Professional Documents
Culture Documents
Interest Rate
Risk II
Chapter Outline
This chapter presents the duration model and
duration gap as measures of an FIs interest rate
risk:
BasiC arithmetic to calculate Duration
Economic meaning of Duration
Immunization using Duration
Problems in applying duration
FINA 481
Fall 2015
A.Addas
Duration: A Simple
Introduction
In general, the longer the term to maturity, the
greater the sensitivity to interest rate changes.
Example: Suppose a $100 loan with a 15%
interest rate, with half repayment after a
year, and the remaining at the end of the year.
Weights
FINA 481
Fall 2015
A.Addas
Duration: A Simple
Introduction
=> Duration = 0.5349 x 0.5 + 0.4651 x 1 =
0.7326 years
This is the Weighted Average Time to Maturity of
this loan
Fall 2015
A.Addas
Computing duration
Consider a 2-year, 8% coupon bond, with a
face value of $1,000 and yield-to-maturity of
12%. Coupons are paid semi-annually.
Therefore, each coupon payment is $40 and
the per period YTM is (1/2) 12% = 6%.
Present value of each cash flow equals CF t
(1+ 0.06)t where t is the period number.
FINA 481
Fall 2015
A.Addas
Example
Bond A: P = $1000 = $1762.34/(1.12)5
Bond B: P = $1000 = $3105.84/(1.12)10
Fall 2015
A.Addas
FINA 481
Fall 2015
A.Addas
Duration Formula
N
CF DF t PV t
t 1
N
CF DF
t 1
t 1
N
PV
t 1
D = Duration in Years
CFt = Cash Flow at the end of Period t
N = Bond Maturity
DFt = Discount Factor =
R = Annual Yield to Maturity
Notice that the weights correspond to the relative present
values of the cash flows.
FINA 481
Fall 2015
A.Addas
Coupon Effect
Bonds with identical maturities will respond
differently to interest rate changes when the
coupons differ.
Think of coupon bonds as a bundle of zerocoupon bonds.
With higher coupons, more of the bonds value
is generated by cash flows which take place
sooner in time.
Consequently, less sensitive to changes in R.
FINA 481
Fall 2015
A.Addas
FINA 481
Fall 2015
A.Addas
15
FINA 481
Fall 2015
A.Addas
16
FINA 481
Fall 2015
A.Addas
17
Impact of Maturity
FINA 481
Fall 2015
A.Addas
18
Impact of Maturity
FINA 481
Fall 2015
A.Addas
19
FINA 481
Fall 2015
A.Addas
20
FINA 481
Fall 2015
A.Addas
21
FINA 481
Fall 2015
A.Addas
22
FINA 481
Fall 2015
A.Addas
23
Maturity of a consol: M = .
Duration of a consol: D = 1 + 1/R
If R = 5% => D = 1 + 1/0.05 = 21 years
Based on TVM, investors would recover their
investment in 21 years. Subsequent cash flows are
pure profits.
FINA 481
Fall 2015
A.Addas
24
Duration Gap
Suppose the bond in the previous example is
the only loan asset (L) of an FI, funded by a 2year certificate of deposit (D).
Maturity gap: ML - MD = 2 -2 = 0
Duration Gap: DL - DD = 1.883 - 2.0 = -0.117
Deposit has greater interest rate sensitivity than the
loan, so DGAP is negative.
FI exposed to rising interest rates.
FINA 481
Fall 2015
A.Addas
25
Features of Duration
Duration and maturity:
D increases with M, but at a decreasing rate.
FINA 481
Fall 2015
A.Addas
26
Features of Duration
Duration and maturity:
D increases with M, but at a decreasing rate.
FINA 481
Fall 2015
A.Addas
27
FINA 481
Fall 2015
A.Addas
28
Fall 2015
A.Addas
29
FINA 481
Fall 2015
A.Addas
30
Immunization example:
In 2010 an insurer guarantees a lump sum
payment in 2015 of $1,469 equal to an
annually compounded rate of 8% over 5 years.
Consider 2 immunization strategies:
Discounted Bond
P = 680.58 = 1000 / (1.08) 5
Buy 1.469 of these bonds
Fall 2015
A.Addas
31
Duration Gap:
From the balance sheet, E=A-L. Therefore,
E=A-L. In the same manner used to determine
the change in bond prices, we can find the change
in value of equity using duration.
Fall 2015
A.Addas
32
FINA 481
Fall 2015
A.Addas
33
An example:
Suppose DA = 5 years, DL = 3 years and rates
are expected to rise from 10% to 11%. (Rates
change by 1%).
Also, A = 100, L = 90 and E = 10.
Find change in E.
DA - DLk]A[R/(1+R)]
= -[5 - 3(90/100)]100[.01/1.1] = - $2.09 million
Fall 2015
A.Addas
34
An example:
If rates rise by 1%:
A/A = -5 x (0.01)/1.1 = -0.04545
A = 100 + (-0.04545 x 100) = 95.45
L/L = -3 x (0.01)/1.1 = -0.02727
L = 90 + (-0.02727 x 90) = 87.54
E = A L = 7.91
FINA 481
Fall 2015
A.Addas
35
But, to set E = 0:
DA = kDL
FINA 481
Fall 2015
A.Addas
36
FINA 481
Fall 2015
A.Addas
37
Set E = 0:
DA = kDL
FINA 481
Fall 2015
A.Addas
38
FINA 481
Fall 2015
A.Addas
39
FINA 481
Fall 2015
A.Addas
40
Convexity
The duration measure is a linear
approximation of a non-linear function.
If there are large changes in R, the approximation
is much less accurate.
Fall 2015
A.Addas
41
Convexity
Recall that duration involves only the first
derivative of the price function.
We can improve on the estimate using a Taylor
expansion.
FINA 481
Fall 2015
A.Addas
42
FINA 481
Fall 2015
A.Addas
43
Calculation of CX
Example: convexity of 8% coupon, 8% yield,
six-year maturity Eurobond priced at $1,000.
CX = 108[P-/P + P+/P]
= 108[(999.53785-1,000)/1,000 +
(1,000.46243-1,000)/1,000)]
= 28.
FINA 481
Fall 2015
A.Addas
44
Default risk.
Floating-rate loans and bonds.
Duration of demand deposits and passbook
savings.
Mortgage-backed securities and mortgages
Duration relationship affected by call or
prepayment provisions.
FINA 481
Fall 2015
A.Addas
45
Contingent Claims
Interest rate changes also affect value of offbalance sheet claims.
Duration gap hedging strategy must include the
effects on off-balance sheet items such as futures,
options, swaps, caps, and other contingent claims.
FINA 481
Fall 2015
A.Addas
46
Chapter Summary
This chapter presented the duration
model and duration gap as measures
of an FIs interest rate risk:
Basis arithmetic to calculate Duration
Economic meaning of Duration
Immunization using Duration
Problems in applying duration
FINA 481
Fall 2015
A.Addas
47
Pertinent Websites
Bank for International Settlements www.bis.org
Securities Exchange Commission www.sec.gov
The Wall Street Journal
www.wsj.com
FINA 481
Fall 2015
A.Addas
48