Chapter Seven
Risk Management for Changing
Interest Rates: Asset-Liability
Management and Duration Techniques
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7-2
Key Topics
• Asset, Liability, and Funds Management
• Advantages and disadvantages of ALM
• Market Rates and Interest Rate Risk
• The Goals of Interest Rate Hedging
• Interest-Sensitive Gap Management
• Duration Gap Management
• Limitations of Interest Rate Risk Management
Techniques
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Introduction
• Even as a financial institution takes on risk, it must protect the value
of its net worth from erosion, which could result in ultimate failure
• Financial-service managers have learned to look at their asset and
liability portfolios as an integrated whole
• They must consider how their institution’s whole portfolio
contributes to the firm’s goals of adequate profitability and
acceptable risk
▫ Known as asset-liability management (ALM)
▫ Can protect against business cycles and seasonal pressures
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ASSET & LIABILITY
MANAGEMENT STRATEGY
• Asset strategy management is the process through
which organizations systematically approach the
planning, production, organization and maintenance of
all their assets.
• Liability strategy management: Is the process of
managing the use of assets and cash flow to reduce the
firms risk of loss from not paying a liability on time.
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• Funds management is the overseeing
and handling of a financial institution's
cash flow. The fund manager ensures that
the maturity schedules of the deposits
coincide with the demand for loans.
• To do this, the manager looks at both the
liabilities and the assets that influence the
bank's ability to issue credit.
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• Asset and liability management (ALM) is a practice
used by financial institutions to mitigate financial risks
resulting from a mismatch of assets and liabilities.
• By strategically matching of assets and liabilities,
financial institutions can achieve greater efficiency and
profitability while also reducing risk.
• Some of the most common risks addressed by ALM are
interest rate risk and liquidity risk.
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ADVANTAGES OF ALM
1. ALM allows a business to effectively manage the liabilities that
they incur. This enables them to be able to strategically prepare for
uncertainties that could happen in the future.
2. ALM help organizations recognize present risks on their balance
sheet. When they’re able to recognize these risks from a mismatch
of assets and liabilities, they can then reduce them.
3. When a business is able to strategically match its assets and
liabilities, they can achieve higher efficiency.
4.They can also increase overall profitability while reducing the
overall risk.
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DISADVANTAGES OF ALM
1. ALM that are worth exploring. Since almost every
organization is going to operate differently than others, there isn’t
a single framework that can get adopted. So not implementing
the proper type of framework and strategy can be detrimental.
2. Another challenge is that asset and liability management is a
long-term strategy. This means it requires some strategic thinking
and forward-looking datasets and projections.
3. Not doing effective coordinated process can make the process
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7-9
Interest Rate Risk: One of the Greatest
Management Challenges
• Changing interest rates impact both the balance sheet and the
statement of income and expenses of financial firms
• 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
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Interest Rate Risk: One of the Greatest
Management Challenges (continued)
• Forces Determining Interest Rates
▫ Loanable Funds Theory: is equilibrium rate of interest that
brings equality b/w the demand for and supply of loanable fund
• The Measurement of Interest Rates
▫ YTM: is the total return anticipated on a bond if the
bond is held until it matures.
▫ Bank Discount: the interest rate on a loan computed in
advance and deducted at the time loan is made.
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Interest Rate Risk: One of the Greatest
Management Challenges (continued)
• Components of Interest Rates
• Interest rates are the price of credit
▫ Demanded by lenders as compensation for the use of
borrowed funds
▫ Expressed in percentage points and basis points (1/100 of a
percentage point)
• Yield to Maturity (YTM)
▫ The discount rate that equalizes the current market value of a
loan or security with the expected stream of future income
payments that the loan or security will generate
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Interest Rate Risk: One of the Greatest
Management Challenges (continued)
• Another popular interest rate measure is the bank
discount rate (DR)
▫ Often quoted on short-term loans and money market
securities (such as Treasury bills)
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Interest Rate Risk: One of the Greatest
Management Challenges (continued)
• Market interest rates are a function of
▫ Risk-free real rate of interest: is a theoretical return on an investment that
caries no risk
▫ Various risk premiums
▫ Default Risk: is the risk a lender takes that a borrower will not meet debt
obligations
▫ Inflation Risk: is when the price increase more than expected
▫ Liquidity Risk: risk that the company will not have enough operational cash.
▫ Call Risk: risk that the bond an investor ha invested in will be redeemed by the
issuer before its maturity date.
▫ Maturity Risk: the amount of extra return you will see on your investment by
purchasing a bond with a longer maturity date.
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One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin
• In order to protect profits against adverse interest
rate changes, management seeks to hold fixed the
financial firm’s net interest margin (NIM)
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One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)
• Among the most popular interest rate hedging strategies in
use today is interest-sensitive gap management
▫ Gap management techniques require management to perform an
analysis of the maturities and repricing opportunities associated with
interest-bearing assets and with interest-bearing liabilities
▫ If management feels its institution is excessively exposed to interest
rate risk, it will try to match as closely as possible the volume of assets
that can be repriced as interest rates change with the volume of
liabilities whose rates can also be adjusted with market conditions
during the same time period
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One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)
• There are several ways to measure the interest-sensitive
gap (IS GAP)
▫ One method – Dollar IS GAP
▫ If interest-sensitive assets (ISA) are $150 million and interest-
sensitive liabilities (ISL) are $200 million
▫ The Dollar IS GAP = ISA – ISL = $150 million – $200 million =
-$50 million
▫ An institution whose Dollar IS GAP is positive is asset sensitive,
while a negative Dollar IS GAP describes a liability-sensitive
condition
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One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)
• Relative IS GAP ratio
▫ A Relative IS GAP greater than zero means the institution is
asset sensitive, while a negative Relative IS GAP describes a
liability-sensitive financial firm
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One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)
• Interest Sensitivity Ratio (ISR)
▫ An ISR of less than 1 tells us we are looking at a liability-
sensitive institution, while an ISR greater than unity points to an
asset-sensitive institution
▫ Only if interest-sensitive assets and liabilities are equal is a
financial institution relatively insulated from interest rate risk
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One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)
• Problems with Interest-Sensitive GAP Management
▫ Interest paid on liabilities tend to move faster than interest rates
earned on assets
▫ The interest rate attached to bank assets and liabilities do not
move at the same speed as market interest rates
▫ The point at which some assets and liabilities are repriced is not
easy to identify
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The Concept of Duration as a Risk-
Management Tool
• Duration is a value-weighted and time-weighted measure of
maturity that considers the timing of all cash inflows from
earning assets and all cash outflows associated with liabilities
▫ Measures the average maturity of a promised stream of future cash
payments.
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The Concept of Duration as a Risk-
Management Tool (continued)
• The net worth (NW) of any business or household is equal
to the value of its assets less the value of its liabilities
• As market interest rates change, the value of both a financial
institution’s assets and its liabilities will change, resulting in
a change in its net worth
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The Concept of Duration as a Risk-
Management Tool (continued)
• Portfolio theory teaches us that
1. A rise in market rates of interest will cause the market value (price) of
both fixed-rate assets and liabilities to decline
2. The longer the maturity of a financial firm’s assets and liabilities, the
more they will tend to decline in market value (price) when market
interest rates rise
• Thus, duration analysis can be used to stabilize, or immunize, the
market value of a financial institution’s net worth
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The 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
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Quick Quiz
• What do the following terms mean: asset management? liability
management? funds management?
• What are the pro and coins of ALM
• Can you explain the concept of gap management?
• What are the varies risk premium? Define each one?
• What is duration? How is a financial institution’s duration gap
determined?
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