CHAPTER 7 FIN - 442

INSTRUCTER : Kazi Md. Tarique

CLASS HANDNOUTS
DURATION
- Duration is a value and time weighted measure of maturity that
consider the timing of all cash inflows from earning assets and
all cash outflows associated with liabilities.
Net worth (NW) of a Bank = Asset Liabilities
If interest rate changes the NW of Bank, but change in NW will
vary depending upon the relative maturities of its assets and
liabilities.
In case of an interest rate rise, a Bank with longer duration asset
than liabilities, will suffer a decline in its NW
- Percentage change in asset market value can be derived by,
) 1 (
*
i
i
D
P
P
+

Example: A bond held by Bank, will mature in 4 years , Market

interest rate 10 %, forecasts suggests it will go up by 1% change in
market value will be,

,
_

10 . 1
01 .
* 4Years
P
P
= -3.64 %
- If Banks wants to hedge against interest rate fluctuation it would
like to keep its assets and liabilities in a way that ensures zero
duration.
Duration Gap= Dollar weighted duration of asset portfolio Dollar
weighted duration of Bank liabilities
But usually asset should exceed liability. So to make a zero gap we
need to make sure.
Dollar weighted duration of the Banks asset portfolio,
=Dollar weighted duration of the Banks liability portfolio * Total
liabilities / Total assets
Positive Duration Gap =
(Dollar weighted asset duration Dollar weighted liability duration) >0
An increase in interest rate will decrease the net worth of Bank
Negative Duration =
(Dollar weighted asset duration Dollar weighted liability duration) <0
A fall in interest rate will decrease the net worth of the Bank
Change in value of Banks worth,
Change Interest Rate
=[- Average Duration of Asset * * Total Asset
(1+ Original Interest Rate)
Change in Interest Rate
-[-Average Duration of Liabilities* *Total Liabilities]
(1+Original Interest Rate)
Example: A Bank has ---
Average Duration of Asset = 3 years
Average Duration of Liabilities = 2 years
Total Assets = $ 120 Mil
Total Liabilities = $ 100 Mil
Interest Rate = 105, Rises by 2%
Change in Value of Banks net worth =
0.02 .02
[-3* * $120 Mil] [-2* * $100 mil] = - $ 2.91 mil
(1+.10) (1+.10)
Duration of An asset =
1
]
1

) 1 (
Re *
te DiscountRa
cieved TimePeriod et lowFromAss nualCashIf ExpectedAn
Assets Markets Price
[Market price=

+
n
te DiscountRa
flow ExpectedIn
1
]
) 1 (
Example: Bank holds $ 1000 par value bond with 10 years to final
Maturity bearing a 10 % coupon rate, current market price is $ 900.
Duration of the Bond is,
1
]
1

+
+
+
+ +
+
+
+
10 10 2 1
) 10 . 1 (
) 10 ( 1000 $
) 10 . 1 (
) 10 ( 100 $
) 10 . 1 (
) 2 ( 100 $
) 01 . 1 (
) 1 ( 100 $
=
$900
$6741.04
=
$900
=7.49 years
Dollar Weighted asset Duration,
=
lAsset tValueOfAl TotalMarke
lio etInPortfo eOfEachAss MarketValu nPortfolio EachAssetI DurationOf *
# Example in Page-
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