Ch. 24 - Note: These notes should at best be considered the...

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Note: These notes should at best be considered the outline or summary of lectures delivered in class. Class lectures contain much more material than these notes indicate . Risk Management Unlike industrial firms, so much of FIs’ assets and liabilities are in securities whose value is affected by interest rates. Also, so much of their earnings and costs result from interest they earn or pay. Thus, when interest rates change they caused substantial changes in FIs’ income and equity value (net worth). An FI therefore is exposed to the risk of interest rate changes. There are two widely-used approaches to measuring the risk of interest rate changes. If one wants to measure the impact of interest rates on the FI’s income, one uses the Income Gap (IG) method – this method uses the book value of assets and liabilities, which is the accounting approach. If one wants to measure the impact on the market value of the FI’s equity, one uses the Duration Gap (DG) method. IG method : Interest rates on some assets and liabilities are set within one year, some within two years, and so on. What determines when rates are reset involves in most cases the maturity of the security – e.g., a loan that is renewable once a year. There are, however, securities that do not mature for many years, yet their rates are reset, e.g., every 6 months – such as a mortgage with ARM. Things a re more complicated than that: There are also securities whose rates are not reset throughout the life of the security –e.g., a 30-year fixed-rate mortgage that has just been issued. But such a mortgage can be repaid and refinanced at a different rate long before maturity – even within the first year; that becomes more likely if interest rates are dropping significantly. Such
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Ch. 24 - Note: These notes should at best be considered the...

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