CHAPTER 6 ASSET-LIABILITY MANAGEMENT: DETERMINING AND MEASURING INTEREST RATES AND CONTROLLING INTEREST-SENSITIVE AND DURATION GAPS

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 bank’s management can coordinate the management of its assets with the management of its liabilities in order to achieve the institution’s goals.

Key Topic In This Chapter • • • • • • Asset, Liability, and Funds Management Market Rates and Interest Rate Risk The Goals of Interest Rate Hedging Interest Sensitive Gap Management Duration Gap Management Limitations of Hedging Techniques

Chapter Outline I. II. Introduction: The Necessity for Coordinating Bank Asset and Liability Management Decisions Asset/Liability Management Strategies A. Asset Management Strategy B. Liability Management Strategy C. Funds Management Strategy Interest Rate Risk: One of the Greatest Asset-Liability Management Strategy 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. The Response of Banks and Other Financial Firms to Interest Rate Risk One of the Goals of Interest-Rate Hedging A. The Net Interest Margin B. Interest-Sensitive Gap Management 1. Asset-Sensitive Position 2. Liability-Sensitive Position 3. Interest-Sensitive Gap

III.

IV.

75

V.

VI.

VII. VIII.

4. Interest Sensitivity Ratio 5. Computer-Based Techniques 6. Strategies in Gap Management The Concept of Duration A. Definition of Duration B. Calculation of Duration C. Net Worth and Duration D. Price Risk and Duration E. Convexity and Duration Using Duration to Hedge Against Interest-Rate Risk A.