Chapter 9

Interest Rate Risk

II

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

 9-2
Overview

 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
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.
 9-4
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.
 9-5
Coupon Effect
 Bonds with identical maturities will
respond differently to interest rate
changes when the coupons differ. This is
more readily understood by recognizing
that coupon bonds consist of a bundle of
“zero-coupon” bonds. With higher
coupons, more of the bond’s value is
generated by cash flows which take
place sooner in time. Consequently, less
sensitive to changes in R.
 9-6
Price Sensitivity of 6% Coupon Bond

r 8% 6% 4% Range
n
40 $802 $1,000 $1,273 $471
20 $864 $1,000 $1,163 $299
10 $919 $1,000 $1,089 $170
2 $981 $1,000 $1,019 $37
 9-7
Price Sensitivity of 8% Coupon Bond

r 10% 8% 6% Range
n
40 $828 $1,000 $1,231 $403
20 $875 $1,000 $1,149 $274
10 $923 $1,000 $1,085 $162
2 $981 $1,000 $1,019 $38
 9-8
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 shows greater changes in
price in response to a 2% change than the
8% bond. The first bond has greater interest
rate risk.
 9-9
Duration
 Duration
 Weighted average time to maturity using the
relative present values of the cash flows as
weights.

 Combines the effects of differences in

coupon rates and differences in maturity.

 Based on elasticity of bond price with

respect to interest rate.
 9-10
Duration: Simple introduction
 Consider a loan with a 15 percent 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 percent
interest per year.
 9-11
Duration: Simple introduction
 9-12
Duration:weighted average time to maturity
 9-13
Duration: zero coupon bond

 Calculate the duration of the one-year, $100, 15

percent interest certificate of deposit. The FI
promises to make only one cash payment to
depositors at the end of the year; that is, CF 1
$115, which is the promised principal ($100)
and interest repayment ($15) to the depositor.
 9-14
Duration: zero coupon bond

CF1 = $115
PV1 =$115/1.15 = $100
X1 = PV 1 / PV 1 =1

Duration = 1*1 =1
 9-15
Maturity Gap Vs Duration
 Maturity Gap:
 MA – ML =0

 Duration:
 DA – DL = 0.7326 – 1 = -0.2674
 9-16
Duration : Practice Q1
 9-17
Duration : Practice Q1
Part (a)
Cash flow in 6 months
= $100,000 x .12 x .5 + $50,000
= $56,000 interest and principal.

Cash flow in 1 year

= $50,000 x 1.06
= $53,000 interest and principal.
 9-18
Duration : Practice Q1
Part (b)
PV of CF1 = $56,000  1.06
= $52,830.19
PV of CF2 = $53,000  (1.06)2
= $47,169.81

PV Total CF = $100,000.00
 9-19
Duration : Practice Q1
Part (c)
Proportiont=.5 = ($52,830.19  $100,000)*100
= 52.830 percent.

Proportiont=1 = ($47,169.81 $100,000)*100

= 47.169 percent.
 9-20
Duration : Practice Q1
Part (d)
Time Cash Flow PVof CF PV of CF x t
½ year $56,000 $52,830.19 $26,415.09
1 year $53,000 $47,169.81 $47,169.81
$100,000.00 $73,584.91

Duration = $73,584.91/$100,000.00
= 0.735849 years
 9-21
Duration : Formula
Duration
D = SNt=1[CFt• t/(1+R)t]/ SNt=1 [CFt/(1+R)t]
Where
D = duration
t = number of periods in the future
CFt = cash flow to be delivered in t periods
N= time-to-maturity
R = yield to maturity.
 9-22
Duration : Formula
 The denominator of the duration equation is
the present value of the cash flows on the
security (which in an efficient market will be
equal to the current market price).

 The numerator is the present value of each

cash flow received on the security multiplied
or weighted by the length of time required to
receive the cash flow.
 9-23
Duration : Formula
 Since the price (P) of the bond must
equal the present value of all its cash
flows, we can state the duration formula
another way:
D = SNt=1[t  (Present Value of CFt/P)]

 Notice that the weights correspond

to the relative present values of the
cash flows.
 9-24
Duration : Assumptions

 Flat yield curve & parallel interest

rate changes
 No default Risk
 9-25
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
 9-26
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
CFt ÷ (1+ 0.06)t where t is the period
number.
 9-27
Duration of 2-year, 8% bond:

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

t year CFt PV(CFt) Weigh W × years

s t (W)
1 0.5 40 37.736 0.041 0.020
2 1.0 40 35.600 0.038 0.038
3 1.5 40 33.585 0.036 0.054
4 2.0 1,040 823.777 0.885 1.770
P = 930.698 1.000 D=1.883
(years)
 9-28
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: ML - MD = 2 -2 = 0

 Duration Gap: DL - DD = 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.
 9-29
Duration : Practice Q2
 9-30
Duration : Practice Q2
Part (a) Coupon Bond
Par value = $1,000 Coupon rate = 10%
Annual payments

R = 8% Maturity = 2 years

Time Cash Flow PV of CF PV of CF x t

1 $100.00 $92.59 $92.59
2 $1,100.00 $943.07 $1,886.15
$1,035.67 $1,978.74

Duration = $1,978.74/$1,035.67
= 1.9106
 9-31
Duration : Practice Q2
R = 10% Maturity = 2 years
Time Cash Flow PV of CF PV of CF x t
1 $100.00 $90.91 $90.91
2 $1,100.00 $909.09 $1,818.18
$1,000.00 $1,909.09

Duration = $1,909.09/$1,000.00
= 1.9091
 9-32
Duration : Practice Q2
R = 12% Maturity = 2 years
Time Cash Flow PV of CF PV of CF x t
1 $100.00 $89.29 $89.23
2 $1,100.00 $876.91 $1,753.83
$966.20 $1,753.83

Duration = $1,753.83/$966.20
= 1.8151
 9-33
Duration : Practice Q2
Part c)
Zero Coupon Bond
Par value = $1,000 Coupon rate = 0%
R = 8% Maturity = 2 years

Time Cash Flow PV of CF PV of CF x t

2 $1,000.00 $857.34 $1,714.68
$857.34 $1,714.68

Duration = $1,714.68/$857.34
= 2.0000
 9-34
Duration : Practice Q2
Zero Coupon Bond
Par value = $1,000 Coupon rate = 0%

R = 10% Maturity = 2 years

Time Cash Flow PV of CF PV of CF x t

2 $1,000.00 $826.45 $1,652.89
$826.45 $1,652.89

Duration = $1,652.89/$826.45
= 2.0000
 9-35
Duration : Practice Q2
Zero Coupon Bond
Par value = $1,000 Coupon rate = 0%

R = 12% Maturity = 2 years

Time Cash Flow PV of CF PV of CF x t
2 $1,000.00 $797.19 $1,594.39
$797.19 $1,594.39

Duration = $1,594.39/$797.19
= 2.0000
 9-36
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
 9-37
Duration & Maturity
 9-38
Duration Pratice Q3
 9-39
Duration Pratice Q3
Time Cash Flow PV of CF PV of CF x t
0.5 $50.00 $47.62 $23.81
1 $50.00 $45.35 $45.35
1.5 $50.00 $43.19 $64.79
2 $50.00 $41.14 $82.27
2.5 $50.00 $39.18 $97.94
3 $50.00 $37.31 $111.93
3.5 $50.00 $35.53 $124.37
4 $50.00 $33.84 $135.37
4.5 $50.00 $32.23 $145.04
5 $1,050.00 $644.61 $3,223.04
$1,000.00 $4,053.91
 9-40
Duration Pratice Q3

Duration = $4,053.91/$1,000.00
= 4.0539
 9-41
Duration Pratice Q3
Time Cash Flow PV of CF PV of CF x t
0.5 $50.00 $47.17 $23.58
1 $50.00 $44.50 $44.50
1.5 $50.00 $41.98 $62.97
2 $50.00 $39.60 $79.21
2.5 $50.00 $37.36 $93.41
3 $50.00 $35.25 $105.74
3.5 $50.00 $33.25 $116.38
4 $50.00 $31.37 $125.48
4.5 $50.00 $29.59 $133.18
5 $1,050.00 $586.31 $2,931.57
$926.40 $3,716.03
Duration = $3,716.03/$926.40 = 4.0113
 9-42
Duration Pratice Q3
Time Cash Flow PV of CF PV of CF x t
0.5 $50.00 $46.73 $23.36
1 $50.00 $43.67 $43.67
1.5 $50.00 $40.81 $61.22
2 $50.00 $38.14 $76.29
2.5 $50.00 $35.65 $89.12
3 $50.00 $33.32 $99.95
3.5 $50.00 $31.14 $108.98
4 $50.00 $29.10 $116.40
4.5 $50.00 $27.20 $122.39
5 $1,050.00 $533.77 $2,668.83
$859.53 $3,410.22
Duration = $3, 410.22/$859.53 = 3.9676
Duration of 2 year 8% bond with 12% 9-43

YTM
Duration of 2 year 6% bond with 12% 9-44

YTM
 9-45
Duration : Example (Coupon Paying Bonds)

 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.
 9-46
Duration : Example (Coupon Paying Bonds)
 9-47
Duration – Practice Q4
 9-48
Duration – Practice Q4
(a) Two-year loan: Principal and interest at end of year two
Par value = $100,000 Coupon rate = 0%
No annual payments
R = 10% Maturity = 2 years
Time Cash Flow PV of CF PV of CF x t
1 $0 $0.00 $0.00
2 $121,000 $100,000.00 $200,000.00
$100,000.00 $200,000.00

Duration = $200,000/$100,000
= 2.000
 9-49
Duration – Practice Q4
(Two-year loan: Interest at end of year one; Principal and
interest at end of year two
Par value = $100,000 Coupon rate = 10%
Annual payments
R = 10% Maturity = 2 years
Time Cash Flow PV of CF PV of CF x t
1 $10,000 $9,090.91 $9,090.91
2 $110,000 $90,909.09 $181,818.18
$100,000.00 $190,909.09

Duration = $190,909.09/$100,000
= 1.9091
 9-50
Duration – Practice Q4
(Two-year loan: Amortized over two years
Par value = $100,000 Coupon rate = 10%
Annual amortized payments = $57,619.05
R = 10% Maturity = 2 years

Time Cash Flow PV of CF PV of CF x t

1 $57,619.05 $52,380.95 $52,380.95
2 $57,619.05 $47,619.05 $95,238.10
$100,000.00 $147,619.05

Duration = $147,619.05/$100,000
= 1.4762
 9-51

 Duration decreases
dramatically when a
portion of the
principal is repaid at
the end of year one.
 Duration often is
described as the
Duration and Repayment
weighted-average Choice
maturity of an asset.
2.25
Years 2.0000 1.9091
 If more weight is 1.75
1.4762
given to early
1.25
payments, the
1 2 3
effective maturity of
Repayment Alternatives
the asset is reduced.
 9-52
Duration of Perpetuities
 Maturity of a consol: M = .

 Duration of a consol:
D = 1 + 1/R
 9-53
Duration of Perpetuities - Example
 Suppose that the yield curve implies R =
5 percent annually.

 Then the duration of the consol bond

would be:
 9-54
Duration of Perpetuities - Example
 Suppose that the yield curve implies R =
5 percent annually.

 Then the duration of the consol bond

would be:

 D = 1 + 1/0.05
= 21 years
 9-55
Duration of Perpetuities - Practice
 9-56
Duration of Perpetuities - Practice
 9-57
Economic Interpretation
 In addition to being a measure of the average life, in a
cash flow sense, of an asset or liability, duration is
also a direct measure of the interest rate sensitivity, or
elasticity, of an asset or liability.

 In other words, the larger the numerical value of D, the

more sensitive is the price of that asset or liability to
changes or shocks in interest rates.

 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
 9-58
Economic Interpretation
 Duration is a measure of interest rate
sensitivity or elasticity of a liability or
asset:
[ΔP/P]  [ΔR/(1+R)] = -D

 Or equivalently,
ΔP/P = -D[ΔR/(1+R)]
= -MD × ΔR

Where, MD is modified duration.

 9-59
Economic Interpretation
ΔP/P = -D[ΔR/(1+R)]
 Equation shows that for small changes in interest
rates, bond prices move in an inversely proportional
fashion according to the size of D.
 Clearly, 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.
 By implication, gains and losses under the duration
model are symmetric.
 That is, the capital gains would be a mirror image of
the capital losses for an equal (small) increase in
interest rates.
 9-60
Economic Interpretation
ΔP/P = -D[ΔR/(1+R)]
= -MD × ΔR
MD = D/(1+R)

 This form is more intuitive because we multiply MD by

the simple change in interest rates rather than the
discounted change in interest rates as in the general
duration equation.
 9-61
Economic Interpretation – Dollar Duration

 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 * Price

 To estimate the change in price, we can rewrite this as:

ΔP = -D[ΔR/(1+R)]P
= -(MD) × (P) × (ΔR)
= -Dollar Duration * Change in R
 9-62
Dollar Duration - Example

 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. Calculate Duration, Modified
Duration, Dollar Duration.
 9-63
Duration : Example (Coupon Paying Bonds)
 9-64
Dollar Duration - Example

The modified duration is:

MD = D/(1 + R)
= 4.993/1.08 = 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.
 9-65
Dollar Duration - Example

The dollar duration is:

Dollar duration
= 4.623 * $1,000 or 0.04623 * 1000
= 4,623 or 46.23

 1 percent (or 100 basis points) change in the

return on the bond would result a change of
$46.23 (4623/100) in the price of the bond
 9-66
Dollar Duration - Example

 Suppose that yields were to rise by one basis point

(1/100th of 1 percent) from 8 to 8.01 percent.

Then:

 ΔP/P = ???
 9-67
Dollar Duration - Example

 Suppose that yields were to rise by one basis point

(1/100th of 1 percent) from 8 to 8.01 percent.

Then:

 ΔP/P = -D[ΔR/(1+R)]
= - (4.993)* [ 0.0001 / 1.08 ]
= - 0.000462 or -0.0462
 9-68
Dollar Duration - Example

 Suppose that yields were to rise by one basis point

(1/100th of 1 percent) from 8 to 8.01 percent.

Then:

ΔP = ???
 9-69
Dollar Duration - Example

 Suppose that yields were to rise by one basis point

(1/100th of 1 percent) from 8 to 8.01 percent.

Then:

ΔP = -Dollar Duration * Change in R

= -4623 * 0.0001
= -0.4623
 9-70
Semi-annual Coupon Payments
 With semi-annual coupon payments:

(ΔP/P)/(ΔR/R) = -D[ΔR/(1+(R/2)]
 9-71
Duration – Practice Q5
 You have discovered that the price of a
bond rose from $975 to $995 when the
yield to maturity fell from 9.75 percent to
9.25 percent. What is the duration of the
bond?
 9-72
Duration – Practice Q5
 9-73
Duration – Practice Q6
 Calculate the duration of a two-year,
$1,000 bond that pays an annual coupon
of 10 percent and trades at a yield of 14
percent. What is the expected change in
the price of the bond if interest rates
decline by 0.50 percent (50 basis
points)?
 9-74
Duration – Practice Q6
Two-year Bond
Par value = $1,000 Coupon rate = 10%
Annual payments
R = 14% Maturity = 2 years
Time Cash Flow PV of CF PV of CF x t
1 $100 $87.72 $87.72
2 $1,100 $846.41 $1,692.83
$934.13 $1,780.55

Duration = $1,780.55/$934.13
= 1.9061
 9-75

 The expected change in price =

 9-76
Duration – Practice Q7
 9-77
Duration – Practice Q7
Modified Duration = D/(1 + R/2)
= 6.763/(1 + .10/2)
= 6.44 years

Dollar Duration = MD * Price

= 6.44 * 1000
= 6440
 9-78
Duration – Practice Q7
Estimated change in price (10% increase)
= -MD x R x P
= -6.44 x 0.001 x $1,000
= -$6.44.

 Estimated change in price (20% decrease)

= -MD x R x P
= -6.44 x -0.002 x $1,000
= $12.88.
 9-79
Duration – Practice Q7 Actual Price Calculation

Semi Annual Bond:

(10 basis points increase in interest rates)

N = 11 * 2 = 22
I = (10 + 0.1)/2 = 5.05%
Pmt = 100 / 2 = 50
FV = Par Value = 1000
PV = Solve = 993.45
 9-80
Duration – Practice Q7 Actual Price Calculation

Semi Annual Bond:

(20 basis points decrease in interest rates)

N = 11 * 2 = 22
I = (10 - 0.2)/2 = 4.9%
Pmt = 100 / 2 = 50
FV = Par Value = 1000
PV = Solve = 1013.28
 9-81
Duration – Practice Q7
Rate Price Actual
Change Estimated Price Error

+ 0.001 $993.56 $993.45 $0.11

- 0.002 $1,012.88 $1,013.28 -$0.40
Duration & Interest Rate Risk Management on a9-82
single security
 To immunize, or protect, itself against interest rate
risk, the insurer needs to determine which investments
would produce a cash flow of exactly what is required
in five years regardless of what happens to interest
rates in the immediate future.
 The FI investing either in a five-year maturity and
duration zero-coupon bond or in a coupon bond with a
five-year duration would produce desired cash flow in
five years no matter what happened to interest rates in
the immediate future.
1) Buying five-year maturity deep discount bonds
(Zero coupon bonds).
2) Buying five-year duration coupon bonds.
 9-83
Interest Rate Risk Management - Example

 There is a six-year maturity Eurobond paying 8 percent

coupons with an 8 percent yield to maturity had a
duration of 4.993 years, or approximately five years.
 If we buy this six-year maturity, five year duration bond
in 2016 and hold it for five years, until 2021, the term
exactly matches the target horizon of the insurer.
 The cash flows generated at the end of five years will
be $1,469 whether interest rates stay at 8 percent or
instantaneously (immediately) rise to 9 percent or fall
to 7 percent.
 Thus, buying a coupon bond whose duration exactly
matches the time horizon of the insurer also
immunizes the insurer against interest rate changes.
 9-84
Interest Rate Risk Management - Example
 9-85
Interest Rate Risk Management – Example
 9-86
Interest Rate Risk Management – Example
 9-87
Interest Rate Risk Management – Example
 9-88
Interest Rate Risk Management – Practice Q8
 9-89
Interest Rate Risk Management – Practice Q8

Five-year Bond
Par value = $1,000 Coupon rate = 15%
Annual payments
R = 9% Maturity = 5 years
Time Cash Flow PV of CF PV of CF x t
1 $150 $137.62 $137.62
2 $150 $126.25 $252.50
3 $150 $115.83 $347.48
4 $150 $106.26 $425.06
5 $1,150 $747.42 $3,737.10
$1,233.38 $4,899.76

Duration =$4899.76/1,233.38
= 3.97
 9-90
Interest Rate Risk Management – Practice Q8

Value of bond at end of year four: PV = $1,045.45.

Future value of interest payments at end of year four:
= $696.15.
Future value of all cash flows at n = 4:
Coupon interest payments over four years $600.00
Interest on interest at 10 percent
$96.15
Value of bond at end of year four $1,045.45
Total future value of investment $1741.60

Yield on purchase of asset at $1,233.38

= $1,741.60*PVIVn=4, i=?%  i = 9.00913%.
 9-91
Interest Rate Risk Management – Practice Q8

Yield on purchase of asset at $1,233.38

N = Investment Horizon = 4 years

PV = Price at which assets was purchased
= -1233.38
FV = Future value of investment after 4 years
= 1741.60
Pmt =0
I = Return on Investment
Solve = 9.00913%
 9-92
Interest Rate Risk Management – Practice Q8

Value of bond at end of year four: PV = $1,064.81.

Future value of interest payments at end of year four:
= $675.92.
Future value of all cash flows at n = 4:
Coupon interest payments over four years $600.00
Interest on interest at 8 percent
$75.92
Value of bond at end of year four $1,064.81
Total future value of investment $1740.73

Yield on purchase of asset at $1,233.38

= $1,740.73*PVIVn=4, i=?%  i = 8.99551%.
 9-93
Interest Rate Risk Management – Practice Q8

Yield on purchase of asset at $1,233.38

N = Investment Horizon = 4 years

PV = Price at which assets was purchased
= -1233.38
FV = Future value of investment after 4 years
= 1740.73
Pmt =0
I = Return on Investment
Solve = 8.99551%
 9-94
Immunizing the Balance Sheet of FI

 The duration model can also evaluate the overall

interest rate exposure for FI, that is, measure the
duration gap on its balance sheet.
 Duration Gap is a measure of overall interest rate risk
exposure for FI.

 TA = TL + E
 Change in Equity = Change in TA – Change in TL
 9-95
Immunizing the Balance Sheet of FI
 9-96
Immunizing the Balance Sheet of FI

 Duration Gap:
 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
 E = -[DA - DLk] *A * (R/(1+R))
 Where, k = L /A
 9-97
Duration and Immunizing
 The formula shows 3 effects:
 Leverage adjusted D-Gap
 The size of the FI
 The size of the interest rate shock
 9-98
Duration and Immunizing
 Leverage adjusted D-Gap
 This gap is measured in years and reflects the
degree of duration mismatch in an FI’s balance
sheet. Specifically, the larger this gap is in
absolute terms, the more exposed the FI is to
interest rate shocks.
 The size of the FI
 The term A measures the size of the FI’s assets.
The larger the scale of the FI, the larger the dollar
size of the potential net worth exposure from any
given interest rate shock.
 The size of the interest rate shock
 The larger the shock, the greater the FI’s
exposure.
 9-99
Duration and Immunizing
 9-100
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.
 9-101
An example:
 E = -[DA - DLk] *A * [R/(1+R)]

= -[5 - 3(90/100)]100[.01/1.1]

= - $2.09.

 Methods of immunizing balance sheet.

 Adjust DA , DL or k.
 9-102
Duration – Practice Q9
 9-103
Duration – Practice Q9
For Bank A, an increase of 100 basis points in interest rate will
cause the market values of assets and liabilities to decrease as
follows:
Loan:
N =7 I =12% FV =
Pmt = 120,000 Solve for PV = 945,737.57

CD:
N = 10 I =11% FV = 1M
Pmt = 100,000 Solve for PV = 941,10768

Therefore, the decrease in value of the asset was $4,629.89 less

than the liability.
 9-104
Duration – Practice Q9
For Bank B, an increase of 100 basis points in interest rate will
cause the market values of assets and liabilities to decrease as
follows:
Bond:
N =7 I =13%
FV = 1976362.88 Pmt = 0
Solve for PV = 840074.08

CD:
N = 10 I =11% FV = 1M
Pmt = 82750 Solve for PV = 839518.43

The bond value decreased $53,932.12, and the CD value fell

$54,487.79.
Therefore, the decrease in value of the asset was $555.67 less
than the liability.
 9-105
Duration – Practice Q10
 9-106
Duration – Practice Q10
Two-year Capital Note (values in thousands of $s)
Par value = $900 Coupon rate = 7.25%
Semiannual payments
R = 7.25% Maturity = 2 years

Time Cash Flow PV of CF PV of CF x t

0.5 $32.625 $31.48 $15.74
1 $32.625 $30.38 $30.38
1.5 $32.625 $29.32 $43.98
2 $932.625 $808.81 $1,617.63
$900.00 $1,707.73

Duration = $1,707.73/$900.00
= 1.8975
 9-107
Duration – Practice Q10

Leverage - adjusted duration gap = [D A - DL k = 9.94 - 1.8975

$900,000
= 8.23 years
$1,000,000
 9-108
Duration – Practice Q10

What is the impact on equity value if the relative change in all market interest rates is
decrease of 20 basis points? Note, the relative change in interest rates is R/(1+R/2
-0.0020.

The change in net worth using leverage adjusted duration gap is given by:

E = - [D A - DL k * A *
R
R
[ 
= - 9.94 - (1.8975) 9 (1,000,000)( -.002) = $16,464
10
1
2
 9-109
Duration – Practice Q10
 If the FI wishes to be immune from the effects of interest rate
risk (either positive or negative changes in interest rates), a
desirable leverage-adjusted duration gap (DGAP) is zero.

 If the FI is confident that interest rates will fall, a positive

DGAP will provide the greatest benefit.

 If the FI is confident that rates will increase, then negative

DGAP would be beneficial.
 9-110
Duration – Practice Q10
 9-111
Immunization and Regulatory Concerns

 Regulators set target ratios for an FI’s

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
 9-112
*Limitations of 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.
 Large interest rate change effects not
accurately captured.
 Convexity
 More complex if nonparallel shift in yield curve.
 Read Book “Difficulties in applying the duration
model”.
 9-113
*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.
 9-114
Duration – Practice Q11
 9-115
Duration – Practice Q11
 9-116
Duration – Practice Q11
Five-year Loan (values in millions of $s)
Par value = $65 Coupon rate = 12% Annual payments
R = 12% Maturity = 5 years

Time Cash Flow PV of CF PV of CF x t

1 $7.8 $6.964 $6.964
2 $7.8 $6.218 $12.436
3 $7.8 $5.552 $16.656
4 $7.8 $4.957 $19.828
5 $72.8 $41.309 $206.543
$65.000 $262.427

Duration = $262.427/$65.000
= 4.0373
 9-117
Duration – Practice Q11

Part b)

DA = Sum of (Value of each asset * duration) / TA

= [30(0) + 65(4.0373) + 125(.36)]/220

= 1.3974 years
 9-118
Duration – Practice Q11
Part c)

Two-year Core Deposits (values in millions of $s)

Par value = $20 Coupon rate = 8%

Annual payments
R = 8% Maturity = 2 years

Time Cash Flow PV of CF PV of CF x t

1 $1.6 $1.481 $1.481
2 $21.6 $18.519 $37.037
$20.00 $38.519

Duration = $38.519/$20.00
= 1.9259
 9-119
Duration – Practice Q11

Part d)

DL = Sum of (Value of each liability * duration)/TL

= [20*(1.9259) + 180*(.401)]/200
= .5535 years
 9-120
Duration – Practice Q11

Part e)

GBI’s leveraged adjusted duration gap is:

= -[DA - DLk]
= 1.3974 - 200/220 * (.5535)
= .8942years
 9-121
Duration – Practice Q11
Part f)
Since GBI’s duration gap is positive, an increase in
interest rates will lead to a decline in net worth.

For a 1 percent increase, the change in net worth is:

ΔE = -[DA - DLk] *A * (R/(1+R))

= -0.8942 x $220 x (0.01)

= -$1,967,280
(new net worth will be $18,032,720).
 9-122
Duration – Practice Q11
Part g)
Since GBI’s duration gap is positive, an decrease in
interest rates will lead to an increase in net worth.

For a 0.5 percent decrease, the change in net worth is:

ΔE = -[DA - DLk] *A * (R/(1+R))

= -0.8942 * (-0.005) * $220
= $983,640
(new net worth will be $20,983,640).
 9-123
Pertinent Websites
Bank for International Settlements
www.bis.org
Securities Exchange Commission
www.sec.gov
The Wall Street Journal
www.wsj.com