Ch_08_EVE - Managing Interest Rate Risk Economic Value of...

Managing Interest Rate
Risk: Economic Value of
Equity
11

Managing Interest Rate Risk:
Economic Value of Equity
n
Economic Value of Equity (EVE)
Analysis
n
Focuses on changes in stockholders’
equity given potential changes in
interest rates
22

Managing Interest Rate Risk:
Economic Value of Equity
n
Duration GAP Analysis
n
Compares the price sensitivity of a
bank’s total assets with the price
sensitivity of its total liabilities to
assess the impact of potential changes
in interest rates on stockholders’
equity
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Managing Interest Rate Risk:
Economic Value of Equity
n
GAP and Earnings Sensitivity versus
Duration GAP and EVE Sensitivity
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Managing Interest Rate Risk:
Economic Value of Equity
n
Recall from Chapter 6
n
Duration is a measure of the effective
maturity of a security
n
Duration incorporates the timing and
size of a security’s cash flows
n
Duration measures how price sensitive
a security is to changes in interest
rates
§
The greater (shorter) the duration, the
greater (lesser) the price sensitivity
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Managing Interest Rate Risk:
Economic Value of Equity
n
Market Value Accounting Issues
n
EVE sensitivity analysis is linked with
the debate concerning whether market
value accounting is appropriate for
financial institutions
n
Recently many large commercial and
investment banks reported large write-
downs of mortgage-related assets,
which depleted their capital
n
Some managers argued that the write-
downs far exceeded the true decline in
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77

Measuring Interest Rate Risk with
Duration GAP
n
Duration GAP Analysis
n
Compares the price sensitivity of a
bank’s total assets with the price
sensitivity of its total liabilities to
assess whether the market value of
assets or liabilities changes more
when rates change
88

Measuring Interest Rate Risk with
Duration GAP
n
Duration, Modified Duration, and
Effective Duration
n
Macaulay’s Duration (D)
where P* is the initial price, i is the market
interest rate, and t is equal to the time until the
cash payment is made
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×
+
=
n
*
) 1 (
Cashflow
D
t
t
t
P
t
i

Measuring Interest Rate Risk with
Duration GAP
n
Duration, Modified Duration, and
Effective Duration
n
Macaulay’s Duration (D)
n
Macaulay’s duration is a measure of
price sensitivity where P refers to the
price of the underlying security:
1010
Δi
i) (1
D
P
ΔP
×
+
- 2245

Measuring Interest Rate Risk with
Duration GAP
n
Duration, Modified Duration, and
Effective Duration
n
Modified Duration
n
Indicates how much the price of a
security will change in percentage
terms for a given change in interest
rates
Modified Duration = D/(1+i)
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