Asset and Liability Management Flashcards
What is duration and duration gap?
Duration:
Duration is a measure of the sensitivity of the price of a bond or a portfolio of bonds to changes in interest rates, representing the weighted average time until all cash flows (coupons and principal) are received.
Duration Gap:
Duration gap is the difference between the duration of a bank’s assets and the duration of its liabilities, used to assess the interest rate risk and potential impact on the bank’s net worth due to changes in interest rates.
Examples of asset and liability management
Asset and Liability Management and maturity transformation
Is asset and liability management important
Yes.
Crucial role on the financial system by performing liquidity and maturity transformation.
Depicted in bank’s balance sheet
Ensures stability and profitability
Asset and Liability Management and liquidity transformation
- Maturity transformation involves using short-term liabilities to fund long-term assets
- e.g. deposits to fund mortgages
- Enhance profitability by exploiting the interest rate spread between short-term borrowing and long-term lending rates
- risk
Tools used for ALM
- duration is a key concept
- duration being managed helps reduce risks
- Duration gap (difference between the duration of assets and duration of liabilities) indicates bank’s exposure to interest rate changes
- Positive = more sensitive to changes
Duration Formula
ΔE = -(Δ r / 1+r) x (D_A - L/A D_L)
Asset and Liability Trade Off
- Trade off by liquidity and profitability
- too many liquid assets can reduce profitability because these assets typically earn lower returns
-holding too many illiquid assets can increase the risk of a bank run - diversity, liquidity buffer, interest rate heeding strategies
Examples
Collapse of Silicon Valley Bank
SBV faced a significant mismatch between its short-term liability and long-term assets coupled with illiquid management, leading to insolvency
