2026

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

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

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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

Determinants of Interest Rate

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

 Bank discount rate (DR)

𝟏𝟎𝟎 − 𝐏𝐮𝐫𝐜𝐡𝐚𝐬𝐞 𝐩𝐫𝐢𝐜𝐞 𝐨𝐧 𝐥𝐨𝐚𝐧 𝐨𝐫 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲) 𝟑𝟔𝟎

𝐃𝐑 = ( × )
𝟏𝟎𝟎 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐝𝐚𝐲𝐬 𝐭𝐨 𝐦𝐚𝐭𝐮𝐫𝐢𝐫𝐲

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Determinants of Interest Rate

 Components of Interest Rates
 Risk-free interest rate
 Risk Premiums: compensation lenders who accept risky IOUs for their
default risk, inflation risk, liquidity risk and so on.
 Maturity premium:
 Interest rates on long-term loans and securities are typically higher than
those on short-term loans and securities.
 The maturity Gap and the Yield Curves

One of the Goals of Interest Rate Hedging

 The fundamental objective is to insulate net income from the damaging effects of volatile
interest rates.
 The management concentrate on those parts of the balance sheet that are most sensitive to
interest rate movements.

Interest Income Interest expense on

from loans − deposits and other
and investments borrowed funds
NIM =
Total earning assets

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Interest-Sensitive Gap Management

 It is one of the most popular strategies to protect or maximize financial
institutions’ Net Interest Margin (NIM).
 The goal: matching as closely as possible the volume of interest-bearing assets and
liabilities that can be repriced within the same time period.

Dollar amount of repriceable Dollar amount of repriceable

(interest-sensitive) = (interest-sensitive)
assets liabilities

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Interest-Sensitive Gap Management

 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 and deposits at the CB
change in response to movements in as market interest rates move during
o Long-term at a fixed-interest
market interest rates within a specific the same time period
rate loans/securities.
planning period  Common examples include:
o Buildings and equipment
 These typically include: o CDs (Certificates of Deposit) about
 Nonrepriceable Liabilities:
o Loans about to mature or coming up to mature or be renewed.
for renewal. o Demand deposits,
o Money-market borrowings, such as
o Short-term securities issued by Federal funds or Repurchase o Long-term savings and
governments and private borrowers Agreements (RPs). retirement accounts,
that are nearing maturity. o Short-term savings accounts and o Equity capital
o Floating-rate loans and securities money-market deposits.

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Interest-Sensitive Gap Management

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

Source: Anthony Saunders et al., 2017

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Interest-Sensitive Gap
 Dollar Interest-Sensitive Gap (IS GAP)
Interest-sensitive assets Interest-sensitive liabilities
𝐈𝐒 𝐆𝐀𝐏 = −
(ISA) (ISL)
o ISA > ISL: Positive (Asset Sensitive) Gap
o ISA < ISL: Negative (Liability Sensitive) Gap
 Relative IS GAP
IS GAP
𝐑𝐞𝐥𝐚𝐭𝐢𝐯𝐞 𝐈𝐒 𝐆𝐀𝐏 =
Total assets
 Interest Sensitive Ratio (ISR)
Interest-sensitive assets
𝐈𝐒𝐑 =
Interest-sensitive liabilities
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Interest-Sensitive Gap
 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 over-
aggregation.

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Interest-Sensitive Gap
Repricing Opportunities for Assets and Liabilities
(Unit: Dollars in millions)

Maturity Interest-Sensitive Interest-Sensitive Cumulative

Size of Gap
Buckets Assets Liabilities Gap
1 day (next 24 hours) $40 $30 +10 +10
Day 2–day 7 120 160 -40 -30
Day 8–day 30 85 65 +20 -10
Day 31–day 90 280 250 +30 +20
Day 91–day 120 455 395 +60 +80
... ... ... ... ...

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Interest-Sensitive Gap Management

 Discussion

What important decisions do financial managers have to make?

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Interest-Sensitive Gap Management

TABLE 7-1: Sample Interest-Sensitivity Analysis (GAP management) for a Bank
(Unit: Millions of dollars)

Asset and One Week Next Next Next More than Total
Liability Items 8–30 Days 31–90 Days 91–360 Days One Year
Assets
Cash and deposits owned 100 -- -- -- -- 100
Marketable securities 200 50 80 110 460 900
Business loans 750 150 220 170 210 1,500
Real estate loans 500 80 80 70 170 900
Consumer loans 100 20 20 70 90 300
Farm loans 50 10 40 60 40 200
Buildings and equipment -- -- -- -- 200 200

Total repriceable assets 1,700 310 440 480 1,170 4,100

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Interest-Sensitive Gap Management

TABLE 7-1: Sample Interest-Sensitivity Analysis (GAP management) for a Bank
(Unit: Millions of dollars)
Asset and One Next Next Next More than Total
Liability Items Week 8–30 Days 31–90 Days 91–360 Days One Year
Liabilities and Net Worth
Checkable deposits 800 100 -- -- -- 900
Savings accounts 50 50 -- -- -- 100
Money market deposits 550 150 -- -- -- 700
Long-term time deposits 100 200 450 150 300 1200
Short-term borrowings 300 100 -- -- -- 400
Other liabilities -- -- -- -- 100 100
Net worth -- -- -- -- 700 700
Total repriceable liabilities 1,800 600 450 150 1,100 4,100
and net worth
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Interest-Sensitive Gap Management

TABLE 7-1: Sample Interest-Sensitivity Analysis (GAP management) for a Bank
(Unit: Millions of dollars)
Asset and One Next Next Next More than Total
Liability Items Week 8–30 Days 31–90 Days 91–360 Days One Year
Total repriceable assets 1,700 310 440 480 1,170 4,100
Total repriceable liabilities and
1,800 600 450 150 1,100 4,100
net worth
Interest-Sensitive GAP -100 -290 -10 +330 +70

Cumulative Gap -100 -390 -400 -70 0

• Suppose:
The average yields on rate-sensitive and fixed assets: 10% and 11%
The average yields on rate-sensitive and non-rate-sensitive liabilities: 8% and 9%

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Impact on Net Interest Income

 The relationship:
Overall change in Size of the
Change in interest rate cumulative Gap
= ×
Net interest income (in percentage points) (in dollars)

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

results in a $100,000 loss in NII

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Impact on Net Interest Income

 Equal Changes in Rates on ISAs and ISLs

Change Change
Cumulative Change in
in Interest in Interest Impact on NII
GAP Rates
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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Impact on Net Interest Income

 Unequal Changes in Rates on RSAs and RSLs
o Spread: the difference between the average yield on RSAs and the average
cost of RSLs
o Expanded Formula: ΔNII=(RSA×ΔRRSA)−(RSL×ΔRRSL)
o 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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Interest-Sensitive GAP Management Strategy

 The weighted interest-sensitive gap management
 An interest-rate sensitivity weight is assigned to each category of rate-
sensitive assets and liabilities.
 These weights act as indicators of how volatile a specific item's rate is
relative to a baseline rate, such as the federal funds rate.
 Refigured Balance Sheet
 Weighted Gap Calculation

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Interest-Sensitive GAP
Management Strategy

 The weighted interest-

sensitive 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.
 Over-aggregation: 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 of Duration
Duration measures the average maturity of an asset or liability in a cash flow sense. It
measures the average time needed to recover the funds committed to an investment.
 The Calculation: Macaulay’s Duration
∑ 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

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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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What is Duration?
 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.
2) A bank grants a loan to one of its customers with the following terms: Term: 5
years; annual Interest Payment of 10% (which equals $100 per year); the Face
(Par) Value: $1,000; Current Market Value (Price): $1,000 (because the current
yield to maturity is also 10%).

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What is Duration?
 The Duration of Zero-Coupon Bonds
• There are no intervening cash flows
• Duration equals its maturity (D=M)
 Consol Bonds (Perpetuities)
• 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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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, market prices move in an
inversely proportional fashion according to the size of D, or Convexity.
o Long-duration securities/loans suffer larger capital losses than short-duration
ones for any given change in rates.

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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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Using Duration to Hedge against Interest rate risk

 Management strategy for an investment
 Content: Matching the duration of assets to the investment horizon (target date)
o Reinvestment Income Effect
o Capital Value (Price) Effect
 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).

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Using Duration to Hedge against Interest rate risk

 Management strategy on the whole balance sheet
 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: 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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Using Duration to Hedge against Interest rate risk

 Management strategy on the whole balance sheet
 Example: Suppose a bank holds assets with durations and market values as
follows:

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Using Duration to Hedge against Interest rate risk

 Management strategy on the whole balance sheet
 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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Using Duration to Hedge against Interest rate risk

 Management strategy on the whole balance sheet
 The effect of the duration gap on net worth (or equity)

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Using Duration to Hedge against Interest rate risk

Interest
Market Interest Rate
Rate Average Composition Market Average
Composition Value Attached to
Attached to Duration (in of Liabilities & Value of Duration
of Assets of Each
Each years) Equity Liabilities (in years)
Assets Category
Category
U.S. Treasury Securities $90 10.00% 7.490 Negotiable CDs $100 6.00% 1.943
Municipal bonds 20 6.00 1.500 Other time deposits 125 7.20 2.750
Commercial loans 100 12.00 0.600 Subordinated notes 50 9.0
Consumer loans 40 13.00 2.250 Total liabilities 275
Equity capital 25
Total 300 Total 300

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Duration Gap Management Strategies

 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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Uses of Derivative Contracts for

management of Interest Rate Risk

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Financial Futures Contracts

 Definition
A financial futures contract is an agreement reached today between a buyer and a
seller that calls for the delivery of a particular financial security (such as Treasury
bonds or Eurodollar deposits) in exchange for cash at some future date.
 Key Features
o Standardization: the quantity of the underlying asset, delivery months, and
trading hours.
o Marking-to-Market: gains or losses are settled daily, adjusting the trader's
equity position based on changes in the contract's price.

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Financial Futures Contracts

 Hedging Strategies
The Short Hedge (Selling Hedge) The Long Hedge (Buying Hedge)
Application Interest rates to is expected to rise Interest rates is expected to fall
Hedging Strategies The bank sells futures contracts The bank buys futures contracts
today and later buys them back at a today and sells them later at a
lower price. higher price.
Objective The profit offsets the decline in the The profit offsets the reduced
value of fixed-rate loans/securities interest income from future asset
or the increase in borrowing costs investments.
on the balance sheet

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Financial Futures Contracts

 Hedging Strategies
 Example 01:
Protecting the Value of a Bond Portfolio. Suppose a bank holds a securities
portfolio containing $10 million in 15-year bonds with a 6% coupon. If market
yields increase from 6% to 6.5%, the market value of the bank's bond portfolio
will drop from $10 million to approximately $9,525,452. This represents a loss of
$474,547.73 in the cash market. The bank sells (goes "short" on) futures contracts
calling for the future delivery of similar underlying securities.

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Financial Futures Contracts

 Hedging Strategies
 Example 02: Hedging against Rising Borrowing (Deposit) Costs
A depository institution expects it will need to raise $100 million in new deposits
over the next three months at a promised interest rate.
The Risk: If rates rise from 10% to 10.5%, the institution's marginal deposit cost
for 90 days would increase from $2,500,000 to 2,625,000—a 125,000 loss in
potential profit.
The Hedge: The institution sells 100 90-day Eurodollar futures contracts today at
a set index price (e.g., 91.5).
The Result: If rates rise to 10.5% as expected, the price of these futures contracts
will fall (e.g., to an index of 91.0). By buying back the 100 contracts at the lower
price, the institution realizes a profit of $125,000. This gain in the futures market
directly offsets the higher interest expense the bank must pay to its depositors.

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Financial Futures Contracts

 Hedging Strategies
 Example 03: Protecting the yield on a future bond purchase
Suppose a financial firm expects to receive a sizable inflow of deposits (e.g., $1
million) in a few weeks or months. The firm intends to invest this cash in 15-
year, 6 percent bonds.
The Risk: If market interest rates will fall to 5.5 percent by the time the cash
arrives, the market price of those bonds would increase from 1million to
1,050,623.25.
The Hedge: The institution enters the futures market as a buyer of contracts (at an
initial price, F0) today.
The result: If market interest rates will fall , The profit generated from the futures
transaction offsets the higher cost of purchasing the bonds in the cash market

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Limitation: Basic Risk

 Definition:
Basic Risk arises if the cash and futures prices do not move in perfect
synchronization, the profit from the futures position may not exactly offset the
loss in the cash market.
 Formula:
Basis = Cash-market price (or rate) – Futures-market price (or rate)
 Returns Based on Basis Risk
• Short Hedge
Dollar return = Basis at termination of hedge − Basis at initiation of hedge
• Long Hedge
Dollar return = Basis at initiation of hedge − Basis at termination of hedge

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Hedging Strategies by Financial Futures Contracts

 Determining the Number of Contracts
 The objective: Offsetting the loss in net worth due to changes in market interest
rates with gains from trades in the futures market.
 The Formula:
L
(D − A × D ) × A
N=
D ×P
Where:
N: the number of futures contracts needed
DF : the duration of the futures contract
PF: the price of the futures contract

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Interest-Rate Options
 Definition
An interest-rate option grants a holder the right to either sell (place or "put") or buy
(take delivery of or "call") a particular financial instrument at a prespecified exercise
price before the option expires.
The buyer of the option pays a fee to the writer (seller) for this privilege, which is known
as the option premium.
 Types of Interest-Rate Options
Put Options give the holder the right to sell securities, loans, or futures contracts at a set
strike price. Financial institutions use put options to protect against rising interest rates,
which cause the market value of existing fixed-rate assets to fall.
Call Options give the holder the right to buy securities or futures at a set strike price.
hey are used to hedge against falling interest rates, which would otherwise increase the
price of securities the institution plans to purchase in the future
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Exhibit 3-5: Payoff Diagrams for Put and Call Options

Purchased by a bank

Strategic Applications in
ALM

Interest-Rate
Options

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Exhibit 3-6: Payoff Diagrams for Put and Call Options

Written by a bank

Strategic Applications in
ALM

Interest-Rate
Options

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Interest-Rate Options
 Example :
Bank plans to issue $150 million in new 180-day interest-bearing deposits (CDs) at
the end of the week.
However, concerning that market interest rates will rise before the CDs are issued,
which would increase their borrowing costs, The bank's asset-liability manager
decides to buy put options on Eurodollar deposit futures at a strike price of 95.00,
the quoted premium for the put option is .50, which is (50 x $25) or $1,250.
Suppose interest rates rise as predicted, the market index of the Eurodollar futures
fall to 94.00.

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Interest-Rate Swaps
 Definition:
An interest-rate swap is a financial contract that allows two parties to exchange
interest payment streams to better manage their exposure to interest-rate
fluctuations and reduce borrowing costs.
 Features:
• Notional Amount: The principal amount of the loans is never exchanged; it is
only used as a basis to calculate the interest payments.
• Netting: On each payment date, the parties typically only exchange the net
difference between the fixed and floating interest amounts, which significantly
reduces credit risk

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Interest-Rate Swaps
 Hedging Strategies in Asset-Liability Management
 Duration Management: A firm can alter the effective duration of its portfolio.
For example, it can shorten duration by swapping a fixed-rate income stream
for a variable-rate one, or lengthen duration by swapping variable-rate expenses
for fixed-rate ones.
 Quality Swaps: A lower-rated borrower (who may only have access to
expensive floating-rate loans) can swap with a higher-rated borrower to
effectively obtain a lower fixed-rate interest cost

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Interest-Rate Swaps
 Hedging Strategies in Asset-Liability Management
 Example: Two businesses can each save on borrowing costs by agreeing to
swap interest payments with each other.

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Interest-Rate Swaps
 Hedging Strategies in Asset-Liability Management
 Associated Risks
o Credit Risk: The danger that a counterparty will fail to honor their interest
payment obligations
o Basis Risk: This occurs when the interest rate index used in the swap (e.g.,
LIBOR) does not move in perfect proportion with the interest rates of the
actual assets or liabilities being hedged.
o Interest Rate Risk: If interest rates move unfavorably, one party may find
themselves paying a significantly higher net interest cost than anticipated

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Interest-Rate Caps, Floors, and Collars

 Interest-Rate Caps
 An interest-rate cap protects its holder against rising market interest rates.
 Mechanism: The borrower pays an up-front fee (premium) to a lender or a third
party. In return, if the market interest rate rises above a specified "cap" level, the
seller of the cap will reimburse the borrower for the additional interest costs
incurred.
 Example: A bank buys an 11% cap on a 100 million loan. If market rates rise to
121 million, effectively ensuring the bank's borrowing rate never exceeds 11%
 ALM Strategy: Financial firms buy caps when they fund fixed-rate assets with
floating-rate liabilities or hold large bond portfolios that drop in value when
rates rise

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Interest-Rate Caps, Floors, and Collars

 Interest-Rate Floors
 Definition: An interest-rate floor protects a lender or investor against falling
interest rates, which can erode earnings on floating-rate loans.
 Mechanism: It guarantees a minimum rate of return regardless of how low market
rates fall. If the index rate (like LIBOR) drops below the floor rate, the seller pays
the buyer the difference.
 Example: A bank extending a $10 million loan might set a floor of 7%. If the
prime rate drops to 6%, the borrower must pay an interest rebate to the lender so
the lender still receives a 7% return.
 ALM Strategy: Intermediaries use floors when their liabilities have longer
maturities than their assets or when they fund floating-rate assets with fixed-rate
debt

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Interest-Rate Caps, Floors, and Collars

 Interest-Rate Collars
 Definition: A collar combines a floor and a cap into a single agreement.
 Mechanism: It "freezes" the loan rate or security yield within a specific range
defined by the floor and the cap.
 Cost Structure: The net premium for a collar can be positive, negative, or zero,
as the premium paid for the cap can be offset by the premium received for
selling a floor.
 Example: A borrower with a $100 million floating-rate loan may request a
collar between 7% (floor) and 11% (cap). The lender pays the borrower if rates
exceed 11%, while the borrower pays the lender if rates fall below 7%

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