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CHAPTER 7

RISK MANAGEMENT FOR CHANGING INTEREST RATES: ASSET-LIABILITY

MANAGEMENT AND DURATION TECHNIQUES

Goals of This Chapter: The purpose of this chapter is to explore the options bankers have today

for dealing with risk especially the risk of loss due to changing interest rates and to see how a

banks management can coordinate the management of its assets with the management of its

liabilities in order to achieve the institutions goals.

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

Chapter Outline

I. Introduction: The Necessity for Coordinating Bank Asset and Liability Management Decisions

II. Asset-Liability Management Strategies

A. Asset Management Strategy

B. Liability Management Strategy

C. Funds Management Strategy

III. Interest Rate Risk: One of the Greatest Management Challenges

A. Forces Determining Interest Rates

B. The Measurement of Interest Rates

1. Yield to Maturity

2. Bank Discount Rate

C. The Components of Interest Rates

1. Risk Premiums

2. Yield Curves

3. The Maturity Gap and the Yield Curve

D. Responses to Interest Rate Risk

7-1

Chapter 07 - Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

IV. One of the Goals of Interest-Rate Hedging: Protect the Net Interest Margin

A. The Net Interest Margin

B. Interest-Sensitive Gap Management as a Risk- Management Tool

1. Asset-Sensitive Position

2. Liability-Sensitive Position

3. Dollar Interest-Sensitive Gap

4. Relative Interest Sensitive Gap

5. Interest Sensitivity Ratio

6. Computer-Based Techniques

7. Cumulative Gap

8. Strategies in Gap Management

C. Problems with Interest-Sensitive GAP Management

V. The Concept of Duration as a Risk-Management Tool

A. Definition of Duration

B. Calculation of Duration

C. Net Worth and Duration

D. Price Sensitivity to Changes in Interest Rates and Duration

E. Convexity and Duration

VI. Using Duration to Hedge Against Interest Rate Risk

A. Duration Gap

1. Dollar Weighted Duration of Assets

2. Dollar Weighted Duration of Liabilities

3. Positive Duration Gap

4. Negative Duration Gap

B. Change in the Banks Net Worth

VII The Limitations of Duration Gap Management

VIII. Summary of the Chapter

Concept Checks

7-1. What do the following terms mean: Asset management? Liability management? Funds

management?

Asset management refers to a banking strategy where management has control over the

allocation of bank assets but believes the bank's sources of funds (principally deposits) are

outside its control. The key decision area for management was not deposits and other borrowings

but assets.

Liability management is a strategy of control over bank liabilities by varying interest rates

offered on borrowed funds.

Funds management combines both asset and liability management approaches into a balanced

liquidity management strategy.

7-2

Chapter 07 - Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

7-2. What factors have motivated financial institutions to develop funds management

techniques in recent years?

The necessity to find new sources of funds in the 1970s and the risk management problems

encountered with troubled loans and volatile interest rates in the 1970s and 1980s led to the

concept of planning and control over both sides of a bank's balance sheet -- the essence of funds

management.

7-3. What forces cause interest rates to change? What kinds of risk do financial firms face

when interest rates change?

Interest rates are determined, not by individual banks, but by the collective borrowing and

lending decisions of thousands of participants in the money and capital markets. They are also

impacted by changing perceptions of risk by participants in the money and capital markets,

especially the risk of borrower default, liquidity risk, price risk, reinvestment risk, inflation risk,

term or maturity risk, marketability risk, and call risk.

Financial institutions can lose income or value no matter which way interest rates go. Rising

interest rates can lead to losses on security instruments and on fixed-rate loans as the market

values of these instruments fall. Falling interest rates will usually result in capital gains on fixedrate securities and loans but an institution will lose income if it has more rate-sensitive assets

than liabilities. Rising interest rates will also cause a loss to income if an institution has more

rate-sensitive liabilities than rate-sensitive assets.

7-4.

Interest rates cannot be set by an individual bank or even by a group of banks; they are

determined by thousands of investors trading in the credit markets. Moreover, each market rate

of interest has multiple components--the risk-free interest rate plus various risk premium. A

change in any of these rate components can cause interest rates to change. To consistently

forecast market interest rates correctly would require bankers to correctly anticipate changes in

the risk-free interest rate and in all rate components.

Another important factor is the timing of the changes. To be able to take full advantage of their

predictions, they also need to know when the changes will take place.

7-5.

What is the yield curve, and why is it important to know about its shape or slope?

The yield curve is the graphic picture of how interest rates vary with different maturities of loans

viewed at a single point in time (and assuming that all other factors, such as credit risk, are held

constant).

7-3

Chapter 07 - Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques

The slope of the yield curve determines the spread between long-term and short-term interest

rates. In banking most of the long-term rates apply to loans and securities (i.e., bank assets) and

most of the short-term interest rates are attached to bank deposits and money market borrowings.

Thus, the shape or slope of the yield curve has a profound influence on a bank's net interest

margin or spread between asset revenues and liability costs.

7-6. What is it that a lending institutions wishes to protect from adverse movements in

interest rates?

A financial institution wishes to protect both the value of assets and liabilities and the revenues

and costs generated by both assets and liabilities from adverse movements in interest rates.

7-7.

The goal of hedging in banking is to freeze the spread between asset returns and liability costs

and to offset declining values on certain assets by profitable transactions so that a target rate of

return is assured.

7-8. 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 percent. What will

happen to its net interest margin?

Net Interest

Margin

$700 mill.

= 0.03 or 3 percent

If interest revenues and interest costs double while earning assets grow by 50 percent, the net

interest margin will change as follows:

($63 mill. - $42 mill.) * 2

$700 mill. * (1.50)

= 0.04 or 4 percent

Clearly the net interest margin increases--in this case by one third.

7-9.

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.

7-4

7-10

A financial firm is asset sensitive when it has more interest-rate sensitive assets maturing or

subject to repricing during a specific time period than rate-sensitive liabilities. A liability

sensitive position, in contrast, would find the financial institution having more interest-rate

sensitive deposits and other liabilities than rate-sensitive assets for a particular planning period.

7-11. 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?

Because interest-sensitive assets are larger than liabilities by $245 million the bank is asset

sensitive.

If interest rates rise, the bank's net interest margin should rise as asset revenues increase by more

than the resulting increase in liability costs. On the other hand, if interest rates fall, the bank's net

interest margin will fall as asset revenues decline faster than liability costs.

7-12. Peoples Savings Bank, a thrift institution, 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. Can you

calculate the expected change in net interest income that this thrift institution might experience?

What change will occur in net interest income if interest rates rise by one and a quarter

percentage points?

For the decrease in interest rates:

Expected

Change in

Net Interest Income

Expected Change

in Net Interest

Income

7-13 How do you measure the dollar interest-sensitive gap? The relative interest-sensitive gap?

What is the interest-sensitivity ratio?

The dollar interest-sensitive gap is measured by taking the repriceable (interest-sensitive) assets

minus the repriceable (interest-sensitive) liabilities over some set planning period. Common

planning periods include 3 months, 6 months and 1 year. The relative interest-sensitive gap is the

dollar interest-sensitive gap divided by some measure of bank size (often total assets).

7-5

The interest-sensitivity ratio is just the ratio of interest-sensitive assets to interest sensitive

liabilities. Regardless of which measure you use, the results should be consistent. If you find a

positive (negative) gap for dollar interest-sensitive gap, you should also find a positive (negative)

relative interest-sensitive gap and an interest sensitivity ratio greater (less) than one.

7-14 Suppose Carroll Bank and Trust reports interest-sensitive assets of $570 million and

interest-sensitive liabilities of $685 million. What is the banks dollar interest-sensitive gap? Its

relative interest-sensitive gap and interest-sensitivity ratio?

Dollar Interest-Sensitive Gap = Interest-Sensitive Assets Interest Sensitive Liabilities

= $570 - $685 = -$115

Relative Gap

Interest-Sensitivity

Ratio

$ IS Gap

Bank Size

=

-$115

$570

Interest-Sensitive Assets

Interest-Sensitive Liabilities

$570

$685

= .8321

7-15 Explain the concept of weighted interest-sensitive gap. How can this concept aid

management in measuring a financial institutions 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.

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, for example, 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. 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 interestsensitive liabilities from the interest-sensitive assets.

This weighted interest-sensitive gap should be more accurate than the unweighted interestsensitive 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.

7-16. What is duration?

7-6

Duration is a value- and time-weighted measure of maturity considers the timing of all cash

inflows from earning assets and all cash outflows associated with liabilities. Duration measures

the average time needed to recover the funds committed to an investment. It is a direct measure

of price risk.

7-17. How is a financial institutions duration gap determined?

A bank's duration gap is determined by taking the difference between the duration of a bank's

assets and the duration of its liabilities. The duration of the banks assets can be determined by

taking a weighted average of the duration of all of the assets in the banks portfolio. The weight

is the dollar amount of a particular type of asset out of the total dollar amount of the assets of the

bank. The duration of the liabilities can be determined in a similar manner. The duration of the

liabilities is then adjusted to reflect that the bank has fewer liabilities than assets.

7-18. 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 banks net

income. It does not take into account the effect of interest rate changes on the market value of the

banks equity capital position. In addition, duration provides a single number which tells the

bank their overall exposure to interest rate risk.

7-19. How can you tell you are fully hedged using duration gap analysis?

You are fully hedged when the dollar weighted duration of the assets portfolio of the bank equals

the dollar weighted duration of the liability portfolio. This means that the bank has a zero

duration gap position when it is fully hedged. Of course, because the bank usually has more

assets than liabilities the duration of the liabilities needs to be adjusted by the ratio of total

liabilities to total assets to be entirely correct.

7-20. 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 institutions portfolio. In addition,

some accounts such as deposits and others dont have well defined patterns of cash flows which

make it difficult to calculate duration for these accounts.

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. Finally, 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.

7-7

7-21. 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?

Liabilities

$467 million

= 2.5 yrs. 3.0 yrs.

Assets

$560 million

= 2.5 years 2.5018 years

= -0.0018 years

Duration Gap = DA DL *

This bank has a very slight negative duration gap; so small in fact that we could consider it

insignificant. If interest rates rise, the bank's liabilities will fall slightly more in value than its

assets, resulting in a small increase in net worth.

7-22. Stilwater Bank and Trust Company has an average asset duration of 3.25 years and an

average liability duration of 1.75 years. Its liabilities amount to $485 million, while its assets

total $512 million. Suppose that interest rates were 7 percent and then rise to 8 percent. What

will happen to the value of the Stilwater bank's net worth as a result of a decline in interest rates?

First, we need an estimate of Stilwater's duration gap. This is:

Duration Gap = 3.25 yrs. 1.75 yrs *

$485 mill.

= + 1.5923 years

$512 mill.

Then, the change in net worth if interest rates rise from 7 percent to 8 percent will be:

.01

x $512 mill

Change in NW = - 3.25 yrs.x

(1

.07)

.01

x$485 mill.

- - 1.75 yrs.x

(1 .07)

= -$7.62 million.

Problems

7-1. A government bond is currently selling for $1,150 and pays $75 per year in interest for

14 years when it matures. If the redemption value of this bond is $1,000, what is its yield to

maturity if purchased today for $1,150?

7-8

$1150

$75

$75

$75

$75

$75

$75

$75

$75

$75

$75

$75

$75

$75

$1075

1

2

3

4

5

6

7

8

9

10

11

12

13

(1 ?) (1 ?) (1 ?) (1 ?) (1 ?) (1 ?) (1 ?) (1 ?) (1 ?) (1 ?)

(1 ?)

(1 ?)

(1 ?)

(1 ?)14

7-2. Suppose the government bond described in problem 1 above is held for five years and

then the savings institution acquiring the bond decides to sell it at a price of $975. Can you figure

out the average annual yield the savings institution will have earned for its five-year investment

in the bond?

$1,150 =

$75

$75

$75

$75

$75

$975

+

+

+

+

+

5

4

1

2

3

(1 HPY) (1 HPY) 5

(1 HPY)

(1 HPY)

(1 HPY)

(1 HPY)

7-3. U.S. Treasury bills are available for purchase this week at the following prices (based

upon $100 par value) and with the indicated maturities:

a.

b.

c.

$97.50, 270 days.

$99.25, 91 days.

Calculate the bank discount rate (DR) on each bill if it is held to maturity. What is the equivalent

yield to maturity (sometimes called the bond-equivalent or coupon equivalent yield) on each of

these Treasury Bills?

7-9

yields) on each of these Treasury bills are:

Discount Rates

a.

*

2.97%

100

182

*

3.05%

98.50

182

b.

*

3.33%

100

270

*

3.47%

97.50

270

c.

*

2.97%

100

91

*

3.03%

99.25

91

7-4. Clarksville Financial reports a net interest margin of 2.75 percent in its most recent

financial report with total interest revenues of $95 million and total interest costs of $82 million.

What volume of earning assets must the bank hold? Suppose the banks interest revenues rises

by 5 percent and its interest costs and earnings assets increase by 9 percent. What will happen to

Clarksvilles net interest margin?

The relevant formula is:

Net Interest Margin = .0275 =

Earning Assets

If revenues rise by 5 percent and costs and earnings assets rise by 9 percent net interest margin

is:

Net Interest Margin =

473(1 .09)

=

99.75 89.38

515.57

7-5. If a credit unions net interest margin, which was 2.50 percent, increases 15 percent and

its total assets, which stood originally at $625 million, rise by 20 percent, what change will occur

in the bank's net interest income?

The correct formula is:

7-10

.025 * (1+.15) =

$625 million * (1 .2)

= $21.5625 million.

7-6. The cumulative interest-rate gap of Jamestown Savings Bank increases 75 percent from

an initial figure of $22 million. If market interest rates rise by 25 percent from an initial level of

4.5 percent, what change will occur in this thrifts net interest income?

The key formula here is:

Change in the = Change in interest rates (in percentage points) * cumulative gap

Net Interest

= (0.045 * .25) x ($22 mill.) * (1+.75)

Income

= .43

Thus, the bank's net interest income will drop by 57 percent.

7-7. Old Settlers State Bank has recorded the following financial data for the past three years

(dollars in millions):

Interest revenues

Interest expenses

Loans (Excluding nonperforming)

Investments

Total deposits

Money market borrowings

Current Year

$80

66

400

200

450

100

Previous Year

$82

68

405

195

425

125

$84

70

400

200

475

75

What has been happening to the banks net interest margin? What do you think caused the

changes you have observed? Do you have any recommendations for Old Settlers management

team?

Net interest margin (NIM) = Net Interest Income/Earning Assets, where

Net Interest Income = Net Interest Revenues - Net Interest Expenses

Earning Assets = Loans + Investments

7-11

NIM (previous) = ($82-68)/ (405 + 195) = 14/600 = 0.0233 or 2.33%

NIM (Two years ago) = ($84-70)/ (400 + 200) = 14/600 = 0.0233 or 2.33%

The net interest margin is steady in all the three years As interest revenues and expenses are

varying simultaneously.There is no fluctuation in the net interest margin.

7-8

The First National Bank of Spotsburg finds that its asset and liability portfolio contains

the following distribution of maturities and repricing opportunities:

Coming

Week

$210

+21

$231

Next

30 Days

$300

+26

$326

Next

31-90 Days

$475

40

$515

More Than

90 Days

$525

70

$595

$350

100

136

$586

$ --276

140

$416

$ --196

100

$296

$ --100

50

$150

GAP

- $355

- $90

$219

+ $445

Cumulative GAP

- $355

- $445

- $226

$219

Loans

Securities

Total IS Assets

Transaction Dep.

Time Accts.

Money Mkt. Borr.

Total IS Liab.

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.

7-9

Fluffy Cloud Savings Bank currently has the following interest-sensitive assets and

liabilities on its balance sheet with the interest-rate sensitivity weights noted.

Interest-Sensitive Assets

Federal fund loans $50

Security holdings $50

Loans and leases $310.8

Index

1.00

1.20

1.45

Interest-Sensitive Liabilities

Index

Money-market borrowings $85

.75

.95

7-12

What is the banks current interest-sensitive gap? Adjusting for these various interest-rate

sensitivity weights what is the banks weighted interest-sensitive gap? Suppose the federal funds

interest rate increases or decreases one percentage point. How will the banks net interest income

be affected (a) given its current balance sheet makeup and (b) reflecting its weighted balance

sheet adjusted for the foregoing rate-sensitive indexes?

Solution:

Dollar IS Gap

(310.8)]

=

$50 + $60 + $450.66

=

$560.66

=

$292.41

a.)

= $410.8 - $335

[(.75)($250) + (.95)($85)]

$187.5 + $80.75

$268.25

= $75.8

= ($75.8) (.01) = $.76 million

Using the regular IS Gap; net income will change by plus or minus $760,000

b.)

= ($292.41) (.01) = $2.9241

Using the weighted IS Gap; net income will change by plus or minus $2,924,100

7-10 Twinkle Savings Association has interest-sensitive assets of $325 million, interestsensitive liabilities of $325 million, and total assets of $500 million. What is the banks dollar

interest-sensitive gap? What is Twinkles relative interest-sensitive gap? What is the value of its

interest-sensitivity ratio? Is it asset sensitive or liability sensitive? Under what scenario for

market interest rates will Twinkle experience a gain in net interest income? A loss in net interest

income?

Dollar Interest-Sensitive Gap = ISA ISL = $325 - $325 = $0

Relative Interest-Sensitive Gap

Interest-Sensitivity Ratio

ISA

ISL

7-13

ISA ISL

Bank Size

=

$325

$325

$0

$500

=1

=0

Here the interest sensitivity Gap is zero as the interest sensitive assets are equal to interest

sensitive liabilities. Twinkle Savings Association is relatively insulated from interest rate risk.

interest revenues from assets and funding costs will change at the same rate. The interestsensitive gap is zero, and the net interest margin is protected regardless of which way interest

rates go.

7-11 Richman Bank,, N.A., has a portfolio of loans and securities expected to generate cash

inflows for the bank as follows:

Expected Cash Inflows of

Principal & Interest

Payments

$1,500,675

746,872

341,555

62,482

9,871

Expected

Current year

Two years from today

Three years from today

Four years from today

Five years from today

Deposits and money market borrowings are expected to require the following cash outflows:

Expected Cash Outflows of

Principal $ Interest Payments

$1,595,786

831,454

123,897

1,005

-----

must be Made

Current year

Two years from today

Three years from today

Four years from today

Five years from today

If the discount rate applicable to the previous cash flows is 5 percent, what is the duration of the

Richmans portfolio of earning assets and of its deposits and money market borrowings? What

will happen to the bank's total returns, assuming all other factors are held constant, if interest

rates rise? If interest rates fall? Given the size of the duration gap you have calculated, in what

type of hedging should Richman engage? Please be specific about the hedging transactions that

are needed and their expected effects.

Richman has asset duration of:

$1,500,675*1 + $746,872 * 2 + $341,555 * 3 + $62,482 * 4 + $9,871 * 5

(1 + 0.05)1

(1 + 0.05)2

(1 + 0.05)3 (1 + 0.05)4

(1 + 0.05)5

DA =

$1,500,675 + $746,872 + $341,555 + $62,482 + $9,871

(1 + 0.05)1 (1 + 0.05)2 (1 + 0.05)3 (1 + 0.05)4 (1 + 0.05)5

7-14

$1,595786 * 1 + $831,454 * 2 + $123,897 * 3 + $1,005 * 4

(1 + 0.05)1

(1 + 0.05)2

(1 + 0.05)3

(1 + 0.05)4

DL=

$1,595,786+ $831,454 + $123,897 +

(1 + 0.05)1

(1 + 0.05)2 (1 + 0.05)3

$1,005

(1 + 0.05)4

Richman's Duration Gap = Asset Duration - Liability Duration = 1.5903 - 1.4075 = 0.1828 years.

Because Richman's Asset Duration is greater than its Liability Duration, the bank has a positive

duration gap, which means that 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. On the other hand, 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.

Given the magnitude of the duration gap, the management of Richman Bank, needs to do a

combination of things to close its duration gap between assets and liabilities. It probably needs

to try to shorten asset duration, lengthen liability duration, and use financial futures or options to

deal with whatever asset-liability gap exists at the moment. The bank may want to consider

securitization or selling some of its assets, reinvesting the cash flows in maturities that will more

closely match its liabilities' maturities. The bank may also consider negotiating some interestrate swaps to change the cash flow patterns of its liabilities to more closely match its asset

maturities.

7-12. Given the cash inflow and outflow figures in Problem 11 for Richman Bank, N.A.,

suppose that interest rates began at a level of 5 percent and then suddenly rise to 5.75 percent. If

the bank has total assets of $5 billion and total liabilities of $4.5 billion, by how much would the

value of Richmans net worth change as a result of this movement in interest rates? Suppose, on

the other hand, that interest rates decline from 5 percent to 4.5 percent. What happens to the

value of Richmans net worth in this case and by how much in dollars does it change? What is

the size of its duration gap?

From Problem #11 we find that Richman's average asset duration is 1.5903 years and average

liability duration is 1.4075 years. If total assets are $5 billion and total liabilities are $4.5 billion,

then Richman has a duration gap of:

7-15

Duration Gap =

1.5903 1.4075 *

1.5903 1.26675

0.3236

$4.5 bill.

$5 bill.

Change in Value of Net Worth = [-DA *

r

r

* A] [- DL *

* L]

(1 r)

(1 r)

(-.05)

(-.05)

Change in NW = - 1.5903 x

x $5 bill - 1.4075 x

x $4.5 bill.

(1 .05)

(1 .05)

+ 0.3786 0.3016

+ 0.0770 billion.

7-13. Watson Thrift Association reports an average asset duration of 7 years, an average

liability duration of 3.25 years. In its latest financial report, the association recorded total assets

of $1.8 billion and total liabilities of $1.5 billion. If interest rates began at 6 percent and then

suddenly climbed to 7.5 percent, what change (in percentage terms) wills this bonds price

experience if market interest rates change as anticipated?

The key formula is:

Change in net worth = [-DA *

r

Dr

* A] - [- DL *

* L]

(1 r)

(1 r)

For the change in interest rates from 6 to 7.5 percent, Watson's net worth will change to:

Change in Net Worth =

(.015)

(.015)

- 7 years x (1 .06) x$1800 bill. - - $3.25 years x (1 .06) x $1500 bill.

= -$109.31 million

On the other hand, if interest rates decline from 6 to 5 percent we have:

7-16

(-.01)

(-.01)

- 7 yrs x (1 .06) x$1800 mill. - - 3.25 yrs x (1 .06) x$1500 mill.

= + $72.88 million

7-14. A financial firm holds a bond in its investment portfolio whose duration is 13.5 years. Its

current market price is $950. While market interest rates are currently at 7 percent for

comparable quality securities, a decrease in interest rates to 6.75 percent is expected in the

coming weeks. What changes (in percentage terms) will this bonds price experience if market

interest rates change as anticipated?

Solution:

P

i

(.0025)

Dx

13.5 x

.03154 or 3.15 percent

P

(1 i)

(1.07)

This bonds price will increased by 3.15 percent or its price will rise to $971.965.

7-15. A savings banks weighted average asset duration is 10 years. Its total liabilities amount

to $925 million, while its assets total 1 billion dollars. What is the dollar-weighted duration of

the banks liability portfolio if it has a zero leverage adjusted duration gap ?

Given the bank has a duration gap equal to zero:

Duration Gap = DA - DL x

Total Liabilitie s

Total Assets

Total Assets

$1000

(10 - 0) x

10.81years

Total Liabilitie s

$925

7-17

7-16 Blue Moon National Bank holds assets and liabilities whose average durations and dollar

amounts are as shown in this table:

Asset and Liability Items

Investment Grade Bonds

Commercial Loans

Consumer Loans

Deposits

Nondeposit Borrowings

Avg.Duration(yrs)

$ Amount

12.00

4.00

8.00

1.10

0.25

$65.00

$400.00

$250.00

$600.00

$50.00

What is the weighted average duration of New Phases asset portfolio and liability portfolio?

What is the leverage-adjusted duration gap?

D A Wi * D i

65

400

250

*12

*4

* 8 1.0909 2.2378 2.7972 6.13 years

715

715

715

D L Wi * D i

600

50

*1.1

* 0.25 1.0154 1.0154 2.03 years

650

650

Duration Gap D A D L *

TL

650

6.13 2.03 *

3.7273

TA

715

7-17 A government bond currently carries a yield to maturity of 7 percent and a market price

of $1161.68. If the bond promises to pay $100 in interest annually for five years, what is its

current duration?

1*

D

$100

$100

$100

$100

$1100

2*

3*

4*

5*

1

2

3

4

(1 .07)

(1 .07)

(1 .07)

(1 .07)

(1 .07) 5

4.22 years

$100

$100

$100

$100

$1100

7-18 Clinton National Bank holds $15 million in government bonds having a duration of 7

years. If interest rates suddenly rise from 6 percent to 7 percent, what percentage change should

occur in the bonds market price?

P

r

.01

D *

-7 *

.066 Or 6.6 percent

P

(1 r)

(1 .06)

7-18

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