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

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Managing Interest Rate Risk: Economic Value of Equity 11
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Managing Interest Rate Risk: n Economic Value of Equity (EVE) Analysis n Focuses on changes in stockholders’ equity given potential changes in interest rates 22
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Managing Interest Rate Risk: 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 33
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Managing Interest Rate Risk: n GAP and Earnings Sensitivity versus Duration GAP and EVE Sensitivity 44
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Managing Interest Rate Risk: 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 55
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Managing Interest Rate Risk: 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 66
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Measuring Interest Rate Risk with 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
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Measuring Interest Rate Risk with 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 99 × + = n * ) 1 ( Cashflow D t t t P t i
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Measuring Interest Rate Risk with 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
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Measuring Interest Rate Risk with 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) 1111
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n Duration, Modified Duration, and Effective Duration n Example n Assume that a ten-year zero coupon bond has a par value of $10,000, current price of $7,835.26, and a market rate of interest of 5%. What is the expected change in the bond’s price if interest rates fall by 25 basis points? 1212
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Ch_08_EVE - Managing Interest Rate Risk: Economic Value of...

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