Chapter Eight

Interest Rate Risk I

Chapter Outline
Introduction
The Central Bank and Interest Rate Risk
The Repricing Model
Rate-Sensitive Assets
Rate-Sensitive Liabilities
Equal Changes in Rates on RSAs and RSLs
Unequal Changes in Rates on RSAs and RSLs
Weaknesses of the Repricing Model
Market Value Effects
Overaggregation
he !roble" of Runoffs
Cash #lo$s fro" Off-%alance Sheet Activities
The Maturity Model
he Maturit& Model $ith a !ortfolio of Assets and Liabilities
Weakness of the Maturity Model
Summary
Appendi !A" Term Structure of Interest Rates
Unbiased E'(ectations heor&
Liquidit& !re"iu" heor&
Market Seg"entation heor&
)*
Solutions for End#of#Chapter $uestions and %ro&lems" Chapter Eight
+, -hat $as the i"(act on interest rates of the borro$ed reserves targeting regi"e used b&
the #ederal Reserve fro" +./0 to +..12
he volatilit& of interest rates $as significantl& lo$er than under the nonborro$ed reserves target
regi"e used in the three &ears i""ediatel& (rior to +./0, #igure /-+ indicates that both the level
and volatilit& of interest rates declined even further after +..1 $hen the #ed decided that it
$ould target (ri"aril& the fed funds rate as a guide for "onetar& (olic&,
0, 3o$ has the increased level of financial "arket integration affected interest rates2
4ncreased financial "arket integration5 or globali6ation5 increases the s(eed $ith $hich interest
rate changes and volatilit& are trans"itted a"ong countries, he result of this quickening of
global econo"ic ad7ust"ent is to increase the difficult& and uncertaint& faced b& the #ederal
Reserve as it atte"(ts to "anage econo"ic activit& $ithin the U,S, #urther5 because #4s have
beco"e increasingl& "ore global in their activities5 an& change in interest rate levels or volatilit&
caused b& #ederal Reserve actions "ore quickl& creates additional interest rate risk issues for
these co"(anies,
1, -hat is the re(ricing ga(2 4n using this "odel to evaluate interest rate risk5 $hat is "eant
b& rate sensitivit&2 On $hat financial (erfor"ance variable does the re(ricing "odel
focus2 E'(lain,
he re(ricing ga( is a "easure of the difference bet$een the dollar value of assets that $ill
re(rice and the dollar value of liabilities that $ill re(rice $ithin a s(ecific ti"e (eriod5 $here
re(rice "eans the (otential to receive a ne$ interest rate, Rate sensitivit& re(resents the ti"e
interval $here re(ricing can occur, he "odel focuses on the (otential changes in the net
interest inco"e variable, 4n effect5 if interest rates change5 interest inco"e and interest e'(ense
$ill change as the various assets and liabilities are re(riced5 that is5 receive ne$ interest rates,
*, -hat is a "aturit& bucket in the re(ricing "odel2 -h& is the length of ti"e selected for
re(ricing assets and liabilities i"(ortant $hen using the re(ricing "odel2
he "aturit& bucket is the ti"e $indo$ over $hich the dollar a"ounts of assets and liabilities
are "easured, he length of the re(ricing (eriod deter"ines $hich of the securities in a (ortfolio
are rate-sensitive, he longer the re(ricing (eriod5 the "ore securities either "ature or need to
be re(riced5 and5 therefore5 the "ore the interest rate e'(osure, An e'cessivel& short re(ricing
(eriod o"its consideration of the interest rate risk e'(osure of assets and liabilities are that
re(riced in the (eriod i""ediatel& follo$ing the end of the re(ricing (eriod, hat is5 it
understates the rate sensitivit& of the balance sheet, An e'cessivel& long re(ricing (eriod
includes "an& securities that are re(riced at different ti"es $ithin the re(ricing (eriod5 thereb&
overstating the rate sensitivit& of the balance sheet,
)8
8, Calculate the re(ricing ga( and the i"(act on net interest inco"e of a + (ercent increase in
interest rates for each of the follo$ing (ositions9
Rate-sensitive assets : ;0<< "illion, Rate-sensitive liabilities : ;+<< "illion,
Re(ricing ga( : RSA - RSL : ;0<< - ;+<< "illion : =;+<< "illion,
>44 : ?;+<< "illion@?,<+@ : =;+,< "illion5 or ;+5<<<5<<<,
Rate-sensitive assets : ;+<< "illion, Rate-sensitive liabilities : ;+8< "illion,
Re(ricing ga( : RSA - RSL : ;+<< - ;+8< "illion : -;8< "illion,
>44 : ?-;8< "illion@?,<+@ : -;<,8 "illion5 or -;8<<5<<<,
Rate-sensitive assets : ;+8< "illion, Rate-sensitive liabilities : ;+*< "illion,
Re(ricing ga( : RSA - RSL : ;+8< - ;+*< "illion : =;+< "illion,
>44 : ?;+< "illion@?,<+@ : =;<,+ "illion5 or ;+<<5<<<,
a, Calculate the i"(act on net interest inco"e on each of the above situations assu"ing a
+ (ercent decrease in interest rates,
>44 : ?;+<< "illion@?-,<+@ : -;+,< "illion5 or -;+5<<<5<<<,
>44 : ?-;8< "illion@?-,<+@ : =;<,8 "illion5 or ;8<<5<<<,
>44 : ?;+< "illion@?-,<+@ : -;<,+ "illion5 or -;+<<5<<<,
b, -hat conclusion can &ou dra$ about the re(ricing "odel fro" these results2
he #4s in (arts ?+@ and ?1@ are e'(osed to interest rate declines ?(ositive re(ricing ga(@
$hile the #4 in (art ?0@ is e'(osed to interest rate increases, he #4 in (art ?1@ has the
lo$est interest rate risk e'(osure since the absolute value of the re(ricing ga( is the lo$est5
$hile the o((osite is true for (art ?+@,
), -hat are the reasons for not including de"and de(osits as rate-sensitive liabilities in the
re(ricing anal&sis for a co""ercial bank2 -hat is the subtle5 but (otentiall& strong5 reason
for including de"and de(osits in the total of rate-sensitive liabilities2 Can the sa"e
argu"ent be "ade for (assbook savings accounts2
he regulator& rate available on de"and de(osit accounts is 6ero, Although "an& banks are able
to offer >O- accounts on $hich interest can be (aid5 this interest rate seldo" is changed and
thus the accounts are not reall& sensitive, 3o$ever5 de"and de(osit accounts do (a& i"(licit
interest in the for" of not charging full& for checking and other services, #urther5 $hen "arket
interest rates rise5 custo"ers dra$ do$n their AAAs5 $hich "a& cause the bank to use higher
))
cost sources of funds, he sa"e or si"ilar argu"ents can be "ade for (assbook savings
accounts,
B, -hat is the ga( ratio2 -hat is the value of this ratio to interest rate risk "anagers and
regulators2
he ga( ratio is the ratio of the cu"ulative ga( (osition to the total assets of the bank, he
cu"ulative ga( (osition is the su" of the individual ga(s over several ti"e buckets, he value
of this ratio is that it tells the direction of the interest rate e'(osure and the scale of that e'(osure
relative to the si6e of the bank,
/, -hich of the follo$ing assets or liabilities fit the one-&ear rate or re(ricing sensitivit& test2
.+-da& U,S, reasur& bills Ces
+-&ear U,S, reasur& notes Ces
0<-&ear U,S, reasur& bonds >o
0<-&ear floating-rate cor(orate bonds $ith annual re(ricing Ces
1<-&ear floating-rate "ortgages $ith re(ricing ever& t$o &ears >o
1<-&ear floating-rate "ortgages $ith re(ricing ever& si' "onths Ces
Overnight fed funds Ces
.-"onth fi'ed rate CAs Ces
+-&ear fi'ed-rate CAs Ces
8-&ear floating-rate CAs $ith annual re(ricing Ces
Co""on stock >o
., Consider the follo$ing balance sheet for -atchoverU Savings5 4nc, ?in "illions@9
Assets Liabilities and Equit&
#loating-rate "ortgages Ae"and de(osits
?currentl& +<D annuall&@ ;8< ?currentl& )D annuall&@ ;B<
1<-&ear fi'ed-rate loans i"e de(osits
?currentl& BD annuall&@ ;8< ?currentl& )D annuall& ;0<
Equit& ;+<
otal Assets ;+<< otal Liabilities E Equit& ;+<<
a, -hat is -atchoverUFs e'(ected net interest inco"e at &ear-end2
Current e'(ected interest inco"e9 ;8" = ;1,8" : ;/,8",
E'(ected interest e'(ense9 ;*,0" = ;+,0" : ;8,*",
E'(ected net interest inco"e9 ;/,8" - ;8,*" : ;1,+",
b, -hat $ill be the net interest inco"e at &ear-end if interest rates rise b& 0 (ercent2
After the 0<< basis (oint interest rate increase5 net interest inco"e declines to9
8<?<,+0@ = 8<?<,<B@ - B<?<,</@ - 0<?,<)@ : ;.,8" - ;),/" : ;0,B"5 a decline of ;<,*",
)B
c, Using the cu"ulative re(ricing ga( "odel5 $hat is the e'(ected net interest inco"e for
a 0 (ercent increase in interest rates2
-achoviaFsG re(ricing or funding ga( is ;8<" - ;B<" : -;0<", he change in net interest
inco"e using the funding ga( "odel is ?-;0<"@?<,<0@ : -;,*",
d, -hat $ill be the net interest inco"e at &ear-end if interest rates increase 0<< basis
(oints on assets5 but onl& +<< basis (oints on liabilities2 4s it reasonable for changes in
interest rates to affect balance sheet in an uneven "anner2 -h&2
After the unbalanced rate increase5 net interest inco"e $ill be 8<?<,+0@ = 8<?<,<B@ -
B<?<,<B@ - 0<?,<)@ : ;.,8" - ;),+" : ;1,*"5 an increase of ;<,1", 4t is not unco""on for
interest rates to ad7ust in an uneven "anner over t$o sides of the balance sheet because
interest rates often do not ad7ust solel& because of "arket (ressures, 4n "an& cases the
changes are affected b& decisions of "anage"ent, hus &ou can see the difference
bet$een this ans$er and the ans$er for (art a,
+<, -hat are so"e of the $eakness of the re(ricing "odel2 3o$ have large banks solved the
(roble" of choosing the o(ti"al ti"e (eriod for re(ricing2 -hat is runoff cash flo$5 and
ho$ does this a"ount affect the re(ricing "odelFs anal&sis2
he re(ricing "odel has four general $eaknesses9
?+@ 4t ignores "arket value effects,
?0@ 4t does not take into account the fact that the dollar value of rate sensitive assets and
liabilities $ithin a bucket are not si"ilar, hus5 if assets5 on average5 are re(riced earlier in
the bucket than liabilities5 and if interest rates fall5 #4s are sub7ect to reinvest"ent risks,
?1@ 4t ignores the (roble" of runoffs5 that is5 that so"e assets are (re(aid and so"e liabilities
are $ithdra$n before the "aturit& date,
?*@ 4t ignores inco"e generated fro" off-balance-sheet activities,
Large banks are able to re(rice securities ever& da& using their o$n internal "odels so
reinvest"ent and re(ricing risks can be esti"ated for each da& of the &ear,
Runoff cash flo$ reflects the assets that are re(aid before "aturit& and the liabilities that are
$ithdra$n unsus(ectedl&, o the e'tent that either of these a"ounts is significantl& greater than
e'(ected5 the esti"ated interest rate sensitivit& of the bank $ill be in error,
++, Use the follo$ing infor"ation about a h&(othetical govern"ent securit& dealer na"ed M,!,
Horgan, Market &ields are in (arenthesis5 and a"ounts are in "illions,
Assets Liabilities and Equit&
Cash ;+< Overnight Re(os ;+B<
)/
+ "onth -bills ?B,<8D@ B8 Subordinated debt
1 "onth -bills ?B,08D@ B8 B-&ear fi'ed rate ?/,88D +8<
0 &ear -notes ?B,8<D@ 8<
/ &ear -notes ?/,.)D@ +<<
8 &ear "unis ?floating rate@
?/,0<D reset ever& ) "onths@ 08 Equit& +8
otal Assets ;118 otal Liabilities E Equit& ;118
a, -hat is the funding or re(ricing ga( if the (lanning (eriod is 1< da&s2 .+ da&s2 0
&ears2 Recall that cash is a noninterest-earning asset,
#unding or re(ricing ga( using a 1<-da& (lanning (eriod : B8 - +B< : -;.8 "illion,
#unding ga( using a .+-da& (lanning (eriod : ?B8 = B8@ - +B< : -;0< "illion,
#unding ga( using a t$o-&ear (lanning (eriod : ?B8 = B8 = 8< = 08@ - +B< : =;88 "illion,
b, -hat is the i"(act over the ne't 1< da&s on net interest inco"e if all interest rates rise
8< basis (oints2 Aecrease B8 basis (oints2
>et interest inco"e $ill decline b& ;*B85<<<, >44 : #I?R@ : -.8?,<<8@ : ;<,*B8",
>et interest inco"e $ill increase b& ;B+058<<, >44 : #I?R@ : -.8?,<<B8@ : ;<,B+08",
c, he follo$ing one-&ear runoffs are e'(ected9 ;+< "illion for t$o-&ear -notes5 and
;0< "illion for eight-&ear -notes, -hat is the one-&ear re(ricing ga(2
#unding or re(ricing ga( over the +-&ear (lanning (eriod : ?B8 = B8 = +< = 0< = 08@ - +B<
: =;18 "illion,
d, 4f runoffs are considered5 $hat is the effect on net interest inco"e at &ear-end if interest
rates rise 8< basis (oints2 Aecrease B8 basis (oints2
>et interest inco"e $ill increase b& ;+B85<<<, >44 : #I?R@ : 18?<,<<8@ : ;<,+B8",
>et interest inco"e $ill decrease b& ;0)058<<5 >44 : #I?R@ : 18?-<,<<B8@ :
-;<,0)08",
+0, -hat is the difference bet$een book value accounting and "arket value accounting2 3o$
do interest rate changes affect the value of bank assets and liabilities under the t$o
"ethods2 -hat is "arking to "arket2
%ook value accounting re(orts assets and liabilities at the original issue values, Current "arket
values "a& be different fro" book values because the& reflect current "arket conditions5 such as
interest rates or (rices, his is es(eciall& a (roble" if an asset or liabilit& has to be liquidated
i""ediatel&, 4f the asset or liabilit& is held until "aturit&5 then the re(orting of book values does
not (ose a (roble",
#or an #45 a "a7or factor affecting asset and liabilit& values is interest rate changes, 4f interest
rates increase5 the value of both loans ?assets@ and de(osits and debt ?liabilities@ fall, 4f assets and
).
liabilities are held until "aturit&5 it does not affect the book valuation of the #4, 3o$ever5 if
de(osits or loans have to be refinanced5 then "arket value accounting (resents a better (icture of
the condition of the #4,
he (rocess b& $hich changes in the econo"ic value of assets and liabilities are accounted is
called "arking to "arket, he changes can be beneficial as $ell as detri"ental to the total
econo"ic health of the #4,
+1, -h& is it i"(ortant to use "arket values as o((osed to book values $hen evaluating the
net $orth of an #42 -hat are so"e of the advantages of using book values as o((osed to
"arket values2
%ook values re(resent historical costs of securities (urchased5 loans "ade5 and liabilities sold,
he& do not reflect current values as deter"ined b& "arket values, Effective financial decision-
"aking requires u(-to-date infor"ation that incor(orates current e'(ectations about future
events, Market values (rovide the best esti"ate of the (resent condition of an #4 and serve as an
effective signal to "anagers for future strategies,
%ook values are clearl& "easured and not sub7ect to valuation errors5 unlike "arket values,
Moreover5 if the #4 intends to hold the securit& until "aturit&5 then the securit&Gs current
liquidation value $ill not be relevant, hat is5 the (a(er gains and losses resulting fro" "arket
value changes $ill never be reali6ed if the #4 holds the securit& until "aturit&, hus5 the changes
in "arket value $ill not i"(act the #4Gs (rofitabilit& unless the securit& is sold (rior to "aturit&,
+*, Consider a ;+5<<< bond $ith a fi'ed-rate +< (ercent annual cou(on ?C(n D@ and a "aturit&
?>@ of +< &ears, he bond currentl& is trading to a "arket &ield to "aturit& ?CM@ of +<
(ercent, Co"(lete the follo$ing table,
#ro" !ar5 ; #ro" !ar5 D
> C(n D CM !rice Change in !rice Change in !rice
/ +<D .D ;+5<88,18 ;88,18 8,818D
. +<D .D ;+5<8.,.8 ;8.,.8 8,..8D
+< +<D .D ;+5<)*,+/ ;)*,+/ ),*+/D
+< +<D +<D ;+5<<<,<<
+< +<D ++D ;.*+,++ -;8/,/. -8,//.D
++ +<D ++D ;.1B,.1 -;)0,<B -),0<BD
+0 +<D ++D ;.18,<B -;)*,.1 -),*.1D
Use this infor"ation to verif& the (rinci(les of interest rate-(rice relationshi(s for fi'ed-
rate financial assets,
Rule One9 4nterest rates and (rices of fi'ed-rate financial assets "ove inversel&, See the
change in (rice fro" ;+5<<< to ;.*+,++ for the change in interest rates fro" +< (ercent to
++ (ercent5 or fro" ;+5<<< to ;+5<)*,+/ $hen rates change fro" +< (ercent to . (ercent,
B<
Rule $o9 he longer is the "aturit& of a fi'ed-inco"e financial asset5 the greater is the
change in (rice for a given change in interest rates, A change in rates fro" +< (ercent to ++
(ercent has caused the +<-&ear bond to decrease in value ;8/,/.5 but the ++-&ear bond $ill
decrease in value ;)0,<B5 and the +0-&ear bond $ill decrease ;)*,.1,
Rule hree9 he change in value of longer-ter" fi'ed-rate financial assets increases at a
decreasing rate, #or the increase in rates fro" +< (ercent to ++ (ercent5 the difference in
the change in (rice bet$een the +<-&ear and ++-&ear assets is ;1,+/5 $hile the difference in
the change in (rice bet$een the ++-&ear and +0-&ear assets is ;0,/),
Rule #our9 Although not "entioned in the te't5 for a given (ercentage ?@ change in interest
rates5 the increase in (rice for a decrease in rates is greater than the decrease in value for an
increase in rates, hus for rates decreasing fro" +< (ercent to . (ercent5 the +<-&ear bond
increases ;)*,+/, %ut for rates increasing fro" +< (ercent to ++ (ercent5 the +<-&ear bond
decreases ;8/,/.,
+8, Consider a +0-&ear5 +0 (ercent annual cou(on bond $ith a required return of +< (ercent,
he bond has a face value of ;+5<<<,
a, -hat is the (rice of the bond2
!V : ;+0<J!V4#Ai:+<D5n:+0 = ;+5<<<J!V4#i:+<D5n:+0 : ;+5+1),0B
b, 4f interest rates rise to ++ (ercent5 $hat is the (rice of the bond2
!V : ;+0<J!V4#Ai:++D5n:+0 = ;+5<<<J!V4#i:++D5n:+0 : ;+5<)*,.0
c, -hat has been the (ercentage change in (rice2
! : ?;+5<)*,.0 - ;+5+1),0B@K;+5+1),0B : -<,<)0/ or L),0/ (ercent,
d, Re(eat (arts ?a@5 ?b@5 and ?c@ for a +)-&ear bond,
!V : ;+0<J!V4#Ai:+<D5n:+) = ;+5<<<J!V4#i:+<D5n:+) : ;+5+8),*B
!V : ;+0<J!V4#Ai:++D5n:+) = ;+5<<<J!V4#i:++D5n:+) : ;+5<B1,B.
! : ?;+5<B1,B. - ;+5+8),*B@K;+5+8),*B : -<,<B+8 or LB,+8 (ercent,
e, -hat do the res(ective changes in bond (rices indicate2
#or the sa"e change in interest rates5 longer-ter" fi'ed-rate assets have a greater change in
(rice,
+), Consider a five-&ear5 +8 (ercent annual cou(on bond $ith a face value of ;+5<<<, he
bond is trading at a "arket &ield to "aturit& of +0 (ercent,
a, -hat is the (rice of the bond2
B+
!V : ;+8<J!V4#Ai:+0D5n:8 = ;+5<<<J!V4#i:+0D5n:8 : ;+5+</,+*
b, 4f the "arket &ield to "aturit& increases + (ercent5 $hat $ill be the bondFs ne$ (rice2
!V : ;+8<J!V4#Ai:+1D5n:8 = ;+5<<<J!V4#i:+1D5n:8 : ;+5<B<,1*
c, Using &our ans$ers to (arts ?a@ and ?b@5 $hat is the (ercentage change in the bondFs
(rice as a result of the + (ercent increase in interest rates2
! : ?;+5<B<,1* - ;+5+</,+*@K;+5+</,+* : -<,<1*+ or L1,*+ (ercent,
d, Re(eat (arts ?b@ and ?c@ assu"ing a + (ercent decrease in interest rates,
!V : ;+8<J!V4#Ai:++D5n:8 = ;+5<<<J!V4#i:++D5n:8 : ;+5+*B,/*
! : ?;+5+*B,/* - ;+5+</,+*@K;+5+</,+* : <,<18/ or 1,8/ (ercent
e, -hat do the differences in &our ans$ers indicate about the rate-(rice relationshi(s of
fi'ed-rate assets2
#or a given (ercentage change in interest rates5 the absolute value of the increase in (rice
caused b& a decrease in rates is greater than the absolute value of the decrease in (rice
caused b& an increase in rates,
+B, -hat is "aturit& ga(2 3o$ can the "aturit& "odel be used to i""uni6e an #4Fs (ortfolio2
-hat is the critical require"ent to allo$ "aturit& "atching to have so"e success in
i""uni6ing the balance sheet of an #42
Maturit& ga( is the difference bet$een the average "aturit& of assets and liabilities, 4f the
"aturit& ga( is 6ero5 it is (ossible to i""uni6e the (ortfolio5 so that changes in interest rates $ill
result in equal but offsetting changes in the value of assets and liabilities and net interest inco"e,
hus5 if interest rates increase ?decrease@5 the fall ?rise@ in the value of the assets $ill be offset b&
a (erfect fall ?rise@ in the value of the liabilities, he critical assu"(tion is that the ti"ing of the
cash flo$s on the assets and liabilities "ust be the sa"e,
+/, >earb& %ank has the follo$ing balance sheet ?in "illions@9
Assets 'ia&ilities and E(uity
Cash ;)< Ae"and de(osits ;+*<
8-&ear treasur& notes ;)< +-&ear Certificates of Ae(osit ;+)<
1<-&ear "ortgages ;0<< Equit& ;0<
otal Assets ;10< otal Liabilities and Equit& ;10<
-hat is the "aturit& ga( for >earb& %ank2 4s >earb& %ank "ore e'(osed to an increase or
decrease in interest rates2 E'(lain $h&2
B0
MA : M<J0< = 8J)< = 0<<J1<NK10< : +.,). &ears5 and ML : M<J+*< = +J+)<NK1<< : <,811,
herefore the "aturit& ga( : MIA! : +.,). L <,811 : +.,+) &ears, >earb& bank is e'(osed to
an increase in interest rates, 4f rates rise5 the value of assets $ill decrease "uch "ore than the
value of liabilities,
+., Count& %ank has the follo$ing "arket value balance sheet ?in "illions5 annual rates@9
Assets 'ia&ilities and E(uity
Cash ;0< Ae"and de(osits ;+<<
+8-&ear co""ercial loan O +<D 8-&ear CAs O )D interest5
interest5 balloon (a&"ent ;+)< balloon (a&"ent ;0+<
1<-&ear Mortgages O /D interest5 0<-&ear debentures O BD interest ;+0<
"onthl& a"orti6ing ;1<< Equit& ;8<
otal Assets ;*/< otal Liabilities E Equit& ;*/<
a, -hat is the "aturit& ga( for Count& %ank2
MA : M<J0< = +8J+)< = 1<J1<<NK*/< : 01,B8 &ears,
ML : M<J+<< = 8J0+< = 0<J+0<NK*1< : /,<0 &ears,
MIA! : 01,B8 L /,<0 : +8,B1 &ears,
b, -hat $ill be the "aturit& ga( if the interest rates on all assets and liabilities increase b&
+ (ercent2
4f interest rates increase one (ercent5 the value and average "aturit& of the assets $ill be9
Cash : ;0<
Co""ercial loans : ;+)J!V4#An:+85 i:++D = ;+)<J!V4#n:+85i:++D : ;+*/,*.
Mortgages : ;0,0<+50.*J!V4#An:1)<5i:.D : ;0B1,8/+
MA : M<J0< = +*/,*.J+8 = 0B1,8/+J1<NK?0< = +*/,*. = 0B1,8/+@ : 01,)< &ears
he value and average "aturit& of the liabilities $ill be9
Ae"and de(osits : ;+<<
CAs : ;+0,)<J!V4#An:85i:BD = ;0+<J!V4#n:85i:BD : ;0<+,1.
Aebentures : ;/,*J!V4#An:0<5i:/D = ;+0<J!V4#n:0<5i:/D : ;+</,00
ML : M<J+<< = 8J0<+,1. = 0<J+</,00NK?+<< = 0<+,1. = +</,00@ : B,B* &ears
he "aturit& ga( : MIA! : 01,)< L B,B* : +8,/) &ears, he "aturit& ga( increased
because the average "aturit& of the liabilities decreased "ore than the average "aturit& of
the assets, his result occurred (ri"aril& because of the differences in the cash flo$
strea"s for the "ortgages and the debentures,
c, -hat $ill ha((en to the "arket value of the equit&2
he "arket value of the assets has decreased fro" ;*/< to ;**0,<B+5 or ;1B,.0., he
"arket value of the liabilities has decreased fro" ;*1< to ;*<.,)+5 or ;0<,)., herefore
B1
the "arket value of the equit& $ill decrease b& ;1B,.0. - ;0<,). : ;+B,01.5 or 1*,*/
(ercent,
d, 4f interest rates increased b& 0 (ercent5 $ould the bank be solvent2
he value of the assets $ould decrease to ;*<.,<*5 and the value of the liabilities $ould
decrease to ;1.+,10, herefore the value of the equit& $ould be ;+B,B0, Although the
bank re"ains solvent5 nearl& )8 (ercent of the equit& has eroded because of the increase in
interest rates,
0<, Iiven that bank balance sheets t&(icall& are accounted in book value ter"s5 $h& should the
regulators or an&one else be concerned about ho$ interest rates affect the "arket values of
assets and liabilities2
he solvenc& of the balance sheet is an i"(ortant variable to creditors of the bank, 4f the ca(ital
(osition of the bank decreases to near 6ero5 creditors "a& not be $illing to (rovide funding for
the bank5 and the bank "a& need assistance fro" the regulators5 or "a& even fail, hus an&
change in the "arket value of assets or liabilities that is caused b& changes in the level of interest
rate changes is of concern to regulators,
0+, 4f a bank "anager is certain that interest rates $ere going to increase $ithin the ne't si'
"onths5 ho$ should the bank "anager ad7ust the bankFs "aturit& ga( to take advantage of
this antici(ated increase2 -hat if the "anager believed rates $ould fall2 -ould &our
suggested ad7ust"ents be difficult or eas& to achieve2
-hen rates rise5 the value of the longer-lived assets $ill fall b& "ore the shorter-lived liabilities,
4f the "aturit& ga( ?or duration ga(@ is (ositive5 the bank "anager $ill $ant to shorten the
"aturit& ga(, 4f the re(ricing ga( is negative5 the "anager $ill $ant to "ove it to$ards 6ero or
(ositive, 4f rates are e'(ected to decrease5 the "anager should reverse these strategies,
Changing the "aturit&5 duration5 or funding ga(s on the balance sheet often involves changing
the "i' of assets and liabilities, Atte"(ts to "ake these changes "a& involve changes in
financial strateg& for the bank $hich "a& not be eas& to acco"(lish, Later in the te't5 "ethods
of achieving the sa"e results using derivatives $ill be e'(lored,
00, Consu"er %ank has ;0< "illion in cash and a ;+/< "illion loan (ortfolio, he assets are
funded $ith de"and de(osits of ;+/ "illion5 a ;+)0 "illion CA and ;0< "illion in equit&,
he loan (ortfolio has a "aturit& of 0 &ears5 earns interest at the annual rate of B (ercent5
and is a"orti6ed "onthl&, he bank (a&s B (ercent annual interest on the CA5 but the
interest $ill not be (aid until the CA "atures at the end of 0 &ears,
a, -hat is the "aturit& ga( for Consu"er %ank2
MA : M<J;0< = 0J;+/<NK;0<< : +,/< &ears
ML : M<J;+/ = 0J;+)0NK;+/< : +,/< &ears
MIA! : +,/< L +,/< : < &ears,
B*
b, 4s Consu"er %ank i""uni6ed or (rotected against changes in interest rates2 -h& or
$h& not2
4t is te"(ting to conclude that the bank is i""uni6ed because the "aturit& ga( is 6ero,
3o$ever5 the cash flo$ strea" for the loan and the cash flo$ strea" for the CA are
different because the loan a"orti6es "onthl& and the CA (a&s annual interest on the CA,
hus an& change in interest rates $ill affect the earning (o$er of the loan "ore than the
interest cost of the CA,
c, Aoes Consu"er %ank face interest rate risk2 hat is5 if "arket interest rates increase or
decrease + (ercent5 $hat ha((ens to the value of the equit&2
he bank does face interest rate risk, 4f "arket rates increase + (ercent5 the value of the
cash and de"and de(osits does not change, 3o$ever5 the value of the loan $ill decrease to
;+B/,+.5 and the value of the CA $ill fall to ;+8.,<+, hus the value of the equit& $ill be
?;+B/,+. = ;0< - ;+/ - ;+8.,<+@ : ;0+,+/, 4n this case the increase in interest rates causes
the "arket value of equit& to increase because of the reinvest"ent o((ortunities on the loan
(a&"ents,
4f "arket rates decrease + (ercent5 the value of the loan increases to ;+/+,/*5 and the value
of the CA increases to ;+)8,<B, hus the value of the equit& decreases to ;+/,BB,
d, 3o$ can a decrease in interest rates create interest rate risk2
he a"orti6ed loan (a&"ents $ould be reinvested at lo$er rates, hus even though
interest rates have decreased5 the different cash flo$ (atterns of the loan and the CA have
caused interest rate risk,
01, #4 4nternational holds seven-&ear Ac"e 4nternational bonds and t$o-&ear %eta Cor(oration
bonds, he Ac"e bonds are &ielding +0 (ercent and the %eta bonds are &ielding +* (ercent
under current "arket conditions,
a, -hat is the $eighted-average "aturit& of #4Fs bond (ortfolio if *< (ercent is in Ac"e
bonds and )< (ercent is in %eta bonds2
Average "aturit& : <,*< ' B &ears = <,)< ' 0 &ears : * &ears
b, -hat (ro(ortion of Ac"e and %eta bonds should be held to have a $eighted-average
&ield of +1,8 (ercent2
Let PJ?<,+0@ = ?+ - P@J?<,+*@ : <,+18, Solving for P5 $e get 08 (ercent, 4n order to get an
average &ield of +1,8 (ercent5 $e need to hold 08 (ercent of Ac"e and B8 (ercent of %eta,
c, -hat $ill be the $eighted-average "aturit& of the bond (ortfolio if the $eighted-
average &ield is reali6ed2
B8
he average "aturit& of the (ortfolio $ill decrease to <,08 ' B = <,B8 ' 0 : 1,08 &ears,
0*, An insurance co"(an& has invested in the follo$ing fi'ed-inco"e securities9 ?a@
;+<5<<<5<<< of 8-&ear reasur& notes (a&ing 8 (ercent interest and selling at (ar value5 ?b@
;85/<<5<<< of +<-&ear bonds (a&ing B (ercent interest $ith a (ar value of ;)5<<<5<<<5 and
?c@ ;)50<<5<<< of 0<-&ear subordinated debentures (a&ing . (ercent interest $ith a (ar
value of ;)5<<<5<<<,
a, -hat is the $eighted-average "aturit& of this (ortfolio of assets2
MA : M8J;+< = +<J;8,/ = 0<J;),0NK;00 : 010K00 : +<,88 &ears
b, 4f interest rates change so that the &ields on all of the securities decrease + (ercent5 ho$
does the $eighted-average "aturit& of the (ortfolio change2
o deter"ine the $eighted-average "aturit& of the (ortfolio for a rate decrease of +
(ercent5 the ne$ value of each securit& "ust be deter"ined, his calculation $ill require
kno$ing the CM of each securit& before the rate change,
-notes are selling at (ar5 so the CM : 8 (ercent, herefore5 the ne$ value $ill be
!V : ;8<<5<<<J!V4#An:85i:*D = ;+<5<<<5<<<J!V4#n:85i:*D : ;+<5**85+/0,
+<-&ear bonds9 !ar : ;)5<<<5<<<5 !V : ;85/<<5<<<5 C(n : B (ercent CM : B,*/8D,
he ne$ !V : ;*0<5<<<J!V4#An:+<5i:),*/8D = ;)5<<<5<<<J!V4#n:+<5i:),*/8D : ;)500050.<,
Aebentures9 !ar : ;)5<<<5<<<5 !V : ;)50<<5<<<5 C(n : . (ercent /,)** (ercent, he
ne$ !V : ;8*<5<<<J!V4#An:0<5i:B,)**D = ;)5<<<5<<<J!V4#n:0<5i:B,)** : ;)5/0<5*+/,
he total value of the assets after the change in rates $ill be ;015*/B5/.<5 and the
$eighted-average "aturit& $ill be M8J+<5**85+/0 = +<J)500050.< =
0<J)5/0<5*+/NK015*/B5/.< : 08<5/8B5+B<K015*/B5/.< : +<,)/ &ears,
c, E'(lain the changes in the "aturit& values if the &ields increase b& + (ercent,
-hen interest rates increase + (ercent5 the value of the -note is ;.58B/5B)*5 the value of
the +<-&ear bond is ;85*+*5..15 and the value of the debenture is ;85))05//05 and the ne$
value of the assets is ;0<5)8)5)1., he $eighted-average "aturit& is +<,*0 &ears,
d, Assu"e that the insurance co"(an& has no other assets, -hat $ill be the effect on the
"arket value of the co"(an&Fs equit& if the interest rate changes in ?b@ and ?c@ occur2
Assu"ing that the co"(an& is financed entirel& $ith equit&5 the "arket value $ill increase
;+5*/B5/.< $hen interest rates decrease + (ercent5 and the "arket value $ill decrease
;+51*151)+ $hen rates increase + (ercent, >otice that for the sa"e absolute rate change5
the increase in value is greater than the decrease in value ?rule nu"ber four in (roble" +0,@
B)
08, he follo$ing is a si"(lified #4 balance sheet9
Assets 'ia&ilities and E(uity
Loans ;+5<<< Ae(osits ;/8<
< Equit& ;+8<
otal Assets ;+5<<< otal Liabilities E Equit& ;+5<<<
he average "aturit& of loans is four &ears5 and the average "aturit& of de(osits is t$o
&ears, Assu"e loan and de(osit balances are re(orted as book value5 6ero-cou(on ite"s,
a, Assu"e that interest rates on both loans and de(osits are . (ercent, -hat is the "arket
value of equit&2
he value of loans : ;+5<<<K?+,<.@
*
: ;B</,*15 and the value of de(osits : ;/8<K?+,<.@
0
:
;B+8,*1, he net $orth : ;B</,*1 - ;B+8,*1 : -;B,<<0/, ?hat is5 net $orth is negative,@
b, -hat "ust be the interest rate on de(osits to force the "arket value of equit& to be
6ero2 -hat econo"ic "arket conditions "ust e'ist to "ake this situation (ossible2
4n this case the de(osit value should equal the loan value, hus5 ;/8<K?+ = x@
0
: ;B</,*1,
Solving for '5 $e get .,81B*D, hat is5 de(osit rates $ill have to increase "ore because
the& have a shorter "aturit&, >ote9 for those using calculators5 &ou need to co"(ute
4KCEAR after entering /8< : #V5 -B</,*1 : !V5 < : !M5 0 : >,
c, Assu"e that interest rates on both loans and de(osits are . (ercent, -hat "ust be the
average "aturit& of de(osits for the "arket value of equit& to be 6ero2
4n this case5 $e need to solve the equation in (art ?b@ for >, he result is 0,++*+ &ears, 4f
interest rates re"ain at . (ercent5 then the average "aturit& of de(osits has to be higher in
order to "atch the value of a *-&ear loan,
0), Iunnison 4nsurance has re(orted the follo$ing balance sheet ?in thousands@9
Assets 'ia&ilities and E(uity
0-&ear reasur& note ;+B8 +-&ear co""ercial (a(er ;+18
+8-&ear "unis ;+)8 8-&ear note ;+)<
Equit& ;*8
otal Assets ;1*< otal Liabilities E Equit& ;1*<
All securities are selling at (ar equal to book value, he t$o-&ear notes are &ielding 8
(ercent5 and the +8-&ear "unis are &ielding . (ercent, he one-&ear co""ercial (a(er
(a&s *,8 (ercent5 and the five-&ear notes (a& / (ercent, All instru"ents (a& interest
annuall&,
a, -hat is the $eighted-average "aturit& of the assets for Iunnison2
BB
MA : M0J;+B8 = +8J;+)8NK;1*< : /,1+ &ears
b, -hat is the $eighted-average "aturit& of the liabilities for Iunnison2
ML : M+J;+18 = 8J;+)<NK;0.8 : 1,+B &ears
c, -hat is the "aturit& ga( for Iunnison2
MIA! : /,1+- 1,+B : 8,+* &ears
d, -hat does &our ans$er to (art ?c@ i"(l& about the interest rate e'(osure of Iunnison
4nsurance2
Iunnison 4nsurance is e'(osed to interest rate risk, 4f interest rates rise5 net $orth $ill
decline because the average "aturit& of the assets is higher than the average "aturit& of the
liabilities, he o((osite holds true if interest rates fall ?hat is5 net $orth $ill increase,@
e, Calculate the values of all four securities of Iunnison 4nsuranceFs balance sheet
assu"ing that all interest rates increase 0 (ercent, -hat is the dollar change in the total
asset and total liabilit& values2 -hat is the (ercentage change in these values2
-notes9 !V : /,B8J!V4#Ai:BD5n:0 = +B8J!V4#i:BD5n:0 : ;+)/,)B
Munis9 !V : +*,/8J!V4#Ai:++D5n:+8 = +)8J!V4#i:++D5n:+8 : ;+*+,0B
Co""ercial !a(er9 !V : ),<B8J!V4#Ai:),8D5n:+ = +18J!V4#i:),8D5n:+ : ;+10,*)
>ote9 !V : +0,/<J!V4#Ai:+<D5n:8 = +)<J!V4#i:+<D5n:8 : ;+*B,/B
otal assets : ;+)/,)B = ;+*+,0B : ;1<.,.* A : -;1<,<) or -/,/* (ercent change
otal liabilities : ;+10,*) = ;+*B,/B : ;0/<,11 L : -;+*,)B or -*,.B (ercent change
f, -hat is the dollar i"(act on the "arket value of equit& for Iunnison2 -hat is the
(ercentage change in the value of the equit&2
E : A - L : -;1<,<) L ?-;+*,)B@ : -;+8,1. -1*,0 (ercent
g, -hat $ould be the i"(act on IunnisonFs "arket value of equit& if the liabilities (aid
interest se"iannuall& instead of annuall&2
he value of liabilities $ill be lo$er $ith se"i-annual co"(ounding5 increasing the value
of net $orth, he one-&ear C! $ill decline in value to ;+10,*0), he five-&ear note $ill
decline in value to ;+*B,)*8, he value of equit& $ill increase to ;0.,/). : ?;+)/,)B =
;+*+,0B@ - ?;+10,*0) = ;+*B,)*8@,
0B, Scandia %ank has issued a one-&ear5 ;+"illion CA (a&ing 8,B8 (ercent to fund a one-&ear
loan (a&ing an interest rate of ) (ercent, he (rinci(al of the loan $ill be (aid in t$o
install"ents5 ;8<<5<<< in ) "onths and the balance at the end of the &ear,
B/
a, -hat is the "aturit& ga( of Scandia %ank2 According to the "aturit& "odel5 $hat
does this "aturit& ga( i"(l& about the interest rate risk e'(osure faced b& the bank2
he "aturit& ga( is + &ear L + &ear : <, he "aturit& ga( "odel $ould state that the
(ortfolio is i""uni6ed against changes in interest rates because assets and liabilities are of
equal "aturit&,
b, -hat is the e'(ected net interest inco"e at the end of the &ear2
!rinci(al received in si' "onths ;8<<5<<<
4nterest received in si' "onths ?,<1 ' ;+5<<<5<<<@ ;1<5<<<
otal ;81<5<<<
!rinci(al received at the end of the &ear ;8<<5<<<
4nterest received at the end of the &ear ?,<1 ' ;8<<5<<<@ ;+85<<<
#uture value of interest received in si' "onths ?;81<5<<< ' +,<1J@ ;8*85.<<
otal (rinci(al and interest received ;+5<)<5.<<
!rinci(al and interest (aid on de(osits ?;+5<<<5<<< ' <,<8B8@ ;+5<8B58<<
>et interest inco"e received ;15*<<

J 4t is assu"ed that the "one& $ill be reinvested at current loan rates, >ote that the
(rinci(al is also included in the anal&sis because interest e'(ense is based on ;+5<<<5<<<,
c, -hat $ould be the effect on annual net interest inco"e of a 0 (ercent interest rate
increase that occurred i""ediatel& after the loan $as "ade2 -hat $ould be the effect
of a 0 (ercent decrease in rates2
4f interest rates increase 0 (ercent5 then the reinvest"ent benefits of cash flo$s in si'
"onths $ill be higher9
!rinci(al received in si' "onths ;8<<5<<<
4nterest received in si' "onths ?,<1 ' ;+5<<<5<<<@ ;1<5<<<
otal ;81<5<<<
!rinci(al received at the end of the &ear ;8<<5<<<
4nterest received at the end of the &ear ?,<1 ' ;8<<5<<<@ ;+85<<<
#uture value of interest received in si' "onths ?;81<5<<< ' +,<*@ ;88+50<<
otal (rinci(al and interest received ;+5<))50<<
!rinci(al and interest (aid on de(osits ?;+5<<<5<<< ' <,<8B8@ ;+5<8B58<<
>et interest inco"e received ;/5B<<
4f interest rates decrease b& 0 (ercent5 then reinvest"ent inco"e is reduced,
!rinci(al received in si' "onths ;8<<5<<<
B.
4nterest received in si' "onths ?,<1 ' ;+5<<<5<<<@ ;1<5<<<
otal ;81<5<<<
!rinci(al received at the end of the &ear ;8<<5<<<
4nterest received at the end of the &ear ?,<1 ' ;8<<5<<<@ ;+85<<<
#uture value of interest received in si' "onths ?;81<5<<< ' +,<0@ ;8*<5)<<
otal (rinci(al and interest received ;+5<885)<<
!rinci(al and interest (aid on de(osits ?;+5<<<5<<< ' <,<8B8@ ;+5<8B58<<
>et inco"e received ;-+5.<<
d, -hat do these results indicate about the "aturit& "odelFs abilit& to i""uni6e (ortfolios
against interest rate e'(osure2
he results indicate that 7ust "atching assets and liabilities b& "aturit& is not sufficient to
i""uni6e a (ortfolio, 4f the ti"ing of the cash flo$s $ithin a (eriod is different for assets
and liabilities5 the effects of interest rate changes are different, #or a trul& effective
i""uni6ation strateg&5 one also needs to account for the ti"ing of cash flo$s,
0/, EA# %ank has a ver& si"(le balance sheet, Assets consist of a t$o-&ear5 ;+ "illion loan
that (a&s an interest rate of L4%OR (lus * (ercent annuall&, he loan is funded $ith a t$o-
&ear de(osit on $hich the bank (a&s L4%OR (lus 1,8 (ercent interest annuall&, L4%OR
currentl& is * (ercent5 and both the loan and de(osit (rinci(al $ill be (aid at "aturit&,
a, -hat is the "aturit& ga( of this balance sheet2
Maturit& ga( : 0 - 0 : < &ears
b, -hat is the e'(ected net interest inco"e in &ear + and &ear 02
4nterest received in &ear + ;/<5<<< 4nterest received in &ear 0 ;/<5<<<
4nterest (aid in &ear + ;B85<<< 4nterest (aid in &ear 0 ;B85<<<
>et interest inco"e in &ear + ;85<<< >et interest inco"e in &ear 0 ;85<<<
c, 4""ediatel& (rior to the beginning of &ear 05 L4%OR rates increased to ) (ercent,
-hat is the e'(ected net interest inco"e in &ear 02 -hat $ould be the effect on net
interest inco"e of a 0 (ercent decrease in L4%OR2
)ear *" 4f interest rates increase 0 (ercent )ear *" 4f interest rates decrease 0 (ercent
4nterest received in &ear 0 ;+<<5<<< 4nterest received in &ear 0 ;)<5<<<
4nterest (aid in &ear 0 ;.85<<< 4nterest (aid in &ear 0 ;885<<<
>et interest inco"e in &ear 0 ;85<<< >et interest inco"e in &ear 0 ;85<<<
d, 3o$ $ould &our results be affected if the interest (a&"ents on the loan $ere received
se"iannuall&2
/<
With 'IBOR at +," Cear + Cear 0
4nterest received in Q &ear ;*<5<<< 4nterest received in Q &ear ;*<5<<<
4nterest received at &ear-end ;*<5<<< 4nterest received at &ear-end ;*<5<<<
Reinvested interest ;+5)<< Reinvested interest ;+5)<<
4nterest (aid in &ear + ;B85<<< 4nterest (aid in &ear 0 ;B85<<<
>et interest inco"e in &ear + ; )5)<< >et interest inco"e in &ear 0 ; )5)<<
With 'IBOR at -," Cear + Cear 0
4nterest received in Q &ear ;8<5<<< 4nterest received in Q &ear ;8<5<<<
4nterest received at &ear-end ;8<5<<< 4nterest received at &ear-end ;8<5<<<
Reinvested interest ;058<< Reinvested interest ;058<<
4nterest (aid in &ear + ;.85<<< 4nterest (aid in &ear 0 ;.85<<<
>et interest inco"e in &ear + ; B58<< >et interest inco"e in &ear 0 ; B58<<
With 'IBOR at *," Cear + Cear 0
4nterest received in Q &ear ;1<5<<< 4nterest received in Q &ear9 ;1<5<<<
4nterest received at &ear-end ;1<5<<< 4nterest received at &ear-end ;1<5<<<
Reinvested interest ;.<< Reinvested interest ;.<<
4nterest (aid in &ear + ;885<<< 4nterest (aid in &ear 0 ;885<<<
>et interest inco"e in &ear + ; 85.<< >et interest inco"e in &ear 0 ; 85.<<
e, -hat i"(lications do these results have on the effectiveness of the "aturit& "odel as
an i""uni6ation strateg&2
Even though the "aturit& ga( is 6ero5 the (ortfolio is not full& i""uni6ed, hat is because
the ti"ings of the cash flo$s are not the sa"e for the assets and liabilities, he onl& $a& to
i""uni6e using the "aturit& "odel is if the ti"ing of the cash flo$s for both assets and
liabilities are the sa"e5 as de"onstrated in !roble" +0?c@,
0., -hat are the $eaknesses of the "aturit& "odel2
#irst5 the "aturit& "odel does not consider the degree of leverage on the balance sheet, #or
e'a"(le5 if assets are not financed entirel& $ith de(osits5 a change in interest rates "a& cause the
assets to change in value b& a different a"ount than the liabilities, Second5 the "aturit& "odel
does not take into account the ti"ing of the cash flo$s of either the assets or the liabilities5 and
thus reinvest"ent andKor refinancing risk "a& beco"e i"(ortant factors in (rofitabilit& and
valuation as interest rates change,
The follo.ing (uestions and pro&lems are &ased on material in the chapter appendi/
1<, he current one-&ear reasur& bill rate is 8,0 (ercent5 and the e'(ected one-&ear rate +0
"onths fro" no$ is 8,/ (ercent, According to the unbiased e'(ectations theor&5 $hat
should be the current rate for a 0-&ear reasur& securit&2
?+,<80@?+,<8/@ : ?+ = R0@
0
: +,++1<+)R ?+ = R0@ : +,<8*..) R0 : ,<88< or 8,8< (ercent
/+
1+, A recent edition of The Wall Street Journal re(orted interest rates of ) (ercent5 ),18
(ercent5 ),)8 (ercent5 and ),B8 (ercent for three-&ear5 four-&ear5 five-&ear5 and si'-&ear
reasur& notes5 res(ectivel&, According to the unbiased e'(ectations theor&5 $hat are the
e'(ected one-&ear rates for &ears *5 85 and )2
M+ = E?ri@N : ?+ = Ri@
i
?+ = Ri-+@
i-+
M+ = E?r*@N : ?+,<)18@
*
?+,<)@
1
: +,<B*+ r* : B,*+ (ercent for (eriod *
M+ = E?r8@N : ?+,<))8@
8
?+,<)18@
*
: +,<B/) r8 : B,/) (ercent for (eriod 8
M+ = E?r)@N : ?+,<)B8@
)
?+,<))8@
8
: +,<B08 r) : B,08 (ercent for (eriod )
10, 3o$ does the liquidit& (re"iu" theor& of the ter" structure of interest rates differ fro" the
unbiased e'(ectations theor&2 4n a nor"al econo"ic environ"ent5 that is5 an u($ard
slo(ing &ield curve5 $hat is the relationshi( of liquidit& (re"iu"s for successive &ears into
the future2 -h&2
he unbiased e'(ectations theor& asserts that long-ter" rates are a geo"etric average of current
and e'(ected short-ter" rates, he liquidit& (re"iu" theor& asserts that long-ter" rates are a
geo"etric average of current and e'(ected short-ter" rates (lus a liquidit& risk (re"iu", he
(re"iu" is assu"ed to increase $ith the "aturit& of the securit& because the uncertaint& of
future returns gro$s as "aturit& increases,
/0