Question

1. The following financial statement is for the current year:

		Second Link Bank
Assets (RM)		Duration	Liabilities (RM)		Duration
Reserves                  5,000,000 Securities                                < 1 year                   5,000,000		0.00 0.40	Checkable 15,000,000 deposits 5,000,000		2.00 0.10
1 to 2 years >2 years Residential mortgages Variable rate Fixed rate Commercial loans <1 year 1 to 2 years >2years Buildings, etc. Total	5,000,000 10,000,000 10,000,000 10,000,000 15,000,000 10,000,000 25,000,000 5,000,000 100,000,000	1.60 7.00 0.50 6.00 0.70 1.40 4.00 0.00	Money market deposits Savings accounts CDs Variable-rate <1 year 1 to 2 years >2 years Interbank loans Borrowings <1 year 1 to 2 years >2 years Bank Capital Total	15,000,000 10,000,000 15,000,000 5,000,000 5,000,000 5,000,000 10,000,000 5,000,000 5,000,000 5,000,000 100,000,000	1.00 0.50 0.20 1.20 2.70 0.00 0.30 1.30 3.10

1. 1. Calculate the duration gap for the bank.                                                   [5 marks]
2. 2. Calculate the expected net worth if interest rates were to raise 100 basis points from the current rate of 10%.                                                                  [4 marks]
   3. What action could the managements take to decrease it interest rate risk?    [6 marks]

Answer 1

1. Duration gap = Average duration of assets - (( Market value of assets / Market value of liabilities )* Average duation of liabilities)

= 2.7 - (( 95/100) *1.03) = 1.72

[ market value of liabilities = 95 (excluding bank capital) , market value of assets = 100]

2. Change in Networth/ Assets = -Duration gap * Change in interest rate / Interest rate

= - 1.72 *0.01/ (1+0.1) = -1.56%

3. The methods can be used to reduce interest rate risks are:

(i) Maturity matching: In this case the bank can match maturities of assets with the liability of the same maturity. For example the one year variable rate CD's can be matched with one year maturity securities. This strategy can avoid interest rate risk but must be implemented in an effective manner.

(ii) Floating rate loans: The bank use floating rate loans to support long term assets with the short term deposits by not overly exposing to interest rate risks. This strategy can be applied when the anticipated interest rate do not change very frequently else the bank's net interest margin will be still affected by interest rate fluctuations.

(iii) Interest rate future contracts: Another solution is to use interest rate futures to hedge interest rate risk. In this method the future price at which the financial instrument can be bought or sold is locked in. This method can be used to reduce the uncertainty about the banks interest margin. For example if interest rate futures are sold, then the adverse effect of rising interest rates on the banks interest expenses can be reduced.

(iv) Interest rate swaps: A interest rate swap is one where in an arrangement is made to exchange periodic cash flows based on specific interest rates. For example, Bank A agrees it to exchange its variable mortgages with Bank B that has fixed mortgages. The strategy taken by the bank depends on its forecast of future interest rates.

Workings:

Assets	Assets in Millions	Duration	Asset weights [Asset value /100]	Weighted duration
Securities
< 1year	5	0.4	0.05	0.02
1 to 2 years	5	1.6	0.05	0.08
> 2years	10	7	0.10	0.70
Residential mortgages
Variable rate	10	0.5	0.10	0.05
Fixed rate	10	6	0.10	0.60
Commercial loans
<1 year	15	0.7	0.15	0.11
1 to 2 years	10	1.4	0.10	0.14
>2 years	25	4	0.25	1.00
Buildings etc	5	0	0.05	-
Average duaration of assets	100			2.70
Liabilities	Assets in Millions	Duration	Asset weights [Asset value /100]	Weighted duration
Checkable deposits	15	2	0.16	0.32
Money market deposits	5	0.1	0.05	0.01
Savings accounts	15	1	0.16	0.16
CDs
Variable rate	10	0.5	0.11	0.05
< 1year	15	0.2	0.16	0.03
1 to 2 years	5	1.2	0.05	0.06
> 2years	5	2.7	0.05	0.14
Interbank loans	5	0	0.05
Borrowings			-
< 1year	10	0.3	0.11	0.03
1 to 2 years	5	1.3	0.05	0.07
> 2years	5	3.1	0.05	0.16
Average duaration of liabilities	100			1.03