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Discuss the ways a bank can protect itself against interest rate risk through asset-liability management strategies.

FRM® Part II · Liquidity and Treasury Risk Measurement and Management · Risk Management for Changing Interest Rates: Asset-Liability Management and Duration Techniques · FRM2.LTR.17.a

The idea

A bank earns on assets and pays on liabilities whose rates and maturities rarely match, so a change in rates moves both net interest income and the market value of equity. Asset-liability management attacks this in layers. The simplest is structural. Match repricing dates and maturities, shorten fixed-rate assets, lengthen or fix liabilities, and make loans floating-rate, which pushes rate risk to borrowers and raises credit risk. Next come measurement-based policies: interest-sensitive gap management, which targets net interest income, and duration gap management, which targets the market value of net worth. Finally come derivatives and securitization: financial futures, swaps, caps, floors and loan sales. A bank hurt by rising rates sells futures, pays fixed in a swap or buys a cap. Hedging costs money and removes some upside, so the exam asks which tool fits which exposure.

A practice question

From the question bank, with the reason each wrong option is wrong.

A bank funds long-term fixed-rate mortgages with short-term deposits and is hurt when market rates rise. Which action most directly reduces that exposure?

  1. Lengthen the repricing period of its assets while shortening that of its depositsWhy not: This widens the repricing mismatch; it makes the asset-heavy, liability-sensitive position worse.
  2. Shorten the average maturity of its fixed-rate assets or switch loans to floating rates - correct
  3. Fund more of its assets with overnight borrowingWhy not: Shorter funding increases repricing risk when rates rise; it is the opposite of a hedge.
  4. Buy an interest rate floor on its assetsWhy not: A floor pays when rates fall, so it protects against the wrong direction for this bank.

The bank is liability-sensitive: deposits reprice fast while mortgage income is fixed. Making assets reprice sooner (shorter maturity or floating rate), or lengthening liabilities, narrows the mismatch. A floor pays off in falling rates, which is not this bank's risk.

A harder one

A liability-sensitive bank enters a one-year swap on a notional of USD 200 million in which it pays a fixed rate of 4.20% and receives a floating rate. Floating averages 5.10% over the year. The bank's net swap settlement for the year is closest to:

  1. Receive USD 1.8 million - correct
  2. Pay USD 1.8 millionWhy not: Reverses the direction: the bank pays 4.20% fixed and receives the higher floating rate, so it receives the difference.
  3. Receive USD 10.2 millionWhy not: Applies the full 5.10% floating rate to the notional instead of the 0.90% net difference.
  4. Pay USD 8.4 millionWhy not: Applies only the fixed leg of 4.20% to the notional and ignores the floating receipt.

Net settlement = (5.10% - 4.20%) x 200 million = 1.8 million received. The gain offsets the higher deposit costs the bank pays when rates rise, so the swap hedges its liability-sensitive position.

The hardest tier

A bank has total assets of USD 5,000 million and a duration gap of +1.8 years. It wants to eliminate the gap by entering a pay-fixed, receive-floating swap. The fixed leg has a duration of 4.5 years and the floating leg 0.25 years. Ignoring yield adjustments, the notional needed is closest to:

  1. USD 2,118 million - correct
  2. USD 2,000 millionWhy not: Uses only the fixed-leg duration of 4.5 and ignores the duration of the floating leg that is received.
  3. USD 1,895 millionWhy not: Adds the floating leg duration instead of subtracting it: 4.5 + 0.25 = 4.75.
  4. USD 36,000 millionWhy not: Divides by the floating duration of 0.25 only, ignoring the fixed leg.

A pay-fixed swap has duration = floating leg duration minus fixed leg duration, a negative number of 4.25 years in magnitude. Required notional = 1.8 x 5,000 / 4.25 = 2,117.6 million. Pay-fixed lowers a positive gap because the swap behaves like being short a bond.

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