Asset/Liability Management
Day 4
Equity Valuation, Duration, EVE, Deposit Betas, & Hedging
Equity Valuation Focus
• Basic fixed income security valuation rule:
• Rates rise  value falls
• Rates fall  value rises
• Market value of equity
• MVEQ is the market value of assets (MVA) minus the
market value of liabilities (MVL)
• Rate changes result in changes in MVA and MVL
• Changes in MVEQ caused by interest rate changes reflect
interest rate risk
2
Duration GAP
• Duration GAP Analysis
• Price sensitivity of bank’s assets and liabilities
• Impact of rate changes on stockholders’ equity value
• Duration measures effective maturity of a security
• Time-weighted average of present value of expected cash
flows relative to its price
• Measures price sensitivity to rate changes
• The greater the duration, the greater the price
sensitivity
• The smaller the duration, the smaller the price
sensitivity
• Duration is NOT maturity.
Duration GAP
• Duration GAP Model
• Focus on managing market value of equity
• Compares duration of assets with duration of liabilities
• The larger the duration GAP, the larger the change in the economic value of
stockholders’ equity when interest rates change
• A duration GAP of zero implies that changes in rates would not affect the
value of equity
4
Positive and Negative Duration GAPs
• Positive DGAP – assets are more price sensitive than
liabilities
• Rates rise: assets fall proportionately more in value than liabilities,
so EVE falls fall
• Rates fall: assets rise proportionately more in value than liabilities,
so EVE rises
• Negative DGAP - liabilities are more price sensitive
than assets
• Rates rise: assets fall proportionately less in value than liabilities,
so EVE rises
• Rates fall: assets rise proportionately less in value than liabilities,
so EVE falls
5
EVE Sensitivity Analysis
• Similar steps as earnings sensitivity analysis
• However, in EVE analysis the focus is 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
6
EVE Sensitivity Analysis
UP300
Rate Shocks
FFS and Other
DOWN200
STATIC
UP400
UP200
10,984
10,852
10,720
10,655
10,589
Net Loans
151,608
147,286
142,412
139,863
137,458
Securities
135,789
124,577
114,611
109,628
104,645
23,186
23,186
23,186
23,186
23,186
321,567
305,901
291,029
283,332
278,878
104,523
96,409
92,206
90,104
88,003
CD’s
93,015
91,544
90,073
89,338
88,603
Checking
51,526
47,526
44,635
43,189
41,744
FFP & Other Borrowings
32,324
30,728
29,077
28,252
27,427
3,279
3,279
3,279
3,279
3,279
284,667
269,486
259,270
254,162
249,055
Non-earning Assets
Assets (Market Value)
MMDA/NOW/Savings
Other
Liabilities (Market Value)
Economic Value of Equity
36,900
36,415
31,759
29,170
26,823
Percentage Change
1.3%
0
-12.8%
-19.9%
-26.3%
Equity Ratio
11.48%
11.90%
10.91%
10.30%
9.72%
7
Assumptions
• Prepayments on loans
• Does the model account for loan floors and caps?
• Call options on investment securities
• Non-Maturity Deposits
• Betas
• Decay Rates
8
Assumptions-Deposit Betas
• Core Deposit accounts typically have administered rates, meaning the
rates change when management at the bank say they change. We do
know however that there is often some response to market rate
changes. To model this sensitivity we use a Beta factor. This is the
percentage of rate change each account will move with a 100 basis
point movement in Fed Funds.
9
Assumptions-Decay Rates
• Decay rates essentially are an assumption about the
average life of your non-maturity deposits. They will
have the most impact on your bank's EVE
measurement. The longer you model these deposits
to be, the more base EVE for the bank. Calculating
the value of all assets and liabilities is a reasonably
straightforward exercise except when it comes to core
deposits. They have a beginning balance and a rate,
but they are missing the term structure (i.e. they're
"non-maturity" deposits). The decay assumptions
you provide give them an assumed term structure.
10
Assumptions-Decay Rates
Decay Rates are the most powerful assumptions in the
measurement of EVE.
They are also the most difficult to determine.
FDICIA Decay Rates
Industry Studies
Bank Deposit Study
Stress Testing
11
Assumptions-Decay Rates
• FDICIA Decay Rates – Developed in 1990’s. Many models use these as
default assumptions. May not be an accurate picture of your bank’s
decay rates.
• Industry Studies – Several models have recently adopted these as
they indicate significantly longer decay rates than FDICIA rates. May
not relate to what is going to happen when rates rise.
Assumptions-Decay Rates
• Bank Deposit Study – Very expensive and likely will not show how
your deposits will react when rates start to rise from these low levels.
• Stress Testing – Whatever assumption is being used for decay rates,
they should be stress tested to see what speed will cause excess risk
to the bank.
Assumptions-Decay Rates
Checking
NOW
MMDA/Savings
Quarter 1
72 Months
60 Months
48 Months
Quarter 2
100 Months
100 Months
100 Months
+200 Basis Points
+300 Basis Points
+400 Basis Points
Quarter 1
-12.8%
-19.9%
-26.3%
Quarter 2
+4.6%
+4.1%
+6.0%
Change in EVE
Surge Deposits
• Bank on previous slide had experienced growth in
NMD’s from 56% to 63% of total deposits over past
two years. ( Approximately $15 million)
• Most banks have experienced sharp growth in NMD’s
over the past two to five years.
• Customers are parking money until rates start up.
• How should this effect decay rates?
Recap
• Longer/Greater Duration = More price sensitivity.
• Inverse Relationship between interest rates and prices/market values.
• EVE is a theoretical liquidation value of the institution –NOT a going
concern valuation.
• Nonetheless, it must be monitored, measured, and understood.
• NMD assumptions –decay rates- and the changes therein are the
most critical variables in EVE.
• Rates are at historic lows. They will go up. ( Reversion to the mean
unless the mean has experienced a generational shift.) What happens
then?
• Modeling and stress testing are prudent, and required.
How Do We Protect Our Institutions From The
Perils Of Rate Changes?
• Hedging, or mitigating , interest rate risk.
• Caps and Floors
• Interest Rate Swaps
Caps and Floors
Essentially insurance policies that are triggered by interest
rates moving past an index point, or strike price.
A one time up-front premium is paid for the contract.
The buyers cash exposure is quantified at the outset.
The buyer of the contract receives no payment unless
triggered- just like your homeowners or auto insurance.
The only residual risk is counterparty performance.
How does it work?
• Assume a Notational Amount of a cap contract of $50M.
• Index is the Prime Rate, currently at 4%.
• Buyer (Bank) is concerned about rates rising, as they are Liability Sensitive.
Should rates rise their deposit costs will go up faster than yields on loans and
bonds.
• Bank purchases a cap contract from securities firm that pays them should Prime
rise above 5%, to be calculated on a quarterly basis, and the term of the contract
is two years.
• Sure enough! 6 quarters later Prime is now 5.5% (Ask me about 1994).
• Investment firm pays Bank cash equal to 50 BP X $50M NA/4, or $62,500.
• Floor contract would operate in a similar fashion, as rates decline.
Notational Amount
•
•
•
•
This is the predetermined amount upon which payments are based.
This is NOT an amount of principal at risk.
This is NOT a market value.
The notational – or theoretical- amount NEVER changes hands.
• So….when we see statements in the news that the “ Bank and thrifts hold a total notational
amount of all outstanding derivative contracts of $178 TRILLION , 15 times our GDP !!!”…Your
reaction should be… So what?
• Notional amounts outstanding represent ACTIVITY…NOT RISK.
• Risk is gauged by the market valuation of the contracts, which is , after netting out bilateral
positions, roughly 4% of the notional amount. After netting and collateralization, the figure is
closer to 3/10 of 1%.
• Still a big number..
• BUT…
Lets Talk Real Risk……
• Global stock of debt and equity outstanding in 2013 was $62 Trillion of
UNSECURED lending..
• $50 Trillion of Equity
• $47 Trillion of Government bonds
• $42 Trillion of Corporate Bonds
• Talk about your default risk!
SWAPS
• Specifically Interest Rate Swaps
• Interest Rate Swaps are simply contracts between two parties to exchange
interest rate cash flows.
• In the simplest, “plain vanilla” swaps, one party pays a fixed rate, and the
counterparty pays a variable rate.
• The payments are based on a notional amount. ( You’re experts on that now. )
• There are other swaps- currency swaps, commodity swaps, subordinated risk
swaps, credit default swaps, zero coupon swaps, variance swaps, total return
swaps….and more!
• An option on a swap is called a swaption.
• There will be 6 questions on your final exam about swaps, so pay attention.
•
Just kidding..
Why would we do an interest rate swap?
• Why indeed..???
• Perhaps to HEDGE our balance sheet, and hence the income statement, against an ADVERSE
movement in interest rates.
• Rates ALWAYS move…sometimes slowly, but inexorably.
• So… for example, if we are liability sensitive, ( our deposits reprice faster than our loans and
bonds), with a loan portfolio of longer term fixed rate loans…What might we do to hedge against
rising rates?
• How about receiving a variable rate stream of income, while paying a fixed rate stream of income
to our counterparty?
• In swap parlance this would be “putting on a variable swap”.
Examplia Gratis
• Lets assume that Bank A has a $100M base of fixed rate loans with 10 year terms.
• The average repricing of our liabilities– (Deposit Beta!!) is 8 months.
• WHEN rates rise, our Net Interest Margin, or NIM, will be squeezed, and our income will
decrease. Can’t have that. What to do?
• Lets enter into an interest rate swap with Brand X firm. (Brand X may actually be acting as a
broker or intermediary in the transaction, but it doesn’t matter.)
• We are going to pay a fixed rate of interest, lets say 1% for the next 3 years.
• We are going to receive a variable rate of interest, lets say 90 day LIBOR, currently at .25%, for the
same period.
• The notional amount of the swap contract is $100M.
• At day 1, we are paying out a net of 75 basis points to Brand X, settling quarterly.
• .0075 X $100M NA/4 = $187,500 quarterly.
• This payment reduces our yield on our fixed rate loan portfolio.
• Rates begin to rise…….
A simple exchange of cash flows.
1% Fixed
Your Bank
Brand X
90 Day LIBOR
Notional Amount is $100M US
Continued…….
A year passes…Sure enough rates are rising. Each quarter the check we send to
Brand X gets smaller.
Eureka! 90 day LIBOR has broken the 1% barrier.
At the end of year 2, 90 day LIBOR stands at 2%.
Now we are getting a quarterly check for $250,000 from Brand X.
100 BP (1%) difference X $100M NA/4 = $250,000.
While our liability funding costs may or may not have moved in tandem with the
movement of LIBOR, whatever increase we experience in our cost of funds is
mitigated, or hedged, by the swap income.
Notes
• Swap agreements are largely standardized by the ISDA, the International Swaps
and Derivatives Association.
• Swap markets are primarily regulated by the Commodities Futures Trading
Commission and the SEC.
• The Dodd-Frank Act mandates that banks can longer speculate in swaps markets,
they may only use swaps to hedge their own balance sheets or on behalf of
customers. ( The Volcker Rule.)
• All swaps are now required to be cleared and netted through transparent
exchanges.
• Regulatory agencies ( Fed, OCC, FDIC, State Banking Commissions) will want clear
explanations of the reasons and rationale behind bank swap positions, as well as
well documented stress testing and concomitant effects if interest rates move
away from your swap strategy.