| The purpose of this study is to examine approaches to the management of interest rate risk in depository financial institutions. The study focuses on the theory of two approaches to managing the degree of risk exposure: maturity management of the institution's assets and liabilities, often referred to as "gap management," and financial futures contracting. The research addresses a few specific problems in application of these tools, in particular: (1) quantity uncertainty for balance sheet accounts, due to prepayment or early withdrawal options held by customers, (2) the nature of the correlation between the short term interest rate and the futures price, and (3) short run price-setting behavior by the depository institution.;Further, if the institution is making short run decisions in a price-setting environment, a decision to manage the interest rate risk exposure will require the institution to forego the prospect of additional expected profit.;Quantity uncertainty also has implications for the use of financial futures contracting. An appropriate futures position will be different from that derived when deposit and loan quantities are known with certainty.;Finally, the study examined the relationship between futures and gap positions. In a frictionless world, either of these tools should be effective in achieving the bank's desired interest rate risk exposure. The analysis pinpoints the parameters which determine how the two tools can be traded off with each other, and further, demonstrates conditions that would lead to a unique optimal combination of futures and gap positions.;Analysis of the maturity management approach shows that, when customer options are appropriately modeled, the conventional prescriptions for managing an institution's risk exposure may have to be altered. For example, if depositors have early withdrawal options, the bank faces quantity uncertainty; this implies that simply matching maturity will not achieve a complete hedge against interest rate risk. |
