1.0693) * $1,001,963
Recall that the average rate on assets
is 6.93%
Effective “Duration” of Equity
By definition, duration measures the
percentage change in market value for
a given change in interest rates
Thus,a bank’s duration of equity
measures the percentage change in
EVE that will occur with a 1 percent
change in rates:
Effective duration of equity
9.9 yrs. = $8,200 / $82,563
Asset/Liability Sensitivity and DGAP
Funding GAP and Duration GAP are NOT
directly comparable
Funding GAP examines various “time
buckets” while Duration GAP represents
the entire balance sheet.
Generally, if a bank is liability (asset)
sensitive in the sense that net interest
income falls (rises) when rates rise and
vice versa, it will likely have a positive
(negative) DGAP suggesting that assets
are more price sensitive than liabilities, on
average.
Strengths and Weaknesses: DGAP and EVE-
Sensitivity Analysis
Strengths
Duration analysis provides a
comprehensive measure of interest rate
risk
Duration measures are additive
This allows for the matching of total
assets with total liabilities rather than the
matching of individual accounts
Duration analysis takes a longer term
view than static gap analysis
Strengths and Weaknesses: DGAP and EVE-
Sensitivity Analysis
Weaknesses
It is difficult to compute duration
accurately
“Correct” duration analysis requires that
each future cash flow be discounted by a
distinct discount rate
A bank must continuously monitor and
adjust the duration of its portfolio
It is difficult to estimate the duration on
assets and liabilities that do not earn or
pay interest
Duration measures are highly subjective
Speculating on Duration GAP
It is difficult to actively vary GAP or
DGAP and consistently win
Interest rates forecasts are frequently
wrong
Even if rates change as predicted,
banks have limited flexibility in vary
GAP and DGAP and must often
sacrifice yield to do so
