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MODULE 3
ASSET-LIABILITY MANAGEMENT:
DETERMINING AND MEASURING
INTEREST RATE RISK

COMMERCIAL BANK MANAGEMENT

Asset-Liability Management (ALM)

Strategies

KEY Interest-Sensitive Gap Management

TOPICS IN
THIS
MODULE Duration Gap Management

Uses of Derivative Contracts for

management of Interest Rate Risk

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Asset-Liability Management (ALM) Strategies

 Asset Management Strategy
 Management control was mainly on the asset side, not funding sources.
 The amount and types of deposits, as well as other borrowed funds, were
mainly determined by customers.
 Managers focused on allocating assets, especially loans. Key decisions:
 Who receives loans
 Loan terms and conditions
 This approach made sense at the time because government regulations limited:
o Interest rates and deposit types
o Access to non-deposit funding sources

Asset-Liability Management (ALM) Strategies

 Liability Management Strategy
 Major changes: Fluctuating interest rates and Increased competition for funds
 Banks began to focus more on managing their sources of funds.
 The key control is pricing, especially: Interest rates and Terms offered on
deposits and borrowings
 By adjusting these, banks can influence the: Volume of funds ; Mix of funding
sources ; Overall cost of funds

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Asset-Liability Management (ALM) Strategies

 Fund Management Strategy
 Integrated management of both assets and liabilities.
 Control volume, mix, return, and cost of both assets & liabilities
 Effective coordination between asset and liability decisions to maximize the
spread and control risk exposure
 Revenues and Costs arise from both sides of the balance sheet.

Interest Rate Risk

 What is interest Risk?
The risk incurred by an FI when the maturities of its assets and liabilities are
mismatched.
 Two major kinds of interest rate risk:
 Refinancing and Reinvestment risk
 Price risk

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Interest Rate Risk

 Responses to Interest rate Risk.
 Interest revenues
 Interest costs
 Net interest margin (NIM)
 Market value of assets
 Market value of liabilities
 Net worth (equity)

Determinants of Interest Rate

 Forces Determining Interest Rates:
 Suppliers of loanable funds and Demanders of loanable funds in the financial
marketplace.
 The central bank’s monetary policy strategy is the primary driver of interest
rate movements.
 Financial market integration increases the speed with which interest rate
changes and associated volatility are transmitted among countries

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Determinants of Interest Rate

 Measurement of Interest Rates:
 Yield to maturity (YTM)
𝐒𝐚𝐥𝐞 𝐨𝐫 𝐫𝐞𝐝𝐞𝐦𝐭𝐢𝐨𝐧
𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐜𝐚𝐬𝐡𝐟𝐥𝐨𝐰 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐜𝐚𝐬𝐡𝐟𝐥𝐨𝐰 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐜𝐚𝐬𝐡𝐟𝐥𝐨𝐰 𝐩𝐫𝐢𝐜𝐞 𝐨𝐟 𝐥𝐨𝐚𝐧 𝐨𝐫 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲
𝐢𝐧 𝐏𝐞𝐫𝐢𝐨𝐝 𝟏 𝐢𝐧 𝐏𝐞𝐫𝐢𝐨𝐝 𝟐 𝐢𝐧 𝐏𝐞𝐫𝐢𝐨𝐝 𝐧 𝐢𝐧 𝐏𝐞𝐫𝐢𝐨𝐝 𝐧
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐦𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞
= + + ⋯+ +
𝐨𝐟 𝐚 𝐥𝐨𝐚𝐧 𝐨𝐫 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲 (𝟏 + 𝐘𝐓𝐌)𝟏 (𝟏 + 𝐘𝐓𝐌)𝟐 𝟏 + 𝐘𝐓𝐌 𝐧 𝟏 + 𝐘𝐓𝐌 𝐧

 Bank discount rate (DR)

𝟏𝟎𝟎 − 𝐏𝐮𝐫𝐜𝐡𝐚𝐬𝐞 𝐩𝐫𝐢𝐜𝐞 𝐨𝐧 𝐥𝐨𝐚𝐧 𝐨𝐫 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲) 𝟑𝟔𝟎
𝐃𝐑 = ( × )
𝟏𝟎𝟎 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐝𝐚𝐲𝐬 𝐭𝐨 𝐦𝐚𝐭𝐮𝐫𝐢𝐫𝐲

Determinants of Interest Rate

 Components of Interest Rates
 Risk-free interest rate: such as the inflation-adjusted return on government
bonds
 Risk Premiums: compensation lenders who accept risky IOUs for their
default risk, inflation risk, term or maturity risk, liquidity risk and so on.
 Maturity and premium: Yield curves _The graphic picture of how interest rate
vary with different maturities of loans (assuming that all other factors are held
constant).

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Interest-Sensitive Gap Management

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Interest-Sensitive Gap Management

 Definition: One of the most popular ALM strategies that a financial firm can
hedge itself against interest rate changes by match as closely as possible the
volume of assets and liabilities that can be repriced within the same time period.

 Goal: Protecting and maximizing the institution's Net Interest Margin (NIM) or
spread.

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Rate-Sensitive Assets (RSA) vs. Rate-Sensitive Liabilities (RSL)

 Repriceable assets are earning assets  Repriceable liabilities are sources of  Non-repriceable Assets:
whose interest income or yield will funds whose interest expense changes o Cash in vault
change in response to movements in as market interest rates move during
o Long-term fixed-rate
market interest rates within a specific the same time period
loans/securities.
planning period  Common examples include:
 Non-repriceable Liabilities:
 These typically include: o CDs (Certificates of Deposit) about
o Demand deposits,
o Loans about to mature or coming up to mature or be renewed.
for renewal. o Long-term savings and
o Money-market borrowings, such as
retirement accounts,
o Short-term securities issued by Federal funds or Repurchase
governments and private borrowers Agreements (RPs). o Equity capital
that are nearing maturity. o Short-term savings accounts and
o Floating-rate loans and securities money-market

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Rate-Sensitive Assets (RSA) vs. Rate-Sensitive Liabilities (RSL)

Table 3-1. Simple FI Balance Sheet (in millions of dollars)

Source: Anthony Saunders et al., 2017

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Measuring the Repricing Gap

 Measuring the Repricing Gap
Interest-Sensitive Gap = RSA – RSL
o If RSA > RSL: The FI has a Positive Gap (Asset Sensitive)
o If RSA < RSL: The FI has a Negative Gap (Liability Sensitive)
o RSA = RSL: Zero Gap

 Purpose: Identifies the direction of risk (refinancing risk vs. reinvestment risk)

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Maturity Buckets
 FIs report repricing gaps across various time frames called maturity buckets.
 Common Buckets:
1. One day
2. More than 1 day to 3 months
3. 3 to 6 months.
4. 6 to 12 months
5. 1 to 5 years
6. More than 5 years
 Note: The choice of time horizon is critical; too long a period may lead to
overaggregation.

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Measuring Impact on Net Interest Income (NII)

 The relationship:
∆𝑁𝐼𝐼 = (𝐺𝐴𝑃 ) × ∆𝑅
 Where:
o ΔNIIi : Change in net interest income for bucket i.
o GAPi : The dollar size of the gap in bucket i.
o ΔRi : The change in interest rates

 Example: A negative gap of -$10 million with a 1% rate increase results in a

$100,000 loss in NII

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Cumulative Gap (CGAP)

 Cumulative Gap (CGAP) is The sum of individual gaps over various repricing
buckets.

 CGAP Effect: ΔNII=(CGAP)×ΔR

 Gap Ratio: CGAP/Total Assets

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Table 3.2. Security Federal Corp., Interest Rate Sensitivity Report, 2014
Cumulative Gap
(CGAP)

Source: Anthony Saunders et al.,

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2017

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Equal Changes in Rates on RSAs and RSLs

Change Change
Change in Impact on
CGAP in Interest in Interest
Rates NII
Income Expense
Positive Increase (↑) Increase (↑) > Increase (↑) Increase (↑)
Positive Decrease (↓) Decrease (↓) > Decrease (↓) Decrease (↓)
Negative Increase (↑) Increase (↑) < Increase (↑) Decrease (↓)
Negative Decrease (↓) Decrease (↓) < Decrease (↓) Increase (↑)

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Unequal Changes in Rates on RSAs and RSLs

 Spread:
The difference between the average yield on RSAs and the average cost of RSLs
 Expanded Formula:
ΔNII=(RSA×ΔRRSA)−(RSL×ΔRRSL)
 Spread Effect:
A positive relation exists between changes in the spread and changes in NII. If
the spread increases, NII increases

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Interest-Sensitive
GAP Management
Strategy
 Defensive Strategy
Set the gap as close to zero as
possible to minimize NII
volatility

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Interest-Sensitive GAP Management Strategy

 Aggressive GAP Management

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Weaknesses of Interest-Sensitive Gap Management

 Ignores Market Value Effects: It only uses book value and fails to capture
changes in the market value of assets and liabilities.
 Overaggregation: Gaps within buckets are ignored; assets might reprice at the
start while liabilities reprice at the end of the same bucket.
 Runoffs and Prepayments: It ignores periodic cash flows (runoffs) from long-
term fixed-rate portfolios that can be reinvested.
Ignores Off-Balance-Sheet (OBS) Items: Cash flows from derivatives like
futures or swaps are not included.

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Duration Gap Management

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Why Duration Gap Management?

Limitations of Repricing Model: The repricing model only focuses on changes in
Net Interest Income (NII) and ignores market value effects on the balance sheet.
Modern ALM Goal: Financial institutions must coordinate asset and liability
decisions to protect Net Worth (Equity) from erosion.
Regulatory Shift: Large banks and international standards (Basel) now favor
duration-based models over simple book value accounting.

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What is Duration?
 Definition: A value- and time-weighted measure of maturity that considers the
timing of all cash inflows from assets and outflows associated with liabilities.
 It measures the "average life" of an asset or liability in a cash flow sense.
 Duration acts as a direct measure of the interest rate sensitivity (or interest
elasticity) of an asset or liability’s value.

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What is Duration?
Concept Questions:
1) Why is duration considered a more complete measure of an asset’s or liability’s
interest rate sensitivity than maturity?
2) When is the duration of an asset equal to its maturity?

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The General Formula (Macaulay’s Duration)

 The Calculation:
∑ CF × DF × t ∑ PV × t
D= =
∑ CF × DF ∑ PV
Where:
• D = Duration measured in years
• CFt = Cash flow received on the security at end of period t
• DFt = Discount factor = 1/(1 + R)t, where r is the annual yield or current level of interest rates in
the market
• n = Last period in which the cash flow is received
• PVt = Present value of the cash flow at the end of the period t, which equals CFt × DFt

 Assumption: Assumes a flat yield curve and no default risk

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The General Formula

(Macaulay’s Duration)
 The Duration of Interest-Bearing Bonds
Example 1: The Duration of a Six-Year
Bond. Bonds pay coupons annually. Suppose
a Bond matures in six years, the annual
coupon is 8 percent, the face value of the bond
is $1,000, and the current yield to maturity (R)
is also 8 percent.

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The General Formula

(Macaulay’s Duration)
 The Duration of Interest-Bearing Bonds
Example 2: The Duration of a Two-Year US
Treasury Bond. U.S. Treasury bonds pay
coupon interest semiannually. Suppose a
Treasury bond matures in two years, the
annual coupon rate is 8 percent, the face value
is $1,000, and the annual yield to maturity (R)
is 12 percent.

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The General  The Duration of Zero-Coupon Bonds

• There are no intervening cash flows
Formula • Duration equals its maturity (D=M)
(Macaulay’s  Consol Bonds (Perpetuities)

Duration) • Have infinite maturity but finite duration. Formula:

𝐷 =1+
• Example 3: Suppose that the yield curve implies R = 5
percent annually. Then the duration of the consol bond
would be: 21 years

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The General Formula (Macaulay’s Duration)

Concept Questions
1) What does the denominator of the duration equation measure?
2) What does the numerator of the duration equation measure?
3) Calculate the duration of a one-year, 8 percent coupon, 10 percent yield bond
that pays coupons quarterly.
4) What is the duration of a zero-coupon bond?
5) What feature is unique about a consol bond compared with other bonds?

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Key Features of Duration

 Duration and Maturity: Duration increases with maturity, but at a decreasing
rate.
 Duration and Yield: Duration decreases as the yield on a security increases
(higher yields discount later cash flows more heavily).
 Duration and Coupon Rate: Duration decreases as the coupon or interest
payment increases (investors recoup their initial investment faster)

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The Economic Meaning of Duration

 Interest Elasticity: D describes the percentage price fall (ΔP/P) for any given
increase in required interest rates.
 The Formula:

o It shows that for small changes in interest rates, bond prices move in an
inversely proportional fashion according to the size of D
o The Relationship: For any given change in rates, long-duration securities suffer
larger capital losses than short-duration ones
o Symmetry: Gains and losses are symmetric for small interest rate changes

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The Economic Meaning of Duration

 Modified Duration (MD): Provides a more intuitive measure by multiplying by
the simple change in rates
o MD = D/(1+R)
o ∆P/P = -MD x dR
 Dollar Duration: Measures the dollar value change in price for a 1% (100 bps)
change in return
o Formula: Dollar duration= MD × P
o Price Change: ΔP = −Dollar duration × ΔR

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 The Problem: Pension funds and insurers must meet promised

payouts in the future despite falling reinvestment rates.

Interest Rate  The Solution: Matching the duration of assets to the

investment horizon (target date) through two approaches:
Risk o Discount Bonds: Buy zero-coupon bonds where maturity
equals the target date (since duration = maturity for
Management zeros).

on a Single o Coupon Bonds: Buy bonds where the calculated duration

matches the target date
Security:  The Offsetting Mechanism: Imunization works because it
Immunization balances two opposing effects of interest rate changes.
o Reinvestment Income Effect: If rates fall, the income
Strategy from reinvesting coupons decreases.
o Capital Value (Price) Effect: If rates fall, the market price
of the bond increases.

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Example: Suppose that in 2019 the insurer has to

make a guaranteed payment, assuming $1,469, to a
policyholder in five years (8% yield environment).
 Strategy: Purchase a 6-year maturity bond with a 5-
Interest Rate year duration.
Risk  The cash flows received by the insurer at Year 5:
Management on o If Rates Stay at 8%: Total = $1,469 (Coupons +
Reinvestment + Sale).
a Single o If Rates Fall to 7%: Reinvestment income drops
Security: by $9, but bond sale proceeds rise by $9. Total =
Immunization $1,469.
o If Rates Rise to 9%: Reinvestment income rises
Strategy by $9, but bond sale proceeds fall by $9. Total =
$1,469

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Interest Rate Risk Management on the Whole Balance

Sheet of an FI
 The duration of an FI’s asset portfolio (A):
D = X D + X D + ⋯X D
 The duration of an FI’s liability portfolio (L):
D = X D + X D + ⋯X D
 Where:
o The Xij’s are the market value proportions of each asset or liability held in the
respective asset and liability portfolios.
oX + X + ⋯X = 1 and j = A, L.

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Interest Rate Risk Management on the Whole Balance

Sheet of an FI
 The effect of the duration gap on net worth (or equity)
∆R
∆E = − D − D k × A × , k = L⁄A
1+R
 Into three components:
o The leverage adjusted duration gap = [DA – DLk]
o The asset size = A
o The size of the interest rate shock = ∆𝑅/(1 + 𝑅)

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Interest Rate Risk Management on the Whole Balance

Sheet of an FI
 The effect of the duration gap on net worth (or equity)

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Interest Rate Risk Management on the Whole Balance

Sheet of an FI
 Management strategy: Balance Sheet Immunization (Net Worth)
 Goal: To fully hedge against interest rate fluctuations
 Method: Set the leverage-adjusted duration gap to zero
 Result: The changes in asset values and liability values will offset each other,
leaving Net Worth unchanged (Portfolio Immunization)

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Interest Rate Risk Management on the Whole Balance

Sheet of an FI
Aggressive Management (Market Timing)
 Approach: Shifting the gap position based on interest rate forecasts to
maximize shareholder wealth

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Difficulties and Limitations

 Duration Matching Can Be Costly. Frequent buying and selling of assets to
maintain a zero- duration gap generates significant transaction costs.
 Immunization Is a Dynamic Problem. Duration changes as time passes and rates
fluctuate, requiring periodic rebalancing
 Large Interest Rate Changes and Convexity. The model assumes a linear
relationship; for large rate changes, duration overpredicts price falls and
underpredicts price rises

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