21.The Dark Star Savings Bank is a small savings bank operating in Dark Star, Colorado. Eleanor Swanson, CEO and President of Dark Star Savings Bank is very concerned about the volatility in the bank's net interest margin. She has talked with other bank presidents, and they have mentioned to her that it might be better for the bank to use other measures of interest rate risk, in addition to a funding gap analysis, including a duration gap measure.
Ms. Swanson asks Bud Fogerty to incorporate duration analysis as an interest rate risk measure. She would also like a summary of the advantages and the limitations of duration analysis and funding gap analysis, and the risk return tradeoff between perfect hedging and a bank's NIM.
Bud Fogerty would like you to take on this task. As a start, he would like you to work with a simple balance sheet and train the other managers in the bank on the concept of duration, how it is calculated for each asset and liability, how duration changes with a change in interest rates, and how the bank's equity value and net interest margin are affected by changes in interest rates. He asks you to examine different scenarios for the bank with a positive duration gap versus a duration gap close to zero.
To help you with this task, Mr. Fogerty has prepared an initial hypothetical balance sheet for the following simplified bank with information on the cash flows, maturities, and annual percentage rates that you need in order to calculate the duration of individual assets and liabilities and the bank's duration gap. He has also prepared a list of questions for you to help you in your analysis.
In your discussion of the limitations and benefits of duration analysis, Mr. Fogerty would like you to keep in mind the fact that a duration gap assumes an equal change in the rates on both assets and liabilities (i.e., a parallel shift in the yield curve). If this is not the case, a zero duration gap, for instance, may not completely protect the value of a bank's equity. Also, since duration is a function of market rates, duration must be closely monitored, since it will change each time a change in rates occurs