Lecture_7 - FINN 3225 Commercial Bank Management Lecture 7 Managing IRR Economic Value of Equity UNC Charlotte October 1st 2014(UNC Charlotte FINN 3225

Lecture_7 - FINN 3225 Commercial Bank Management Lecture 7...

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FINN 3225 - Commercial Bank Management Lecture 7 - Managing IRR: Economic Value of Equity UNC Charlotte October 1st, 2014 (UNC Charlotte) FINN 3225 - Commercial Bank Management October 1st, 2014 1 / 23
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Duration Gap Analysis We use duration gap to try to estimate changes in a bank’s economic value of equity or EVE EVE is just the market value of assets minus the market value of liabilities A bank with $ 100M in market value of assets and $ 90M in market value of liabilities has EVE of $ 10M If rates increase and market value of assets drops to $ 96M and market value of liabilities drops to $ 88M, then EVE will drop to $ 8M (UNC Charlotte) FINN 3225 - Commercial Bank Management October 1st, 2014 2 / 23
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Duration Gap Analysis (cont’d) Three different measures of duration: 1 Macaulay’s duration D = n t [ CF t / ( 1 + i ) t ] × t P * Δ P P ≈ - D ( 1 + i ) × Δ i 2 Modified duration D / ( 1 + i ) 3 Effective duration Eff Dur = P i - - P i + P 0 ( i + - i - ) P i - is price if rates fall, P i + is price of rates increase, P 0 is current price, i + is initial rate plus increase, i - is initial rate minus fall Helpful for bonds with embedded options (UNC Charlotte) FINN 3225 - Commercial Bank Management October 1st, 2014 3 / 23
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Duration Gap Analysis (cont’d) To conduct duration gap analysis, we: 1 forecast interest rates 2 estimate the market value of all bank assets, liabilities, and EVE 3 estimate the weighted average duration of assets and weighted average duration of liabilities; use these to estimate duration gap 4 forecast changes in EVE across different interest rate environments (UNC Charlotte) FINN 3225 - Commercial Bank Management October 1st, 2014 4 / 23
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Duration Gap Analysis (cont’d) Duration of assets: DA = n i w i D a i w i = A i / MVA : weight for asset i is the size of asset i relative to total market value of n total assets D a i is duration of asset i Duration of liabilities: DL = m j w j D l j w j = L j / MVL : weight for liability j is the size of liability j relative to total market value of m total liabilities D l j is duration of asset j (UNC Charlotte) FINN 3225 - Commercial Bank Management October 1st, 2014 5 / 23
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Duration Gap Analysis (cont’d) Once we calculate EVE, we can get the change in EVE as Δ EVE = Δ MVA - Δ MVL We can estimate the change in the market value of
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