Interest Rate Risk

II
Chapter 9
2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin
9-2
Overview
The weakness of repricing model is its
reliance on book value rather than market
value of assets and liabilities.
This chapter discusses a market value-
based model for assessing and managing
interest rate risk:
Duration
Computation of duration
Economic interpretation
Immunization using duration
* Problems in applying duration
9-3
Duration
Duration is a more complete measure of an
asset or liability's interest rate sensitivity
than is maturity because duration takes into
account the time of arrival (or payment) of all
cash flows as well as the asset's (or
liability's) maturity.

9-4
Duration
Consider a loan with a 15 % interest rate and
required repayment of half the $100 in principal at
the end of six months and the other half at the end
of the year. The loan is financed with a one-year
CD paying 15% interest per year.
The promised cash flows (CF) received by the Fl
from the loan at the end of one-half year and at
the end of the year

0 6 m
1 y
CF6m= 53.75
CF1y= 57. 5
9-5
Duration
50.2
49.8
53.75
57.5
duration is the weighted-average time to maturity on the loan using
the relative present values of the cash flows as weights. In present
value terms, the relative importance of the cash flows arriving at
time t 6m year and time t = 1 year are as follows:
50.2
0.502 50.2%
49.8
0.498
49.8%
9-6
Duration
That is, the Fl receives 50.2 percent of cash flows on
the loan with the first payment at the end of six months
(t = 1/2) and 49.8 percent with the second payment at
the end of the year (t = 1).
By definition, the sum of the (present value) cash flow
weights must equal .502 + .498 = 1
We can now calculate the duration (D), or the
weighted-average time to maturity, of the loan using
the present value of its cash flows as weights:
D, = X
1/2
(1/2) + X
1
(1)
= .502(1/2) + .498 (1) = .749 years

9-7
Duration
Thus, while the maturity of the loan is one year, its
duration, or average life a cash flow sense, is only
.749 years.
The duration is less than the maturity of loan
because in present value terms 50.2 % of the cash
flows are received at the end of one-half year.
Note that duration is measured in years since we
weight the time (t) at which cash flows are
received by the relative present value importance
of cash flows {X1/2, Xl etc.).
9-8
Duration
We next calculate the duration of the one-year, $100, 15 %
interest certificate of deposit. The FI promises to make only one
cash payment to depositors at the end of year

CF: = $115, which is the promised principal ($100) and interest
repayment ($15) to the depositor.
Since weights are calculated in present value terms.
CF
1
= $115, and PV
1
= $115/1.15 = $100
Because all cash flows are received in one payment at the end of
the year, X
1
= PV
1
/PV
i
= 1, the duration of the deposit is
D
D
= X
l
* 1
D
D
= 1 * 1 = 1 year
9-9
Duration
Thus, only when all cash flows are limited to one
payment at the end of the period with no intervening
cash flows does duration equal maturity.
This example also illustrates that while the maturities on
the loan and the deposit are both one year (and thus the
difference or gap in maturities is zero), the duration gap
is negative:
gap in maturities = M
L
M
D
=1-1=0
duration gap =D
L
- D
D
= .749 - 1 =-.251 years
As will become clearer, to measure and to hedge
interest rate risk, the FI needs to manage its
duration gap rather than its maturity gap.
9-10
Price Sensitivity and Maturity
In general, the longer the term to
maturity, the greater the sensitivity to
interest rate changes.
Example: Suppose the zero coupon yield
curve is flat at 12%.
Bond A pays $1762.34 in five years. Bond
B pays $3105.85 in ten years, and both are
currently priced at $1000.
9-11
Example continued...
Bond A: P = $1000 = $1762.34/(1.12)
5

Bond B: P = $1000 = $3105.84/(1.12)
10

Now suppose the interest rate increases by
1%.
Bond A: P = $1762.34/(1.13)
5
= $956.53
Bond B: P = $3105.84/(1.13)
10
= $914.94
The longer maturity bond has the greater drop in
price because the payment is discounted a
greater number of times.
9-12
General formula for Duration
Duration
Weighted average time to maturity using the relative present values of the
cash flows as weights.

9-13
Duration
For bonds that pay interest semiannually,
the duration equation becomes


where t = , 1,l 1/2..., N.
9-14
Duration
Example1: Eurobonds pay coupons annually. Suppose a Eurobond
matures in 6 years, the annual coupon is 8 percent, the face value of
the bond is $1,000, and the current yield to maturity (R) is also 8
percent.
We show the calculation of its duration in Table.
Column 1 lists the time period (in years) in which a cash flow (CF) is
received.
Column 2 lists the CF received in time period t.
Column 3 lists the discount factor used to convert a future value to a
present value. 1/(1+R)
t
Column 4 is the present value of the CF received in each period t (Column
2 times Column 3).
The sum of Column 4 is the present value of the bond: the denominator of
the duration equation. Column 5 is the present value of the CF received
each period
times the time it takes to receive the CF (Column 4 times Column 1).
The sum of Column 5
is the time weighted present value of the bond: the numerator of the
duration equation.
As the calculation indicates, the duration or weighted-average time to
maturity on this bond is 4.993 years.
9-15
Duration
9-16
Duration
Definition of Duration
The weighted-average time to maturity on a security.
The interest elasticity of a security's price to small interest
rate changes.
Features of Duration
Duration increases with the maturity of a fixed-income
security, but at a decreasing rate.
Duration decreases as the yield on a security increases.
Duration decreases as the coupon or interest payment
increases.
Risk Management with Duration
Duration is equal to the maturity of an immunized security.
Duration gap is used by Fis to measure and manage the
interest rate risk of an overall balance sheet.
9-17
Duration
Example 2: U.S. Treasury bonds pay coupon interest
semiannually.
Suppose a Treasury bond matures in two years, the annual coupon
rate is 8 percent, the face value is $1,000, and the annual yield to
maturity (R) is 12 percent.
As the calculation indicates, the duration, or weighted-average time to
maturity, on this bond is 1.883 years.
9-18
Duration
if the annual coupon rate is lowered to
6%duration rises to 1.909 years. Since 6
percent coupon payments are lower than 8
percent, it takes longer to recover the initial
investment in the bond

9-19
Duration
duration is calculated for the original 8 percent bond,
assuming that the yield to maturity increases to 16 percent.
The higher the yield to maturity on the bond, the more the
investor earns on reinvested coupons and the shorter the
time to recover the initial investment

9-20
Duration
when the maturity on a bond decreases to 1 year its
duration falls to 0.980 year. Thus, the shorter the maturity
on the bond, the more quickly the initial investment is
recovered.

9-21
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
Present value of each cash flow equals CF
t

(1+ 0.12)
t
where t is the period number.
9-22
Duration of 2-year, 8% bond:

Face value = $1,000, YTM = 12%


t years CFt PV(CFt) Weight (W) W years
1 0.5 40 37.7964473 0.040366192 0.020183096
2 1.0 40 35.71428571 0.038142466 0.038142466
3 1.5 40 33.74682795 0.036041243 0.054061864
4 2.0 1040 829.0816327 0.8854501 1.7709002
P = 936.3391936 1 1.883287625
D=1.88328763
9-23
Duration Gap
Suppose the bond in the previous example
is the only loan asset (L) of an FI, funded by
a 2-year certificate of deposit (D).
Maturity gap: M
L
- M
D
= 2 -2 = 0
Duration Gap: D
L
- D
D
= 1.885 - 2.0 = -0.115
Deposit has greater interest rate sensitivity than
the loan, so DGAP is negative.
FI exposed to rising interest rates.
9-24
Duration of Zero-coupon Bond
Bond sell at a discount from face value on issue
Pay the face value (e.g 1000) on maturity
Have no intervening cash flows between issue and maturity.
The current price an investor is willing to pay for such a bond is equal to the
present value of the single, fixed (face value) payement on the bond that is
received on maturity (here 1000$)




R: is the required annually compounded yield to maturity
N: is the number of year to maturity
P: the price
Because there are no intervening cash flows between issue and maturity


For a zero coupon bond, duration equals maturity since 100% of its present
value is generated by the payment of the face value, at maturity.
For all other bonds:
duration < maturity
( )
N
R
p
+
=
1
1000
B B
M D =
9-25
Special Case
Maturity of a consol bond : M = .
Duration of a consol: D = 1 + 1/R
Suppose the the Yield curve implies R=5%
annually. The duration of the consol bond:


If interest rate rise the duration of consol
bond falls.

y D
c
21
05 . 0
1
1 = + =
y D
c
6
2 . 0
1
1 = + =
9-26
Features of Duration
Duration and maturity:
D increases with M, but at a decreasing rate.
Duration and yield-to-maturity:
D decreases as yield increases.
Duration and coupon interest:
D decreases as coupon increases
9-27
Economic Interpretation
Duration is a measure of interest rate sensitivity or elasticity of the
securitys price to small interest rate changes:



for small changes in interest rates, bond prices move in an inversely
proportional fashion according to the size of D.
for any given change in interest rates, long duration securities suffer a
larger capital loss (or receive a higher capital gain) should interest
rates rise (fall) than do short-duration securities.






where MD is modified duration.
R MD
R
R
D
P
P
R
D
MD when
D
R
R
P
P
A =
(

+
A
=
A
+
=
=
(

+
A

A
1
1
1
9-28
Economic Interpretation
To estimate the change in price, we can rewrite
this as:





Duration is a measure of the percentage change in
the price of a security for a 1 percent change in
the return on the security

Note the direct linear relationship between P and -D.
P R MD
P
R
R
D P
A =

+
A
= A
1
9-29
Economic Interpretation
Dollar duration is the dollar value change in the
price of a security to a 1 percent change in the
return on the security.
The dollar duration is defined as the modified
duration times the price of a security:
Dollar duration = MD X P
Thus, the total dollar change in value of a security
will increase by an amount equal to the dollar
duration times the change in the return on the
security:
P = -Dollar duration X R
9-30
Semi-annual Coupon Payments
With semi-annual coupon payments:



(
(

+
A
=
A
R
R
D
P
P
2
1
1
9-31
An example:
Consider Example 1 for the six-year Eurobond with an 8
percent coupon and 8 percent yield.
We determined its duration was D = 4.993 years.
The modified duration is:
MD=D/(1+R) MD= 4.993/1.08 MD=4.623
That is, the price of the bond will increase by
4.623 percent for a 1 percent decrease in the
interest rate on the bond.
Dollar duration =4.623 x $1,000 = 4623
or a 1 percent (or 100 basis points) change in the
return on the bond would resuit a change of
$46.23 in the price of the bond.

9-32
suppose that yields were to rise by one basis point (1/100th
of 1 percent) from 8 to 8.01 percent.
Then:






The bond price had been $1,000, which was the present
value of a six-year bond with 8 percent coupons and 8
percent yield. The duration model, and specifically dollar
duration, predicts that the price of the bond would fall to
$999.5377 after the increase in yield by one basis point.



462 . 0
1000 000462 . 0
=
= AP
9-33
EXAMPLE
Consider a consol bond with an 8 percent
coupon paid annually, an 8 percent yield,
and calculated duration of 13.5 years
(Dc = 1 + 1/.08 = 13.5).
Thus, for a one-basis-point change in the
yield (from 8 percent to 8.01 percent):
9-34
EXAMPLE
Recall from Example 2 the two-year T-bond with semiannual coupons
whose duration we derived as 1.883 years when annual yields were 12
percent. The modified duration is:


the price of the bond will increase by 1.776 percent for a 1 percent
decrease in the interest rate on the bond
the dollar duration is:


or a 1 percent (or 100 basis points) change in the return on the bond
would result a change of $16.53 in the price of the bond.
Thus, a one-basis-point rise in interest rates would have the following
predicted effect on its price:


or the price of the bond
would fall by 0.01776
percent from $930.70
to $930.5326.
9-35
Duration as Index of Interest Rate
Risk
An example:
Consider three loan plans, all of which have
maturities of 2 years. The loan amount is
$1,000 and the current interest rate is 3%.
Loan #1, is a two-payment loan with two
equal payments of $522.61 each.
Loan #2 is structured as a 3% annual
coupon bond.
Loan # 3 is a discount loan, which has a
single payment of $1,060.90.
9-36
t years CFt PV(CFt) 3% Weight (W) W years
1 1 522.61 507.3883495 0.507389163 0.507389163
2 2 522.61 492.6100481 0.492610837 0.985221675
1045.22 999.9983976 1 1.492610837
D 1.492610837
t years CFt PV(CFt) 2% Weight (W) W years
1 1 522.61 512.3627451 0.504950495 0.504950495
2 2 522.61 502.3164168 0.495049505 0.99009901
1045.22 1014.679162 1 1.495049505
D 1.495049505
t years CFt PV(CFt) 3% Weight (W) W years
1 1 30 29.41176471 0.028851593 0.028851593
2 2 1030 990.0038447 0.971148407 1.942296813
1060 1019.415609 1 1.971148407
D 1.971148407
t years CFt PV(CFt) 2% Weight (W) W years
1 1 30 29.12621359 0.029126214 0.029126214
2 2 1030 970.8737864 0.970873786 1.941747573
1060 1000 1 1.970873786
D 1.970873786
t years CFt PV(CFt) Weight (W) W years
1 2 1060.9 1000 1 2
1 2 1060.9 1019.70396 1 2
9-37
Duration as Index of Interest Rate Risk
Yield

Loan Value 2% 3% P N D
Equal
Payment

$1014.68 $1000 $14.68 2 1.493
3% Coupon $1019.42 $1000 $19.42 2 1.971

Discount $1019.70 $1000 $19.70 2 2.000


9-38
Duration and interest Rate Risk
Management on the Whole Balance
Sheet of an FI
The Duration Gap for a Financial Institution
To estimate the overall duration gap of an FI,
we determine first the duration of an FI's asset
portfolio (A) and the duration of its liability
portfolio (L). These can be calculated as:
9-39
The X
ij
's in the equation are the market value
proportions of each asset or liability held in the
respective asset and liability portfolios.
Thus, if new 30-year Treasury bonds were 1
percent of a life insurer's portfolio and (the
duration of those bonds) was equal to 9.25 years,
then X
1A
Df = .01(9.25) = 0.0925.
More simply, the duration of a portfolio of assets or
liabilities is a market value weighted average of the
individual durations of the assets or liabilities on the
FI's balance sheet.
A
D
1
9-40
Consider an FI's simplified market value balance sheet:
9-41
Immunizing the Balance Sheet of an FI
when interest rates change, the change in the FI's equity or net
worth (E) is equal to the difference between the change in the
market values of assets and liabilities on each side of the balance
sheet.
Since E = A - L, we need to determine how A and L are
related to duration.
From the duration model (assuming annual compounding of
interest):


9-42
Immunizing the Balance Sheet of an FI
These equations can be rewritten to show the dollar
changes in assets and liabilities on an FI's balance sheet
9-43
Immunizing the Balance Sheet of an FI
9-44
Duration and Immunizing
9-45
An example:
Suppose D
A
= 5 years, D
L
= 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.




The Fl could lose $2.09 million in net worth if rates rise
1 percent. Since the Fl started with $10 million in equity,
the loss of $2.09 million is almost 21 percent of its initial
net worth. (2.09/10) The market value balance sheet after
the rise in rates by 1 percent would look like this:

9-46
46 . 2
1 . 1
01 . 0
90 3
55 . 4
1 . 1
01 . 0
100 5
= =
A
= A
= =
A
= A
R
R
L D L
R
R
A D A
L
A
9-47
Duration and Immunizing
Even though the rise in interest rates would not push the Fl into economic
insolvency, it reduces the FLs net worth-to-assets ratio from 10 (10/100) to
8.29 percent (7.91/95.45).
To counter this effect, the manager might reduce the FI's adjusted duration
gap. In an extreme case, the gap might be reduced to zero:





To do this, the FI should not directly set DA = DL, which ignores the fact that
the FI's assets (A) do not equal its borrowed liabilities (L) and that k (which
reflects the ratio L/A) is not equal to 1.
But, to set AE = 0:
DA = kDL
9-48
Immunization and Regulatory Concerns
suppose the manager increased the duration of the FI's
liabilities to five years, the same as DA. Then:


The FI is still exposed to a loss of $0.45 million if rates
rise by 1 percent. An appropriate strategy would
involve changing DL until:




9-49
Immunization and Regulatory Concerns
In this case the FI manager sets DL = 5.55 years, or slightly
longer than DA = 5 years, to compensate for the fact that only 90
percent of assets are funded by borrowed liabilities, with the
other 10 percent funded by equity.
Note that the FI manager has at least three other ways to reduce
the adjusted duration gap to zero
Reduce DA. Reduce DA from 5 years to 2.7 years (equal
to kDL or (0.9*3) such that:

Reduce DA and increase DL. Shorten the duration
of assets and lengthen the duration of liabilities at the same
time. One possibility would be to reduce DA to
4 years and to increase DL to 4.44 years such that:


9-50
Immunization and Regulatory Concerns
Change k and DL. Increase k (leverage) from 0.9
to 0.95 and increase DL from 3 years to 5.26 years such
that:
9-51
*Contingent Claims
Interest rate changes also affect value of off-
balance 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.
9-52
Pertinent Websites
Bank for International Settlements
www.bis.org
Securities Exchange Commission
www.sec.gov
The Wall Street Journal
www.wsj.com