Due to the increasing volatility of interest rates in present society, bank managers become more concerned about the exposure to interest rate risk (Mishkin and Eakins 2009). Recent market volatility provides motivation for bank managers to consider interest rate risk management strategy carefully (Richie, Mautz and Sackley 2010). It will cause the fail for a business if interest rate risk did not be managed properly (Hemert 2010). Therefore, it is crucial to minimize the risk which is created by interest rate volatility (Barbarin, Launois and Devolder 2009). Interest rate risk was defined by Viney (2003) as exists unexpected changes in interest rates may affect the cash flow of a business and the value of existing financial instruments, or the repricing of associated cash flows and maturing instruments. It is necessary to demonstrate interest rate risk from the balance sheet of a bank. The first step to manage interest rate risk is to decide which assets and liabilities are rate-sensitive. Normally, bankers select 12 months for determining the rate-sensitive of both assets and liabilities, which means interest rates of these assets and liabilities will be repriced within one year (Mehta and Fung 2004). After this procedure, bank managers will analyze what will happen if interest rates rise or fall by two analysis approaches. It is extremely important to use these two main methods to reduce interest rate risk for commercial banks (Berndt, Ritchken and Sun 2010). This essay will not only manifest income gap analysis and duration gap analysis approaches, but also explain some problems and weaknesses of these two gap analysis approaches.
The first approach is called income gap analysis. This is one simple and quick approach to manage interest rate risk (Mishkin and Eakins 2009). The first step of this method is to decide assets and liabilities whether are rate sensitive. Normally, rate sensitive assets are securities with maturities of less than one year. On the other hand, the obviously rate sensitive liabilities are money market deposit accounts, variable rate certificates of deposit and certificates of deposit with less than one year to maturity, federal funds, and borrowing with maturities of less than one year (Mishkin and Eakins 2009). In this method, bankers can use rate sensitive assets to subtract rate sensitive liabilities to calculate Gap amount (Simons 1995). Moreover, RSAs stand for rate sensitive assets, and RSLs are rate sensitive liabilities. Thus, Gap analysis formula can be written as: Gap=RSAs-RSLs. Furthermore, bank managers may utilize Gap and the change in interest rates to reveal the change in bank income. Multiply Gap times the change in interest rates can attain the result on bank income. If I stands for the change in bank income, and i represents the change in interest rates. The change in bank income can be written as: I=Gapi. Hence, if Gap is positive, the rise of interest rates induces the increasing bank income. Conversely, if Gap is negative, interest rates and bank income move in opposite directions (Clarke 2003). The income gap analysis approach illustrates that if a bank is holding more rate sensitive assets than liabilities, a rise in interest rates will increase the net interest margin and income, and a decline in interest rates will reduce the net interest margin and bank income (Gup and Lutton 2009). For instance, if the bank has -$20 million gap, and the interest rate rise by 2%. The change in bank income should be -$400,000. It means the income of the bank will reduce $400,000. On the other hand, if the gap of the bank is $20 million, and the interest rate still rise by 2%. The change in bank income will be positive, which is $400,000.
The second approach to manage interest rate risk is called duration gap analysis. The income gap analysis focuses only on the effect of interest rate changes on bank income. Compare with income gap analysis, duration gap analysis approach demonstrates the sensitive of the market value of the financial institution’s net worth to the changes in interest rates. This analysis approach is based on Macaulay’s concept of duration, the average lifetime of a debt security’s stream of payment (Bierwag and Fooladi 2006). Duration can be used to measure the interest rate risk of any financial assets (Casabona, Fabozzi and Francis 1984). Basically it means the larger the duration gap, the more sensitive the bank is to the changes in the market interest rate (Simons 1995). As an owner or a manager of a financial institution, this person should not only pay attention on the effect of changes in interest rates on income, but also ought to care about the effect of changes in interest rates on the market value of the net worth (Mishkin and Eakins 2009). Before utilize duration gap analysis approach to manage interest rate risk, it is vital to understand how to calculate duration. As Macaulay’s concept of duration, duration is a weighted average of the maturities of the cash payment (Bierwag and Fooladi 2006). Hence, the duration calculation formula can be written as: In this formula, DUR is duration. t stands for years until cash payment is made. means cash payment. i is interest rate, and n represents years to maturity of the security. After determine the duration by this formula, the banker can use duration gap analysis formula to calculate how the market value of each asset and liability changes when there is a change in interest rates. After this the banker could calculate the effect on net worth (Mishkin and Eakins 2009). The formula for duration gap analysis can be written as: In this formula, means percentage change in market value of the security. i represents interest rate, and DUR is duration. It seems complicated to calculate duration and use duration gap analysis method to manage interest rate risk by bank managers, however, this approach has been programmed in most bank management computer systems. Thus, the banker can just put in all numbers to calculate easily. Both income gap analysis approach and duration gap analysis approach illustrate that the bank will suffer from a rise in interest rates (Bierwag and Kaufman 1991). Thanks to income gap analysis approach and duration gap analysis approach, bankers can realize earlier that banks will lose income when interest rates increase in the future. That is why these two gap analysis methods are very useful tools for managing the exposure to interest rate risk.
Although both income gap analysis approach and duration gap analysis approach are extremely significant for bankers to assess interest rate risk, there are still some problems and weaknesses with those two methods (Mehta and Fung 2004). The first problem is that the income gap cannot be estimated very accurate by bank managers. The banker has to estimate the proportion of fixed rate assets and liabilities which are rate sensitive. However, some rate sensitive assets and liabilities cannot be evaluated easily and accurately, such as prepayment of loans and customer shifts out of deposit (Mishkin and Eakins 2009). This weakness also occurs during duration gap analysis procedure. The reason is that some of the cash payments are uncertain. As the result of uncertain payments, it is hard to calculate duration gap accurately. Another weakness of income gap and duration gap analysis is that these two approaches ignore the fluctuation of yield curve. In real financial market, the level of interest rates and maturities will change differently. Thus, the yield curve will fluctuate instead of exactly flat (Haubrich and Cherny 2010). In order to solve this problem, bank managers need to take the fluctuation of yield curve into account (Heidari and Wu 2009). In other words, duration gap analysis method only works well for small changes in interest rates. In present financial market, bank managers are using some more sophisticated approached to measure interest rate risk, however, income gap and duration gap analysis approaches are the most basic approaches for interest rate risk management. These two approaches are able to provide a first assessment of interest rate risk. Therefore, although these two approaches are quite basic, they are still extremely useful tools in interest rate risk management.
In conclusion, this essay introduced two basic approaches to manage interest rate risk. The first one is called income gap analysis approach. This approach is the simplest one to measure the sensitive of bank income to changes in interest rates. Bank managers can use rate sensitive assets to substrate rate sensitive liabilities first to attain Gap amount first, then use Gap amount times the change in interest rates to reveal the effect on bank income. The second approach is duration gap analysis. Bankers can utilize the duration calculation formula to obtain duration number. After this, bank managers should use the formula for duration gap analysis to and find out what will happen when interest rates change. Although these two approaches are extremely useful to manage interest rates risk, there are still several problems and weaknesses should be bewared by bankers. Due to the rate sensitive assets and liabilities cannot be estimated accurate, both income gap analysis and duration gap analysis are not perfectly accurate. Furthermore, duration gap analysis is based the assumption that the level of interest rates changes and interest rates on all maturities change by the same amount. It means duration gap analysis only can work well for small changes in interest rates (Mishkin and Eakins 2009).
