Interest rate derivatives and asset-liability management by commercial banks

New England Economic Review, Jan-Feb, 1995 by Katerina Simons

Parkinson, Patrick and Paul Spindt. 1986. "The Use of Interest Rate Futures by Commercial Banks." In Myron Kwast, ed., Financial Futures and Options in the U.S. Economy, pp. 221-48. Washington, D.C.: Board of Governors of the Federal Reserve System.

Sinkey, Joseph and David Carter. 1994. "The Derivative Activities of U.S. Commercial Banks." In The (Declining?) Role of Banking. Federal Reserve Bank of Chicago. Proceedings of the 30th Annual Conference on Bank Structure and Competition, (May), pp. 165-85.

RELATED ARTICLE: Box 1: Glossary

Interest Rate Cap. An interest rate cap protects a floating-rate borrower against a rise in interest rates. At specified intervals over the life of the contract the seller pays the buyer the difference (if any) between a specified reference rate and the cap rate.

Interest Rate Floor. An interest rate floor protects a floating-rate investor against a decline in interest rates. At specified intervals over the life of the contract the seller pays the buyer the difference (if any) between a floor rate and a specified reference rate.

Interest Rate Collar. An interest rate collar is the purchase of an interest rate cap and the sale of an interest rate floor.

Swap. A swap is an agreement between two parties to exchange a series of cash flows for a period of time. The main categories of swap contracts are interest rate, currency, equity, and commodity swaps.

Plain-Vanilla Interest Rate Swap. The most common type of swap, it consists of an exchange between two parties of fixed-rate interest for floating-rate interest in the same currency.

Swaption. A swaption is a contract that gives the buyer the right, but not the obligation, to enter into a specified swap contract on a future date.

RELATED ARTICLE: Box 2: A Simple Example of Duration Gap

Suppose a bank has one asset, a $300 loan to be repaid in two equal annual installments, and two liabilities, a $200 1-year certificate of deposit and a $100 6-month certificate of deposit. For simplicity, suppose also that the interest rates on the loan and both CDs as well as the discount rate used to calculate the net present value are all equal to 5 percent. Since the CDs have one payment each coming at maturity, their durations are equal to their maturities, so that the liability duration weighted by the present value of liabilities is 1 year x ($200/$300) 0.5 year x ($100/$300) = 0.83 year.

The duration of the loan is not equal to its maturity. To calculate the duration, note that at the interest rate of 5 percent per year, the loan will be repaid in equal installments of $161.34 each year. The present values of these cash flows discounted at 5 percent are $153.66 and $146.34. Thus, the duration of the loan is 1 year x ($153.66/$300) 2 years x ($146.34/$300) = 1.49 years.

The duration gap of this balance sheet is the difference between the duration of assets (1.49 years) weighted by the present value of assets and the duration of liabilities weighted by the present value of liabilities. Thus, the duration gap is (1.49 years x $300) - (0.83 years x $300), or 196 dollar-years.