Interest Rate Risk II

1
INTRODUCTION
a weakness of the repricing model is its
reliance on book values rather than market
values of assets and liabilities

2
DURATION: A SIMPLE
INTRODUCTION
 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

3
DURATION: A SIMPLE
INTRODUCTION
 Consider a loan with a 15 percent
(semiannually) 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.
The promised cash flows (CF) received by the
FI from the loan at the end of one-half year and
at the end of the year appear in Figure 9–1

4
DURATION: A SIMPLE
INTRODUCTION

Interest = principal * time * interest rate

CF ½ = $50 + $7.50 ($100 × ½ × 15%)
CF1= $50 + $3.75 ($50 × ½ × 15%).

5
DURATION: A SIMPLE
INTRODUCTION
 Assuming that the current required
interest rates are 15 percent per annum,
we calculate the present values (PV) of
the two cash flows (CF) shown in Figure
9–2 as:

6
DURATION: A SIMPLE
INTRODUCTION
 Duration
The weighted-average time to maturity
on an investment

7
DURATION: A SIMPLE
INTRODUCTION
 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:
 DL= W1X1 + W2X2
 DL = X1/2 *(1/2) + X1*(1)
=0.5349(1/2) + 0.4651(1) = 0.7326 years
X = time
W = PV of CFs 8
DURATION: A SIMPLE
INTRODUCTION
 We next calculate the duration of the one-
year, $100, 15 percent interest certificate of
deposit.

 CF1=$115, and PV1 = $115/1.15 = $100

9
DURATION: A SIMPLE
INTRODUCTION
 Because all cash flows are received in one
payment at the end of the year, W1 =
PV1/PV1 = 1, the duration of the deposit is:
DD = X1 * 1 = 1 * 1 = 1Year
 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.

10
DURATION: A SIMPLE
INTRODUCTION
 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:

11
DURATION: A SIMPLE
INTRODUCTION

As will become clearer,

to measure and to
hedge interest rate
risk, the FIs needs to
manage its duration
gap rather than its
maturity gap

12
A GENERAL FORMULA FOR
DURATION
 You can calculate the duration for any
fixed-income security that pays interest
annually using the following general
formula:

13
14
15
A GENERAL FORMULA FOR
DURATION
 The Duration of Interest-Bearing
Bonds
 Eurobonds pay coupons annually.
Suppose 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 The Duration of a Six-
Year Eurobond
16
the initial investment of $1,000 is recovered after 4.993
years. Between 4.993 years and maturity (6 years), the
bond produces a profit or return to the investor.

17
A GENERAL FORMULA FOR
DURATION
 U.S. Treasury bonds pay coupon interest
semiannually. Suppose the annual coupon rate
is 8 percent, the face value is $1,000, and the
annual yield to maturity (R) is 12 percent.
Calculate the duration of the 2 year bond

18
A GENERAL FORMULA FOR
DURATION
 The Duration of a Zero-Coupon Bond
 Because there are no intervening cash flows
such as coupons between issue and maturity,
the following must be true:
DB = MB
 That is, the duration of a zero-coupon bond
equals its maturity. Note that only for zero-
coupon bonds are duration and maturity equal.
Indeed, for any bond that pays some cash flows
prior to maturity, its duration will always be less
than its maturity.

19
A GENERAL FORMULA FOR
DURATION
 The Duration of a Consol Bond
(Perpetuities)
 consol bond: A bond that pays a fixed coupon
each year forever.
 Mc = 
 formula for the duration of a consol bond is:

where R is the required yield to maturity.

20
A GENERAL FORMULA FOR
DURATION
 Suppose that the yield curve implies R = 5 percent
annually; then the duration of the consol bond would
be:

 Thus, while maturity is infinite, duration is finite.

Specifically, on the basis of the time value of money,
recovery of the initial investment on this perpetual
bond takes 21 years. After 21 years, the bond
produces profit for the bondholder.

21
Quiz
 What does the denominator of the duration
equation measure?
 What does the numerator of the duration
equation measure?
 Calculate the duration of a one-year, 8 percent
coupon, 10 percent yield bond that pays coupons
quarterly.
 What is the duration of a zero-coupon bond?
 What feature is unique about a consol bond
compared with other bonds?
22
23
DURATION AND INTEREST
RATE RISK
 So far, you have learned how to calculate
duration
 For FIs, the major relevance of duration is as a
measure for managing interest rate risk
exposure.
 Also important is the role of duration in allowing
the FI to reduce and even eliminate interest
rate risk on its balance sheet or some subset of
that balance sheet(single investment).
24
Duration and Interest Rate Risk
Management on a Single Security

 life insurance company managers face the

problem of structuring their asset
investments so they can pay out a given
cash amount to policyholders in some future
period.
 The risk to the life insurance company
manager is that interest rates on the funds
generated from investing the holder’s
premiums could fall

25
DURATION AND INTEREST
RATE RISK
 Thus, the accumulated returns on the
premiums invested could not meet the
target or promised amount.
 In effect, the insurance company would
be forced to draw down its reserves and
net worth to meet its payout
commitments.

26
DURATION AND INTEREST
RATE RISK
 Suppose it is 2010 and the insurer has to make a
guaranteed payment to a policyholder in five years,
2015.
 We assume that this target guaranteed payment is
$1,469,
 It is equivalent to investing $1,000 at an annually
compounded rate of 8 percent over five years.
 To protect, itself against interest rate risk, the insurer
needs to determine which investments would
produce a cash flow of exactly $1,469 in five years
regardless of what happens to interest rates in the
immediate future.

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DURATION AND INTEREST
RATE RISK

28
DURATION AND INTEREST
RATE RISK
 Buy Five-Year Maturity Discount
Bonds
Given a $1,000 face value and an 8
percent yield and assuming annual
compounding, the current price per five-
year discount bond would be $680.58 per
bond:

29
DURATION AND INTEREST
RATE RISK
 If the insurer bought 1.469 of these bonds at
a total cost of $1,000 in 2010, these
investments would produce exactly $1,469 on
maturity in five years ($1,000*(1.08)5 =
$1,469).
 The reason is that the duration of this bond
portfolio exactly matches the target horizon
for the insurer’s future liability to its
policyholder.
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DURATION AND INTEREST
RATE RISK
 Intuitively, since no intervening cash flows
or coupons are paid by the issuer of the
zero-coupon discount bonds, future
changes in interest rates have no
reinvestment income effect.
 Thus, the return would be unaffected by
intervening interest rate changes.

31
DURATION AND INTEREST
RATE RISK
 Suppose no five-year discount bonds
exist. Then the portfolio manager may
seek to invest in appropriate duration
coupon bonds to hedge interest rate risk.
In this example the appropriate
investment would be in five-year duration
coupon bearing bonds.

32
DURATION AND INTEREST
RATE RISK
 Buy a Five-Year Duration Coupon Bond
 We demonstrated earlier in Table 9–2(slide
number 17) that 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 2010 and hold it for five
years, until 2015, the term exactly matches
the target horizon of the insurer.

33
DURATION AND INTEREST
RATE RISK
 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.

34
Example 9-6: Interest rate
remains at 8%
 The cash flows received by the insurer on
the bond if interest rates stay at
8%throughout the five years would be:
 1. Coupons, 5*80 = 400
 2. reinvestment income = 80*(FVIFA8%,5)-
400 = 69
 3. proceeds from sale of bond at the end of
fifth year = 1000 (i.e., 1080/1.08)
 Total = $1469
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36
DURATION AND INTEREST
RATE RISK
 Next, we show that since this bond has a
duration of five years, matching the insurer’s
target period, even if interest rates were to
instantaneously fall to 7 percent or rise to 9
percent, the expected cash flows from the bond
would still exactly
sum to $1,469.
 That is, the coupons + reinvestment income +
principal at the end of the fifth year would be
immunized. In other words, the cash flows on the
bond are protected against interest rate changes.

37
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39
DURATION AND INTEREST
RATE RISK
 These examples demonstrate that matching the
duration of a coupon bond—or any other fixed–
interest rate instrument, such as a loan or
mortgage—to the FI’s target or investment
horizon immunizes the FI against instantaneous
shocks to interest rates.
 The gains or losses on reinvestment income that
result from an interest rate change are exactly
offset by losses or gains from the bond proceeds
on sale.

40
Duration and Interest Rate Risk
Management on the Whole Balance
Sheet of an FI
 So far we have looked at the durations of
individual instruments and ways to select
individual fixed-income securities to protect
FIs such as life insurance companies and
pensions funds with pre-committed liabilities
such as future pension plan payouts.
 The duration model can also evaluate the
overall interest rate exposure for an FI
 Duration gap: A measure of overall interest
rate risk exposure for an FI

41
DURATION AND INTEREST
RATE RISK
 The Duration Gap for an 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:

42
The Xij’s in the equation are the
market value proportions of each asset
or liability held in the respective asset
and liability portfolios.
43
DURATION AND INTEREST
RATE RISK
 Thus, if new 30-year Treasury bonds were 1
percent of a life insurer’s portfolio and D1A
(the duration of those bonds) was equal to
9.25 years, then X1AD1A =0.01(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.

44
From the Balance sheet
A=L+E
A = L + E
 E = A -  L
45
DURATION AND INTEREST
RATE RISK
 That is, 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—the changes in the
market values of assets and liabilities on the
balance sheet—are related to duration.

46
 A/A and  L/L, the percentage change in the market
values of assets and liabilities,
 DA or DL, the duration of the FI’s asset or liability
portfolio,
 The term R/(1 + R) reflects the shock to interest rates

47
DURATION AND INTEREST
RATE RISK
 These equations can be rewritten to
show the dollar changes in assets and
liabilities on an FI’s balance sheet:

48
DURATION AND INTEREST
RATE RISK
 We can substitute these two expressions
into the equation E = A− L.

 Rearranging and combining this equation

results in a measure of the change in
the market value of equity on an FI’s
balance sheet for a change in interest rates:

49
DURATION AND INTEREST
RATE RISK
 where k = L/A is a measure of the FI’s
leverage, that is, the amount of borrowed
funds or liabilities rather than owners’
equity used to fund its asset portfolio. The
effect of interest rate changes on the
market value of an FI’s equity or net worth
(E) breaks down into three effects:

50
DURATION AND INTEREST
RATE RISK
1. The leverage adjusted duration gap =
[DA − DLk]
2. The size of the FI. (A)
3. The size of the interest rate shock = 
R/(1 + R).

51
DURATION AND INTEREST
RATE RISK
 The leverage adjusted duration gap = [DA − DLk].
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 =  R/(1 + R). The
larger the shock, the greater the FI’s exposure.

52
DURATION AND INTEREST
RATE RISK
 Given this, we express the exposure of
the net worth of the FI as:
 E= - [Leverage adjusted duration gap]
* [Asset size] * [Interest rate shock]

53
DURATION AND INTEREST
RATE RISK
 Interest rate shocks are largely external to
the FI and often result from changes in the
Federal Reserve’s monetary policy.
 The size of the duration gap and the size of
the FI, however, are under the control of
management (internal).

54
 Equation (9) and the duration model provide an FI
manager with a benchmark measure of the FI’s
performance for various interest rate changes and
therefore the extent to which the FI is exposed to interest
rate risk. If, for an expected change in interest rates,
managers find the change in equity will be small or
negative, the duration model can be used to identify
changes needed on or off the FI’s balance sheet to
reduce or even immunize the FI against interest rate risk.
 Using an example, the next section explains how a
manager can use information on an FI’s duration gap to
restructure the balance sheet to limit losses in even
immunize stockholders’ net worth against interest rate
risk (i.e., to set the balance sheet up before a change in
interest rates, so that E is nonnegative for an expected
change in interest rates
55
56
57
58
DURATION AND INTEREST
RATE RISK
 Even though the rise in interest rates would not
push the FI into economic insolvency, it
reduces the FI’s 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:

59
DURATION AND INTEREST
RATE RISK
 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. To see the
importance of factoring in leverage, suppose
the manager increased the duration of the
FI’s liabilities to five years, the same as
DA. Then:

60
DURATION AND INTEREST
RATE RISK
 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:

61
DURATION AND INTEREST
RATE RISK
 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:

62
DURATION AND INTEREST
RATE RISK
 Reduce DA. Reduce DA from 5 years to 2.7 years (equal to
kDL or (.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:

 Change k and DL. Increase k (leverage) from .9 to .95 and

increase DL from 3 years
to 5.26 years such that:

63
Quiz
 Refer to the example of the insurer in Examples 9–6 through
9–8. Suppose rates fell to 6
percent. Would the FI’s portfolio still be immunized? What if
rates rose to 10 percent?
 How is the overall duration gap for an FI calculated?
 How can a manager use information on an FI’s duration gap
to restructure, and thereby
immunize, the balance sheet against interest rate risk?
 Suppose DA = 3 years, DL = 6 years, k = .8, and A =
$100million. What is the effect on
owners’ net worth if R/(1 + R) rises 1 percent? (E =
$1,800,000)

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