Question

I need help with this question. Please show all work and calculations and explain your answers properly. 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. 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?)?

Answer 1

Interest Sensitive Assets = $1.5 Billion, Average duration of assets = 3.6 years

Interest-sensitive liabilities = $1.8 billion, Average duration of liabilities = 4.0 years

Debt / Equity = 4

GAP = Interest Sensitive Assets - Interest-sensitive liabilities = $ 0.3 Billion

Duration GAP = Duration of assets - Duration of liabilities   = - 0.4 years

b) % Change in Net Worth = - Duration Gap * (Change in Interest rate/ (1+ Current Interest rate))

Duration gap is negative. If interest rates rise, liabilities will lose more value than assets, thus increasing the value of the firm's equity. If interest rates decline, liabilities will gain more value than assets, thus decreasing the value of the firm's net worth aand the interest income..

c) For negative duration gap exposure by taking a long position in financial futures.