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Chapter Five
Risk Management for Changing Interest
Rates: Asset-Liability Management and
Duration Techniques
Key Topics
• Asset, Liability, and Funds
• Market Rates and Interest Rate Risk
• The Goals of Interest Rate Hedging
• Interest-Sensitive Gap Management
p. 133-134
• Even as a financial institution takes on risk, it must protect the
value of its net worth from declining, which could result in
ultimate failure
• Financial-service managers have learned to look at their asset
and liability portfolios (a bunch of different investments) as a
group of investments that work together.
• They must consider how their institution’s whole portfolio
contributes to the firm’s goals of profitability and acceptable
▫ Known as asset-liability management (ALM)
▫ Can protect against business cycles and ups and downs.
Asset-Liability Management Strategies p.134-135
• Asset Management Strategy
▫ Control over assets, no control over
• Liability Management Strategy
▫ Control over liabilities by changing rates and
other terms
• Funds Management Strategy
▫ Works with both strategies
EXHIBIT 7–1 Asset-Liability Management in Banking and
Financial Services
p. 135
Interest Rate Risk: One of the Greatest
Management Challenges
p. 135-136
• 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
EXHIBIT 7–2 Determination of the Rate of Interest in the
Financial Marketplace Where the Demand and Supply of Loanable
Funds (Credit) Interact to Set the Price of Credit p. 136
Interest Rate Risk: One of the Greatest
Management Challenges (continued) p.137
• Forces Determining Interest Rates
▫ Loanable Funds Theory
• The Measurement of Interest Rates
▫ Bank Discount
• Components of Interest Rates
Interest Rate Risk: One of the Greatest
Management Challenges (continued) p. 137
• 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
Interest Rate Risk: One of the Greatest
Management Challenges (continued) p. 137
• How to Calculate the Yield to Maturity
Interest Rate Risk: One of the Greatest
Management Challenges (continued) p. 137
• 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)
Interest Rate Risk: One of the Greatest
Management Challenges (continued) p. 137
• The DR measure ignores the effect of compounding and is
based on a 360-day year
• Unlike the YTM measure, which assumes a 365-day year
and assumes that interest income is compounded at the
calculated YTM
• The DR measure uses the face value of a financial
instrument to calculate its yield or rate of return
▫ Makes calculations easier but is theoretically incorrect
• The purchase price of a financial instrument is a much
better base to use in calculating the instrument’s true rate of
Interest Rate Risk: One of the Greatest
Management Challenges (continued) p. 137
• To convert a DR to the equivalent yield to maturity,
we can use the formula
Interest Rate Risk: One of the Greatest
Management Challenges (continued) p. 138
• Market interest rates are a function of
▫ Risk-free real rate of interest
▫ Various risk premiums
▫ Default Risk – risky borrower
▫ Inflation Risk – rising prices
▫ Liquidity Risk – difficult to sell quickly
▫ Call Risk – borrower pays off loan early
▫ Maturity Risk – have higher interest rates
due to greater opportunity for loss
One of the Goals of Interest Rate Hedging: 躲闪 duǒshǎn
Protect the Net Interest Margin
p. 141
• In order to protect profits against adverse interest
rate changes, management seeks to hold fixed the
financial firm’s net interest margin (NIM)
One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued)
• A financial firm can hedge itself against interest rate
changes – no matter which way rates move – by making
sure for each time period that
• The gap is the portion of the balance sheet affected by
interest rate risk
One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued) p. 143
• If interest-sensitive assets exceed the volume of interestsensitive liabilities subject to repricing, the financial firm is
said to have a positive gap and to be asset sensitive
• In the opposite situation, suppose an interest-sensitive
bank’s liabilities are larger than its interest-sensitive assets
One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued) p. 145
• The net interest margin is influenced by multiple factors:
1. Changes in the level of interest rates, up or down
2. Changes in the spread (difference or margin) between asset
yields and liability costs
3. Changes in the volume of interest-bearing (earning) assets a
financial institution holds as it expands or shrinks the overall scale
of its activities
4. Changes in the volume of interest-bearing liabilities that are used
to fund earning assets as a financial institution grows or shrinks in
5. Changes in the mix of assets and liabilities that management draws
upon as it shifts between floating and fixed-rate assets and
liabilities, between shorter and longer maturity assets and
liabilities, and between assets bearing higher versus lower
expected yields
One of the Goals of Interest Rate Hedging:
Protect the Net Interest Margin (continued) p. 147
• We calculate a firm’s net interest income to see how it will
change if interest rates rise
• Net interest income can be derived from the following formula
Chapter Summary
1. Managers of banks focus on the management of risk –
controlling possible loss due to changes in market rates on
interest, borrowers not paying their loans, regulation changes.
2. Focus of this chapter was to show you the tools that managers
can use.
3. Early banking history focused on asset management because
liabilities are controlled by customers.
4. Liability management became popular when managers
realized they could have more control by changing interest rates.
Chapter Summary (cont)
5. Funds management is using tools from both.
6. Managers have to deal with interest-rate risk every day,
since the market is always changing.
7. Protecting the net interest margin, or the SPREAD between
interest revenues and interest costs, managers use interest
sensitive gap management tools
Chapter Concept Checks
5-1 What do the following terms mean: Asset
management? Liability management? Funds
• Asset management refers to a banking strategy where
management has control over the allocation 分配
(fēnpèi) of bank assets but believes the bank's sources
of funds (principally deposits) are outside its control.
The key decision area for management is not deposits
and other borrowings but assets. The financial
manager exercises control over the allocation of
incoming funds by deciding who is granted loans and
what the terms on those loans will be.
Chapter Concept Checks
• Liability management is a strategy wherein greater
control towards bank liabilities is exercised. This is done
mainly by opening up new sources of funding and
monitoring the volume, mix and cost of their deposits
and non-deposit items.
• Funds management combines both asset and liability
management approaches into a balanced liquidity
management strategy. Effective coordination in
managing assets and liabilities will help to maximize
the spread (difference or margin) between revenues
and costs and control risk exposure.
Chapter Concept Checks
• 5-3. What forces cause interest rates to change? What
kinds of risk do financial firms face when interest rates
• 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 views 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.
Chapter Concept Checks
• 5-4 What makes it so difficult to correctly forecast 预测
(yùcè) interest rate changes?
Interest rates cannot be set by an individual bank or
even by a group of banks. They are determined by
thousands of investors (the public, consumers like you
and me) trading in the credit markets. Moreover, each
market rate of interest has multiple parts—the risk-free
real interest rate plus various risk costs. A change in any
of these rate parts can cause interest rates to change.
This makes it difficult to forecast interest rate changes.
Chapter Concept Checks
• 5-7. What is the goal of hedging?
• The goal of hedging in banking is to freeze (hold), or
protect 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
Chapter Concept Checks
5-8. 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
National’s net interest margin? Suppose the bank’s
interest revenues and interest costs double, while its
earning assets increase by 50 percent. What will happen
to its net interest margin?
See slide 15 or page 141
Chapter Concept Checks
The bank’s net interest margin is 3% computed as
Net interest margin =
$63 −$42 
= 0.03 (3%)
If interest revenues and interest costs double while
earning assets grow by 50 percent, the net interest
margin will change as follows:
Net interest margin=
63 −42 2
700   (1.50)
0.04 (4%)
Clearly the net interest margin increases—in this case by
one third.

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