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CHAP_08_ Risk management for changing interest rates

CHAP_08_ Risk management for changing interest rates - RISK...

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William Chittenden edited and updated the PowerPoint slides for this edition. RISK MANAGEMENT FOR CHANGING INTEREST RATE: ASSET-LIABILITY MANAGEMENT DURATION Chapter 8
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Key topics 1. Asset, Liability, and Funds management 2. Market rates and interest-rate risk 3. The goals of interest-rate hedging 4. Interest-sensitive gap management 5. Duration gap management 6. Limitations of hedging techniques 7-2
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Asset-Liability Management The purpose of Asset-Liability management is to control a bank’s sensitivity to changes in market interest rates and limit its losses in its net income or equity. 7-3
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Asset and Liability Management Committee (ALCO) The ALCO’s primary responsibility is interest rate risk management. The ALCO coordinates the bank’s strategies to achieve the optimal risk/reward trade-off.
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Historical view of asset-liability management Asset management strategy (control over assets, no control over liabilities) Liability management strategy (control over liabilities by changing rates and other terms) Funds management strategy (work with both strategies) 7-5
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Interest rate risk: one of the main challenges Forces determining interest rates Loanable funds theory The measurement of interest rates YTM Bank discount Components of interest rates 7-6
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Yield to maturity (YTM) = + = n 1 t t t YTM) (1 CF Price Market 7-7
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Bank discount rate (DR) Maturity to Days # 360 * FV Price Purchase - FV DR = Where: FV equals Face Value of a Security, such as Treasury Bills 7-8
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Market interest rates Function of: Risk-free real rate of interest Various risk premiums Default risk Inflation risk Liquidity risk Call risk Maturity risk 7-9
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Yield curves Graphical picture of relationship between yields and maturities on securities Generally created with treasury securities to keep default risk constant Shape of the yield curve Upward – long-term rates higher than short- term rates Downward – short-term rates higher than long- term rates Horizontal – short-term and long-term rates the same Shape of the yield curve and a maturity gap 7-10
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Net interest margin Assets Earnings Total Expenses Interest - Income Interest NIM = 7-11
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Goal of interest rate hedging One important goal of interest rate hedging is to insulate the bank from the damaging effects of fluctuating interest rates on profits. 7-12
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Quick quiz 1. What forces cause interest rates to change? 2. What makes it so difficult to correctly forecast interest rate changes? 3. What is the yield curve, and why is it important to know about its shape and slope? 4. What is the goal of hedging? First National Bank of Bannerville has posted interest revenues of $63 million and interest costs from all of its borrowings of $42 million. If this bank possesses $700 million in total earning assets, what is First National’s net interest margin? Suppose the bank’s interest revenues and interest costs double, while its earning assets increase by 50%. What will happen to its net interest margin?
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