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MANAGING INTEREST RATE RISK: DURATION GAP AND MARKET VALUE OF EQUITY - page 26 / 39

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Stabilizing the book value of net interest income

This can be done for a 1-year time horizon, with the appropriate duration gap measure:

 DGAP* MVRSA(1- DRSA) - MVRSL(1- DRSL) where

MVRSA = cumulative market value of RSAs, MVRSL = cumulative market value of RSLs, DRSA = composite duration of RSAs for the given time horizon; equal to the sum of the products of each asset’s duration with the relative share of its total asset market value, and DRSL = composite duration of RSLs for the given time horizon; equal to the sum of the products of each liability’s duration with the relative share of its total liability market value.

If DGAP* is positive, the bank’s net interest income will decrease when interest rates decrease, and increase when rates increase.

If DGAP* is negative, the relationship is reversed.

Only when DGAP* equals zero is interest rate risk eliminated.

Banks can use duration analysis to stabilize a number of different variables reflecting bank performance.

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