TOPIC: INTEREST RATE AND FOREIGN EXCHANGE RISK MANAGEMENT

(i) The role of interest rates in the economy

(ii) Components of interest rate risk
(iii) Models of interest rates
(iv) Gap management
(v) Duration management

Interest rate risk management

Financial managers face risk arising from changes in interest rates, i.e. a lack of certainty about
the amounts or timings of cash payments and receipts.

Many companies borrow, and if they do they have to choose between borrowing at a fixed rate
of interest (usually by issuing bonds) or borrow at a floating (variable) rate (possibly
through bank loans).There is some risk in deciding the balance or mix between floating rate
and fixed rate debt. Too much fixed-rate debt creates an exposure to falling long-term
interest rates and too much floating-rate debt creates an exposure to a rise in short-term
interest rates.

In addition, companies face the risk that interest rates might change between the point when the
company identifies the need to borrow or invest and the actual date when they enter into the
transaction.

Managers are normally risk-averse, so they will look for techniques to manage and reduce these
risks.

Interest rate risk exposure

Interest rate risk

Interest rate risk refers to the risk of an adverse movement in interest rates and thus a reduction
in the company's net cash flow.
Compared to currency exchange rates, interest rates do not change continually:

 currency exchange rates change throughout the day

 interest rates can be stable for much longer periods but changes in interest rates can be
substantial.

It is the duty of the corporate treasurer to reduce (hedge) the company's exposure to the interest
rate risk

Roles of interest rates in an economy

Interest rates are the terms at which money or goods today may be traded off for money or
goods at a future date - the price we pay to bring consumption forward in time and the
compensation we receive for postponing consumption.

The interest rate is also the price of money - the price we pay in order to have liquid holdings
and the compensation we receive for storing our savings in less liquid forms.

The interest rate is also used as an instrument in economic policy. Setting the interest rate to
achieve a monetary policy objective, often price stability or low and stable inflation, is usually
the responsibility of the central bank.

The interest rate therefore has several roles to play in the economy and these roles are fairly
closely linked.

(i) The interest rate shall in the short and medium term contribute to stable inflation and
stable developments in production. This will require active use of the interest rate
as a policy instrument.
 Interest rates have a direct connection with inflation. Inflation is the idea that the
purchasing power of a given amount of money declines over time because of
increasing prices. Interest rates are paid to savers as a way of offsetting the negative
effect of inflation on purchasing power.

The higher the level of inflation, the higher interest rates need to be to offset the
impact of inflation. By the same token, low inflation allows interest rates to remain
low. If inflation begins to rise, there is a case to be made for raising interest rates,
which would conflict with keeping rates low to stimulate the economy.

To further complicate matters, the same low rates designed to increase economic
growth could end up creating too much growth, which would trigger
inflationary pressures on prices, leading to an increase in rates.

(ii) But the interest rate should also contribute to equilibrium in the market for real
capital in the long run. To achieve this, the real interest rate must not overtime
deviate too much from the return on real capital. Substantial deviations can give rise
to undesirable fluctuations in the markets for real capital that have no basis in
economic fundamentals

(iii) Cost of borrowing

Borrowers obviously benefit from low interest rates. Borrowers include national as well as
state and local governments, all manner of businesses, and consumers buying goods and services
and homes that qualify for financing (that is, paying off the purchase price over time). It is
interesting to note that, in a period when borrowing rates are so low, many governments are
unwilling to borrow further to improve infrastructure and otherwise invest in their respective
economies, which would in turn add to economic growth. Of course the other side of this point
is that the borrowing ultimately needs to be paid for with either higher taxes, or with additional
borrowing at possibly less favorable future rates

(iv) Return on savings

The people and businesses that have excess savings to invest, and are punished by ultra-low
interest rates because they can’t get a decent investment return on their money.
Businesses that are adversely affected include insurance companies, which rely on interest
income to keep their premiums lower, and banks, which benefit from the spread between their
borrowing costs and the interest they charge customers on their loans.

(v) Impact on Financial Markets

Turning to the impact of interest rates on financial markets, there are a few key points to
establish
 (a) When interest rates rise, the prices of existing bonds decline; the more gradual the
time frame over which rates are increased, the less prices are impacted
negatively.
(b) Another significant factor on the extent of the price declines is how long it takes
for the bonds to mature, at which time new bonds can be purchased paying the
higher rates.
(c) The impact of rising rates on stocks is far less clear. It may be positive,
indicating stronger economic growth; but rising rates increase costs to
businesses, and provide a more attractive investment alternative (bonds), which
would then be paying higher interest rates.
(d) The relationship between bond returns and inflation can be sobering: If savers
earn 2% interest, and inflation is 2%, then purchasing power has not increased at
all. If the interest is taxable, an apparent positive result can be negative, after
accounting for inflation and taxation. Even so, bonds continue to provide a useful
buffer in portfolios against the much more extreme price volatility of stocks.

Components of interest rate risk

Sources of Interest-Rate Risk

Before we examine individual methods of measuring interest-rate risk, we shall define interest-
rate risk and its basic sources.

We can define interest-rate risk as a loss ensuing from:

(a) an adverse change in cash flow,

(b) an adverse change in the value of interest-rate sensitive assets and liabilities, in
consequence of a change in interest rates.

Whether the change in interest rates is favourable or unfavourable depends on the presence of
certain components, or sources of interest-rate risk in the balance sheet and off-balance sheet
accounts of the bank.

The basic components of interest-rate risk may be said to include:

(i) Maturities mismatching of balance sheet and off-balance sheet items( re-pricing
risk)
This can defined as a non-alignment in the maturity (in the case of fixed interest
rates) and revaluation (in the case of variable interest rates) of assets, liabilities and
off-balance sheet instruments.
The size and nature of the temporal non-alignment corresponds to a large extent to the
forecast changes in interest rates.
Building societies have a special standing in the banking sector in Slovakia, where
the possibilities to manage the time structure of their assets and liabilities are limited
by the nature of their business.
 (ii) Basis value risk
This is connected with the imperfect correlation in the adaptation of interest rates
to assets and liabilities with otherwise similar maturities and revaluation.

In the case of a change in an interest rate, these differences in adaptation of interest

rates can cause an adverse impact on financial flows and the value of the bank. Until
1 January 2004 building societies had a special standing in this source of interest-rate
risk, where the law determined a 3-percentage range between interest rates on
deposits are and building society loans.

(iii) Yield curve risk

This arises when changes in the values, slope and shape of the yield curve have an adverse
impact on the financial flows and value of the bank.

(iv) Optionality,
Or the existence of inserted options in the assets, liabilities and off-balance sheet
instruments.
The risk lies in the fact that through the use of inserted options the expected
financial flows from financial instruments change, which subsequently has an
impact on the size of the interest-rate risk.
An example of instruments with inserted options are for example various types of
loans, bonds with the possibility of early repayment, current accounts, etc. The
growing emergence of options in various banking products increases the importance
of monitoring this source of risk.

Three ways, or models, of measuring the asset– liability gap exposure of an FI:
(a) The re- pricing (or funding gap) model.
(b) The maturity model.
(c) The duration model.

The repricing model

The re-pricing model attempts to measure how a FI’s interest income will change relative to
interest expense over a given time period if interest rates change.
The model classifies assets and liabilities as “fixed rate” or “rate sensitive” based on whether
the earnings or costs will change on these accounts during the planning period if interest rates
change.
Rate sensitive accounts (RSA) are those where the cash inflows on an asset or outflows on a
liability will change at some point within the planning period if interest rates change.
Accounts are classified as fixed rate if the cash inflows on an asset or outflows on a liability
will not change within the planning period even if interest rates change. Conceptually one
can then compare the rate sensitivities of the two sides of the balance sheet and estimate how
Net Interest Income (NII) is likely to change if interest rates change.

The repricing gap is a measure of the difference between the value of assets that will reprice
and the value of liabilities that will reprice within a specific time period, where reprice
means the potential to receive a new interest rate.

Rate sensitivity represents the time interval where repricing can occur. The model focuses on
the potential changes in the net interest income variable. In effect, if interest rates change,
interest income and interest expense will change as the various assets and liabilities are repriced,
that is, receive new interest rates.

The maturity bucket is the time window over which the dollar amounts of assets and liabilities
are measured. The length of the repricing period determines which of the securities in a portfolio
are rate-sensitive. The longer the repricing period, the more securities either mature or
need to be repriced, and, therefore, the more the interest rate exposure.

An excessively short repricing period omits consideration of the interest rate risk exposure of
assets and liabilities are that repriced in the period immediately following the end of the
repricing period, i.e., it understates the rate sensitivity of the balance sheet.
An excessively long repricing period includes many securities that are repriced at different times
within the repricing period, thereby overstating the rate sensitivity of the balance sheet

Interest–sensitive assets and liabilities

short–term securities issued by the government and private borrowers; short–term loans made
by the bank to customers; variable–rate loans made by the bank to borrowing customers;
borrowings from money markets; short–term savings accounts; money–market deposits;
variable–rate deposits

Rate Sensitive Assets (Liabilities) RSA (RSL) are repriced within a period of time called a
maturity bucket.
Repricing occurs whenever either maturity or a roll date is reached. The roll date is the reset
date specified in floating rate instruments that determines the new market benchmark rate
used to set cash flows (e.g., coupon payments).

6 maturity buckets:
1 day; 1day–3 months; 3–6 months; 6–12 months; 1–5 yrs; > 5 yrs

The repricing model

Repricing Gap (GAP) = RSA – RSL

ΔR = interest rate shock
ΔNII = GAP × ΔR for each maturity bucket i
Cumulative Gap (CGAP) = Σi GAPi
ΔNII = CGAP × ΔRi
where ΔRi is the average interest rate change on RSA and RSL

Gap Ratio = CGAP/Assets

Example of repricing model

Assets $ millions Liabilities &net $ millions

worth

Short term customer loan 50 Equity capital 20

(fixed)
( 1 year fixed rate)

Long term consumer loans 25 Demands deposits 40

( 2 years fixed rate)

3 months T- bills 30 Passbook savings 30

6 months T-bills 35 CDS ( 3 months) 40

3 years T-bills 70 Bankers acceptances 20

(3 months)

Mortgage (10 years fixed 20 Commercial papers 60

rate)
( 6 months)

Mortgage ( 30 years, 40 Time deposits 20

floating rate, 9 months
adjust period) ( 1 year)

Time deposits 40

( 2 years)

270 270

Example of repricing model (cont.)

• 1 day GAP = 0 – 0 = 0 (DD and passbook excluded)
• (1day–3mth] GAP = 30 – (40+20) = –$30m
• (3mth–6mth] GAP = 35 – 60 = –$25m
• (6mth–12mth] GAP = (50+40) – 20 = $70m
• (1yr–5yr] GAP = (25+70) – 40 = $55m
• >5 yr GAP = 20 – (20+40+30) = –$70m

• 1yr CGAP = 0 –30 –25+70 = $15m

• 1yr Gap Ratio = 15/270 = 5.6%
• 5yr CGAP = 0 –30 –25+70+55 = $70m
• 5yr Gap Ratio = 70/270 = 25.9%

Assume a 1% increase in interest rates:

• 1 day ΔNII = 0 × 0.01 = 0
• (1day–3mth] ΔNII = –$30m × 0.01 = –$300,000
• (3mth–6mth] ΔNII = –$25m × 0.01 = –$250,000
• (6mth–12mth] ΔNII = $70m × 0.01 = $700,000
• (1yr–5yr] ΔNII = $55m × 0.01 = $550,000
• >5yr GAP = –$70m × 0.01 = –$700,000
• 1yr ΔNII = $15m × 0.01 = $150,000
• 5yr ΔNII = $70m × 0.01 = $700,000

Unequal shifts in interest rates

• ΔNII = (RSA × ΔRRSA) – (RSL × ΔRRSL)
• Even if GAP=0 (RSA=RSL), unequal shifts in interest rates can cause ΔNII
• Must compare relative size of RSA and RSL (GAPs) to relative size of interest rate shocks:
ΔRRSA – ΔRRSL = spread = Basis Risk
• The bank can restructure its assets and liabilities, on or off the balance sheet, to benefit from
projected interest rate changes.
– Positive gap: increase in rates increases NII
– Negative gap: decrease in rates increases NII

Strengths of the repricing model

(i) Simplicity
(ii) Low data input requirements
(iii) Used by smaller banks to get an estimate of cash flow effects of interest rate shocks

Weaknesses of the repricing model

(i) The re-pricing model (RPM) measures only short term profit changes, not
shareholder wealth changes. As such it suffers from the same problems as the goal of
maximizing profits. In particular the repricing model(RPM) ignores cash flows changes
that occur outside the maturity bucket and ignores the change in current value of
future cash flows as interest rates change.
(ii) The maturity buckets are arbitrarily chosen and can be difficult to manage. It is
possible to have a positive 3 month RS gap, a negative 6 month RS gap and a positive 1
year RS gap. Managing this requires detailed forecasts of interest rate changes over
the various arbitrarily chosen time periods.
 (iii) All assets and liabilities that mature within the
maturity bucket are considered equally rate sensitive. This is de-facto not true if a
spread effect exists.
(iv)The RPM ignores runoffs. Runoffs are receipts of cash on FRA or payments due on
FRLs that occur during the maturity bucket period. This cash must be reinvested by
the intermediary and it is rate sensitive. Runoffs are not calculated in the basic version of
the RPM presented here.
(v) The RPM ignores prepayments. Prepayment patterns are affected by changing interest
rates and are difficult to predict. Prepayments increase with declining rates so assets that
were considered fixed rate may become rate sensitive by being prepaid within the
maturity bucket.
(vi)The RPM ignores cash flows generated from off balance sheet activities. These cash
flows are also often sensitive to the level of interest rates, so the RPM underestimates the
interest rate sensitivity of the institution.

Maturity Model

Market value – based maturity model

One extension is the maturity gap (MG):
MG = WARSA – WARSL

where:
WARSA = weighted average rate–sensitive assets
WARSL = weighted average rate–sensitive liabilities

Explicitly incorporates market–value effects.

For fixed-income assets and liabilities:
(i) Rise (fall) in interest rates leads to fall (rise) in market price.
(ii) The longer the maturity, the greater the effect of interest rate changes on market price.
(iii) Fall in value of longer–term securities increases at diminishing rate for given increase
in interest rates.

Maturity gap is the difference between the average maturity of assets and liabilities.
If the maturity gap is zero, it is possible to immunize the portfolio, so that changes in interest
rates will result in equal but offsetting changes in the value of assets and liabilities and net
interest income.

Thus, if interest rates increase (decrease), the fall (rise) in the value of the assets will be offset by
a perfect fall (rise) in the value of the liabilities.
The critical assumption is that the timing of the cash flows on the assets and liabilities must be
the same.
Large banks are able to reprice securities every day using their own internal models so
reinvestment and repricing risks can be estimated for each day of the year.
Goal is “immunization,” bank wants to be immune to changes in interest rates.
If MA – ML = 0, is the bank immunized?

Extreme example: Suppose liabilities consist of 1-year zero coupon bond with face value $100.
Assets consist of 1-year loan, which pays back $99.99 shortly after origination, and 1 cent at the
end of the year.
NB: Not immunized, although maturity gap equals zero.

Reason: Differences in market value sensitivity to changes in interest rates.

If the relation between rate changes and price changes were both linear and equal on both sides
of the balance sheet then:
– Gap size determines the impact an interest rate change on net worth.
– Setting MA – ML = 0 would protect the balance sheet for value changes due to interest rate
fluctuations.

The maturity model better reflects the economic reality or the true value of assets and liabilities
if the bank portfolio was liquidated at today’s prices. If the maturity of a bank’s assets is
greater than the maturity of its liabilities, an increase in interest rates will cause the value
of the assets to fall more than the value of the liabilities because the assets mature later.

The bigger the maturity gap, the more a bank’s net worth will suffer by an increase in interest
rates.

The maturity model has two major shortcomings:

(i) It does not account for the degree of leverage in the bank’s balance sheet, and
(ii) it ignores the timing of the cash flows from the bank’s assets and liabilities.

As a result of these shortcomings, a strategy of matching asset and liability maturities moves
the bank in the direction of hedging itself against interest rate risk, but it is easy to show that
this strategy does not always eliminate all interest rate risk for a bank.

Q. If a bank risk manager is certain that interest rates were going to increase (fall) within the
next six months, how should the bank manager adjust the bank’s maturity gap to take
advantage of this anticipated increase?

When rates rise, the value of the longer–lived assets will fall by more the shorter–lived liabilities.
If the maturity gap is positive, the bank manager will want to shorten the maturity gap.
If the repricing gap is negative, the manager will want to move it towards zero or positive.
If rates are expected to decrease, the manager should reverse these strategies. Changing the
maturity or repricing gaps on the balance sheet often involves changing the mix of assets and
liabilities. Attempts to make these changes may involve changes in financial strategy for the
bank which may not be easy to accomplish.

Book value accounting reports assets and liabilities at the original issue values. Current
market values may be different from book values because they reflect current market conditions,
such as interest rates or prices. This is especially a problem if an asset or liability has to be
liquidated immediately.

For a bank, a major factor affecting asset and liability values is interest rate changes. If
interest rates increase, the value of both loans (assets) and deposits and debt (liabilities) fall.
If assets and liabilities are held until maturity, it does not affect the book valuation of the bank.
However, if deposits or loans have to be refinanced, then market value accounting presents a
better picture of the condition of the bank.
The process by which changes in the economic value of assets and liabilities are accounted is
called marking to market. The changes can be beneficial as well as detrimental to the total
economic health of the bank.
• Book values represent historical costs of securities purchased, loans made, and liabilities
sold. They do not reflect current values as determined by market values. Effective financial
decision–making requires up–to–date information that incorporates current expectations about
future events.
• Market values provide the best estimate of the present condition of a bank and serve as an
effective signal to managers for future strategies.
• Book values are clearly measured and not subject to valuation errors, unlike market values. The
paper gains and losses resulting from market value changes will never be realized if the bank
holds the security until maturity.
• Thus, the changes in market value will not impact the bank’s profitability unless the security is
sold prior to maturity.

• If bank balance sheets typically are accounted in book value terms, why be concerned about
how interest rates affect the market values of assets and liabilities?
• The solvency of the balance sheet is an important variable to creditors of the bank. If the
capital position of the bank decreases to near zero, creditors may not be willing to provide
funding for the bank, and the bank may need assistance from the regulators, or may even fail.
• Thus any change in the market value of assets or liabilities that is caused by changes in the
level of interest rate changes is of concern to regulators and customers.

Duration Model

Duration – the weighted –average time to maturity on an investment using the relative present
values of the cash flows as weights.

On a one time value of money basis, duration measures the period of time required to
recover the initial investment on the loan. Any cash flows received prior to the loan’s duration
reflect recovery of the initial investment, while cash flows received after the period of the loan’s
duration and before its maturity are the profits, or return, earned by the financial institution.

Duration analysis weights the time at which cash flows are received by the relative importance
in present value terms of the cash flows arriving at each point in time.
Features of duration
(i) Duration increases with the maturity of a fixed – income security, but at a decreasing
rate
(ii) Duration decreases as the yield on a security increases
(iii) Duration decreases as the coupon or interest payment increases

Risk management with duration

(i) Duration is equal to the maturity of an immunized security
(ii) Duration gap is used by financial institutions to measure and manage the interest
rate risk of an overall balance sheet

Duration gap analysis

An alternative method for measuring interest-rate risk, called duration gap analysis, examines
the sensitivity of the market value of the financial institution’s net worth to changes in
interest rates.

Duration analysis is based on Macaulay’s concept of duration, which measures the average
lifetime of a security’s stream of payments.
Duration is a useful concept, because it provides a good approximation, particularly when
interest-rate changes are small, of the sensitivity of a security’s market value to a change in
its interest rate using the following formula:

% ∆P = -DUR X ∆i/1+i ----------------------(1)

Where
% ∆P = (pi+1 – pt)/pt = percent change in market value of the security
DUR = duration
i= interest rate

Duration is additive; that is, the duration of a portfolio of securities is the weighted average
of the durations of the individual securities, with the weights reflecting the proportion of
the portfolio invested in each. What this means is that the bank manager can figure out the
effect that interest-rate changes will have on the market value of net worth by calculating the
average duration for assets and for liabilities and then using those figures to estimate the effects
of interest-rate changes

Table: Duration of the first bank assets and liabilities

Assets Amount Duration Weighted duration

($ millions) Years (years)

Reserves & cash 50 0.0 0.00

items
Securities:

Less than 1 year 5 0.4 0.02

1 to 2 years 5 1.6 0.08

Greater than 2 years 10 7.0 0.70

Residential
mortgages

Variable rate 10 0.5 0.05

Fixed rate ( 30 year) 10 6.0 0.60

Commercial loans

Less than 1 year 15 0.7 0.11

1 to 2 years 10 1.4 0.14

Greater than 2 years 25 4.0 1.00

Physical capital 5 0.0 0.00

Average duration 2.70

Liabilities

Checkable deposits 15 2.0 0.32

Money market 5 0.1 0.01

deposit accounts

Savings deposits 15 1.0 0.16

CDS

Variable rate 10 0.5 0.05

Less than 1 year 15 0.2 0.05

1 to 2 years 5 1.2 0.06

Greater than 2 years 5 2.7 0.14

 Overnight funds 5 0.0 0.00

Borrowings

Less than 1 year 10 0.3 0.03

1 to 2 years 5 1.3 0.07

Greater than 2 years 5 3.1 0.16

Average duration 1.03

For each asset, the manager then calculates the weighted duration by multiplying the duration
times the amount of the asset divided by total assets, which in this case is $100 million. For
example, in the case of securities with maturities less than one year, the manager multiplies the
0.4 year of duration times $5 million divided by $100 million to get a weighted duration of 0.02.

(Note that physical assets have no cash payments, so they have a duration of zero years.)
Doing this for all the assets and adding them up, the bank manager gets a figure for the average
duration of the assets of 2.70 years.

The manager follows a similar procedure for the liabilities, noting that total liabilities excluding
capital are $95 million. For example, the weighted duration for checkable deposits is determined
by multiplying the 2.0-year duration by $15 million divided by $95 million to get 0.32. Adding
up these weighted durations, the manager obtains an average duration of liabilities of 1.03 years.

Example 1:

The bank manager wants to know what happens when interest rates rise from 10% to 11%. The
total asset value is $100 million, and the total liability value is $95 million.
Required: Calculate the change in the market value of the assets and liabilities.

Solution
With a total asset value of $100 million, the market value of assets falls by $2.5 million
($100 million x 0.025 = - $2.5 million):

%∆P = - DUR x ∆i/1+ i

= -2.70 x 0.01/1+0.1 = - 2.5%

With total liabilities of $95 million, the market value of liabilities falls by $0.9 million
($95 million x 0.009 = - $0.9 million):
%∆p = - DUR x ∆i/1+i
= -1.03 x 0.01/ 1+0.1 = -0.9%

The result is that the net worth of the bank would decline by $1.6 million (-$2.5
million - ( -$0.9 million) = -$2.5 million + $0.9 million = - $1.6 million).
Alternative method
Example 2
The bank manager could have gotten to the answer even more quickly by calculating
what is called a duration gap, which is defined as follows

The duration gap for First Bank is 1.72 years:

Duration gap ( DURgap) = DURa – ( L/A x DURl) ---------------- (2)

Where:
DURa = average duration of assets
DURl = average duration of liabilities
L – market value of liabilities
A – market value of assets

DURgap = 2.70 – (95/100 x 1.03) = 1.72 years

To estimate what will happen if interest rates change, the bank manager uses the DURgap
calculation in Equation 1 to obtain the change in the market value of net worth as a percentage of
total assets. In other words, the change in the market value of net worth as a percentage of assets
is calculated as

Example 3

What is the change in the market value of net worth as a percentage of assets if interest rates rise
from 10% to 11%? (Use Equation 3.)

Solution
A rise in interest rates from 10% to 11% would lead to a change in the market value of net worth
as a percentage of assets of -1.6%:

∆NW/A = - DURgap x ∆i/1+i-------------------------------- (3)

∆NW/A = -1.72 x 0.01/1+0.1 = -1.6%

With assets totaling $100 million, Example 3 indicates a fall in the market value of net worth of
$1.6 million, which is the same figure that we found in Example 1. As our examples make clear,
both income gap analysis and duration gap analysis indicate that the First Bank will suffer
from a rise in interest rates. Indeed, in this example, we have seen that a rise in interest rates
from 10% to 11% will cause the market value of net worth to fall by $1.6 million, which is
one-third the initial amount of bank capital. Thus the bank manager realizes that the bank
faces substantial interest- rate risk because a rise in interest rates could cause it to lose a lot
of its capital. Clearly, income gap analysis and duration gap analysis are useful tools for telling a
financial institution manager the institution’s degree of exposure to interest-rate risk.
Exercise
Income gap and duration gap analysis. If interest rates fall from 10% to 5%, the first bank will
find its income increasing and the market value of its net worth rising.

Duration gap model

Duration gap (DGAP) model focuses on managing net interest income or the market value of
stockholders’ equity, recognizing the timing of all cash flows for every security on a bank’s
balance sheet. Unlike static GAP analysis, which focuses on rate sensitivity or the frequency of
repricing, duration gap analysis focuses on price sensitivity.

Duration gap and market value of equity sensitivity analysis represent alternative methods of
analyzing interest rate risk. They emphasize the price sensitivity of assets and liabilities to
changes in interest rates and the corresponding impact on stockholders’ equity. As the labels
suggest, they incorporate estimates of the duration of assets and duration of liabilities, which
reflect the value of promised cash flows through final maturity. Duration gap analysis
compares the duration of bank assets with the duration of bank liabilities and examines
how the market value of stockholders’ equity will change when interest rates change. This
analysis requires that a bank to specify a performance target (the market value of equity or net
interest income) and strategically manage the difference between the average duration of total
assets and the average duration of total liabilities (DGAP). The general relationship between the
sign of a bank’s duration gap and the impact of changing rates on market value of equity is
summarized below:

DGAP summary
DGAP Change in Change in market (economic value)
interest rate

Assets Liabilities Equity

positive increase decrease ˃ decrease → decrease

positive decrease increase ˃ increase → decrease

negative increase decrease ˂ decrease → increase

Negative decrease increase ˂ increase →decrease

zero increases decreases = decreases → none

zero decreases increase = increases → none

Strategies for Managing Interest-Rate Risk

Once financial institution managers have done the duration and income gap analysis for their
institutions, they must decide which alternative strategies to pursue. If the manager of the First
Bank firmly believes that interest rates will fall in the future, he or she may be willing to take
no action knowing that the bank has more rate-sensitive liabilities than rate-sensitive assets, and
so will benefit from the expected interest-rate decline. However, the bank manager also
realizes that the First Bank is subject to substantial interest-rate risk, because there is always a
possibility that interest rates will rise rather than fall, and as we have seen, this outcome could
bankrupt the bank. The manager might try to shorten the duration of the bank’s assets to
increase their rate sensitivity either by purchasing assets of shorter maturity or by converting
fixed rate loans into adjustable-rate loans. Alternatively, the bank manager could lengthen the
duration of the liabilities. With these adjustments to the bank’s assets and liabilities, the bank
would be less affected by interest-rate swings.

For example, the bank manager might decide to eliminate the income gap by increasing the
amount of rate-sensitive assets to $49.5 million to equal the $49.5 million of rate-sensitive
liabilities. Or the manager could reduce rate-sensitive liabilities to $32 million so that they
equal rate-sensitive assets. In either case, the income gap would now be zero, so a change in
interest rates would have no effect on bank profits in the coming year.
Alternatively, the bank manager might decide to immunize the market value of the bank’s net
worth completely from interest-rate risk by adjusting assets and liabilities so that the
duration gap is equal to zero. To do this, the manager can set DURgap equal to zero in
Equation 2 and solve for DURa:

DURa= L/A x DURl = 95/100 x 1.03 = 0.98

These calculations reveal that the manager should reduce the average duration of the bank’s
assets to 0.98 year. To check that the duration gap is set equal to zero, the calculation is:
DURgap = 0.98 – (95/100 x 1.03) = 0

In this case, as in Equation 3, the market value of net worth would remain unchanged when
interest rates change. Alternatively, the bank manager could calculate the value of the duration of
the liabilities that would produce a duration gap of zero. To do this would involve setting
DURgap equal to zero in Equation 2 and solving for DURl:

DURl = DURa x A/L = 2.70 x 100/95 = 2.84

This calculation reveals that the interest-rate risk could also be eliminated by increasing the
average duration of the bank’s liabilities to 2.84 years. The manager again checks that the
duration gap is set equal to zero by calculating

DURgap = 2.70 – (95/100 x 2.84) = 0

One problem with eliminating a financial institution’s interest-rate risk by altering the balance
sheet is that doing so might be very costly in the short run. The financial institution may be
locked into assets and liabilities of particular durations because of its field of expertise.
Fortunately, recently developed financial instruments, such as financial futures, options, and
interest-rate swaps, help financial institutions manage their interest-rate risk without requiring
them to rearrange their balance sheets.