Duration is an important measure of the interest rate sensitivity of assets and liabilities as it takes into account the time of arrival of cash flows and the maturity of assets and liabilities. It is the weighted average time to maturity of all the preset values of cash flows. Duration basically refers to the average life of the asset or the liability. The following equation describes the percentage fall in price of the bond for a given increase in the required interest rates or yields:- DP p = D ( dR /1+R) The larger the value of the duration, the more sensitive is the price of that asset or liability to changes in interest rates. As per the above equation, the bank will be immunized from interest rate risk if the duration gap between assets and the liabilities is zero. The one important benefit of duration model is that it uses the market value of assets and liabilities. 6.12 Under this technique assumptions were made on various conditions, for example: – • Several interest rate scenarios were specified for the next 5 or 10 years. These specified conditions like declining rates, rising rates, a gradual decrease in rates followed by a sudden rise, etc. Ten or twenty scenarios could be specified in all. • Assumptions were made about the performance of assets and liabilities under each scenario. They included prepayment rates on mortgages or surrender rates on insurance products. • Assumptions were also made about the firm’s performance like, the rates at which new business would be acquired for various products, demand for the product, etc. • Market conditions and economic factors like, inflation rates and industrial cycles were also included. Based upon these assumptions, the performance of the firm’s balance sheet could be projected under each scenario. If projected performance was poor under specific scenarios, the ALM committee would adjust assets or liabilities to address the indicated exposure. Let us consider the procedure for sanctioNING g a commercial loan. The borrower, who approaches the bank, has to appraise the banks credit department on various parameters like, industry prospects, operational efficiency, financial efficiency, management qualities and other things, which would influence the working of the company. On the basis of this appraisal, the banks would then prepare a credit grading sheet after covering all
the aspects of the company and the business in which the company is in. Then the borrower would then be charged a certain rate of interest which would cover the risk of lending. The main shortcoming of scenario analysis was that it was highly dependent on the choice of scenarios. It also required that many assumptions were to be made about how specific assets or liabilities will perform under specific scenarios. Gradually, the firms recognized a potential for different type of risks which was overlooked in ALM analysis.
