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One key to risk management is having a sense of how the value of your assets and liabilities would be affected by a change in interest rates. As a rst step, we maintain the idea of a single interest rate, but ask what would happen to asset values if the interest rate changed a bit Duration provides an approximate measure of how sensitive an asset price is to such a change
Warusawitharana, JHU e266, Spring 2013 p.2/??
Question What happens to the price of a bond when the constant interest rate rises a bit from i0 to i1 ?
The price falls: prices move inversely to yields
Defn: the change in the price of a capital asset is called a capital gain or loss
In this case, we are talking about a capital loss
Question So we take a capital loss on our bond asset when the interest rate changes Wed like to know how big this will be
How sensitive is our asset value to a small change in interest rates
Side note: small change Remember that our valuation of the M -period stream is an M th order polynomial in i Figuring out exactly what happens when i changes is going to require that we evaluate (1 + i)1 , . . . , (1 + i)M .
And there isnt going to be an exact analytic expression for the answer
Approximation But for small changes in i, we can form an approximate expression For those with calculus, we (again) a use rst order Taylor series approximation
The same thing underlying ln(1 + z) z.
For those without calculus, when you hear small change you should suspect that the underlying math involves calculus, and likely involves something like a Taylor series approx.
Bottom line For a bond (or any stream) there is a quantity, , called duration
well give the denition of in a moment, but . . .
The duration of a stream is closely related to the capital gains or losses from an interest rate change: i 100 %P 1+i
Bottom line Note means change in; % means percent change in.
In our example: i = i1 i0 P1 P0 %P = 100 P0
Note about the text The book plays a bit fast and loose with the 100 factor writing (e.g., p66): %P 0.0615 = 6.15% While the items on the left and right are percents, the middle item is not and really shouldnt be sitting in the middle without a 100. Let this be a lesson to you: folks are often a bit unclear about whether things are in percent or not and you have to think about things in context to tell.
Warusawitharana, JHU e266, Spring 2013 p.9/??
Tedious aside Sometimes the (1 + i) term in the equation above is included in the denition of duration If /(1 + i) then we have the alternative formulation %P i 100 Generally: is called Macaulay duration (after its inventor); is called modied duration
More on Frederick Macaulay (1882-1970) later.
Terminology: A basis point is 1/100th of a percentage point, so half a percentage point is also called 50 basis points. And suppose my stream has duration 6.2 years
Concretely Then, when rates rise by 50 basis points from 3 percent my capital loss is: 6.2 0.005 0.03 1.03 I lose about 3 percent of my value.
More generally, For a given change in the interest rate, the capital gain or loss rises linearly with the duration of the bond.
Longer duration means greater sensitivity of the bond price to changes in the interest rate.
The present value of the payments is, P V1 , . . . , P VM , The present value of the full stream is the sum of these
M
PV =
j=1
P Vj
Formula for duration What share of the present value comes in the payment at time j? P Vj wj = PV And since, the wj s are shares, wj = w1 + . . . + wM = 1
=
j=1
j wj
where wj is the share of the pres. val. coming in payment j years in future
Duration in words Duration is a weighted average of the times to payment where the weights are the share of the total present value contributed by the particular payment
Calculus aside For those with calculus, to see where this formula comes from play with ln(P V )/i
Important factoid For a single payment (say, an IOU or zero coupon bond or Treasury bill), what is the duration?
Duration equals maturity for a single payment. You can verify this with the formula
One way to think about duration I have a stream the price of which has some duration, . I might ask, what maturity of simple IOU (single payment) has (approximately) the same sensitivity to interest rate changes as my complicated stream?
A single payment with maturity equal to the , the duration of the original stream will have the same sensitivity
Short hand From the standpoint of capital gains and losses, the price of a stream with payments at many points in time and duration behaves approximately like a the price of a single future payment at maturity
Note Duration analysis is used extensively by the nance industry in risk management
A simple example Take a nancial institution that raises money by selling 3-month IOUs and uses the proceeds to purchase 30-year mortgages Our rm has one asset a (30-year mortgage) and one liability (3-month bond) Suppose the present value of the two bonds is the same, $1000
Balance sheet so far Our rm Assets mortgage 1000 Liabilities bond 1000
Balance sheet so far If these were all the items on the balance sheet the net worth of the rm would be. . .
zero. On the verge of bankruptcy.
Suppose the rm some other asset that is not at all sensitive to interest rates
Balance sheet so far Our rm Assets mortgage 1000 other 30 Liabilities bond 1000
Question Would a rise in interest rates raise or lower net worth? The value of my main asset and liability both (rise or fall). . .
Fall: prices move inversely to interest rates
Question Thus, the question is whether the value of my assets or liabilities falls more . Which will it be?
The one with the greater duration will move more.
Question Approx. how large a rise in interest rates is required to wipe out my net worth and bankrupt the rm?
Remember the formula The price sensitivity formula %P i/(1 + i) 100 The dollar (as opposed to percent) change will be, P %P/100 .
Thus
N W 1, 000mort i/(1 + i) 1, 000bond i/(1 + i) Or with i = 0.03 and 1000/(1.03) 971: N W (mort bond ) 971 i
Thus Repeat: N W [(mort bond ) 971] i If my assets and liabilities had the same durations, interest rate changes would (approximately) leave my net worth unchanged.
The rm is perfectly hedged against small interest rate movements
Thus The term in square brackets is sometimes called the duration gap and we will see that banks regularly do duration gap analysis
Aside to avoid confusion In our simple example, we have one asset and one liability in the calculation and both have the same value at the time the gap is computed. In a richer example, we would weight the durations for different assets and liabilities by their respective values in creating a duration gap.
We will return to this point in talking about risk management at commercial banks
So what i will bankrupt me? For our case, suppose my 3-month bond is a pure discount bond, and my mortgage is a 30-year xed rate mortgage both are paying 3 percent.
Duration of the bond? 0.25, it has one-payment in 3 months
So what i will bankrupt me? Thus, about a 25 basis point rise in the interest rate from 0.03 will bankrupt me.
(12.85 0.25) 971 0.0025 30, my net worth
Surely you jest? One might suppose that this was a fanciful example
What nut case would run a rm that would be bankrupted by a 25 basis point move in interest rates?
But both the recent crisis and the savings and loan crisis of the 1980s had elements very much like those in this example
Aside: S&L crisis, thumbnail Savings and loans are bank-like entities that take deposits and make mortgage loans. They were insured by the savings and loan version of the FDIC, cleverly called the FSLIC (zz-lick) About 1000 thrifts went bust costing the government about $150 billion
This is a kind of direct cost, ignoring spillovers to economic performance
Duration basic facts Duration gives a measure of the sensitivity of the price of a stream to changes in the interest rate The sensitivity measure is only an approximation
Duration basic facts For any xed stream, as interest rates increase, duration . . . decreases
Intuition: at a higher interest rate, later payments are worth less in present value terms, so these later payments receive smaller weights (the wj s in our duration formula).
Duration basic facts Similarly, for a xed interest rate, shifting more of the payments earlier in time will lower duration. Thus, for a coupon bond, raising the coupon rate (with xed par value) will . . . lower duration
Coupon payments come earlier that the par value, which is the last payment. Raising the coupon rate means that more of the payments come earlier