1

ASSET / LIABILITY
MANAGEMENT
2
Asset / Liability Management
Also known as asset-liability management, gap
management
Activity usually run in a Treasury Department of a
bank
Managed weekly or biweekly by a committee
Activity began in late 1970s as a result of high and
volatile interest rates
Banks assume much interest rate risk since they
borrow in one set of markets and lend in another

3
Asset / Liability Management
Measuring interest rate risk
Focus is on GAP , there are 3 types of GAPs.
Dollar Gap, Funds Gap, Repricing Gap
Maturity Gap
Duration Gap
4
GAP
GAP
t
= RSA
t
RSL
t

where t = particular time interval

RSA
t
= $ of assets which are reset during
interval t, Rate-Sensitive-Assets
RSL
t
= $ of liabilities which are reset during
interval t, Rate-Sensitive-Liabilities

5
GAP
Example:
Bank with assets & liabilities of following
maturities

Days
0 60 61 90 91 120 121 - 180
Assets 10 0 40 20
Liabilities 20 5 30 50
GAP (A-L) -10 -5 10 -30
6
GAP
Example (cont.)
Cumulative GAP = C GAP
= GAP over whole period
C GAP = -10 5 + 10 30
= - 35
Note: If + GAP, then lose if rates fall
If GAP, then lose if rates rise
7
GAP
Federal Reserve has required banks to report
quarterly the repricing GAPs (schedule RC-J) as
follows:
1 day
2 day 3 months
over 3 months 6 months
over 6 months 1 year
over 1 year 5 year
over 5 year
8
GAP
Problems with GAP
1. Uses book-value approach: Focuses only on
income effect and not on capital gains effect
from rate changes.
2. Aggregation: Ignores distribution of
assets/liabilities within buckets could still
have mismatch
3. Runoffs ignored: Interest and principal paid
plus loan prepaid must be invested. This
feature is ignored.
9
Maturity Gap
Background
Consider a 1year bond with coupon 10% and YTM 10%


If rates increase to 11%



Conclude: If r| P+ AP / Ar < 0
100 + 0.10 100
1 + 0.10
P = = = 100
100 + 0.10 100
1 + 0.11
P = = = 99.10
110
1.10
110
1.11
10
Maturity Gap
Consider a 2 year bond


If rates increase to 11%




Price fell more than 1 year bond!
P = + = 100
110
1.10
2
10
1.10

P = + = 98.29
110
1.11
2
10
1.11

11
Maturity Gap
Conclusion:
The longer the maturity, the
greater the fall in price for a
given level increase in interest
rates.
12
Maturity Gap
Consider a 3 year bond


If rates increase to 11%




P = + + = 100
10
1.10
2
10
1.10

110
1.10
3
P = + + = 97.56
10
1.11
2
10
1.11

110
1.11
3
13
Maturity Gap
Notice Decline:


Time P0 Pn P0 Pn Pn1 Pn
1 yr 100 99.10 0.90 0.90
2 yr 100 98.29 1.71 0.81
3 yr 100 97.56 2.44 0.73
14
Maturity Gap
Conclude: The fall increases at a diminishing
rate as a function of maturity.
Maturity
AP
1
2 3
15
Maturity Gap
Now, these principles apply to
banks since they have portfolios
of interest-rate sensitive assets
and liabilities.
16
Maturity Gap
Let M
A
= W
A1
M
A1
+ W
A2
M
A2
+ + W
An
M
An
Where M
A
= average maturity of banks assets
M
Aj
= maturity of asset j
W
Aj
= market value of asset j as a % of total
asset market value
And M
L
= W
L1
M
L1
+ W
L2
M
L2
+ + W
Ln
M
Ln

Where M
L
= average maturity of banks liabilities
17
Maturity Gap
Then MG = M
A
M
L
For a minimum of interest rate risk, want: MG = 0
Typically, MG > 0 i.e. M
A
> M
L

Ex) Bank borrows at 1 yr deposit of $90 paying
10% and invests in $100 3 yr bond at 10% with
$10 of equity.
A L
B 100 90 D
10 E
18
Maturity Gap
Suppose rates rise to 11%, then 3 yr bond is
worth $97.56 (as before) and deposit is
worth
P = 99 / 1.11 = 89.19
Thus
Assets Liabilities
97.56 89.19
8.37
E = 97.56 89.19
AE = AA AL = 2.44 (0.81)
AE = 1.63
E = 10 1.63 = 8.37
19
Maturity Gap
Thus, equity must absorb interest-rate risk exposure.
Notice
MG = M
A
M
L
= 3 1 = 2
By previous propositions
If MG > 0
If r|, then bank will LOSE
If r+, then bank will GAIN
If MG < 0
If r|, then bank will GAIN
If r+, then bank will LOSE
20
Maturity Gap
At what rate change will bank become insolvent?
AE = 10 or AA AL = 10
Want:



If r 16% 12.07 (4.66) = 7.41
If r 17% 15.47 (5.38) = 10.09 YES!
+ + 100 [ 90] = 10
10
(1+x)
2
10
1 + x

110
(1+x)
3
99
1 + x

21
Maturity Gap
What if bank has matched with MG = 0, that is
invested in 1 yr bond, then
If r 11% from 10%
AA = 99.10 100 = 0.90
AL = 89.11 90 = 0.89
If r 12%
AA = 98.21 100 = 1.79
AL = 88.39 90 = 1.61
AE = 0.90 + 0.89 = 0.01
AE = 1.79 + 1.61 = 0.18
22
Maturity Gap
Setting MG = 0 does NOT insure one
completely from interest-rate risk but does
work quite well.
Reasons why some risk remains:
1. Amounts not matched (as before)
2. Timing of cash flows not considered
3. Rates may not move exactly together
Using a Duration Gap measure will resolve #2.
23
DURATION
Duration of an asset or liability is the
weighted-average time until cash flows are
received or paid.

The weights are the PV of each cash flow as
a % of the PV of all cash flows.

24
DURATION

= =
=
N
t
t
N
t
t
PV t PV D
1 1
Where N = last period of CF
CFt = cash flow at time t
PVt = CFt / (1+R)
t
R = yield on asset or liability
25
DURATION
Example:
Duration of 8% $1,000 6 year Euro-bond,
Eurobonds pay interest annually, yield is
8%.
26
DURATION
Example (cont.)
T CF
t
1/(1+R)
t
PV
t
PV
t
t
1 80 0.9259 74.07 74.07
2 80 0.8573 68.59 137.18
3 80 0.7938 63.51 190.53
4 80 0.7350 58.80 235.20
5 80 0.6806 54.45 272.25
6 1080 0.6302 680.58 4083.48
D = 4993.71 / 1000 = 4.993 years
27
DURATION
Features of Duration
1. Duration increases with maturity at a
decreasing rate.
0
) / (
<
A
A A A
M
M D
0 > A A M D
2. Duration increases as yield decreases.
0 / < A A R D
3. The higher the coupon, the lower the duration.
0 / < A A C D
28
DURATION
Consider a bond with annual coupon
payments C


or

N
R
F C
R
C
R
C
P
) 1 (
...
) 1 ( 1
2
+
+
+ +
+
+
+
=

=
+
=
N
t
t
t
R
C
P
1
) 1 (
29
DURATION

=
+
+
= =
A
A
N
t
t
t
R
tC
dR
dP
R
P
1
1
) 1 (

=
+ +
=
A
A
N
t
t
t
R
C
R
D
R
P
1
) 1 ( 1

= =
=
N
t
t
N
t
t
PV t PV D
1 1
Since and
t
t
t
R
CF
PV
) 1 ( +
=
Hence
R
R
D
P
P
+
A
=
A
1

30
DURATION
R
R
D
P
P
+
A
=
A
1
% Price Change
P
P A
R
R
+
A
1
0
Slope = D
31
DURATION
Example:
Consider 6 year Eurobond from before.
Recall D = 4.99
If yields rise 10 basis points
P
P A
= (4.99)(0.001/1.08) = 0.000462 = 0.0462%

If P=1000, price would fall to 999.538
32
DURATION
Example (cont):
For semi-annual payments, the equation
must be modified:
R
R
D
P
P
5 . 0 1+
A
=
A
R
R
D
P
P
+
A
=
A
1
Annual
Payment
33
DURATION
Example:
2 yr treasury with coupon of 8%, pays semi-
annually with price of $964.54, with face
value of $1000.
964.54 = + + +
40
(1+0.5R)
2
40
(1+0.5R)

40
(1+0.5R)
3
1040
(1+0.5R)
4
R = 0.10 yrs 89 . 1
54 . 964
37 . 1818
= =

P
t PV
D
t
34
DURATION GAP
Now we can apply these ideas to a bank.
Recall:
R
R
D
P
P
+
A
=
A
1
Now consider a bank and let:
A = value of assets
A A = change in value of assets
L = value of liabilities, excluding equity
A L = change in value of liabilities
35
DURATION GAP (Cont.)
Then,
) 1 ( R
R
D
A
A
A
+
A
=
A
Where, D
A
= weighted-average duration of the assets
=e
1
D
1
+ e
2
D
2
+ + e
n
D
n

e
i
= MV of asset i / total MV of assets

36
DURATION GAP (Cont.)
And for liabilities, we have the same:
) 1 ( R
R
D
L
L
L
+
A
=
A
Where, D
L
= e
1
D
1
+ e
2
D
2
+ + e
m
D
m

e
i
= MV of liability i / total MV of assets
37
DURATION GAP (Cont.)
Now, let
AE = AA AL
= - (D
A
A D
L
L) AR / (1+R)

So, AE / A = - DG AR / (1+R)
where DG = D
A
D
L
L / A
Duration Gap
AE = -DG A AR / (1+R)
38
DURATION GAP (Cont.)
Thus, the change in the net worth of a bank
depends on:
1. The duration gap of the bank (DG)
2. The size of the bank (A)
3. The size of the interest rate shock
(AR / (1+R))
39
DURATION GAP (Cont.)
Example:
Bank with D
A
= 5 years, D
L
= 3 years, R = 0.10,
A = $100 million, L = $90 million,
E = $10 million. If R 11%, what is effect on
net worth?
40
DURATION GAP (Cont.)
Example (cont.) :
AE = - (D
A
D
L
L/A) A AR / (1+R) = -$2.09 million
Thus, E : 10 million 7.91 million
Notice: AA = -D
A
A AR / (1+R) = -$4.55 million
AL = - D
L
L AR / (1+R) = -$2.46 million
41
DURATION GAP (Cont.)
Example (cont.) :
A L A L
100 90 95.45 87.54
10 7.91
Note: Both A and L fall with interest rate rise .
DG = 2.3 years
42
DURATION GAP (Cont.)
Thus,
If DG > 0 and R | bank lose
DG > 0 and R + bank gain
If DG < 0 and R | bank gain
DG < 0 and R + bank lose
Note: this is opposite to GAP = RSA RSL
if GAP > 0 and R | bank gain
Why?
43
DURATION GAP (Cont.)
Why? GAP in $ domain
DG in time domain
Want DG = 0 for fall protection, notice
DG = D
A
D
L
L / A
= D
A
D
L
(A K) / A where K = capital
= D
A
D
L
(1 k) where k = K/A
Duration depends directly on capital ratio!
DG = D
A
D
L
+ D
L
k DG | as k |
44
DURATION GAP (Cont.)
However, bank with more capital is better protected.
To see this, AE = -DG A AR / (1+R)
AE
E
=
-DG
A
E
AR
(1+R)

AE
E
=
-DG
1
k
AR
(1+R)

Thus, the larger the k, the smaller the % change in
equity will be.
45
DURATION GAP (Cont.)
Ex) In previous example,
AE / E = - 2.09 M / 10 M = -20.9%
Ex) Suppose same example except L = 95 M
So, K = 5, and k = 0.05
DG = D
A
D
L
(1 k) = 2.1
AE = - 1.95
E : 5 3.05
AE / E = - 2.15 1/0.05 0.01/1.10 = - 39.1%
or AE / E = -1.95/5 = -39%
46
DURATION GAP
Example: BANK

ASSETS AMT D LIABILITIES AMT D
ST Securities 150 0.5 DD 400 0
LT Securities 100 3.5 ST CDs 350 0.4
Loans Float 400 0 LT CDs 150 2.5
Loans Fixed 350 2 Equity 100
Total 1000 1000
47
DURATION GAP
Example: (continue)
D
A
=0.150.5+0.13.5+0.40+0.352=1.125 year

D
L
= 0+ 0.4+ 2.5=0.572 year

DG = D
A
D
L
= 1.125 0.572 0.9 = 0.6102

400
900

350
900

150
900

L
A

48
DURATION
Example: (continue)

If R = 0.08 0.08 0.09
AE
A

= DG
AR
1 + R

AE
A

= 0.6102 = 0.00565
0.01
1 + 0.08

AE = 0.00565 1000 = 5.65
E from 100 94.35
49
DURATION GAP

Although Duration Gap takes timing
of cash flows into account, there are
problems with its implementation and
use.
50
DURATION GAP
Problems with DG
1. Not easy to manipulate D
A
and D
L
. (reason for
using artificial hedges such as swaps, options, or
futures)
2. Immunization is a DYNAMIC problem. (i.e.,
requires constant rebalancing)
3. Large rate changes and convexity (model only
applies to small changes)
51
DURATION GAP
P
P A
R
R
+
A
1
Model
Actual
We are here
52
DURATION GAP
P
P A
R
R
+
A
1
Actual
Model
AR +
If AR > 0, DG overpredicts P decrease
53
DURATION GAP
If AR < 0, DG underpredicts P increase
P
P A
R
R
+
A
1
Actual
Model
AR
54
DURATION GAP
Problems with DG (Continue)
Convexity =
It can be measured.
Convexity is good for banks. They do better
as a result.
measure of curvature
of duration curve
55
DURATION GAP
Problems with DG (Continue)
4. Flat Term Structure. (Notice all rates R, implies
flat term structure. There are models which
make different assumptions.)
5. Non-Traded Assets. (Small business loans and
consumer loans have no market value estimates
as R changes.)
6. Not consider Default Risk or Prepayment Risk.
56
DURATION GAP
Problems with DG (Continue)
7. Duration of Equity. (Should equity be included?
POSSIBLY.)
To see this, using dividend growth model
d
1
= div in year 1
k = required return
g = growth rate in dividend
P
0
=
d
1
(k g)

57
DURATION GAP
Problems with DG (Continue)
Recall
R
R
D
P
P
+
A
=
A
1
or
P
R
dR
dP
P
R
R
P
R
R
P
P
D
+
=
+
A
A
=
A
+ A
=
1 1 1
but
2
1
) ( g k
d
dk
dP
dR
dP

= =
58
DURATION GAP
Problems with DG (Continue)
So
) (
) 1 (
) (
) 1 (
) (
1
2
1
2
1
g k
d
k
g k
d
P
k
g k
d
D
+

=
+

=
g k
k
D

+
=
1
Example:
Stock with k=10%, g=5%
D

= = 22 years
1.10

0.05

59
DURATION GAP
Problems with DG (Continue)
8. DD and Passbook savings Duration?
Must analyze runoff and turnover as well as rate
elasticity.
60
TYPES OF RISK FOR BANKS
1. Market risk
Equity price
Interest rate
2. Liquidity risk
3. Credit risk (default)
Use of credit derivatives
4. Operation risk
Technology
Processing
Legal
Regulatory
61
How to manage Interest Rate Risk
1. Do nothing
2. Attempt to set GAPs to zero
3. Derivatives
Forward contracts
Interest rate futures contracts (e.g. Eurodollar, TBill)
Option contracts (exchange-traded)
Exotic options (OTC)
4. Interest rate swaps
Plain-vanilla
Exotic