CHAPTER 7ASSET-LIABILITY MANAGEMENT: DETERMINING AND MEASURING INTEREST RATES AND CONTROLLING INTEREST-SENSITIVE AND DURATION GAPSGoals of This Chapter: The purpose of this chapter is to explore the options bankers have today for dealing with risk especially the risk of loss due to changing interest rates and to see how a banks management can coordinate the management of its assets with the management of its liabilities in order to achieve the institutions goals. Key Topic In This Chapter Asset, Liability, and Funds Management Market Rates and Interest Rate Risk The Goals of Interest Rate Hedging Interest Sensitive Gap Management Duration Gap Management Limitations of Hedging TechniquesChapter OutlineI.Introduction: The Necessity for Coordinating Bank Asset and Liability Management DecisionsII.Asset/Liability Management StrategiesA.Asset Management StrategyB.Liability Management StrategyC.Funds Management StrategyIII.Interest Rate Risk: One of the Greatest Asset-Liability Management Strategy ChallengesA.Forces Determining Interest RatesB.The Measurement of Interest Rates1.Yield to Maturity2.Bank Discount RateC. The Components of Interest Rates1.Risk Premiums2.Yield Curves3.The Maturity Gap and the Yield CurveD.Response to Interest Rate RiskIV.One of the Goals of Interest-Rate HedgingA.The Net Interest MarginB.Interest-Sensitive Gap Management1.Asset-Sensitive Position2.Liability-Sensitive Position3.Dollar Interest-Sensitive Gap4.Relative Interest Sensitive Gap5.Interest Sensitivity Ratio6.Computer-Based Techniques 7.Cumulative Gap8.Strategies in Gap ManagementC. Duration Gap ManagementV.The Concept of DurationA. Definition of DurationB. Calculation of DurationC. Net Worth and DurationD. Price Risk and DurationE. Convexity and DurationVI.Using Duration to Hedge Against Interest-Rate RiskA.Duration Gap1.Dollar Weighted Duration of Assets2.Dollar Weighted Duration of Liabilities3.Positive Duration Gap4.Negative Duration GapB.Change in the Banks Net WorthVII.The Limitations of Duration Gap ManagementVIII.Summary of the ChapterConcept Checks7-1.What do the following terms mean: Asset management? Liability management? Funds management?Asset management refers to a banking strategy where management has control over the allocation of bank assets but believes the banks sources of funds (principally deposits) are outside its control. Liability management is a strategy of control over bank liabilities by varying interest rates offered on borrowed funds. Funds management combines both asset and liability management approaches into a balanced liquidity management strategy.7-2.What factors have motivated financial institutions to develop funds management techniques in recent years?The necessity to find new sources of funds in the 1970s and the risk management problems encountered with troubled loans and volatile interest rates in the 1970s and 1980s led to the concept of planning and control over both sides of a banks balance sheet - the essence of funds management.7-3.What forces cause interest rates to change? What kinds of risk do financial firms face when interest rates change?Interest rates are determined, not by individual banks, but by the collective borrowing and lending decisions of thousands of participants in the money and capital markets. They are also impacted by changing perceptions of risk by participants in the money and capital markets, especially the risk of borrower default, liquidity risk, price risk, reinvestment risk, inflation risk, term or maturity risk, marketability risk, and call risk.Financial institutions can lose income or value no matter which way interest rates go. Rising interest rates can lead to losses on security instruments and on fixed-rate loans as the market values of these instruments fall. Falling interest rates will usually result in capital gains on fixed-rate securities and loans but an institution will lose income if it has more rate-sensitive assets than liabilities. Rising interest rates will also cause a loss to income if an institution has more rate-sensitive liabilities than rate-sensitive assets.7-4.What makes it so difficult to correctly forecast interest rate changes?Interest rates cannot be set by an individual bank or even by a group of banks; they are determined by thousands of investors trading in the credit markets. Moreover, each market rate of interest has multiple components-the risk-free interest rate plus various risk premia. A change in any of these rate components can cause interest rates to change. To consistently forecast market interest rates correctly would require bankers to correctly anticipate changes in the risk-free interest rate and in all rate components. Another important factor is the timing of the changes. To be