1. The portfolio managers of a firm determined that over the next year interest-

Question

1. The portfolio managers of a firm determined that over the next year interest-sensitive assets are in the amount of $1.5 billion while interest-sensitive liabilities are in the amount of $1.8 billion. Moreover, when considering all of the firm's assets and liabilities, they determined that the average duration of assets is 3.6 years while the average duration of liabilities is 4.0 years. The firm’s debt-to-equity ratio is 4-to-1.

a- Calculate GAP and Duration GAP (DGAP) for this situation. (See Chapter 19 of the Madura text for a description and example of these calculations).

b- What will happen to net interest income and relative asset prices (market values) as interest rates rise or fall? (In other words, how are net income and overall market value impacted by changes in interest rates?)

c- What strategies could management employ to hedge against this risk? For instance should it buy or sell futures, call options or put options (i.e., for each derivative is it a buy or sell strategy?)?

Explanation / Answer

Ans;

GAP = Duration of Assets - Duration of Liabilities

            = 3.6 - 4

            = -0.40 Years

Duration GAP = Modified Duration of Assets - Weight of Liabilities * Modified Duration of Liabilities

Weight = Rate Sensitive Liabilities / Rate Sensitive Assets

            = 1.8 / 1.5

            = 1.2

Duration GAP = 3.6 years - (1.2*4.0 years)

                       = -1.2 years

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