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# Chapter 9

Interest Rate
Risk II

Prepared by Lois Tullo, Schulich School of Business, York University

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

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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

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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

## Think of it this way: on a TVM basis, the

banks initial investment in the loan is
recovered after 0.7326 years
After that it earns a profit
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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.

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Example
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.
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## Duration: Definition and Features

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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.

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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.
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Yield

Yield

Yield

Yield

## Remarks on Preceding Slides

In general, longer maturity bonds experience
greater price changes in response to any
change in the discount rate.
The range of prices is greater when the coupon
is lower.
The 6% bond will show a greater change in price
in response to a 2% change than the 8% bond. The
6% bond has greater interest rate risk.

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## Balance Sheet Example

Consider FI held bond with 8% YTM, 10%
coupon, 12 years to maturity, FV=\$1000
Financed by issuing bond at 10% YTM, 10%
coupon, 12 years to maturity, FV=\$1000
PV of each bond =?

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## Balance Sheet Example

Market Value Balance Sheet:

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Impact of Maturity

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Impact of Maturity

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## Consider two ten-year maturity instruments:

A ten-year zero coupon bond.
A two-cash flow bond that pays \$999.99 almost
immediately and one penny, ten years hence.

## Small changes in yield will have a large effect on

the value of the zero but essentially no impact on the
hypothetical bond.
Most bonds are between these extremes
The higher the coupon rate, the more similar the bond is
to our hypothetical bond with higher value of cash flows
arriving sooner.

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## Duration of Zero-coupon Bond

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

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## Duration of a Consol Bond

Consol bonds are perpetual (never mature)

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.
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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.
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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.

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Features of Duration
Duration and maturity:
D increases with M, but at a decreasing rate.

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## Economic Meaning of Duration

Duration is a measure of interest rate
sensitivity or elasticity of a liability or asset:
Or equivalently,
P/P = -D[R/(1+R)] = -MD R
where MD is modified duration:

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## Economic Meaning of Duration

To estimate the change in price, we can rewrite
this as:
P = -D[R/(1+R)]P = -(MD) (R) (P)

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## Semi-annual Coupon Payments

With semi-annual coupon payments:
(P/P)/(R/R) = -D[R/(1+(R/2)]

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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

## Six Year Coupon Bond (Table 9.2)

P5 = 1080 / 1.08 = \$1000
Duration = 4.993 years (same as liability)
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## Immunizing the Balance Sheet of an FI

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.

## E = [-DAA + DLL] R/(1+R) or

Or: EDA - DLk]A(R/(1+R))
where k = L/A
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## Duration and Immunizing

The formula shows 3 effects:
Measure of exposure to interest rate risk

## The size of the FI

Measured by Assets

## The size of the interest rate shock

E = [Leverage adjusted Duration Gap] x Assets x Interest Rate Shock

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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

## Methods of immunizing balance sheet.

Adjust DA , DL or k.
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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

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## Regulators set target ratios for an FIs capital

(net worth):
Capital (Net worth) ratio = E/A

## If target is to set (E/A) = 0:

DA = DL

But, to set E = 0:
DA = kDL

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## If target is to set (E/A) = 0:

DA = DL
E = -(5-(0.9) x 5) x \$100m x (0.01/1.1) = -\$0.45m

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Set E = 0:
DA = kDL

## Ex: Set DL=5.55

E = -(5-(0.9) x 5.55) x \$100m x (0.01/1.1) = 0

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## Difficulties in Applying Duration

Immunizing the entire balance sheet need not be
costly. Duration can be employed in combination with
hedge positions to immunize.
Immunization is a dynamic process since duration
depends on instantaneous R.

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## Difficulties in Applying Duration

Large interest rate change effects not accurately
captured.
Convexity

## More complex if nonparallel shift in yield curve.

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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.

## All fixed-income securities are convex.

Convexity is desirable, but greater convexity
causes larger errors in the duration-based
estimate of price changes.
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Convexity
Recall that duration involves only the first
derivative of the price function.
We can improve on the estimate using a Taylor
expansion.

## In practice, the expansion rarely goes beyond

second order (using the second derivative).

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## Modified duration & Convexity

P/P = -D[R/(1+R)] + (1/2) CX (R)2 or
P/P = -MD R + (1/2) CX (R)2
Where MD implies modified duration and CX is a
measure of the curvature effect.
CX = Scaling factor [capital loss from 1bp rise in
yield + capital gain from 1bp fall in yield]
Commonly used scaling factor is 108.

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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.

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## Duration Measure: Other Issues

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.

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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.

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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

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Pertinent Websites
Bank for International Settlements www.bis.org
Securities Exchange Commission www.sec.gov
The Wall Street Journal
www.wsj.com

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