Topic 6 Interest rate risk II: the duration model

Answers to end-of-chapter questions

Book value accounting reports assets and liabilities at the original issue values. Market value
accounting reports assets and liabilities at their current market values. Current market values
may be different from book values because they reflect current market conditions, such as
current interest rates. FIs generally report their balance sheets using book value accounting
methods. This is a problem if an asset or liability has to be liquidated immediately. If the asset or
liability is held until maturity, then the reporting of book values does not pose a problem.

For an FI, a major factor affecting asset and liability values is interest rate changes. If interest
rates increase, the value of both loans (assets) and deposits and debt (liabilities) fall. If assets and
liabilities are held until maturity, it does not affect the book valuation of the FI. However, if
deposits or loans have to be refinanced, then market value accounting presents a better picture of
the condition of the FI. The process by which changes in the economic value of assets and
liabilities are accounted is called marking to market. The changes can be beneficial as well as
detrimental to the total economic health of the FI.

Duration measures the weighted-average life of an asset or liability in economic terms. As such,
duration has economic meaning as the interest sensitivity (or interest elasticity) of an asset's
value to changes in the interest rate. Duration differs from maturity as a measure of interest rate
sensitivity because duration takes into account the time of arrival and the rate of reinvestment of
all cash flows during the assets life. Technically, duration is the weighted-average time to
maturity using the relative present values of the cash flows as the weights.

3
(a) What will be the cash flows at the end of six months and at the end of the year?

CF1/2 = ($100 000 × 0.12 × ½) + $50 000 = $56 000 interest and principal
CF1 = ($50 000 × 0.12 × ½) + $50 000 = $53 000 interest and principal

(b) What is the present value of each cash flow discounted at the market rate? What is the total
present value?

PV of CF1/2 = $56 000  1.06 = $52 830.19

PV of CF1 = $53 000  (1.06)2 = $47 169.81

PV Total CF = $100 000

(c) What proportion of the total present value of cash flows occurs at the end of 6 months?
What proportion occurs at the end of the year?

X½ = $52 830.19  $100 000 = 0.5283 = 52.83%

X1 = $47 169.81  $100 000 = 0.4717 = 47.17%

(d) What is the duration of this loan?

Duration = 0.5283(1/2) + 0.4717(1) = 0.7358 years

Or, using the table form:

t CF PV of CF PV of CF × t
½ $56 000 $52 830.19 $26 415.09
1 $53 000 $47 169.81 $47 169.81
$100 000.00 $73 584.91

Duration = $73 584.91/$100 000.00 = 0.7358 years

(a) What is the duration of the coupon bond if the current yield-to-maturity (R) is 8 per cent? 10
per cent? 12 per cent?

Coupon Bond: Par value = $1000 Coupon rate = 10% Annual payments
R = 8% Maturity = 2 years

t CF PV of CF PV of CF × t
½ $100 $92.59 $92.59
1 $1100 $943.07 $1886.15
$1035.67 $1978.74

Duration = $1978.74/$1035.67 = 1.9106 years

R = 10% Maturity = 2 years

t CF PV of CF PV of CF × t
½ $100 $90.91 $90.91
1 $1100 $909.09 $1818.18
$1000.00 $1909.09

Duration = $1909.09/$1000.00 = 1.9091 years

R = 12% Maturity = 2 years

t CF PV of CF PV of CF × t
½ $100 $89.29 $89.23
1 $1100 $876.91 $1753.83
$966.20 $1843.11

Duration = $1843.11/$966.20 = 1.9076 years

(b) How does the change in the current yield to maturity affect the duration of this coupon
bond?

Increasing the yield to maturity decreases the duration of the bond.

(c) Calculate the duration of the zero-coupon bond with a yield to maturity of 8 per cent, 10 per
cent and 12 per cent.

Zero Coupon Bond: Par value = $1000 Coupon rate = 0%

R = 8% Maturity = 2 years
 t CF PV of CF PV of CF × t
2 $1000 $857.34 $1714.68
$857.34 $1714.68

Duration = $1714.68/$857.34 = 2.0000

R = 10% Maturity = 2 years

t CF PV of CF PV of CF × t
2 $1000 $826.45 $1652.89
$826.45 $1652.89

Duration = $1652.89/$826.45 = 2.0000

R = 12% Maturity = 2 years

t CF PV of CF PV of CF × t
2 $1000 $797.19 $1594.39
$797.19 $1594.39

Duration = $1594.39/$797.19 = 2.0000 years

(d) How does the change in the yield to maturity affect the duration of the zero-coupon bond?

Changing the yield to maturity does not affect the duration of the zero coupon bond.

(e) Why does the change in the yield to maturity affect the coupon bond differently than it
affects the zero-coupon bond?

Increasing the yield to maturity on the coupon bond allows for a higher reinvestment income
that more quickly recovers the initial investment. The zero-coupon bond has no cash flow until
maturity.

5 What is the duration of a five-year, $1000 Treasury Bond with a 10 per cent semi-annual
coupon selling at par? Selling with a yield to maturity of 12 per cent? 14 per cent? What can
you conclude about the relationship between duration and yield to maturity? Plot the
relationship. Why does this relationship exist? LO 6.1, 6.2

Five-year Treasury Bond: Par value = $1000 Coupon rate = 10% Semi-annual payments
R = 10% Maturity = 5 years

t CF PV of CF PV of CF × t
0.5 $50 $47.62 $23.81
1 $50 $45.35 $45.35
1.5 $50 $43.19 $64.79
2 $50 $41.14 $82.27
2.5 $50 $39.18 $97.94
3 $50 $37.31 $111.93
3.5 $50 $35.53 $124.37
4 $50 $33.84 $135.37
4.5 $50 $32.23 $145.04
5 $1050 $644.61 $3223.04
$1000.00 $4053.91

Duration = $4053.91/$1000.00 = 4.0539 years

R = 12% Maturity = 5 years

t CF PV of CF PV of CF × t
0.5 $50 $47.17 $23.58
1 $50 $44.50 $44.50
1.5 $50 $41.98 $62.97
2 $50 $39.60 $79.21
2.5 $50 $37.36 $93.41
3 $50 $35.25 $105.74
3.5 $50 $33.25 $116.38
4 $50 $31.37 $125.48
4.5 $50 $29.59 $133.18
5 $1050 $586.31 $2931.57
$926.40 $3716.03

Duration = $3716.03/$926.40 = 4.0113 years

R = 14% Maturity = 5 years

t CF PV of CF PV of CF × t
0.5 $50 $46.73 $23.36
1 $50 $43.67 $43.67
1.5 $50 $40.81 $61.22
2 $50 $38.14 $76.29
2.5 $50 $35.65 $89.12
3 $50 $33.32 $99.95
3.5 $50 $31.14 $108.98
4 $50 $29.10 $116.40
4.5 $50 $27.20 $122.39
5 $1050 $533.77 $2668.83
$859.53 $3410.22

Duration = $3410.22/$859.53 = 3.9676 years

Duration and YTM

4.08 4.0539

4.04 4.0113
Years

4.00 3.9676
3.96
3.92
0.10 0.12 0.14

Yield to maturity

(a) Calculate the duration for a bond that has a maturity of four years, three years and two
years?

Four-year Treasury Bond: Par value = $1000 Coupon rate = 10% Semi-annual payments
R = 10% Maturity = 4 years

t CF PV of CF PV of CF × t
0.5 $50 $47.62 $23.81
1 $50 $45.35 $45.35
1.5 $50 $43.19 $64.79
2 $50 $41.14 $82.27
2.5 $50 $39.18 $97.94
3 $50 $37.31 $111.93
3.5 $50 $35.53 $124.37
4 $50 $710.53 $2842.73
$1000.00 $3393.19

Duration = $3393.19/$1000.00 = 3.3932 years

R = 10% Maturity = 3 years

t CF PV of CF PV of CF × t
0.5 $50 $47.62 $23.81
1 $50 $45.35 $45.35
1.5 $50 $43.19 $64.79
2 $50 $41.14 $82.27
2.5 $50 $39.18 $97.94
3 $50 $783.53 $2350.58
$1000.00 $3393.19

Duration = $2664.74/$1000.00 = 2.6647 years

R = 10% Maturity = 2 years

t CF PV of CF PV of CF × t
0.5 $50 $47.62 $23.81
1 $50 $45.35 $45.35
1.5 $50 $43.19 $64.79
2 $50 $863.84 $1727.68
$1000.00 $1861.62

Duration = $1861.62/$1000.00 = 1.8616 years

(b) What conclusions can you reach about the relationship of duration and the time to maturity?
Plot the relationship.

As maturity decreases, duration decreases at a decreasing rate. Although the graph below does
not illustrate with great precision, the change in duration is less than the change in time to
maturity.
 Duration and maturity

4.00
3.3932

3.00
2.6647
Years

2.00
1.8616
1.00

0.00
2 3 4

Time to maturity

17

(a) Show that the duration of this bond is equal to five years.

Six-year Bond: Par value = $1000 Coupon rate = 8% Annual payments

R = 9% Maturity = 6 years

t CF PV of CF PV of CF × t
1 $80 $73.39 $73.39
2 $80 $67.33 $134.67
3 $80 $61.77 $185.32
4 $80 $56.67 $226.70
5 $80 $51.99 $259.97
6 $1080 $643.97 $3863.81
$955.14 $4743.87

Duration = $4743.87/955.14 = 4.97  5 years

(b) Show that if interest rates rise to 10 per cent within the next year and your investment
horizon is five years from today, you will still earn a 9 per cent yield on your investment.

Value of bond at end of year five: PV = ($80 + $1000)  1.10 = $981.82.

Future value of interest payments at end of year five: $80 × FVIF (n=4, i=10%) = $488.41.
Future value of all cash flows at n = 5:

Coupon interest payments over five years $400.00

Interest on interest at 10 per cent $88.41
Value of bond at end of year five $981.82
Total future value of investment $1470.23

Yield on purchase of asset at $955.14 = $1470.23 × PVIV (n=5, i=?%)  i = 9.00924%.

(c) Show that a 9 per cent yield also will be earned if interest rates fall next year to 8 per cent.

Value of bond at end of year five:

PV = ($80 + $1000)  1.08 = $1000.

Future value of interest payments at end of year five:

$80 × FVIF (n=5, i=8%) = $469.33.

Future value of all cash flows at n = 5:

Coupon interest payments over five years $400.00

Interest on interest at 8 per cent $69.33
Value of bond at end of year five $1000.00
Total future value of investment $1469.33

Yield on purchase of asset at $955.14 = $1469.33 × PVIV (n=5, i=?%)  i = 8.99596 per cent.

21

The change in net worth for a given change in interest rates is given by the following equation:

R
E   D A  D L k  * A *
L
where k 
1 R A

Thus, three factors are important in determining E.

(i) [DA – DL k] or the leveraged adjusted duration gap. The larger this gap, the more
exposed is the FI to changes in interest rates.
(ii) A, or the size of the FI. The larger is A, the larger is the exposure to interest rate
changes.
(iii) ΔR/(1+R), or the interest rate shock. The larger is the shock, the larger is the interest
rate risk exposure.

22
(a) What is the leverage adjusted duration gap of Financial Institution XY?

The duration of the capital note is 1.8975 years.

Two-year capital note (values in thousands of $s)

Par value = $900 Coupon rate = 7.25% Semi-annual payments
R = 7.25% Maturity = 2 years

T CF PV of CF PV of CF × 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 $1617.63
$900.00 $1707.73

Duration = $1707.73/$900.00 = 1.8975

The leverage-adjusted duration gap can be found as follows:

$900 000
Leverage  adjusted duration gap  D A  DL k  9.94 1.8975  8.23 225 years
$1 000 000

(b) What is the impact on equity value if the relative change in all market interest rates is a
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  D L k * A *
R
R

  9.94  (1.8975) 9
10

(1 000 000)(.002)  $16 464
1
2

(c) Using the information calculated in parts (a) and (b), what can be said about the desired
duration gap for a financial institution if interest rates are expected to increase or decrease.

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 a negative DGAP would be beneficial.

(d) Verify your answer to part (c) by calculating the change in the market value of equity
assuming that the relative change in all market interest rates is an increase of 30 basis
points.

R
E   D A  D L k * A *   8.23225(1 000 000)(.003)   $24 697
R
1
2
(e) What would the duration of the assets need to be to immunise the equity from changes in
market interest rates?

Immunising the equity from changes in interest rates requires that the DGAP be 0.
Thus, (DA – DLk) = 0  DA = DLk, or DA = 1.8975 × 0.9 = 1.70775 years.

26

In this case, the duration of the assets and liabilities should be equal. Thus, if E = A, then by
definition the leveraged adjusted duration gap is positive, since E would exceed kA by the
amount of (1 – k) and the FI would face the risk of increases in interest rates. In reference to
problems 23 and 25, the adjustments on the asset side of the balance sheet would not need to be
as strong, although the difference likely would not be large if the FI in question is a depository
institution such as a bank or savings institution.
27

The three criticisms are:

(a) Immunisation is a dynamic problem because duration changes over time. Thus, it is
necessary to rebalance the portfolio as the duration of the assets and liabilities change
over time.
(b) Duration matching can be costly because it is not easy to restructure the balance sheet
periodically, especially for large FIs.
(c) Duration is not an appropriate tool for immunising portfolios when the expected interest
rate changes are large because of the existence of convexity. Convexity exists because
the relationship between security price changes and interest rate changes is not linear,
which is assumed in the estimation of duration. Using convexity to immunise a
portfolio will reduce the problem.

Chapt 7
1
Derivatives are financial assets whose value is determined by the value of some underlying
asset. As such, derivative contracts are instruments that provide the opportunity to take some
action at a later date based on an agreement to do so at the current time. Although the contracts
differ, the price, timing and extent of the later actions are usually agreed upon at the time the
contracts are arranged. Normally, the contract values depend on the activity of the underlying
asset.
Derivative contracts have value to managers of FIs because of their ability to help in managing
the various types of risk prevalent in the institutions. As of December 2010, the largest category
of globally used over-the-counter derivatives was interest rate derivatives.

A spot contract is an exchange of cash or immediate payment, for financial assets or any other
type of assets, at the time the agreement to transact business is made, that is, at time 0. Futures
and forward contracts both are agreements between a buyer and a seller at time 0 to exchange
the asset for cash (or some other type of payment) at a later time in the future. The specific grade
and quantity of asset is identified at time 0, as is the specific price paid and time the transaction
will eventually occur.

One of the differences between futures and forward contracts is the uniqueness of forward
contracts because they are negotiated between two parties. On the other hand, futures contracts
are standardised because they are offered by and traded on an exchange. Futures contracts are
marked to market daily by the exchange and the exchange guarantees the performance of the
contract to both parties. Thus, the risk of default by either party is minimised from the viewpoint
of the other party. No such guarantee exists for a forward contract. Finally, delivery of the asset
almost always occurs for forward contracts, but seldom occurs for futures contracts. Instead, an
offsetting or reverse transaction occurs through the exchange prior to the maturity of the
contract.

3
A hedge involves protecting the price of or return on an asset from adverse changes in price or
return in the market. A naive hedge usually involves the use of a derivative instrument that has
the same underlying asset as the asset being hedged. Thus, if a change in the price of the cash
asset results in a gain, the same change in market value will cause the derivative instrument to
generate a loss that offsets the gain in the cash asset.
5

To be short in futures contracts means that you have agreed to sell the underlying asset at a
future time, while being long means that you have agreed to buy the asset at a later time. In each
case, the price and the time of the future transaction are agreed upon when the contracts are
initially negotiated.

7
(a) A commercial bank plans to issue CDs in three months.
The bank should sell a forward contract to protect against an increase in interest rates.

(b) An insurance company plans to buy bonds in two months.

The insurance company should buy a forward contract to protect against a decrease in interest
rates.

(c) A savings bank is going to sell Treasury securities it holds in its investment portfolio next
month.
The savings bank should sell a forward contract to protect against an increase in interest rates.

(d) A finance company has assets with a duration of six years and liabilities with a
duration of 13 years.
The finance company should buy a forward contract to protect against decreasing interest
rates that would cause the value of liabilities to increase more than the value of assets, thus
causing a decrease in equity value.

12

Assets $150 Liabilities $135

Equity $15
Total $150 Total $150

The duration of the assets is six years and the duration of the liabilities is four years. The bank
is expecting interest rates to fall from 10 per cent to 9 per cent over the next year.

(a) What is the duration gap for Hedge Row Bank?

DGAP = DA – k DL = 6 – (0.9)(4) = 6 – 3.6 = 2.4 years

(b) What is the expected change in net worth for Hedge Row Bank if the forecast is
accurate?

Expected E = –DGAP[R/(1 + R)]A = –2.4(–0.01/1.10)$150m = $3.272 million

(c) What will be the effect on net worth if interest rates increase 100 basis points?

Expected E = –DGAP[R/(1 + R)]A = –2.4(0.01/1.10)$150 = –$3.272.

(d) If the existing interest rate on the liabilities is 6 per cent, what will be the effect on
net worth of a 1 per cent increase in interest rates?
Solving for the impact on the change in equity under this assumption involves finding the
impact of the change in interest rates on each side of the balance sheet and then determining
the difference in these values. The analysis is based on the equation:

Expected E = A – L
A = –DA[RA/(1 + RA)]A = –6[0.01/1.10]$150m = –$8.1818 million
and L = –DL[RL/(1 + RL)]L = –4[0.01/1.06]$135m = –$5.0943 million

Therefore, E = A – L = –$8.1818m – (–$5.0943m) = – $3.0875 million

13
The price sensitivity of a futures contract depends on the duration of the asset underlying the
contract. In the case of a bank accepted bill contract, the duration is 0.25 years. In the case of
a T-bond contract, the duration is much longer.

16

Calculation of duration of the futures position

$1000 bond, 8% coupon, R = 8.5295% and R = 8.2052%, n = 20
years
Cash Price = $95
Time Flow PV of CF PV of CF × t
1 80 73.71268 73.71268
2 80 67.91950 135.83900
3 80 62.58161 187.74482
4 80 57.66323 230.65291
5 80 53.13139 265.65695
6 80 48.95572 293.73430
7 80 45.10822 315.75751
8 80 41.56301 332.50477
9 80 38.29659 344.66933
10 80 35.28681 352.86807
11 80 32.51357 357.64923
12 80 29.95828 359.49933
13 80 27.60381 358.84957
14 80 25.43439 356.08145
15 80 23.43546 351.53196
16 80 21.59364 345.49819
17 80 19.89656 338.24155
18 80 18.33286 329.99152
19 80 16.89206 320.94906
20 1080 210.12054 4202.41084
Total 9853.84304
950.00000

Duration = 10.3725

(a) Should the bank go short or long on the futures contracts to establish the correct
macrohedge?

The bank should sell futures contracts since an increase in interest rates would cause the value
of the equity and the futures contracts to decrease. But the bank could buy back the futures
contracts to realise a gain to offset the decreased value of the equity.
(b) How many contracts are necessary to fully hedge the bank?

If the market value of the underlying 20-year, 8 per cent benchmark bond is $95 per $100, the
market rate is 8.5295 per cent (using a calculator) and the duration is 10.3725 as shown on the
last page of this chapter solutions. The number of contracts to hedge the bank is:

 ( D A  kDL ) A (6  (0.9)4)$150m
NF     365 contracts
DF x PF 10.3725 x $95 000

(c) Verify that the change in the futures position will offset the change in the cash balance
sheet position for a change in market interest rates of plus 100 basis points and minus 50
basis points.

For an increase in rates of 100 basis points, the change in the cash balance sheet position is:

Expected E = –DGAP[R/(1 + R)]A = –2.4(0.01/1.10)$150m = –$3 272 727.27. The

change in bond value = –10.3725(0.01/1.085295)$95 000 = –$9079.41 and the change in 365
contracts is –9079.41 × –365 = $3 313 986.25. Since the futures contracts were sold, they
could be repurchased for a gain of $3 313 986.25. The sum of the two values is a net gain of
$41 258.98.

For a decrease in rates of 50 basis points, the change in the cash balance sheet position is:

Expected E = –DGAP[R/(1 + R)]A = –2.4(–0.005/1.10)$150m = $1 636 363.64. The

change in each bond value = –10.37255(–0.005/1.085295)$95 000 = $4539.71 and the
change in 365 contracts is $4539.71 × –365 = –$1 656 993.13. Since the futures contracts
were sold, they could be repurchased for a loss of $1 656 993.13. The sum of the two values
is a loss of $20 629.49.

(d) If the bank had hedged with bank accepted bill futures contracts that had a market
value of $98 per $100 of face value, how many futures contracts would have been
necessary to hedge fully the balance sheet?

If Treasury bill futures contracts are used, the duration of the underlying asset is 0.25 years,
the face value of the contract is $1 000 000 and the number of contracts necessary to hedge
the bank is:
 ( DA  kDL ) A  (6  (0.9)4)$150m  $360 000 000
NF      1469 contracts
DF x PF 0.25 x $980 000 $245 000

What additional issues should be considered by the bank in choosing between T-bond or bank
accepted bill futures contracts?

In cases where a large number of Treasury Bonds are necessary to hedge the balance sheet
with a macrohedge, the FI may need to consider whether a sufficient number of deliverable
Treasury Bonds are available. The number of bank accepted bill contracts necessary to hedge
the balance sheet is greater than the number of Treasury Bonds, the bill market is usually
much deeper and the availability of sufficient deliverable securities should be less of a
problem.
22

Both options and futures contracts are useful in managing risk. Other than the pure
mechanics, the primary difference between these contracts lies in the requirement of what
must be done on or before maturity. Futures and forward contracts require that the buyer or
seller of the contracts must execute some transaction. The buyer of an option has the choice to
execute the option or to let it expire without execution. The writer of an option must perform
a transaction only if the buyer chooses to execute the option.

25
(a) What are the two ways to use call and put options on T-bonds to generate positive
cash flows when interest rates decline? Verify your answer with a diagram.

First we must know whether the option is on price or yield as these move inversely.
Assuming we are dealing with an option on price, the FI can either (a) buy a call option or (b)
sell a put option on interest rate instruments, such as T-bonds, to generate positive cash flows
in the event that interest rates decline. In the case of a call option, positive cash flows will
increase as long as interest rates continue to decrease. See Figure 7.6 in the textbook as an
example of positive cash flows minus the premium paid for the option. Although not labelled
in this diagram, interest rates are assumed to be decreasing as you move from left to right on
the X-axis. Thus, bond prices are increasing.
The sale of a put option generates positive cash flows from the premium received. Figure
7.9 n the textbook shows that the payoff will decrease as the price of the bond falls. Of
course, this can only happen if interest rates are increasing. Again, although not labelled in
this diagram, interest rates are assumed to be increasing as you move from right to left on the
X-axis.

(b) Under what balance sheet conditions can an FI use options on T-bonds to hedge its
assets and/or liabilities against interest rate declines?

An FI can use call options on T-bonds to hedge an underlying cash position that decreases in
value as interest rates decline. This would be true if, in the case of a macrohedge, the FI’s
duration gap is negative and the repricing gap is positive. In the case of a microhedge, the FI
can hedge a single fixed-rate liability against interest rate declines.

(c) Is it more appropriate for FIs to hedge against a decline in interest rates with long
calls or short puts?

An FI is better off purchasing calls as opposed to writing puts for two reasons. First,
regulatory restrictions in some countries limit an FI’s ability to write naked short options.
Second, since the potential positive cash inflow on the short put option is limited to the size
of the put premium, there may be insufficient cash inflow in the event of interest rate declines
to offset the losses in the underlying cash position.