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Chapter 7

FIN 3120 Chapter 7: CH 7 Risk Management for Changing Interest Rates

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University of Denver
FIN 3120
Chi Hung Leung

Ch 7: Risk Management for Changing Interest Rates: AssetLiability Management and Duration Techniques NW=TATL o When interest rates increase, price of assets will fall more than price of liabilities Reduction in net worth o When interest rate increase, bonds prices decreases Longer maturity, the more the price will change over time AssetLiability Management: control a banks sensitivity to change in market interest rates and limit its losses in its net income or equity o asset management strategy: control over assets, no control over liabilities o liability management strategy: control over liabilities by changing rate and other terms o funds management strategy: works with both strategies Interest Rate Risk: o Price risk: when interest rates rise, the market value of the bond or asset falls o Reinvestment risk: when interest rates fall, the coupon payments on the bond are reinvested at the lower rates o Interest rates are the price of credit o Yield to Maturity (YTM) The discount rate that equalizes the current market value of a loan or security when the present value of the expected future income stream that the loan or security will generate YTM = RATE(nper,pmt,pv,fv) o Market interest rates are a function of Rf rate of interest Various risk premiums Default risk Inflation risk Liquidity risk Call risk Maturity risk Nominal market interest rate = rf interest rate + risk premiums o Yield Curves: between maturity and yields Upward: longterm rates are higher than shortterm rates (expansion) Downward: shortterm rates are higher than longterm rates (recession) Horizontal: shortterm and longterm rates are equal o Interest Rate Hedging: in order to protect profits against adverse interest rate changes; management seeks to hold fixed the financial firms net interest rate margin (NIM) NIM = net interest incomeTA Interestsensitive gap management: Assetsensitive bank has: o Positive dollar interestsensitive gap o Positive relative interestsensitive gap o Interest sensitivity ratio greater than one o Interest rates rise > NIM rises
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