Managing Interest Rate Risk:

GAP and Earnings Sensitivity

Chapter 5
Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright 2006 by South-Western, a division of Thomson Learning
Interest Rate Risk
Interest Rate Risk
The potential loss from unexpected
changes in interest rates which can
significantly alter a banks profitability
and market value of equity.

Interest Rate Risk: GAP & Earnings
Sensitivity
When a banks assets and liabilities do
not reprice at the same time, the result
is a change in net interest income.
The change in the value of assets and
the change in the value of liabilities will
also differ, causing a change in the
value of stockholders equity

Interest Rate Risk
Banks typically focus on either:
Net interest income or
The market value of stockholders' equity
GAP Analysis
A static measure of risk that is commonly
associated with net interest income (margin)
targeting
Earnings Sensitivity Analysis
Earnings sensitivity analysis extends GAP
analysis by focusing on changes in bank
earnings due to changes in interest rates and
balance sheet composition
Asset and Liability Management
Committee (ALCO)

The ALCOs primary responsibility is
interest rate risk management.
The ALCO coordinates the banks
strategies to achieve the optimal
risk/reward trade-off.


Two Types of Interest Rate Risk
Spread Risk (reinvestment rate risk)
Changes in interest rates will change
the banks cost of funds as well as the
return on their invested assets. They
may change by different amounts.
Price Risk
Changes in interest rates may change
the market values of the banks assets
and liabilities by different amounts.
Interest Rate Risk:
Spread (Reinvestment Rate) Risk
If interest rates change, the bank will have
to reinvest the cash flows from assets or
refinance rolled-over liabilities at a different
interest rate in the future.
An increase in rates, ceteris paribus,
increases a banks interest income but also
increases the banks interest expense.

Static GAP Analysis considers the impact of
changing rates on the banks net interest
income.
Interest Rate Risk:
Price Risk
If interest rates change, the market
values of assets and liabilities also
change.
The longer is duration, the larger is the
change in value for a given change in
interest rates.

Duration GAP considers the impact of
changing rates on the market value of
equity.
Measuring Interest Rate Risk with GAP
Example:
A bank makes a $10,000 four-year car
loan to a customer at fixed rate of
8.5%. The bank initially funds the car
loan with a one-year $10,000 CD at a
cost of 4.5%. The banks initial spread
is 4%.


What is the banks risk?
4 year Car Loan 8.50%
1 Year CD 4.50%
4.00%
Measuring Interest Rate Risk with GAP
Traditional Static GAP Analysis
GAP
t
= RSA
t
-RSL
t
RSA
t
Rate Sensitive Assets
Those assets that will mature or reprice in
a given time period (t)
RSL
t
Rate Sensitive Liabilities
Those liabilities that will mature or reprice
in a given time period (t)
Measuring Interest Rate Risk with GAP
Traditional Static GAP Analysis
What is the banks 1-year GAP with the
auto loan?
RSA
1yr
= $0
RSL
1yr
= $10,000
GAP
1yr
= $0 - $10,000 = -$10,000
The banks one year funding GAP is -10,000
If interest rates rise in 1 year, the banks
margin will fall. The opposite is also true
that if rates fall, the margin will rise.
Measuring Interest Rate Risk with GAP
Traditional Static GAP Analysis
Funding GAP
Focuses on managing net interest
income in the short-run
Assumes a parallel shift in the yield
curve, or that all rates change at the
same time, in the same direction and by
the same amount.
Does this ever happen?
Traditional Static GAP Analysis
Steps in GAP Analysis
Develop an interest rate forecast
Select a series of time buckets or
intervals for determining when assets
and liabilities will reprice
Group assets and liabilities into these
buckets
Calculate the GAP for each bucket
Forecast the change in net interest
income given an assumed change in
interest rates
What Determines Rate Sensitivity (Ignoring
Embedded Options)?
An asset or liability is considered rate
sensitivity if during the time interval:
It matures
It represents and interim, or partial, principal
payment
It can be repriced
The interest rate applied to the outstanding
principal changes contractually during the
interval
The outstanding principal can be repriced
when some base rate of index changes and
management expects the base rate / index to
change during the interval
What are RSAs and RSLs?
Considering a 0-90 day time bucket, RSAs and
RSLs include:
Maturing instruments or principal payments
If an asset or liability matures within 90 days,
the principal amount will be repriced
Any full or partial principal payments within
90 days will be repriced
Floating and variable rate instruments
If the index will contractually change within
90 days, the asset or liability is rate sensitive
The rate may change daily if their base rate
changes.
Issue: do you expect the base rate to
change?
Factors Affecting Net Interest Income
Changes in the level of interest rates
Changes in the composition of assets
and liabilities
Changes in the volume of earning
assets and interest-bearing liabilities
outstanding
Changes in the relationship between
the yields on earning assets and rates
paid on interest-bearing liabilities
Factors Affecting Net Interest Income:
An Example
Consider the following balance sheet:
Assets Yield Liabilities Cost
Rate sensitive 500 $ 8.0% 600 $ 4.0%
Fixed rate 350 $ 11.0% 220 $ 6.0%
Non earning 150 $ 100 $
920 $
Equity
80 $
Total 1,000 $ 1,000 $
GAP = 500 - 600 = -100
NII = (0.08 x 500 + 0.11 x 350) - (0.04 x 600 + 0.06 x 220)
NIM = 41.3 / 850 = 4.86%
NII = 78.5 - 37.2 = 41.3
Expected Balance Sheet for Hypothetical Bank
Examine the impact of the following changes
A 1% increase in the level of all short-term
rates?
A 1% decrease in the spread between
assets yields and interest costs such that
the rate on RSAs increases to 8.5% and the
rate on RSLs increase to 5.5%?
Changes in the relationship between short-
term asset yields and liability costs
A proportionate doubling in size of the
bank.
1% increase in short-term rates
Assets Yield Liabilities Cost
Rate sensitive 500 $ 9.0% 600 $ 5.0%
Fixed rate 350 $ 11.0% 220 $ 6.0%
Non earning 150 $ 100 $
920 $
Equity
80 $
Total 1,000 $ 1,000 $
GAP = 500 - 600 = -100
NII = (0.09 x 500 + 0.11 x 350) - (0.05 x 600 + 0.06 x 220)
NIM = 40.3 / 850 = 4.74%
NII = 83.5 - 43.2 = 40.3
Expected Balance Sheet for Hypothetical Bank
With a negative GAP, more
liabilities than assets reprice
higher; hence NII and NIM fall
1% decrease in the spread
Assets Yield Liabilities Cost
Rate sensitive 500 $ 8.5% 600 $ 5.5%
Fixed rate 350 $ 11.0% 220 $ 6.0%
Non earning 150 $ 100 $
920 $
Equity
80 $
Total 1,000 $ 1,000 $
GAP = 500 - 600 = -100
NII = (0.085 x 500 + 0.11 x 350) - (0.055 x 600 + 0.06 x 220)
NIM = 34.8 / 850 = 4.09%
NII = 81 - 46.2 = 34.8
Expected Balance Sheet for Hypothetical Bank
NII and NIM fall (rise) with a
decrease (increase) in the
spread.
Why the larger change?
Changes in the Slope of the Yield Curve
If liabilities are short-term and assets
are long-term, the spread will
widen as the yield curve increases in
slope
narrow when the yield curve
decreases in slope and/or inverts
Proportionate doubling in size
Assets Yield Liabilities Cost
Rate sensitive 1,000 $ 8.0% 1,200 $ 4.0%
Fixed rate 700 $ 11.0% 440 $ 6.0%
Non earning 300 $ 200 $
1,840 $
Equity
160 $
Total 2,000 $ 2,000 $
GAP = 1000 - 1200 = -200
NII = (0.08 x 1000 + 0.11 x 700) - (0.04 x 1200 + 0.06 x 440)
NIM = 82.6 / 1700 = 4.86%
NII = 157 - 74.4 = 82.6
Expected Balance Sheet for Hypothetical Bank
NII and GAP double, but NIM
stays the same.
What has happened to risk?
Changes in the Volume of Earning Assets and
Interest-Bearing Liabilities
Net interest income varies directly with
changes in the volume of earning
assets and interest-bearing liabilities,
regardless of the level of interest rates
RSAs increase to $540 while fixed-rate assets
decrease to $310 and RSLs decrease to $560
while fixed-rate liabilities increase to $260
Assets Yield Liabilities Cost
Rate sensitive 540 $ 8.0% 560 $ 4.0%
Fixed rate 310 $ 11.0% 260 $ 6.0%
Non earning 150 $ 100 $
920 $
Equity
80 $
Total 1,000 $ 1,000 $
GAP = 540 - 560 = -20
NII = (0.08 x 540 + 0.11 x 310) - (0.04 x 560 + 0.06 x 260)
NIM = 39.3 / 850 = 4.62%
NII = 77.3 - 38 = 39.3
Expected Balance Sheet for Hypothetical Bank
Although the banks GAP
(and hence risk) is lower,
NII is also lower.
Changes in Portfolio Composition and Risk
To reduce risk, a bank with a negative
GAP would try to increase RSAs
(variable rate loans or shorter
maturities on loans and investments)
and decrease RSLs (issue relatively
more longer-term CDs and fewer fed
funds purchased)
Changes in portfolio composition also
raise or lower interest income and
expense based on the type of change
Changes in Net Interest Income are directly
proportional to the size of the GAP
If there is a parallel shift in the yield
curve:

It is rare, however, when the yield
curve shifts parallel
If rates do not change by the same
amount and at the same time, then net
interest income may change by more
or less.
We can figure out how much. How?
exp exp
i GAP NII A =
Summary of GAP and the Change in NII
GAP
Change in
Interest
Income
Change in
Interest
Income
Change in
Interest
Expense
Change in
Net Interest
Income
Positive Increase Increase > Increase Increase
Positive Decrease Decrease > Decrease Decrease
Negative Increase Increase < Increase Decrease
Negative Decrease Decrease < Decrease Increase
Zero Increase Increase = Increase None
Zero Decrease Decrease = Decrease None
GAP Summary
Rate, Volume, and Mix Analysis
Banks often publish a summary of how net
interest income has changed over time.
They separate changes over time to:
shifts in assets and liability
composition and volume
changes associated with movements in
interest rates.
The purpose is to assess what factors
influence shifts in net interest income over
time.
Measuring Interest Rate Risk: Synovus
Interest earned on: Volume Yield/Rate Net Change Volume Yield/Rate Net Change
Taxable loans, net 149,423 $ (117,147) 32,276 161,222 36,390 197,612
Tax-exempt loans, net 1,373 (586) 787 1,108 (450) 658
Taxable investment securities (5,313) (916) (6,229) 4,507 2,570 7,077
Tax-exempt investment securities 2,548 74 2,622 2,026 (206) 1,820
Interest earning deposits with banks 223 (176) 47 28 48 76
Federal funds sold and securities
purchased under resale agreements
406 (1,745) (1,339) 1,447 1,410 2,857
Mortgage loans held for sale 7,801 (1,680) 6,121 (113) 549 436
Total interest income 156,461 (122,176) 34,285 170,225 40,311 210,536
Interest paid on:
Interest bearing demand deposits 6,074 (12,517) (6,443) 1,537 5,433 6,970
Money market accounts 21,380 (36,244) (14,864) 4,654 13,888 18,542
Savings deposits (369) (3,307) (3,676) (660) (67) (727)
Time deposits 32,015 (22,545) 9,470 38,824 32,812 71,636
Federal funds purchased and securities
sold under repurchase agreements
(6,165) (29,744) (35,909) 23,148 15,870 39,018
Other borrowed funds 21,318 (4,272) 17,046 21,960 3,361 25,321
Total interest expense 74,253 (108,629) (34,376) 89,463 71,297 160,760
Net interest income 82,208 (13,547) 68,661 80,762 (30,986) 49,776
2004 Compared to 2003 2003 Compared to 2002
Change Due to * Change Due to *
Interest Rate-Sensitivity Reports
Classifies a banks assets and liabilities into time intervals
according to the minimum number of days until each
instrument is expected to be repriced.
GAP values are reported a periodic and
cumulative basis for each time interval.
Periodic GAP
Is the Gap for each time bucket and
measures the timing of potential income
effects from interest rate changes
Cumulative GAP
It is the sum of periodic GAP's and
measures aggregate interest rate risk over
the entire period
Cumulative GAP is important since it
directly measures a banks net interest
sensitivity throughout the time interval.
Measuring Interest Rate Risk with GAP
1-7
Days
8-30
Days
31-90
Days
91-180
Days
181-365
Days
Over
1 year
Not Rate
Sensitive Total
Assets
U.S. Treas & ag 0.7 3.6 1.2 0.3 3.7 9.5
MM Inv 1.2 1.8 3.0
Municipals 0.7 1.0 2.2 7.6 11.5
FF & Repo's 5.0 5.0
Comm loans 1.0 13.8 2.9 4.7 4.6 15.5 42.5
Install loans 0.3 0.5 1.6 1.3 1.9 8.2 13.8
Cash 9.0 9.0
Other assets 5.7 5.7
Total Assets 6.3 15.0 10.0 10.0 9.0 35.0 14.7 100.0
Liabilities and Equity
MMDA 5.0 12.3 17.3
Super NOW 2.2 2.2
CD's < 100,000 0.9 2.0 5.1 6.9 1.8 2.9 19.6
CD's > 100,000 1.9 4.0 12.9 7.9 1.2 27.9
FF purchased -
NOW 9.6 9.6
Savings 1.9 1.9
DD 13.5 13.5
Other liabilities 1.0 1.0
Equity 7.0 7.0
Total Liab & Eq. 5.0 11.0 30.3 24.4 3.0 4.8 21.5 100.0
Periodic GAP 1.3 4.0 -20.3 -14.4 6.0 30.2
Cumulative GAP 1.3 5.3 -15.0 -29.4 -23.4 6.8
Advantages and Disadvantages of
Static GAP Analysis
Advantages
Easy to understand
Works well with small changes in interest
rates
Disadvantages
Ex-post measurement errors
Ignores the time value of money
Ignores the cumulative impact of interest rate
changes
Typically considers demand deposits to be
non-rate sensitive
Ignores embedded options in the banks
assets and liabilities
Measuring Interest Rate Risk with
the GAP Ratio
GAP Ratio = RSAs/RSLs
A GAP ratio greater than 1 indicates a
positive GAP
A GAP ratio less than 1 indicates a
negative GAP
What is the Optimal GAP
There is no general optimal value for a
bank's GAP in all environments.
Generally, the farther a bank's GAP is
from zero, the greater is the bank's
risk.
A bank must evaluate its overall risk
and return profile and objectives to
determine its optimal GAP

GAP and Variability in Earnings
Neither the GAP nor GAP ratio provide
direct information on the potential variability
in earnings when rates change.
Consider two banks, both with $500 million
in total assets.
Bank A: $3 mil in RSAs and $2 mil in RSLs.
GAP = $1 mil and GAP ratio = 1.5 mil
Bank B: $300 mil in RSAs and $200 mil RSLs.
GAP equals $100 mill and 1.5 GAP ratio.
Clearly, the second bank assumes greater
interest rate risk because its net interest
income will change more when interest rates
change.
Link Between GAP and Net Interest Margin

Many banks will specify a target GAP
to earning asset ratio in the ALCO
policy statements

rates interest in change % Expected
NIM) ted NIM)(Expec in Change % (Allowable
assets Earning
Gap Target
=
Establishing a Target GAP: An Example
Consider a bank with $50 million in
earning assets that expects to
generate a 5% NIM.
The bank will risk changes in NIM
equal to plus or minus 20% during the
year
Hence, NIM should fall between 4% and
6%.

Establishing a Target GAP: An Example
(continued)
If management expects interest rates to vary
up to 4 percent during the upcoming year,
the banks ratio of its 1-year cumulative
GAP (absolute value) to earning assets
should not exceed 25 percent.
Target GAP/Earning assets
= (.20)(0.05) / 0.04 = 0.25
Managements willingness to allow only a 20
percent variation in NIM sets limits on the
GAP, which would be allowed to vary from
$12.5 million to $12.5 million, based on $50
million in earning assets.
Speculating on the GAP
Many bank managers attempt to adjust
the interest rate risk exposure of a
bank in anticipation of changes in
interest rates.
This is speculative because it assumes
that management can forecast rates
better than the market.

Can a Bank Effectively Speculate on the GAP?
Difficult to vary the GAP and win as
this requires consistently accurate
interest rate forecasts
A bank has limited flexibility in
adjusting its GAP; e.g., loan and
deposit terms
There is no adjustment for the timing
of cash flows or dynamics of the
changing GAP position
Earnings Sensitivity Analysis
Allows management to incorporate the
impact of different spreads between
asset yields and liability interest costs
when rates change by different
amounts.
Steps to Earnings Sensitivity Analysis
Forecast future interest rates
Identify changes in the composition of
assets and liabilities in different rate
environments
Forecast when embedded options will be
exercised
Identify when specific assets and liabilities
will reprice given the rate environment
Estimate net interest income and net
income
Repeat the process to compare forecasts of
net interest income and net income across
different interest rate environments.
Earnings Sensitivity Analysis and the
Exercise of Embedded Options
Many bank assets and liabilities
contain different types of options, both
explicit and implicit:
Option to refinance a loan
Call option on a federal agency bond
the bank owns
Depositors have the option to withdraw
funds prior to maturity
Cap (maximum) rate on a floating-rate
loan
Earnings Sensitivity Analysis
Recognizes that Different Interest
Rates Change by Different Amounts
at Different Times
It is well recognized that banks are
quick to increase base loan rates but
are slow to lower base loan rates when
rates fall.
Recall the our example from before:
GAP
1Yr
= $0 - $10,000 = -$10,000
What if rates increased?
1 year GAP Position
4 year Car Loan 8.50%
1 Year CD 4.50%
4.00%
Change in Rates Base Change in Rates
-3 -2 -1 GAP
1yr
+1 +2 +3
-1,000 -2,000 -8,000 -10,000 -10,000 -10,000 -10,000
Re-finance the auto loans All CDs will mature
What about the 3 Month GAP Position?
Base GAP
3m
= $10,000 - $10,000 = 0


3 Month GAP Position
Change in Rates Base Change in Rates
-3 -2 -1 GAP
3m
+1 +2 +3
+8,000 +6,000 +2,000 0 -1,000 -3,000 -6,000
Re-finance auto loans, and
less likely to pull CDs
People will pull the CDs
for higher returns
The implications of embedded options
Does the bank or the customer determine
when the option is exercised?
How and by what amount is the bank being
compensated for selling the option, or how
much must it pay to buy the option?
When will the option be exercised?
This is often determined by the
economic and interest rate environment
Static GAP analysis ignores these
embedded options
Earnings Sensitivity Analysis (Base Case)
Example
Assets
3 Months >3-6 >6-12 >1-3 >3-5 >5-10 >10-20 >20
Total or Less Months Months Years Years Years Years Years
Loans
Prime Based 100,000 100,000
Equity Credit Lines 25,000 25,000
Fixed Rate >1 yr 170,000 18,000 18,000 36,000 96,000 2,000
Var Rate Mtg I Yr 55,000 13,750 13,750 27,500
30-Yr Fix Mortgage 250,000 5,127 5,129 9,329 32,792 28,916 116,789 51,918
Consumer 100,000 6,000 6,000 12,000 48,000 28,000
Credit Card 25,000 3,000 3,000 6,000 13,000
I nvestments
Eurodollars 80,000 80,000
CMOs FixRate 35,000 2,871 2,872 5,224 13,790 5,284 4,959
US Treasury 75,000 5,000 5,000 25,000 40,000
Fed Funds Sold 25,000 25,000
Cash & Due From Banks 15,000 15,000
Loan Loss Reserve -15,000 -15,000
Non-earning Assets 60,000 60,000
Total Assets 1,000,000 278,748 53,751 101,053 228,582 104,200 121,748 51,918 60,000
Earnings Sensitivity Analysis (Base Case)
Example
Liabilities and GAP Measures
3 Months >3-6 >6-12 >1-3 >3-5 >5-10 >10-20 >20
Total or Less Months Months Years Years Years Years Years
Deposits
MMDAs 240,000 240,000
Retail CDs 400,000 60,000 60,000 90,000 160,000 30,000
Savings 35,000 35,000
NOW 40,000 40,000
DDA Personal 55,000 55,000
Comm'l DDA 60,000 24,000 36,000
Borrowings
TT&L 25,000 25,000
L-T notes FR 50,000 50,000
Fed Funds Purch 0
NIR Liabilities 30,000 30,000
Capital 65,000 65,000
Tot Liab & Equity 1,000,000 349,000 60,000 90,000 160,000 30,000 50,000 0 261,000
Swaps- Pay Fixed 50,000 -25,000 -25,000
GAP -20,252 -6,249 11,053 43,582 49,200 71,748 51,918 -201,000
CUMULATIVE GAP -20,252 -26,501 -15,448 28,134 77,334 149,082 201,000 0
Interest Rate
Forecasts
M o s t L i k e l y F o r e c a s t a n d R a t e R a m p s D e c . 2005
P
e
r
c
e
n
t
6
5
4
3
2
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1 1 1
2006
3 5 7 9 1 1 1
2007
3 5 7 9 1 2
F e d F u n d s F o r e c a s t v s . I m p l i e d F o r w a r d R a t e s
T i m e ( m o n t h )
F
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F
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3 . 7 5
3 . 5 0
3 . 2 5
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1 3 5 7 9 1 1 1 3
M a r k e t I m p l i e d R a t e s
M o s t L i k e l y F o r e c a s t
1 5 1 7 1 9 2 1 2 3
2
(.5)
1.0
.5
ALCO Guideline
Board Limit
(1.0)
(1.5)
C
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i
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N
I
I
(
$
M
M
)
(2.0)
(2.5)
(3.0)
- 300 -200 -100 +100 +200 +300 ML
Ramped Change in Rates from Most Likely (Basis Points)
Sensitivity of Earnings: Year Two
1.0
.5
2
ALCO Guideline
Board Limit
(1.0)
(.5)
(1.5)
C
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(2.0)
(2.5)
(3.0)
(3.5)
- 300 -200 -100 +100 +200 +300 ML
Ramped Change in Rates from Most Likely (Basis Point)
Sensitivity of Earnings: Year One
Earnings Sensitivity Analysis Results
For the bank:
The embedded options can potentially
alter the banks cash flows
Interest rates change by different
amounts at different times
Summary results are known as
Earnings-at-Risk or Net Interest
Income Simulation
Earnings Sensitivity Analysis
Earnings-at-Risk
The potential variation in net interest income
across different interest rate environments,
given different assumptions about balance
sheet composition, when embedded options
will be exercised, and the timing of repricings.
Demonstrates the potential volatility in
earnings across these environments
The greater is the potential variation in
earnings (earnings at risk), the greater is
the amount of risk assumed by a bank , or
The greater is the maximum loss, the
greater is risk
Income Statement GAP
Income Statement GAP
Forecasts the change in net interest
income given a 1% rise or fall in the
banks benchmark rate over the next
year.
It converts contractual GAP data to
figures evidencing the impact of a 1%
rate movement.
Income statement GAP is also know in
the industry as Beta GAP analysis
Income Statement GAP Adjusts the
Balance Sheet GAP to Incorporate the
Earnings Change Ratio
The Earnings Change Ratio
This ratio indicates how the yield on
each asset and rate paid on each
liability is assumed to change relative
to a 1 percent move in the benchmark
rate.
Balance Income Balance Income
Sheet Statement Sheet Statement
GAP* GAP GAP* GAP
A B A X B C D C x D
Fixed Rate $5,661 100% $5,661 $5,661 100% $5,661
Floating Rate 3,678 100% 3,678 3,678 100% 3,678
Principal Cash Flows
Agencies 200 71% 142 200 71% 142
Agy Callables 2,940 71% 2,087 300 60% 180
CMO Fixed 315 58% 183 41 51% 21
Fed Funds Sold 2,700 96% 2,592 2,700 96% 2,592
Floating Rate
$15,494 $14,343 $12,580 $12,274
Savings $1,925 75% $1,444 $1,925 5% $96
Money Mkt Accts 11,001 60% 6,601 11,001 40% 4,400
NOW 2,196 80% 1,757 2,196 20% 439
Fed Funds Purch/Repo 0 96% 0 0 96% 0
CDs - IOOM 3,468 85% 2,948 3,468 85% 2,948
CDs < 100M 4,370 84% 3,671 4,370 84% 3,671
$22,960 $16,420 $22,960 $11,554
($7,466) ($2,077) ($10,380) $719
$29,909 $29,909 $29,909 $29,909
-24.96% -6.94% -34.71% 2.40%
($20.8) $7.2
0.07% 0.02%
5.20% 5.20%
1.34% 0.46%
Amounts In Thousands Prime Down 100bp Prime Up 100bp
ECR
t
ECR
t
Rate-Sensitive Assets
Loans
Securities
Total Rate-Sensitive Assets
Rate-Sensitive Liabilities
Total Rate-Sensitive
Liabilities
Rate Sensitivity Gap (Assets-
Liab)
Total Assets
Percentage Change in Net
GAP as a Percent of Total
Assets
Change in Net Interest
Change in Net Interest
Net Interest Margin
I
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o
m
e

S
t
a
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G
A
P

Managing the GAP and Earnings Sensitivity
Risk
Steps to reduce risk
Calculate periodic GAPs over short
time intervals.
Fund repriceable assets with matching
repriceable liabilities so that periodic
GAPs approach zero.
Fund long-term assets with matching
noninterest-bearing liabilities.
Use off-balance sheet transactions to
hedge.
Adjust the Effective Rate Sensitivity of a
Banks Assets and Liabilities
Objective Approaches
Reduce asset
sensitivity
Buy longer-term securities.
Lengthen the maturities of loans.
Move from floating-rate loans to term loans.
Increase asset
sensitivity
Buy short-term securities.
Shorten loan maturities.
Make more loans on a floating-rate basis.
Reduce liability
sensitivity
Pay premiums to attract longer-term deposit
instruments.
Issue long-term subordinated debt.
Increase liability
sensitivity
Pay premiums to attract short-term deposit
instruments.
Borrow more via non-core purchased
liabilities.
Managing Interest Rate Risk:
Duration GAP and Economic Value
of Equity
Chapter 6
Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright 2006 by South-Western, a division of Thomson Learning
Measuring Interest Rate Risk with Duration
GAP
Economic Value of Equity Analysis
Focuses on changes in stockholders
equity given potential changes in
interest rates
Duration GAP Analysis
Compares the price sensitivity of a
banks total assets with the price
sensitivity of its total liabilities to
assess the impact of potential changes
in interest rates on stockholders
equity.
Recall from Chapter 4
Duration is a measure of the effective
maturity of a security.
Duration incorporates the timing and
size of a securitys cash flows.
Duration measures how price sensitive
a security is to changes in interest
rates.
The greater (shorter) the duration, the
greater (lesser) the price sensitivity.
Duration and Price Volatility
Duration as an Elasticity Measure
Duration versus Maturity
Consider the cash flows for these two
securities over the following time line
0 5 10 15 20
$1,000
0 5
900
10 15 20 1
$100
Duration versus Maturity
The maturity of both is 20 years
Maturity does not account for the differences in
timing of the cash flows
What is the effective maturity of both?
The effective maturity of the first security is:
(1,000/1,000) x 20 = 20 years
The effective maturity of the second security is:
[(900/1,000) x 1]+[(100/1,000) x 20] = 2.9 years
Duration is similar, however, it uses a
weighted average of the present values of the
cash flows
Duration versus Maturity
Duration is an approximate measure of
the price elasticity of demand
Price in Change %
Demanded Quantity in Change %
- Demand of Elasticity Price =
Duration versus Maturity
The longer the duration, the larger the
change in price for a given change in
interest rates.

i) (1
i
P
P
- Duration
+
A
A
~
P
i) (1
i
Duration - P
(

+
A
~ A
Measuring Duration
Duration is a weighted average of the
time until the expected cash flows
from a security will be received,
relative to the securitys price
Macaulays Duration

Security the of Price
r) + (1
(t) CF
r) + (1
CF
r) + (1
(t) CF
= D
n
1 = t
t
t
k
1 = t
t
t
k
1 = t
t
t

=
Measuring Duration
Example
What is the duration of a bond with a
$1,000 face value, 10% annual coupon
payments, 3 years to maturity and a
12% YTM? The bonds price is $951.96.


years 2.73 =
951.96
2,597.6

(1.12)
1000
+
(1.12)
100
(1.12)
3 1,000
+
(1.12)
3 100
+
(1.12)
2 100
+
(1.12)
1 100
D
3
1 = t
3 t
3 3 2

1
=

=

Measuring Duration
Example
What is the duration of a bond with a
$1,000 face value, 10% coupon, 3 years
to maturity but the YTM is 5%?The
bonds price is $1,136.16.


years 2.75 =
1,136.16
3,127.31
1136.16
(1.05)
3 * 1,000
+
(1.05)
3 * 100
+
(1.05)
2 * 100
+
(1.05)
1 * 100
D
3 3 2

1
= =
Measuring Duration
Example
What is the duration of a bond with a
$1,000 face value, 10% coupon, 3 years
to maturity but the YTM is 20%?The
bonds price is $789.35.


years 2.68 =
789.35
2,131.95
789.35
(1.20)
3 * 1,000
+
(1.20)
3 * 100
+
(1.20)
2 * 100
+
(1.20)
1 * 100
D
3 3 2

1
= =
Measuring Duration
Example
What is the duration of a zero coupon
bond with a $1,000 face value, 3 years
to maturity but the YTM is 12%?




By definition, the duration of a zero
coupon bond is equal to its maturity


years 3 =
711.78
2,135.34
(1.12)
1,000
(1.12)
3 * 1,000
D
3
3
= =
Duration and Modified Duration
The greater the duration, the greater
the price sensitivity
Modified Duration gives an estimate of
price volatility:


i Duration Modified -
P
P
A ~
A
i) (1
Duration s Macaulay'
Duration Modified
+
=
Effective Duration
Effective Duration
Used to estimate a securitys price
sensitivity when the security contains
embedded options.
Compares a securitys estimated price in
a falling and rising rate environment.
Effective Duration



Where:
P
i-
= Price if rates fall
P
i+
= Price if rates rise
P
0
= Initial (current) price
i
+
= Initial market rate plus the increase in rate
i
-
= Initial market rate minus the decrease in rate
) i (i P
P P
Duration Effective
-
0
i - i
-
-
+
+
=
Effective Duration
Example
Consider a 3-year, 9.4 percent semi-
annual coupon bond selling for $10,000
par to yield 9.4 percent to maturity.
Macaulays Duration for the option-free
version of this bond is 5.36 semiannual
periods, or 2.68 years.
The Modified Duration of this bond is
5.12 semiannual periods or 2.56 years.
Effective Duration
Example
Assume, instead, that the bond is
callable at par in the near-term .
If rates fall, the price will not rise much
above the par value since it will likely
be called
If rates rise, the bond is unlikely to be
called and the price will fall
Effective Duration
Example
If rates rise 30 basis points to 5%
semiannually, the price will fall to
$9,847.72.
If rates fall 30 basis points to 4.4%
semiannually, the price will remain at
par
54 2
0
.
0.044) .05 $10,000(
9,847.72 $ $10,000
Duration Effective = =
-
-
Duration GAP
Duration GAP Model
Focuses on either managing the
market value of stockholders equity
The bank can protect EITHER the
market value of equity or net interest
income, but not both
Duration GAP analysis emphasizes the
impact on equity

Duration GAP
Duration GAP Analysis
Compares the duration of a banks
assets with the duration of the banks
liabilities and examines how the
economic value stockholders equity
will change when interest rates
change.

Two Types of Interest Rate Risk
Reinvestment Rate Risk
Changes in interest rates will change
the banks cost of funds as well as the
return on invested assets
Price Risk
Changes in interest rates will change
the market values of the banks assets
and liabilities
Reinvestment Rate Risk
If interest rates change, the bank will
have to reinvest the cash flows from
assets or refinance rolled-over
liabilities at a different interest rate in
the future
An increase in rates increases a banks
return on assets but also increases the
banks cost of funds
Price Risk
If interest rates change, the value of
assets and liabilities also change.
The longer the duration, the larger the
change in value for a given change in
interest rates
Duration GAP considers the impact of
changing rates on the market value of
equity
Reinvestment Rate Risk and Price Risk
Reinvestment Rate Risk
If interest rates rise (fall), the yield from
the reinvestment of the cash flows
rises (falls) and the holding period
return (HPR) increases (decreases).
Price risk
If interest rates rise (fall), the price falls
(rises). Thus, if you sell the security
prior to maturity, the HPR falls (rises).
Reinvestment Rate Risk and Price Risk
Increases in interest rates will increase
the HPR from a higher reinvestment
rate but reduce the HPR from capital
losses if the security is sold prior to
maturity.
Decreases in interest rates will
decrease the HPR from a lower
reinvestment rate but increase the
HPR from capital gains if the security
is sold prior to maturity.
Reinvestment Rate Risk and Price Risk
An immunized security or portfolio is
one in which the gain from the higher
reinvestment rate is just offset by the
capital loss.
For an individual security,
immunization occurs when an
investors holding period equals the
duration of the security.
Steps in Duration GAP Analysis
Forecast interest rates.
Estimate the market values of bank assets,
liabilities and stockholders equity.
Estimate the weighted average duration of
assets and the weighted average duration of
liabilities.
Incorporate the effects of both on- and off-
balance sheet items. These estimates are
used to calculate duration gap.
Forecasts changes in the market value of
stockholders equity across different
interest rate environments.

Weighted Average Duration of Bank Assets
Weighted Average Duration of Bank
Assets (DA)


Where
w
i
= Market value of asset i divided by
the market value of all bank assets
Da
i
= Macaulays duration of asset i
n = number of different bank assets

=
n
i
i i
Da w DA
Weighted Average Duration of Bank Liabilities
Weighted Average Duration of Bank
Liabilities (DL)


Where
z
j
= Market value of liability j divided by
the market value of all bank liabilities
Dl
j
= Macaulays duration of liability j
m = number of different bank liabilities

=
m
j
j j
Dl z DL
Duration GAP and Economic Value of Equity
Let MVA and MVL equal the market values
of assets and liabilities, respectively.
If:
and
Duration GAP

Then:


where y = the general level of interest
rates
L (MVL/MVA)D - DA DGAP =
MVA
y) (1
y
DGAP - EVE
(

+
A
=
MVL MVA EVE =
Duration GAP and Economic Value of Equity
To protect the economic value of
equity against any change when rates
change , the bank could set the
duration gap to zero:
MVA
y) (1
y
DGAP - EVE
(

+
A
=
1 Par Years Market
$1,000 % Coup Mat. YTM Value Dur.
Assets
Cash $100 100 $
Earning assets
3-yr Commercial loan 700 $ 12.00% 3 12.00% 700 $ 2.69
6-yr Treasury bond 200 $ 8.00% 6 8.00% 200 $ 4.99
Total Earning Assets 900 $ 11.11% 900 $
Non-cash earning assets - $ - $
Total assets 1,000 $ 10.00% 1,000 $ 2.88
Liabilities
Interest bearing liabs.
1-yr Time deposit 620 $ 5.00% 1 5.00% 620 $ 1.00
3-yr Certificate of deposit 300 $ 7.00% 3 7.00% 300 $ 2.81
Tot. Int Bearing Liabs. 920 $ 5.65% 920 $
Tot. non-int. bearing - $ - $
Total liabilities 920 $ 5.65% 920 $ 1.59
Total equity 80 $ 80 $
Total liabs & equity 1,000 $ 1,000 $
Hypothetical Bank Balance Sheet
700
) 12 . 1 (
3 700
) 12 . 1 (
3 84
) 12 . 1 (
2 84
) 12 . 1 (
1 84
3 3 2 1

+

= D
Calculating DGAP
DA
($700/$1000)*2.69 + ($200/$1000)*4.99 = 2.88
DL
($620/$920)*1.00 + ($300/$920)*2.81 = 1.59
DGAP
2.88 - (920/1000)*1.59 = 1.42 years
What does this tell us?
The average duration of assets is greater than the
average duration of liabilities; thus asset values
change by more than liability values.
1 Par Years Market
$1,000 % Coup Mat. YTM Value Dur.
Assets
Cash 100 $ 100 $
Earning assets
3-yr Commercial loan 700 $ 12.00% 3 13.00% 683 $ 2.69
6-yr Treasury bond 200 $ 8.00% 6 9.00% 191 $ 4.97
Total Earning Assets 900 $ 12.13% 875 $
Non-cash earning assets - $ - $
Total assets 1,000 $ 10.88% 975 $ 2.86
Liabilities
Interest bearing liabs.
1-yr Time deposit 620 $ 5.00% 1 6.00% 614 $ 1.00
3-yr Certificate of deposit 300 $ 7.00% 3 8.00% 292 $ 2.81
Tot. Int Bearing Liabs. 920 $ 6.64% 906 $
Tot. non-int. bearing - $ - $
Total liabilities 920 $ 6.64% 906 $ 1.58
Total equity 80 $ 68 $
Total liabs & equity 1,000 $ 975 $
1 percent increase in all rates.
3
3
1 t
t
1.13
700
1.13
84
PV + =

=
Calculating DGAP
DA
($683/$974)*2.68 + ($191/$974)*4.97 = 2.86
DA
($614/$906)*1.00 + ($292/$906)*2.80 = 1.58
DGAP
2.86 - ($906/$974) * 1.58 = 1.36 years
What does 1.36 mean?
The average duration of assets is greater than the
average duration of liabilities, thus asset values
change by more than liability values.
Change in the Market Value of Equity



In this case:
MVA ]
y) (1
y
DGAP[ - EVE
+
A
=
91 12 000 1
10 1
01
. $ , $ ]
.
.
1.42[ - EVE = =
Positive and Negative Duration GAPs
Positive DGAP
Indicates that assets are more price sensitive
than liabilities, on average.
Thus, when interest rates rise (fall), assets will
fall proportionately more (less) in value than
liabilities and EVE will fall (rise) accordingly.
Negative DGAP
Indicates that weighted liabilities are more
price sensitive than weighted assets.
Thus, when interest rates rise (fall), assets will
fall proportionately less (more) in value that
liabilities and the EVE will rise (fall).

DGAP Summary
Assets Liabilities Equity
Positive Increase Decrease > Decrease Decrease
Positive Decrease Increase > Increase Increase
Negative Increase Decrease < Decrease Increase
Negative Decrease Increase < Increase Decrease
Zero Increase Decrease = Decrease None
Zero Decrease Increase = Increase None
DGAP Summary
DGAP
Change in
Interest
Rates
An Immunized Portfolio
To immunize the EVE from rate
changes in the example, the bank
would need to:
decrease the asset duration by 1.42
years or
increase the duration of liabilities by
1.54 years
DA / ( MVA/MVL)
= 1.42 / ($920 / $1,000)
= 1.54 years
1 Par Years Market
$1,000 % Coup Mat. YTM Value Dur.
Assets
Cash 100 $ 100 $
Earning assets
3-yr Commercial loan 700 $ 12.00% 3 12.00% 700 $ 2.69
6-yr Treasury bond 200 $ 8.00% 6 8.00% 200 $ 4.99
Total Earning Assets 900 $ 11.11% 900 $
Non-cash earning assets - $ - $
Total assets 1,000 $ 10.00% 1,000 $ 2.88
Liabilities
Interest bearing liabs.
1-yr Time deposit 340 $ 5.00% 1 5.00% 340 $ 1.00
3-yr Certificate of deposit 300 $ 7.00% 3 7.00% 300 $ 2.81
6-yr Zero-coupon CD* 444 $ 0.00% 6 8.00% 280 $ 6.00
Tot. Int Bearing Liabs. 1,084 $ 6.57% 920 $
Tot. non-int. bearing - $ - $
Total liabilities 1,084 $ 6.57% 920 $ 3.11
Total equity 80 $ 80 $
Immunized Portfolio
DGAP = 2.88 0.92 (3.11) 0
1 Par Years Market
$1,000 % Coup Mat. YTM Value Dur.
Assets
Cash 100.0 $ 100.0 $
Earning assets
3-yr Commercial loan 700.0 $ 12.00% 3 13.00% 683.5 $ 2.69
6-yr Treasury bond 200.0 $ 8.00% 6 9.00% 191.0 $ 4.97
Total Earning Assets 900.0 $ 12.13% 874.5 $
Non-cash earning assets - $ - $
Total assets 1,000.0 $ 10.88% 974.5 $ 2.86
Liabilities
Interest bearing liabs.
1-yr Time deposit 340.0 $ 5.00% 1 6.00% 336.8 $ 1.00
3-yr Certificate of deposit 300.0 $ 7.00% 3 8.00% 292.3 $ 2.81
6-yr Zero-coupon CD* 444.3 $ 0.00% 6 9.00% 264.9 $ 6.00
Tot. Int Bearing Liabs. 1,084.3 $ 7.54% 894.0 $
Tot. non-int. bearing - $ - $
Total liabilities 1,084.3 $ 7.54% 894.0 $ 3.07
Total equity 80.0 $ 80.5 $
Immunized Portfolio with a 1% increase in rates
Immunized Portfolio with a 1% increase in rates
EVE changed by only $0.5 with the
immunized portfolio versus $25.0
when the portfolio was not immunized.
Stabilizing the Book Value of Net Interest Income
This can be done for a 1-year time horizon,
with the appropriate duration gap measure
DGAP* MVRSA(1- DRSA) - MVRSL(1- DRSL)
where:
MVRSA = cumulative market value of RSAs
MVRSL = cumulative market value of RSLs
DRSA = composite duration of RSAs for the
given time horizon
Equal to the sum of the products of each assets
duration with the relative share of its total asset
market value
DRSL = composite duration of RSLs for the
given time horizon
Equal to the sum of the products of each liabilitys
duration with the relative share of its total liability
market value.
Stabilizing the Book Value of Net Interest Income
If DGAP* is positive, the banks net interest
income will decrease when interest rates
decrease, and increase when rates increase.
If DGAP* is negative, the relationship is
reversed.
Only when DGAP* equals zero is interest
rate risk eliminated.
Banks can use duration analysis to stabilize
a number of different variables reflecting
bank performance.
Economic Value of Equity Sensitivity Analysis
Effectively involves the same steps as
earnings sensitivity analysis.
In EVE analysis, however, the bank
focuses on:
The relative durations of assets and
liabilities
How much the durations change in
different interest rate environments
What happens to the economic value of
equity across different rate environments
Embedded Options
Embedded options sharply influence the
estimated volatility in EVE
Prepayments that exceed (fall short of)
that expected will shorten (lengthen)
duration.
A bond being called will shorten duration.
A deposit that is withdrawn early will
shorten duration.
A deposit that is not withdrawn as
expected will lengthen duration.
Book Value Market Value Book Yield Duration*
Loans
Prime Based Ln $ 100,000 $ 102,000 9.00%
Equity Credit Lines $ 25,000 $ 25,500 8.75% -
Fixed Rate > I yr $ 170,000 $ 170,850 7.50% 1.1
Var Rate Mtg 1 Yr $ 55,000 $ 54,725 6.90% 0.5
30-Year Mortgage $ 250,000 $ 245,000 7.60% 6.0
Consumer Ln $ 100,000 $ 100,500 8.00% 1.9
Credit Card $ 25,000 $ 25,000 14.00% 1.0
Total Loans $ 725,000 $ 723,575 8.03% 2.6
Loan Loss Reserve $ (15,000) $ 11,250 0.00% 8.0
Net Loans $ 710,000 $ 712,325 8.03% 2.5
I nvestments
Eurodollars $ 80,000 $ 80,000 5.50% 0.1
CMO Fix Rate $ 35,000 $ 34,825 6.25% 2.0
US Treasury $ 75,000 $ 74,813 5.80% 1.8
Total Investments $ 190,000 $ 189,638 5.76% 1.1
Fed Funds Sold $ 25,000 $ 25,000 5.25% -
Cash & Due From $ 15,000 $ 15,000 0.00% 6.5
Non-int Rel Assets $ 60,000 $ 60,000 0.00% 8.0
Total Assets $ 100,000 $ 100,000 6.93% 2.6
First Savings Bank Economic Value of Equity
Market Value/Duration Report as of 12/31/04
Most Likely Rate Scenario-Base Strategy
A
s
s
e
t
s

Book Value Market Value Book Yield Duration*
Deposits
MMDA $ 240,000 $ 232,800 2.25% -
Retail CDs $ 400,000 $ 400,000 5.40% 1.1
Savings $ 35,000 $ 33,600 4.00% 1.9
NOW $ 40,000 $ 38,800 2.00% 1.9
DDA Personal $ 55,000 $ 52,250 8.0
Comm'l DDA $ 60,000 $ 58,200 4.8
Total Deposits $ 830,000 $ 815,650 1.6
TT&L $ 25,000 $ 25,000 5.00% -
L-T Notes Fixed $ 50,000 $ 50,250 8.00% 5.9
Fed Funds Purch - - 5.25% -
NIR Liabilities $ 30,000 $ 28,500 8.0
Total Liabilities $ 935,000 $ 919,400 2.0
Equity $ 65,000 $ 82,563 9.9
Total Liab & Equity $ 1,000,000 $ 1,001,963 2.6
Off Balance Sheet Notional
lnt Rate Swaps - $ 1,250 6.00% 2.8 50,000
Adjusted Equity $ 65,000 $ 83,813 7.9
First Savings Bank Economic Value of Equity
Market Value/Duration Report as of 12/31/04
Most Likely Rate Scenario-Base Strategy
L
i
a
b
i
l
i
t
i
e
s

Duration Gap for First Savings Bank EVE
Market Value of Assets
$1,001,963
Duration of Assets
2.6 years
Market Value of Liabilities
$919,400
Duration of Liabilities
2.0 years
Duration Gap for First Savings Bank EVE
Duration Gap
= 2.6 ($919,400/$1,001,963)*2.0
= 0.765 years
Example:
A 1% increase in rates would reduce
EVE by $7.2 million
= 0.765 (0.01 / 1.0693) * $1,001,963
Recall that the average rate on assets
is 6.93%
Sensitivity of EVE versus Most Likely (Zero Shock)
Interest Rate Scenario
2
(10.0)
20.0
10.0
8.8 8.2
(8.2)
(20.4)
(36.6)
13.6
ALCO Guideline
Board Limit
(20.0)
(30.0)
C
h
a
n
g
e

i
n

E
V
E

(
m
i
l
l
i
o
n
s

o
f

d
o
l
l
a
r
s
)
(40.0)
-300 -200 -100 +100 +200 +300 0
Shocks to Current Rates
Sensitivity of Economic Value of Equity measures the change in the economic value of
the corporations equity under various changes in interest rates. Rate changes are
instantaneous changes from current rates. The change in economic value of equity is
derived from the difference between changes in the market value of assets and changes
in the market value of liabilities.
Effective Duration of Equity
By definition, duration measures the
percentage change in market value for
a given change in interest rates
Thus, a banks duration of equity
measures the percentage change in
EVE that will occur with a 1 percent
change in rates:
Effective duration of equity
9.9 yrs. = $8,200 / $82,563
Asset/Liability Sensitivity and DGAP
Funding GAP and Duration GAP are NOT
directly comparable
Funding GAP examines various time
buckets while Duration GAP represents
the entire balance sheet.
Generally, if a bank is liability (asset)
sensitive in the sense that net interest
income falls (rises) when rates rise and
vice versa, it will likely have a positive
(negative) DGAP suggesting that assets
are more price sensitive than liabilities, on
average.
Strengths and Weaknesses: DGAP and EVE-
Sensitivity Analysis
Strengths
Duration analysis provides a
comprehensive measure of interest rate
risk
Duration measures are additive
This allows for the matching of total
assets with total liabilities rather than the
matching of individual accounts
Duration analysis takes a longer term
view than static gap analysis
Strengths and Weaknesses: DGAP and EVE-
Sensitivity Analysis
Weaknesses
It is difficult to compute duration
accurately
Correct duration analysis requires that
each future cash flow be discounted by a
distinct discount rate
A bank must continuously monitor and
adjust the duration of its portfolio
It is difficult to estimate the duration on
assets and liabilities that do not earn or
pay interest
Duration measures are highly subjective
Speculating on Duration GAP
It is difficult to actively vary GAP or
DGAP and consistently win
Interest rates forecasts are frequently
wrong
Even if rates change as predicted,
banks have limited flexibility in vary
GAP and DGAP and must often
sacrifice yield to do so
Gap and DGAP Management Strategies
Example
Cash flows from investing $1,000 either
in a 2-year security yielding 6 percent or
two consecutive 1-year securities, with
the current 1-year yield equal to 5.5
percent. 0 1 2
$60 $60
Two-Year Security
0 1 2
$55 ?
One-Year Security & then
another One-Year Security
Gap and DGAP Management Strategies
Example
It is not known today what a 1-year security
will yield in one year.
For the two consecutive 1-year securities to
generate the same $120 in interest, ignoring
compounding, the 1-year security must
yield 6.5% one year from the present.
This break-even rate is a 1-year forward
rate, one year from the present:
6% + 6% = 5.5% + x
so x must = 6.5%
Gap and DGAP Management Strategies
Example
By investing in the 1-year security, a
depositor is betting that the 1-year
interest rate in one year will be greater
than 6.5%
By issuing the 2-year security, the
bank is betting that the 1-year interest
rate in one year will be greater than
6.5%
Yield Curve Strategy
When the U.S. economy hits its peak,
the yield curve typically inverts, with
short-term rates exceeding long-term
rates.
Only twice since WWII has a recession
not followed an inverted yield curve
As the economy contracts, the Federal
Reserve typically increases the money
supply, which causes the rates to fall
and the yield curve to return to its
normal shape.
Yield Curve Strategy
To take advantage of this trend, when
the yield curve inverts, banks could:
Buy long-term non-callable securities
Prices will rise as rates fall
Make fixed-rate non-callable loans
Borrowers are locked into higher rates
Price deposits on a floating-rate basis
Lengthen the duration of assets
relative to the duration of liabilities
Interest Rates and the Business Cycle
The general level of interest rates and the shape of the yield curve
appear to follow the U.S. business cycle.
In expansionary
stages rates rise until
they reach a peak as
the Federal Reserve
tightens credit
availability.
T i m e
I
n
t
e
r
e
s
t
R
a
t
e
s
(
P
e
r
c
e
n
t
)
E x p a n s i o n
C o n t r a c t i o n
E x p a n s i o n
L o n g - T e r m R a t e s
S h o r t - T e r m R a t e s
P e a k
T r o u g h
DATE WHEN 1-YEAR RATE
FIRST EXCEEDS 10-YEAR RATE
LENGTH OF TIME UNTIL
START OF NEXT RECESSION
Apr. 68 20 months (Dec. 69)
Mar. 73 8 months (Nov. 73)
Sept. 78 16 months (Jan. 80)
Sept. 80 10 months (July 81)
Feb. 89 17 months (July 90)
Dec. 00 15 months (March 01)
The inverted yield curve has predicted the last
five recessions
In contractionary
stages rates fall until
they reach a trough
when the U.S.
economy falls into
recession.
Using Derivatives to Manage
Interest Rate Risk
Chapter 7
Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright 2006 by South-Western, a division of Thomson Learning
Derivatives
A derivative is any instrument or
contract that derives its value from
another underlying asset, instrument,
or contract.

Managing Interest Rate Risk
Derivatives Used to Manage Interest
Rate Risk
Financial Futures Contracts
Forward Rate Agreements
Interest Rate Swaps
Options on Interest Rates
Interest Rate Caps
Interest Rate Floors

Characteristics of Financial Futures
Financial Futures Contracts
A commitment, between a buyer and a
seller, on the quantity of a
standardized financial asset or index
Futures Markets
The organized exchanges where
futures contracts are traded
Interest Rate Futures
When the underlying asset is an
interest-bearing security
Characteristics of Financial Futures
Buyers
A buyer of a futures contract is said to
be long futures
Agrees to pay the underlying futures
price or take delivery of the underlying
asset
Buyers gain when futures prices rise
and lose when futures prices fall
Note that prices and interest rates
move inversely, so buyers gain when
rates fall.
Characteristics of Financial Futures
Sellers
A seller of a futures contract is said to
be short futures
Agrees to receive the underlying
futures price or to deliver the
underlying asset
Sellers gain when futures prices fall
and lose when futures prices rise
The same for sellers, so they gain when
rates rise.
Characteristics of Financial Futures
Cash or Spot Market
Market for any asset where the buyer
tenders payment and takes possession
of the asset when the price is set
Forward Contract
Contract for any asset where the buyer
and seller agree on the assets price
but defer the actual exchange until a
specified future date
Characteristics of Financial Futures
Forward versus Futures Contracts
Futures Contracts
Traded on formal exchanges
Examples: Chicago Board of Trade and the
Chicago Mercantile Exchange
Involve standardized instruments
Positions require a daily marking to
market
Positions require a deposit equivalent
to a performance bond
Characteristics of Financial Futures
Forward versus Futures Contracts
Forward contracts
Terms are negotiated between parties
Do not necessarily involve
standardized assets
Require no cash exchange until
expiration
No marking to market

Types of Futures Traders
Speculator
Takes a position with the objective of
making a profit
Tries to guess the direction that prices
will move and time trades to sell (buy)
at higher (lower) prices than the
purchase price.
Types of Futures Traders
Hedger
Has an existing or anticipated position in the
cash market and trades futures contracts to
reduce the risk associated with uncertain
changes in the value of the cash position
Takes a position in the futures market whose
value varies in the opposite direction as the
value of the cash position when rates change
Risk is reduced because gains or losses on
the futures position at least partially offset
gains or losses on the cash position.
Types of Futures Traders
Hedger versus Speculator
The essential difference between a
speculator and hedger is the objective
of the trader.
A speculator wants to profit on trades
A hedger wants to reduce risk
associated with a known or anticipated
cash position
Types of Futures Traders
Commission Brokers
Execute trades for other parties
Locals
Trade for their own account
Locals are speculators
Scalper
A speculator who tries to time price
movements over very short time
intervals and takes positions that
remain outstanding for only minutes
Types of Futures Traders
Day Trader
Similar to a scalper but tries to profit
from short-term price movements
during the trading day; normally
offsets the initial position before the
market closes such that no position
remains outstanding overnight
Position Trader
A speculator who holds a position for a
longer period in anticipation of a more
significant, longer-term market move.
Types of Futures Traders
Spreader versus Arbitrageur
Both are speculators that take
relatively low-risk positions
Futures Spreader
May simultaneously buy a futures
contract and sell a related futures
contract trying to profit on anticipated
movements in the price difference
The position is generally low risk
because the prices of both contracts
typically move in the same direction
Types of Futures Traders
Arbitrageur
Tries to profit by identifying the same asset
that is being traded at two different prices in
different markets at the same time
Buys the asset at the lower price and
simultaneously sells it at the higher price
Arbitrage transactions are thus low risk and
serve to bring prices back in line in the sense
that the same asset should trade at the same
price in all markets

Margin Requirements
Initial Margin
A cash deposit (or U.S. government
securities) with the exchange simply
for initiating a transaction
Initial margins are relatively low, often
involving less than 5% of the
underlying assets value
Maintenance Margin
The minimum deposit required at the
end of each day
Margin Requirements
Unlike margin accounts for stocks,
futures margin deposits represent a
guarantee that a trader will be able to
make any mandatory payment
obligations
Same effect as a performance bond
Margin Requirements
Marking-to-Market
The daily settlement process where at
the end of every trading day, a traders
margin account is:
Credited with any gains
Debited with any losses
Variation Margin
The daily change in the value of margin
account due to marking-to-market
Expiration and Delivery
Expiration Date
Every futures contract has a formal
expiration date
On the expiration date, trading stops
and participants settle their final
positions
Less than 1% of financial futures
contracts experience physical delivery
at expiration because most traders
offset their futures positions in
advance
Example
90-Day Eurodollar Time Deposit
Futures
The underlying asset is a Eurodollar
time deposit with a 3-month maturity.
Eurodollar rates are quoted on an
interest-bearing basis, assuming a 360-
day year.
Each Eurodollar futures contract
represents $1 million of initial face
value of Eurodollar deposits maturing
three months after contract expiration.
Example
90-Day Eurodollar Time Deposit
Futures
Forty separate contracts are traded at
any point in time, as contracts expire
in March, June, September and
December each year
Buyers make a profit when futures
rates fall (prices rise)
Sellers make a profit when futures
rates rise (prices fall)
Example
90-Day Eurodollar Time Deposit
Futures
Contracts trade according to an index
that equals
100% - the futures interest rate
An index of 94.50 indicates a futures rate
of 5.5 percent
Each basis point change in the futures
rate equals a $25 change in value of
the contract (0.001 x $1 million x
90/360)
The first column indicates the
settlement month and year
Each row lists price and yield
data for a distinct futures
contract that expires
sequentially every three
months
The next four columns report
the opening price, high and
low price, and closing
settlement price.
The next column, the change
in settlement price from the
previous day.
The two columns under Yield
convert the settlement price to
a Eurodollar futures rate as:
100 - Settlement Price
= Futures Rate
Eurodollar Futures
Eurodollar (CME)-$1,000,000; pts of 100%
OPEN HIGH LOW SETTLE CHA YIELD CHA
OPEN
INT
Mar 96.98 96.99 96.98 96.99 3.91 823,734
Apr 96.81 96.81 96.81 96.81 _.01 3.19 .01 19,460
June 96.53 96.55 96.52 96.54 3.46 1,409,983
Sept 96.14 96.17 96.13 96.15 _.01 3.05 .01 1,413,496
Dec 95.92 95.94 95.88 95.91 _.01 4.09 .01 1,146,461
Mr06 95.78 95.80 95.74 95.77 _.01 4.23 .01 873,403
June 95.64 95.60 95.62 95.64 _.01 4.34 .01 567,637
Sept 95.37 95.58 95.53 95.54 _.01 4.44 .01 434,034
Dec 95.47 95.50 95.44 95.47 4.53 300,746
Mr07 95.42 95.44 95.37 95.42 4.58 250,271
June 95.31 95.38 95.31 95.37 .01 4.63 _.01 211,664
Sept 95.27 95.32 95.23 95.31 .02 4.69 _.02 164,295
Dec 95.21 95.27 95.18 95.26 .03 4.74 _.03 154,123
Mr08 95.16 95.23 95.11 95.21 .04 4.79 _.04 122,800
June 95.08 95.17 95.07 95.14 .05 4.84 _.05 113,790
Sept 95.03 95.13 95.01 95.11 .06 4.89 _.06 107,792
Dec 94.95 95.06 94.94 95.05 .07 4.95 _.07 96,046
Mr09 94.91 95.02 94.89 95.01 .08 4.99 _.07 81,015
June 94.05 94.97 94.84 94.97 .08 5.03 _.08 76,224
Sept 94.81 94.93 94.79 94.92 .08 5.08 _.08 41,524
Dec 94.77 94.38 94.74 94.87 .08 5.15 _.08 40,594
Mr10 94.77 94.64 94.70 94.83 .09 5.27 _.09 17,481
Sept 94.66 94.76 94.62 94.75 .09 5.25 _.09 9,309
Sp11 94.58 94.60 94.47 94.60 .09 5.40 _.09 2,583
Dec 94.49 94.56 94.43 94.56 .09 5.44 _.09 2,358
Mr12 94.48 94.54 94.41 94.53 .09 5.47 _.09 1,392
Est vol 2,082,746; vol Wed 1,519,709; open int 8,631,643, _160,422.
The Basis
The basis is the cash price of an asset
minus the corresponding futures price
for the same asset at a point in time
For financial futures, the basis can be
calculated as the futures rate minus
the spot rate
It may be positive or negative,
depending on whether futures rates
are above or below spot rates
May swing widely in value far in
advance of contract expiration

4.50




4.09
3.00

1.76



1.09
0
March 10, 2005 August 23, 2005 Expiration
December 20, 2005
B a s i s F u t u r e s R a t e - C a s h R a t e
C a s h R a t e
D e c e m b e r 2005
F u t u r e s R a t e
R
a
t
e

(
P
e
r
c
e
n
t
)

The Relationship Between Futures Rates and
Cash Rates - One Possible Pattern on March 10
Speculation versus Hedging
A speculator takes on additional risk
to earn speculative profits
Speculation is extremely risky
A hedger already has a position in the
cash market and uses futures to adjust
the risk of being in the cash market
The focus is on reducing or avoiding
risk

Speculation versus Hedging
Example
Speculating
You believe interest rates will fall, so
you buy Eurodollar futures
If rates fall, the price of the underlying
Eurodollar rises, and thus the futures
contract value rises earning you a profit
If rates rise, the price of the Eurodollar
futures contract falls in value, resulting in
a loss

Speculation versus Hedging
Example
Hedging
A bank anticipates needing to borrow
$1,000,000 in 60 days. The bank is
concerned that rates will rise in the
next 60 days
A possible strategy would be to short
Eurodollar futures.
If interest rates rise (fall), the short
futures position will increase (decrease)
in value. This will (partially) offset the
increase (decrease) in borrowing costs
Speculation versus Hedging
With financial futures, risk often
cannot be eliminated, only reduced.
Traders normally assume basis risk in
that the basis might change adversely
between the time the hedge is initiated
and closed
Perfect Hedge
The gains (losses) from the futures
position perfectly offset the losses
(gains) on the spot position at each
price
Profit Diagrams for the December 2005
Eurodollar Futures Contract: Mar 10, 2005
Steps in Hedging
Identify the cash market risk exposure to reduce
Given the cash market risk, determine whether a
long or short futures position is needed
Select the best futures contract
Determine the appropriate number of futures
contracts to trade.
Buy or sell the appropriate futures contracts
Determine when to get out of the hedge position,
either by reversing the trades, letting contracts
expire, or making or taking delivery
Verify that futures trading meets regulatory
requirements and the banks internal risk policies
A Long Hedge
A long hedge (buy futures) is appropriate
for a participant who wants to reduce spot
market risk associated with a decline in
interest rates
If spot rates decline, futures rates will
typically also decline so that the value of the
futures position will likely increase.
Any loss in the cash market is at least
partially offset by a gain in futures

Long Hedge Example
On March 10, 2005, your bank expects to
receive a $1 million payment on November
8, 2005, and anticipates investing the funds
in 3-month Eurodollar time deposits
The cash market risk exposure is that the
bank will not have access to the funds for
eight months.
In March 2005, the market expected
Eurodollar rates to increase sharply as
evidenced by rising futures rates.
Long Hedge Example
In order to hedge, the bank should buy
futures contracts
The best futures contract will generally
be the December 2005, 3-month
Eurodollar futures contract, which is
the first to expire after November 2005.
The contract that expires immediately
after the known cash transactions date
is generally best because its futures
price will show the highest correlation
with the cash price.

Long Hedge Example
The time line of the banks hedging
activities would look something like
this:

March 10, 2005 November 8, 2005 December 20, 2005
Cash: Anticipated investment
Futures: Buy a futures contract
Invest $1 million
Sell the futures contract
Expiration of Dec. 2005
futures contract
Long Hedge Example
3.99%
90
360
$1,000,000
$9,975
return Effective = =
Date Cash Market Futures Market Basis
3/10/05 Bank anticipates investing $1 million Bank buys one December 2005 4.09% - 3.00% = 1.09%
(Initial futures in Eurodollars in 8 months; current Eurodollar futures contract at
position) cash rate = 3.00% 4.09%; price = 95.91
11/8/05 Bank invests $1 million in 3 - month Bank sells one December 2005

4.03% - 3.93% = 0.10%
(Close futures Eurodollars at 3.93% Eurodollar futures contract at
position) 4.03%; price = 95.97%
Net effect Opportunity gain: Futures profit: Basis change: 0.10% - 1.09%
3.93% - 3.00% = 0.93%; 4.09% - 4.03% = 0.06%; = - 0.99%
93 basis points worth 6 basis points worth
$25 each = $2,325 $25 each = $150

Cumulative e investment income:
Interest at 3.93% = $1,000,000(.0393)(90/360) = $9,825
Profit from futures trades = $ 150
Total = $9,975
A Short Hedge
A short hedge (sell futures) is appropriate
for a participant who wants to reduce spot
market risk associated with an increase in
interest rates
If spot rates increase, futures rates will
typically also increase so that the value of
the futures position will likely decrease.
Any loss in the cash market is at least
partially offset by a gain in the futures
market
Short Hedge Example
On March 10, 2005, your bank expects
to sell a six-month $1 million
Eurodollar deposit on August 15, 2005
The cash market risk exposure is that
interest rates may rise and the value of
the Eurodollar deposit will fall by
August 2005
In order to hedge, the bank should sell
futures contracts
Short Hedge Example
The time line of the banks hedging
activities would look something like
this:

March 10, 2005 August 17, 2005 September 20, 2005
Cash: Anticipated sale of
investment
Futures: Sell a futures contract
Sell $1 million Eurodollar
Deposit
Buy the futures contract
Expiration of Sept. 2005
futures contract
Short Hedge Example
Date Cash Market Futures Market Basis
3/10/05 Bank anticipates selling Bank sells one Sept. 3.85% - 3.00% = 0.85%
$1 million Eurodollar 2005 Eurodollar futures
deposit in 127 days; contract at 3.85%;
current cash rate price = 96.15
= 3.00%
8/17/05 Bank sells $1 million Bank buys one Sept. 4.14% - 4.00% = 0.14%
Eurodollar deposit at 2005 Eurodollar futures
4.00% contract at 4.14%;
price = 95.86
Net result: Opportunity loss. Futures profit: Basis change: 0.14% - 0.85%
4.00% - 3.00% = 1.00%; 4.14% - 3.85% 3 0.29%; =-0.71%
100 basis points worth 29 basis points worth
$25 each = $2,500 $25 each = $725

Effective loss = $2,500 - $725 = $1,775
Effective rate at sale of deposit = 4.00% - 0.29% = 3.71%
or 3.00% - (0.71%) = 3.71%
Change in the Basis
Long and short hedges work well if the
futures rate moves in line with the spot
rate
The actual risk assumed by a trader in
both hedges is that the basis might
change between the time the hedge is
initiated and closed
In the long hedge position above, the
spot rate increased by 0.93% while the
futures rate fell by 0.06%. This caused
the basis to fall by 0.99% (The basis
fell from 1.09% to 0.10%, or by 0.99%)
Change in the Basis
Effective Return from a Hedge
Total income from the combined cash
and futures positions relative to the
investment amount
Effective return
Initial Cash Rate - Change in Basis
In the long hedge example:
3.00% - (-0.99%) = 3.99%
Basis Risk and Cross Hedging
Cross Hedge
Where a trader uses a futures contract
based on one security that differs from
the security being hedged in the cash
market
Example
Using Eurodollar futures to hedge changes
in the commercial paper rate
Basis risk increases with a cross
hedge because the futures and spot
interest rates may not move closely
together
Microhedging Applications
Microhedge
The hedging of a transaction
associated with a specific asset,
liability or commitment
Macrohedge
Taking futures positions to reduce
aggregate portfolio interest rate risk
Microhedging Applications
Banks are generally restricted in their
use of financial futures for hedging
purposes
Banks must recognize futures on a
micro basis by linking each futures
transaction with a specific cash
instrument or commitment
Many analysts feel that such micro
linkages force microhedges that may
potentially increase a firms total risk
because these hedges ignore all other
portfolio components
Creating a Synthetic Liability with a Short Hedge
3/10/05 7/3/05 9/30/05
Six-Month Deposit
Time Line
Three-Month Cash Eurodollar
3.25%
Synthetic
Six-Month Deposit
3.00%
3.88%
-0.48%
3.40%
Three-Month Synthetic Eurodollar
Profit =
All In Six-Month Cost = 3.20%
Creating a Synthetic Liability with a Short Hedge
Summary of Relevant Eurodollar Rates and Transactions
March 10, 2005
3-month cash rate = 3.00%; bank issues a $1 million, 91-day Eurodollar deposit
6-month cash rate = 3.25%
Bank sells one September 2005 Eurodollar futures; futures rate = 3.85%
July 3, 2005
3-month cash rate = 3.88%; bank issues a $1 million, 91-day Eurodollar deposit
Buy: One September 2005 Eurodollar futures; futures rate = 4.33%


Date Cash Market Futures Market Basis
3/10/05 Bank issues $1 million, 91-day Eurodollar time deposit Bank sells one September 2005 0.85%

at 3.00%; 3-mo. interest expense = $7,583. Eurodollar futures contract at 3.85%

7/3/05 Bank issues $1 million, 91-day Eurodollar time deposit Bank buys one September 2005 0.45%

at 3.88%; 3-mo. interest expense = $9,808 (increase
in interest expense over previous period = $2,225).
Eurodollar futures contract at 4.33%;

Net effect: 6-mo. interest expense = $17,391 Profit on futures = $1,200

3.20%
182
360
$1,000,000
$1,200 - $17,391
cost borrowing Effective = =

Interest on 6-month Eurodollar deposit issued March 10 = $13,144 at 3.25%; vs. 3.20% from synthetic liability
The Mechanics of Applying a Microhedge
1. Determine the banks interest rate
position
2. Forecast the dollar flows or value
expected in cash market transactions
3. Choose the appropriate futures
contract

The Mechanics of Applying a Microhedge
4. Determine the correct number of futures
contracts

Where
NF = number of futures contracts
A = Dollar value of cash flow to be hedged
F = Face value of futures contract
Mc = Maturity or duration of anticipated cash
asset or liability
Mf = Maturity or duration of futures contract

b
Mf F
Mc A
NF

=

contract futures on movement rate Expected
instrument cash on movement rate Expected
b =
The Mechanics of Applying a Microhedge
5. Determine the Appropriate Time
Frame for the Hedge
6. Monitor Hedge Performance

Macrohedging
Macrohedging
Focuses on reducing interest rate risk
associated with a banks entire
portfolio rather than with individual
transactions
Macrohedging
Hedging: GAP or Earnings Sensitivity
If GAP is positive, the bank is asset sensitive
and its net interest income rises when
interest rates rise and falls when interest
rates fall
If GAP is negative, the bank is liability
sensitive and its net interest income falls
when interest rates rise and rises when
interest rates fall

Positive GAP
Use a long hedge
Negative GAP
Use a short hedge
Hedging: GAP or Earnings Sensitivity
Positive GAP
Use a long hedge
If rates rise, the banks higher net
interest income will be offset by losses
on the futures position
If rates fall, the banks lower net
interest income will be offset by gains
on the futures position

Hedging: GAP or Earnings Sensitivity
Negative GAP
Use a short hedge
If rates rise, the banks lower net
interest income will be offset by gains
on the futures position
If rates fall, the banks higher net
interest income will be offset by losses
on the futures position
Hedging: Duration GAP and EVE Sensitivity
To eliminate interest rate risk, a bank
could structure its portfolio so that its
duration gap equals zero


MVA ]
y) (1
y
DGAP[ - EVE
+
A
=
Hedging: Duration GAP and EVE Sensitivity
Futures can be used to adjust the
banks duration gap
The appropriate size of a futures
position can be determined by solving
the following equation for the market
value of futures contracts (MVF), where
DF is the duration of the futures
contract

0
i 1
DF(MVF)
i 1
DL(MVRSL)
i 1
DA(MVRSA)
f l a
=
+
+
+

+
Hedging: Duration GAP and EVE Sensitivity
Example:
A bank has a positive duration gap of
1.4 years, therefore, the market value
of equity will decline if interest rates
rise. The bank needs to sell interest
rate futures contracts in order to hedge
its risk position
The short position indicates that
the bank will make a profit if futures
rates increase

Hedging: Duration GAP and EVE Sensitivity
Example:
Assume the bank uses a Eurodollar
futures contract currently trading at
4.9% with a duration of 0.25 years, the
target market value of futures
contracts (MVF) is:



MVF = $4,024.36, so the bank should
sell four Eurodollar futures contracts
0
(1.049)
0.25(MVF)
(1.06)
1.61($920)
(1.10)
2.88($900)
= +
Hedging: Duration GAP and EVE Sensitivity
Example:
If all interest rates increased by 1%, the
profit on the four futures contracts
would total 4 x 100 x $25 = $10,000,
which partially offset the $12,000
decrease in the economic value of
equity associated with the increase in
cash rates
Recall from Exhibit 6.2, the unhedged
bank had a reduction in EVE of $12,000
Accounting Requirements and Tax Implications
Regulators generally limit a banks use of
futures for hedging purposes
If a bank has a dealer operation, it can use
futures as part of its trading activities
In such accounts, gains and losses on these
futures must be marked-to-market, thereby
affecting current income
Microhedging
To qualify as a hedge, a bank must show that
a cash transaction exposes it to interest rate
risk, a futures contract must lower the banks
risk exposure, and the bank must designate
the contract as a hedge
Using Forward Rate Agreements to Manage
Interest Rate Risk
Forward Rate Agreements
A forward contract based on interest rates based on a
notional principal amount at a specified future date
Buyer
Agrees to pay a fixed-rate coupon payment (at the
exercise rate) and receive a floating-rate payment
Seller
Agrees to make a floating-rate payment and receive a
fixed-rate payment
The buyer and seller will receive or pay cash when
the actual interest rate at settlement is different
than the exercise rate
Forward Rate Agreements (FRA)
Similar to futures but differ in that
they:
Are negotiated between parties
Do not necessarily involve
standardized assets
Require no cash exchange until
expiration
There is no marking-to-market
No exchange guarantees performance
Notional Principal
The two counterparties to a forward
rate agreement agree to a notional
principal amount that serves as a
reference figure in determining cash
flows.
Notional
Refers to the condition that the
principal does not change hands, but is
only used to calculate the value of
interest payments.
Notional Principal
Buyer
Agrees to pay a fixed-rate coupon
payment and receive a floating-rate
payment against the notional principal
at some specified future date.
Seller
Agrees to pay a floating-rate payment
and receive the fixed-rate payment
against the same notional principal.
Example: Forward Rate Agreements
Suppose that Metro Bank (as the
seller) enters into a receive fixed-
rate/pay floating-rating forward rate
agreement with County Bank (as the
buyer) with a six-month maturity
based on a $1 million notional
principal amount
The floating rate is the 3-month LIBOR
and the fixed (exercise) rate is 7%
Example: Forward Rate Agreements
Metro Bank would refer to this as a 3 vs. 6
FRA at 7 percent on a $1 million notional
amount from County Bank
The phrase 3 vs. 6 refers to a 3-month
interest rate observed three months from
the present, for a security with a maturity
date six months from the present
The only cash flow will be determined in six
months at contract maturity by comparing
the prevailing 3-month LIBOR with 7%
Example: Forward Rate Agreements
Assume that in three months 3-month
LIBOR equals 8%
In this case, Metro Bank would receive from
County Bank $2,451.
The interest settlement amount is $2,500:
Interest = (.08 - .07)(90/360) $1,000,000 = $2,500.
Because this represents interest that would
be paid three months later at maturity of the
instrument, the actual payment is discounted
at the prevailing 3-month LIBOR:
Actual interest = $2,500/[1+(90/360).08]=$2,451
Example: Forward Rate Agreements
If instead, LIBOR equals 5% in three
months, Metro Bank would pay County
Bank:
The interest settlement amount is $5,000
Interest = (.07 -.05)(90/360) $1,000,000 = $5,000
Actual interest = $5,000 /[1 + (90/360).05] = $4,938
Example: Forward Rate Agreements
The FRA position is similar to a
futures position
County Bank would pay fixed-
rate/receive floating-rate as a hedge if
it was exposed to loss in a rising rate
environment.
This is analogous to a short futures
position
Example: Forward Rate Agreements
The FRA position is similar to a
futures position
Metro Bank would take its position as a
hedge if it was exposed to loss in a
falling (relative to forward rate) rate
environment.
This is analogous to a long futures
position
Basic Interest Rate Swaps
Basic or Plain Vanilla Interest Rate
Swap
An agreement between two parties to
exchange a series of cash flows based
on a specified notional principal
amount
Two parties facing different types of
interest rate risk can exchange interest
payments
Basic Interest Rate Swaps
Basic or Plain Vanilla Interest Rate
Swap
One party makes payments based on a
fixed interest rate and receives floating
rate payments
The other party exchanges floating rate
payments for fixed-rate payments
When interest rates change, the party
that benefits from a swap receives a
net cash payment while the party that
loses makes a net cash payment
Basic Interest Rate Swaps
Conceptually, a basic interest rate
swap is a package of FRAs
As with FRAs, swap payments are
netted and the notional principal never
changes hands
Basic Interest Rate Swaps
Using data for a 2-year swap based on
3-month LIBOR as the floating rate
This swap involves eight quarterly
payments.
Party FIX agrees to pay a fixed rate
Party FLT agrees to receive a fixed rate
with cash flows calculated against a
$10 million notional principal amount

Basic Interest Rate Swaps
Basic Interest Rate Swaps
Firms with a negative GAP can reduce
risk by making a fixed-rate interest
payment in exchange for a floating-rate
interest receipt
Firms with a positive GAP take the
opposite position, by making floating-
interest payments in exchange for a
fixed-rate receipt
Basic Interest Rate Swaps
Basic interest rate swaps are used to:
Adjust the rate sensitivity of an asset
or liability
For example, effectively converting a
fixed-rate loan into a floating-rate loan
Create a synthetic security
For example, enter into a swap instead
of investing in a security
Macrohedge
Use swaps to hedge the banks
aggregate interest rate risk
Basic Interest Rate Swaps
Swap Dealers
Handle most swap transactions
Make a market in swap contracts
Offer terms for both fixed-rate and
floating rate payers and earn a spread for
their services
Basic Interest Rate Swaps
Comparing Financial Futures, FRAs,
and Basic Swaps



There is some credit risk with swaps in
that the counterparty may default on
the exchange of the interest payments
Only the interest payment exchange is
at risk, not the principal
Objective Financial Futures FRAs & Basic Swaps
Profit If Rates Rise Sell Futures Pay Fixed, Receive Floating
Profit If Rates Fall Buy Futures Pay Floating, Receive Fixed
Position
Interest Rate Caps and Floors
Interest Rate Cap
An agreement between two
counterparties that limits the buyers
interest rate exposure to a maximum
limit
Buying a interest rate cap is the same
as purchasing a call option on an
interest rate
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4 Percent
A. Cap 5 Long Call Opt ion on Three-Mont h LIBOR
Dollar Payout
(Three-month LIBOR
- 4%) 3 Notional
Principal Amount
1C
Three-Month
LIBOR
Value
Date
Value
Date
Value
Date
Time
B. Cap Payoff: St rike Rat e5 4 Percent *
Value
Date
Value
Date
Floating
Rate
Rat e
4 Percent
Interest Rate Caps and Floors
Interest Rate Floor
An agreement between two
counterparties that limits the buyers
interest rate exposure to a minimum
rate
Buying an interest rate floor is the
same as purchasing a put option on an
interest rate
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4 Percent
A. Floor = Long Put Opt ion on Three-Mont h LIBOR
Dollar Payout
(4%- Three-month
LIBOR) X Notional
Principal Amount
1P
Three-Month
LIBOR
Value
Date
Value
Date
Value
Date
Time
B. Floor Payoff: St rike Rat e= 4 Percent *
Value
Date
Value
Date
Floating
Rate
Rat e
4 Percent
Interest Rate Caps and Floors
Interest Rate Collar
The simultaneous purchase of an
interest rate cap and sale of an interest
rate floor on the same index for the
same maturity and notional principal
amount
A collar creates a band within which
the buyers effective interest rate
fluctuates
It protects a bank from rising interest
rates
Interest Rate Caps and Floors
Zero Cost Collar
A collar where the buyer pays no net
premium
The premium paid for the cap equals
the premium received for the floor
Reverse Collar
Buying an interest rate floor and
simultaneously selling an interest rate
cap
It protects a bank from falling interest
rates
Pricing Interest Rate Caps and Floors
The size of the premiums for caps and
floors is determined by:
The relationship between the strike
rate an the current index
This indicates how much the index
must move before the cap or floor is in-
the-money
The shape of yield curve and the
volatility of interest rates
With an upward sloping yield curve,
caps will be more expensive than floors
Pricing Interest Rate Caps and Floors
Term Bid Offer Bid Offer Bid Offer
Caps
1 year 24 30 3 7 1 2
2 years 51 57 36 43 10 15
3 years 105 115 74 84 22 29
5 years 222 240 135 150 76 5
7 years 413 433 201 324 101 116
10 years 549 573 278 308 157 197
Floors
1 year 1 2 15 19 57 55
2 years 1 6 31 37 84 91
3 years 7 16 40 49 128 137
5 years 24 39 75 88 190 205
7 years 38 60 92 106 228 250
10 years 85 115 162 192 257 287
1.50% 2.00% 2.50%
A. Caps/Floors
4.00% 5.00% 6.00%