ASSET / LIABILITY MANAGEMENT

Asset / Liability Management

    

Also known as asset-liability management, gap management Activity usually run in a Treasury Department of a bank Managed weekly or biweekly by a committee Activity began in late 1970s as a result of high and volatile interest rates Banks assume much interest rate risk since they borrow in one set of markets and lend in another
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Asset / Liability Management



Measuring interest rate risk



Focus is on GAP , there are 3 types of GAPs.

Dollar Gap, Funds Gap, Repricing Gap  Maturity Gap  Duration Gap


GAP
 GAPt

= RSAt RSLt

where t = particular time interval RSAt = $ of assets which are reset during interval t, Rate-Sensitive-Assets RSLt = $ of liabilities which are reset during interval t, Rate-Sensitive-Liabilities
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GAP
Example: Bank with assets & liabilities of following maturities Days 0 60 61 90 91 120 121 - 180 Assets 10 0 40 20 Liabilities 20 5 30 50 GAP (A-L) -10 -5 10 -30
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GAP
Example (cont.) Cumulative GAP = C GAP = GAP over whole period C GAP = -10 5 + 10 30 = - 35

Note: If + GAP, then lose if rates fall If GAP, then lose if rates rise
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GAP
Federal Reserve has required banks to report quarterly the repricing GAPs (schedule RC-J) as follows: 1 day 2 day 3 months over 3 months 6 months over 6 months 1 year over 1 year 5 year over 5 year
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GAP
Problems with GAP
1.

2.

3.

Uses book-value approach: Focuses only on income effect and not on capital gains effect from rate changes. Aggregation: Ignores distribution of assets/liabilities within buckets could still have mismatch Runoffs ignored: Interest and principal paid plus loan prepaid must be invested. This feature is ignored.

Maturity Gap
Background
Consider a 1year bond with coupon 10% and YTM 10% 100 + 0.10 v 100 110 P = = = 100 1.10 1 + 0.10 If rates increase to 11% P = 100 + 0.10 v 100 110 = = 99.10 1.11 1 + 0.11 (P / (r < 0
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Conclude: If ro Pq

Maturity Gap
Consider a 2 year bond
10 110 P = + 2 = 100 1.10 1.10

If rates increase to 11%

10 110 P = + 2 = 98.29 1.11 1.11

Price fell more than 1 year bond!

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Maturity Gap
Conclusion: The longer the maturity, the greater the fall in price for a given level increase in interest rates.
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Maturity Gap
Consider a 3 year bond
10 110 10 P = + 2 + 1.103 = 100 1.10 1.10

If rates increase to 11%

110 10 10 P = + 2 + 1.113 = 97.56 1.11 1.11

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Maturity Gap
Notice Decline:
Time 1 yr 2 yr 3 yr P0 100 100 100 Pn 99.10 98.29 97.56 P0 Pn 0.90 1.71 2.44 Pn1 Pn 0.90 0.81 0.73

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Maturity Gap
Conclude: The fall increases at a diminishing rate as a function of maturity.
(P

Maturity
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Maturity Gap
Now, these principles apply to banks since they have portfolios of interest-rate sensitive assets and liabilities.

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Maturity Gap
Let MA = WA1MA1 + WA2MA2 + + WAnMAn
Where MA = average maturity of banks assets MAj = maturity of asset j WAj = market value of asset j as a % of total asset market value And ML = WL1ML1 + WL2ML2 + + WLnMLn

Where ML = average maturity of banks liabilities

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Maturity Gap
Then MG = MA ML For a minimum of interest rate risk, want: MG = 0 Typically, MG > 0 i.e. MA > ML Ex) Bank borrows at 1 yr deposit of $90 paying 10% and invests in $100 3 yr bond at 10% with $10 of equity.
A B 100 L 90 10 D E
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Maturity Gap
Suppose rates rise to 11%, then 3 yr bond is worth $97.56 (as before) and deposit is worth P = 99 / 1.11 = 89.19 Thus
Assets Liabilities 97.56 89.19 8.37
E = 97.56 89.19 (E = (A (L = 2.44 (0.81) (E = 1.63 E = 10 1.63 = 8.37
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Maturity Gap
Thus, equity must absorb interest-rate risk exposure. Notice MG = MA ML = 3 1 = 2 By previous propositions
If If MG > 0 MG < 0 If ro, then bank will LOSE If rq, then bank will GAIN If ro, then bank will GAIN If rq, then bank will LOSE
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Maturity Gap
At what rate change will bank become insolvent?
(E = 10 or (A (L = 10

Want:
99 10 110 10 + + 100 [ 90] = 10 2 3 1+x 1 + x (1+x) (1+x)

If r p 16% If r p 17%

12.07 (4.66) = 7.41 15.47 (5.38) = 10.09

YES!

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Maturity Gap
What if bank has matched with MG = 0, that is invested in 1 yr bond, then If r p 11% from 10%
(A = 99.10 100 = 0.90 (L = 89.11 90 = 0.89 (E = 0.90 + 0.89 = 0.01

If r p 12%
(A = 98.21 100 = 1.79 (L = 88.39 90 = 1.61 (E = 1.79 + 1.61 = 0.18

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Maturity Gap
Setting MG = 0 does NOT insure one completely from interest-rate risk but does work quite well. Reasons why some risk remains:
1. 2. 3.

Amounts not matched (as before) Timing of cash flows not considered Rates may not move exactly together

Using a Duration Gap measure will resolve #2.

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DURATION


Duration of an asset or liability is the weighted-average time until cash flows are received or paid. The weights are the PV of each cash flow as a % of the PV of all cash flows.

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DURATION
N N

D ! PVt t
t !1

PV
t !1

Where

N = last period of CF CFt = cash flow at time t PVt = CFt / (1+R)t R = yield on asset or liability

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DURATION
Example:
Duration of 8% $1,000 6 year Euro-bond, Eurobonds pay interest annually, yield is 8%.

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DURATION
Example (cont.)
T 1 2 3 4 5 6 CFt 80 80 80 80 80 1080 1/(1+R)t 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 PVt 74.07 68.59 63.51 58.80 54.45 680.58 PVt t 74.07 137.18 190.53 235.20 272.25 4083.48
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D = 4993.71 / 1000 = 4.993 years

DURATION
Features of Duration
1. Duration increases with maturity at a decreasing rate.
(((D / (M ) (M

(D (M " 0

2. Duration increases as yield decreases. (D / (R 0 3. The higher the coupon, the lower the duration. (D / (C 0
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DURATION
Consider a bond with annual coupon payments C
C C CF P!   ...  2 1  R (1  R ) (1  R) N

or

Ct P! (1  R ) t t !1

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DURATION
N tCt (P dP ! !  (R dR (1  R) t 1 t !1

Since D ! PVt t
t !1

PV
t !1

CFt and PVt ! (1  R) t

(P (R Ct D N (P ! Hence (1  R) t P !  D 1  R (R 1  R t !1
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DURATION
(P % Price Change P

(P (R ! D P 1 R

(R 1 R
Slope = D
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DURATION
Example:
Consider 6 year Eurobond from before. Recall D = 4.99 If yields rise 10 basis points
(P = (4.99)v(0.001/1.08) = 0.000462 = 0.0462% P
If P=1000, price would fall to 999.538
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DURATION
Example (cont):
For semi-annual payments, the equation must be modified: Annual
(P (R ! D P 1 0.5R
Payment

(P (R ! D P 1 R
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DURATION
Example:
2 yr treasury with coupon of 8%, pays semiannually with price of $964.54, with face value of $1000.
40 40 40 1040 964.54 = + 2 + (1+0.5R)3 + (1+0.5R)4 (1+0.5R) (1+0.5R) R = 0.10

PV t ! 1818.37 ! 1.89 yrs D!

t

964.54

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DURATION GAP
Now we can apply these ideas to a bank. Recall:
(P (R ! D P 1 R

Now consider a bank and let: A = value of assets ( A = change in value of assets L = value of liabilities, excluding equity ( L = change in value of liabilities
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DURATION GAP (Cont.)

Then,
(A (R !  DA A (1  R )
Where, DA = weighted-average duration of the assets =[1D1 + [2D2 + + [nDn [i = MV of asset i / total MV of assets
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DURATION GAP (Cont.)

And for liabilities, we have the same:
(L (R !  DL L (1  R )

Where, DL = [1D1 + [2D2 + + [mDm [i = MV of liability i / total MV of assets

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DURATION GAP (Cont.)

Now, let (E = (A (L = - (DAA DLL) (R / (1+R) So, (E / A = - DG (R / (1+R) where DG = DA DLL / A (E = -DG A (R / (1+R)
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Duration Gap

DURATION GAP (Cont.)

Thus, the change in the net worth of a bank depends on: 1. The duration gap of the bank (DG) 2. The size of the bank (A) 3. The size of the interest rate shock ((R / (1+R))
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DURATION GAP (Cont.)

Example: Bank with DA = 5 years, DL = 3 years, R = 0.10, A = $100 million, L = $90 million, E = $10 million. If R p 11%, what is effect on net worth?

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DURATION GAP (Cont.)

Example (cont.) : (E = - (DA DLL/A) A (R / (1+R) = -$2.09 million Thus, E : 10 million p 7.91 million Notice: (A = -DA A (R / (1+R) = -$4.55 million (L = - DL L (R / (1+R) = -$2.46 million

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DURATION GAP (Cont.)

Example (cont.) :
A 100 L 90 10 A 95.45 L 87.54 7.91

Note: Both A and L fall with interest rate rise . DG = 2.3 years
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DURATION GAP (Cont.)

Thus, If DG > 0 and R o bank lose DG > 0 and R q bank gain If DG < 0 and R o bank gain DG < 0 and R q bank lose Note: this is opposite to GAP = RSA RSL if GAP > 0 and R o bank gain Why?
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DURATION GAP (Cont.)

GAP p in $ domain DG p in time domain Want DG = 0 for fall protection, notice DG = DA DL L / A = DA DL (A K) / A where K = capital = DA DL (1 k) where k = K/A Duration depends directly on capital ratio! DG = DA DL + DLk DG o as k o Why?
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DURATION GAP (Cont.)

However, bank with more capital is better protected. To see this, (E = -DG A (R / (1+R) (E A = -DG E E (E 1 -DG = k E (R (1+R) (R (1+R)

Thus, the larger the k, the smaller the % change in equity will be.
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DURATION GAP (Cont.)

Ex) In previous example,
(E / E = - 2.09 M / 10 M = -20.9% Ex) Suppose same example except L = 95 M So, K = 5, and k = 0.05 DG = DA DL (1 k) = 2.1 (E = - 1.95 E : 5 p 3.05 (E / E = - 2.15 1/0.05 0.01/1.10 = - 39.1% or (E / E = -1.95/5 = -39%
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DURATION GAP
Example: BANK
D 0 0.4 2.5

ASSETS AMT D LIABILITIES AMT ST Securities 150 0.5 DD 400 LT Securities 100 3.5 ST CDs 350 Loans Float 400 0 LT CDs 150 Loans Fixed 350 2 Equity 100 Total 1000 1000

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DURATION GAP
Example: (continue)
DA=0.15v0.5+0.1v3.5+0.4v0+0.35v2=1.125 year 400 350 DL= v0+ v0.4+ 150 v2.5=0.572 year 900 900 900 L DG = DA DL A = 1.125 0.572 v 0.9 = 0.6102

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DURATION
Example: (continue)
(R (E = DG 1 + R A

If R = 0.08 0.08 p 0.09

0.01 (E = 0.6102 = 0.00565 1 + 0.08 A (E = 0.00565 v 1000 = 5.65 E from 100 p 94.35
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DURATION GAP
Although Duration Gap takes timing of cash flows into account, there are problems with its implementation and use.

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DURATION GAP
Problems with DG
1.

2.

3.

Not easy to manipulate DA and DL. (reason for using artificial hedges such as swaps, options, or futures) Immunization is a DYNAMIC problem. (i.e., requires constant rebalancing) Large rate changes and convexity (model only applies to small changes)
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DURATION GAP
(P P

We are here Actual Model (R 1 R

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DURATION GAP
(P P
Actual Model

(R +

(R 1 R

If (R > 0, DG overpredicts P decrease

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DURATION GAP
(P P
Actual Model

(R 

(R 1 R

If (R < 0, DG underpredicts P increase

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DURATION GAP
Problems with DG (Continue)
measure of curvature Convexity = of duration curve It can be measured. Convexity is good for banks. They do better as a result.

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DURATION GAP
Problems with DG (Continue)
4.

5.

6.

Flat Term Structure. (Notice all rates R, implies flat term structure. There are models which make different assumptions.) Non-Traded Assets. (Small business loans and consumer loans have no market value estimates as R changes.) Not consider Default Risk or Prepayment Risk.
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DURATION GAP
Problems with DG (Continue)
7.

Duration of Equity. (Should equity be included? POSSIBLY.) To see this, using dividend growth model d1 P0 = (k g) d1 = div in year 1 k = required return g = growth rate in dividend
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DURATION GAP
Problems with DG (Continue)
Recall or
(P (R ! D P 1 R
(P 1  R (P 1  R dP 1  R D! ! ! P (R (R P dR P

but

dP dP d1 ! ! dR dk (k  g ) 2
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DURATION GAP
Problems with DG (Continue)
So

d1 (1  k ) d1 (1  k ) (k  g ) D! ! 2 2 (k  g ) (k  g ) P d1
Example: Stock with k=10%, g=5% 1.10 D= = 22 years 0.05
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1 k D! kg

DURATION GAP
Problems with DG (Continue)
8.

DD and Passbook savings Duration? Must analyze runoff and turnover as well as rate elasticity.

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TYPES OF RISK FOR BANKS

1.

Market risk
 

Equity price Interest rate

2. 3.

Liquidity risk Credit risk (default)



Use of credit derivatives Technology Processing Legal Regulatory

4.

Operation risk
   

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How to manage Interest Rate Risk

1. 2. 3.

Do nothing Attempt to set GAPs to zero Derivatives

   

Forward contracts Interest rate futures contracts (e.g. Eurodollar, TBill) Option contracts (exchange-traded) Exotic options (OTC) Plain-vanilla Exotic
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4.

Interest rate swaps