Financial Risk Management

Interest Rate Risk

Outline
Term structure of interest rates
Duration
Using swaps to manage interest rate risk
3
Term Structure of I nterest Rates
Yield



Yield curve



Maturity
4
History of interest rates
5
(Macauly) duration
Weighted average term to maturity
Measure of average maturity of the
bonds promised cash flows
Duration formula:


where:

t is measured in years
P
) 1 /(
) ( PV
) ( PV
t
t t
t
y CF
Bond
CF
w
+
= =
D
m
= t w
t
( )
t =1
T

w
t
=1
t =1
q

6
Duration - The expanded equation





Duration is shorter than maturity for all
bonds except zero coupon bonds
Duration of a zero-coupon bond is equal to its
maturity
D
m
= t w
t
t =1
T

= t
PV(C
t
)
PV(Bond)



(

(
t =1
T

=
1
C
1
(1 + y)
1



(

(
+ 2
C
2
(1+ y)
2



(

(
+ ... + N
C
N
(1+ y)
N



(

(
C
1
(1+ y)
1
+
C
2
(1 + y)
2
+... +
C
N
(1+ y)
N
7
Modified duration (D*
m
)



Direct measure of price sensitivity to interest
rate changes
Can be used to estimate percentage price
volatility of a bond
y
D
D
m
m
+
=
1
*
AP
P
= D
m
*
Ay
8
Derivation of modified duration






So D*
m
measures the sensitivity of the %
change in bond price to changes in yield
y
D
D
m
m
+
=
1
*
P =
C
t
(1+ y)
t
t =1
N

cP
cy
=
1
1 + y
t
C
t
(1 + y)
t
|
\

|
.
t =1
N

cP
cy
=
D
m
1 + y
P = D
m
*
P
1
P
cP
cy
= D
m
*
9
An example
Compare the price sensitivities of:
Two-year 8% coupon bond with duration of 1.8853 years
Zero-coupon bond with maturity AND duration of 1.8853 years
Semiannual yield = 5%
Suppose yield increases by 1 basis point to 5.01%



Upshot: Equal duration assets are equally sensitive to
interest rate movements
Original Price New Price % Change
Coupon bond 964.54 964.19 -.0189
Zero bond 831.96 831.61 -.0189
10
Another example
Consider a 3-year 10% coupon bond selling at
$107.87 to yield 7%. Coupon payments are made
annually.
87 . 107 79 . 89 73 . 8 35 . 9 bond of Price
79 . 89
) 07 . 1 (
110
) (
73 . 8
) 07 . 1 (
10
) (
35 . 9
) 07 . 1 (
10
) (
3
3
2
2
1
= + + =
= =
= =
= =
CF PV
CF PV
CF PV
Duration (D
m
) = 1*
9.35
107.87
|
\
|
.
+ 2 *
8.73
107.87
|
\
|
.
+ 3 *
89.79
107.87
|
\
|
.
= 2.7458
11
Another example
Modified duration of this bond:


If yields increase to 7.10%, how does the bond price
change?
The percentage price change of this bond is given by:

= 2.5661.0010100
= .2566
5661 . 2
07 . 1
7458 . 2
*
= =
m
D
AP
P
100 = D
m
*
Ay 100
12
Another example
What is the predicted change in dollar terms?




New predicted price: $107.87 .2768 = $107.5932

Actual dollar price (using PV equation): $107.5966
AP =
.2566
100
P
=
.2566
100
$107.87
= $.2768
Good
approximation!
13
Nature of Swaps
A swap is an agreement to exchange
cash flows at specified future times
according to certain specified rules
14
An Example of a Plain Vanilla
Interest Rate Swap
An agreement by Microsoft to receive 6-
month LIBOR & pay a fixed rate of 5%
per annum every 6 months for 3 years on a
notional principal of $100 million
15
---------Millions of Dollars---------
LIBOR FLOATING FIXED Net
Date Rate Cash Flow Cash Flow Cash Flow
Mar.5, 2004 4.2%
Sept. 5, 2004 4.8% +2.10 2.50 0.40
Mar.5, 2005 5.3% +2.40 2.50 0.10
Sept. 5, 2005 5.5% +2.65 2.50 +0.15
Mar.5, 2006 5.6% +2.75 2.50 +0.25
Sept. 5, 2006 5.9% +2.80 2.50 +0.30
Mar.5, 2007 6.4% +2.95 2.50 +0.45
Cash Flows to Microsoft
16
Typical Uses of an
Interest Rate Swap
Converting a liability from
fixed rate to floating rate
floating rate to fixed rate

Converting an investment from
fixed rate to floating rate
floating rate to fixed rate

17
Intel and Microsoft (MS)
Transform a Liability

Intel MS
LIBOR
5%
LIBOR+0.1%
5.2%
18
Financial Institution is Involved

F.I.
LIBOR
LIBOR
LIBOR+0.1%
4.985%
5.015%
5.2%
Intel MS
19
Intel and Microsoft (MS)
Transform an Asset

Intel
MS
LIBOR
5%
LIBOR-0.2%
4.7%
20
Financial Institution is Involved

Intel
F.I. MS
LIBOR LIBOR
4.7%
5.015% 4.985%
LIBOR-0.2%
21
Quotes By a Swap Market Maker
Maturity Bid (%) Offer (%) Swap Rate (%)
2 years 6.03 6.06 6.045
3 years 6.21 6.24 6.225
4 years 6.35 6.39 6.370
5 years 6.47 6.51 6.490
7 years 6.65 6.68 6.665
10 years 6.83 6.87 6.850
22
The Comparative Advantage
Argument

AAACorp wants to borrow floating
BBBCorp wants to borrow fixed
Fixed Floating
AAACorp 4.0% 6-month LIBOR + 0.30%
BBBCorp 5.20% 6-month LIBOR + 1.00%
23
The Swap

AAACorp
BBBCorp
LIBOR
LIBOR+1%
3.95%
4%
24
The Swap when a Financial
Institution is Involved

AAACorp
F.I.
BBBCorp
4%
LIBOR
LIBOR
LIBOR+1%
3.93%
3.97%
25
The Nature of Swap Rates
Six-month LIBOR is a short-term AA borrowing
rate
The 5-year swap rate has a risk corresponding to
the situation where 10 six-month loans are made
to AA borrowers at LIBOR
This is because the lender can enter into a swap
where income from the LIBOR loans is
exchanged for the 5-year swap rate