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# FIN 683

Financial Institutions Management
Measuring and Managing
Interest-Rate Risk
Professor Robert B.H. Hauswald

Cash-Flow Based Interest-Rate
Risk Measurement
• Market-value based models for assessing and
managing interest rate risk: beats accounting!
– Duration
– Computation of duration
– Economic interpretation

• Immunization using duration: balance-sheet
management for financial institutions
– Problems in applying duration
9/18/2012

Duration and Immunization © Robert B.H. Hauswald

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Price Sensitivity and Maturity
• The sensitivity to interest rate changes
– rises in the term to maturity: more cash flow(s)
affected by the change in yield (discount rate)
– falls in the coupon (interest payment)

• Suppose the zero coupon yield curve is flat
at 12%: consider two zero bonds
– Bond A pays \$1790.85 in five years.
– Bond B pays \$3207.14 in ten years, and both
are currently priced at \$1000.
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Duration and Immunization © Robert B.H. Hauswald

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The Power of Discounting
– Bond A: P = \$1000 = \$1790.85/(1.06)10
– Bond B: P = \$1000 = \$3207.14/(1.06)20

• Now suppose the annual interest rate increases
by 1% (0.5 % semiannually): parallel shift
– Bond A: P = \$1762.34/(1.065)10 = \$954.03
– Bond B: P = \$3105.84/(1.065)20 = \$910.18

• The longer bond has the greater drop in price
– the payment is discounted a greater number of times.
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Duration and Immunization © Robert B.H. Hauswald

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– With higher coupons. same maturity – Bonds with identical maturities respond differently to interest rate changes when the coupons differ.H. longer maturity bonds experience greater price changes in response to any change in the discount rate • The range of prices is greater when the coupon is lower – A 6% bond will have a larger change in price in response to a 2% change than an 8% bond – The 6% bond has greater interest rate risk 9/18/2012 Duration and Immunization © Robert B.H. Hauswald 5 Fixed-Income Instruments • In general. Hauswald 6 .Coupon Effect • Different coupons. it is less sensitive to changes in R – again: the power of discounting 9/18/2012 Duration and Immunization © Robert B. more of the bond’s value is generated by earlier cash flows – Consequently. • Notice that any coupon bond simply consists of a bundle of “zero-coupon” bonds.

Hauswald 7 Bond Value Maturity and Bond-Price Sensitivity Consider two otherwise identical bonds.99 almost immediately and one penny ten years hence a large effect on the value of the zero but almost no impact on the hypothetical bond Most FI instruments fall between these extremes – – the higher the coupon. Hauswald Discount Rate Long Maturity Bond 8 .H. the more similar it is to our hypothetical bond with higher value of cash flows arriving sooner 9/18/2012 Duration and Immunization © Robert B.Hypothetical Example • Consider two ten-year maturity instruments: – – • Small changes in yield will have – – • A ten-year zero coupon bond A two-cash flow “bond” that pays \$999. The long-maturity bond will have much more volatility with respect to changes in the yield Par Short Maturity Bond C 9/18/2012 Duration and Immunization © Robert B.H.

Duration • Weighted average time to maturity using the relative present values of cash flows as weights – takes into account the effects of differences in both coupon rates and differences in maturity • Based on elasticity of bond price with respect to interest rate: derivative scaled by bond price – simple differentiation of price function wrt yield • The units of duration are years: cash-flow adjusted maturity 9/18/2012 Duration and Immunization © Robert B. Hauswald Macaulay Duration • Formula Where D = Macaulay duration (in years) t = number of periods in the future CFt = cash flow to be delivered in t periods N = time-to-maturity DFt = discount factor 9-10 9/18/2012 Duration and Immunization © Robert B. Hauswald 9 .H.H.

D is equal to: 9/18/2012 Duration and Immunization © Robert B.Duration • Since the price (P) of the bond equals the sum of the present values of all its cash flows. • For semiannual cash flows. Hauswald 11 Semiannual Cash Flows • Important reminders: – we must express t in years (for consistency) – the present values are computed using the appropriate periodic interest rate. Macaulay duration.H. Hauswald 12 . we can state the duration formula another way: • Notice the weights correspond to the relative present values of the cash flows 9/18/2012 Duration and Immunization © Robert B.H.

Hauswald 13 Duration and IR Sensitivity 9/18/2012 Duration and Immunization © Robert B.Duration of Zero = Its Maturity • For a zero-coupon bond. Macaulay duration equals maturity – 100% of its present value is generated by the payment of the face value. at maturity • For all other bonds. duration < maturity – can you see why? 9/18/2012 Duration and Immunization © Robert B.H. Hauswald 14 .H.

YTM = 12% t years CFt PV(CFt) 1 0.038 3 1.000. each coupon payment is \$40 and the per period YTM is (1/2) × 12% = 6% – yield already adjusted for semi-annual compounding • Present value of each cash flow equals CFt ÷ (1+ 0.885 1. Hauswald 16 . 8% Bond: Face Value = \$1.06)t where t is the period number 9/18/2012 Duration and Immunization © Robert B.H.Example • Consider a 2-year.698 1. Hauswald 15 Duration of 2-Year.777 0.736 Weight W × years (W) 0.H.041 0.040 823.5 40 37.0 40 35.600 0.883 (years) 9/18/2012 Duration and Immunization © Robert B.000 D=1.000 and yield-to-maturity of 12% – coupons are paid semi-annually: how many periods? • Therefore.020 2 1.770 P = 930. 8% coupon bond face – value of \$1.038 0.036 0.0 1.054 4 2.5 40 33.585 0.

– Duration of a consol: D = 1 + 1/R • Floating rate note or any other variableinterest fixed-income instrument – duration = length of reset period – inverse floater: tricky and surprising… 9/18/2012 Duration and Immunization © Robert B. but at a decreasing rate • Duration and yield-to-maturity – D decreases as yield increases • Duration and coupon interest – D decreases as coupon increases • Duration is additive: how fortunate! 9/18/2012 Duration and Immunization © Robert B.H. UK – if c and y are the coupon and yield: its price? – Maturity of a consol: M = ∞..Duration: Special Cases • Consols (“perps” in the jargon): perpetual bonds issued by governments.g.H. e. Hauswald 17 Properties of Duration • Duration and maturity – D increases with M. Hauswald 18 .

H.Economic Interpretation • Duration is a measure of interest rate sensitivity or elasticity of a liability or asset: [∆P/P] ÷ [∆R/(1+R)] = -D • Or equivalently. Hauswald 20 .let’s see what the problem is… y 9/18/2012 Duration and Immunization © Robert B. ∆P/P = -D[∆R/(1+R)] = -MD × ∆R where MD is modified duration 9/18/2012 Duration and Immunization © Robert B.H. Hauswald 19 Duration and Yield Sensitivity dP = − P ⋅ Modified Duration dy \$ Duration is related to the rate of change in a bonds price as its yield changes: linear (first-order) approximation of price changes in yield .

When interest rates change. Hauswald 21 Predicting Price Changes • To estimate the change in price. Find modified duration of bond 3. Find Macaulay duration of bond 2. we can express the previous equation as: ∆P = -D[∆R/(1+R)]P = -(MD) × (∆R) × (P) • Note the direct linear relationship between ∆P and -D : what does this imply? 9/18/2012 Duration and Immunization © Robert B. the change in a bond’s price is related to the change in yield according to ∆P * × 100 = −Dm × ∆y × 100 P – – – Find percentage price change of bond Find predicted dollar price change in bond Add predicted dollar price change to original price of bond ⇒ Predicted new price of bond (…or use XLS) 9/18/2012 Duration and Immunization © Robert B.H.H.Predicting Price Changes 1. Hauswald 22 .

H. we can compute the change in price as ∆P = -Dollar duration × ∆R • Allows us to compute the direct price impact of yield or interest-rate changes 9/18/2012 Duration and Immunization © Robert B. Hauswald 23 Semi-annual Coupon Payments • With semi-annual coupon payments the percentage change in price is given by ∆P/P = -D[∆R/(1+(R/2)] • As always.H.Dollar Duration • Dollar duration equals modified duration times price – Dollar duration = MD × Price • Using dollar duration. for more frequent compounding we need to adjust – yield – number of (time) periods 9/18/2012 Duration and Immunization © Robert B. Hauswald 24 .

H. Hauswald 25 Immunization • Matching the maturity of an asset investment with a future payout responsibility – does not necessarily eliminate interest rate risk – but introduces fundamental principle: match assets and liabilities along risk sensitivity • Matching durations will immunize against changes in interest rates – why? 9/18/2012 Duration and Immunization © Robert B. Hauswald 26 .Managing Interest-Rate Risk • Measuring interest-rate exposure – duration: – potential problems? • Managing interest-rate exposure: – principle: – implementation? • Overall objective: 9/18/2012 Duration and Immunization © Robert B.H.

• Loan #3 is a discount loan.70 2 2. – amount is \$1.68 \$1000 \$14. Hauswald 27 Duration as Index of Interest Rate Risk Yield Loan Value 2% 3% ∆P N D Equal \$1014. all of which have maturities of 2 years.61 each. 9/18/2012 Duration and Immunization © Robert B. • Loan #2 is structured as a 3% annual coupon bond.68 2 1.42 2 1.90.70 \$1000 \$19. • Loan #1 is a two-payment loan with two equal payments of \$522. Hauswald 28 .42 \$1000 \$19.000 Duration and Immunization © Robert B. which has a single payment of \$1.H.Small Business Lending: in Ks • Consider three loan plans.493 Payment 3% Coupon \$1019.000 and the current interest rate is 3%.060.H.971 Discount 9/18/2012 \$1019.

ML = 2 -2 = 0. so DGAP is negative – FI exposed to rising interest rates 9/18/2012 Duration and Immunization © Robert B.8 . then: Maturity gap: MA . then there is a risk that – adverse changes in the interest rate will increase the present value of the liabilities – more than the present value of assets is increased • Result? 9/18/2012 Duration and Immunization © Robert B.H.8 years.2. but Duration Gap: DA .Balance-Sheet Immunization • Duration is a measure of the interest rate risk exposure for an FI • If the durations of liabilities and assets are not matched. Hauswald 30 . Hauswald 29 Duration Gap • A simple FI balance sheet: – a 2-year coupon bond is the only loan asset (A) – a 2-year certificate of deposit itsonly liability (L) • If the duration of the bond is 1.0 = -0.H.DL = 1.2 – Deposit has greater interest rate sensitivity than the bond.

or ∆E = −[DA .Immunizing the Balance Sheet • Duration Gap: the DGAP – From the balance sheet.H. we can find the change in value of equity using duration. ∆E = ∆A – ∆L – reflects what management priority? • Like for changes in bond prices. ∆E = [-DAA + DLL] ∆R/(1+R). therefore. Hauswald Duration and Immunizing • The formula shows 3 effects: – Leverage adjusted D-Gap – The size of the FI – The size of the interest rate shock • How does each factor affect the value of a financial institution? – leverage: – size: – interest-rate shock: 9/18/2012 Duration and Immunization © Robert B.DLk]A(∆R/(1+R)) 9-31 9/18/2012 Duration and Immunization © Robert B. Hauswald 32 .H. E = A – L.

1] = .\$2. DL or k: what is least expensive? 9/18/2012 Duration and Immunization © Robert B.DLk]A[∆R/(1+R)] = -[5 . DL = 3 years and rates are expected to rise from 10% to 11%.An Example • Suppose DA = 5 years. – Rates change by 1% – balance sheet: A = 100.01/1. to set ∆E = 0: – DA = kDL • Who should managers make happy? – shows what? 9/18/2012 Duration and Immunization © Robert B.H.H. Hauswald 33 Immunization and Regulation • Regulators set target ratios for an FI’s capital (net worth): immunize capital ratio – Capital (Net worth) ratio = E/A • If target is to set ∆(E/A) = 0: DA = DL – accept without proof • But.09.. Hauswald 34 .3(90/100)]100[. • Find change in E ∆Ε = −[DA . L = 90 and E = 10. • Methods of immunizing balance sheet – simply adjust DA .

but – greater convexity causes larger errors in the duration-based estimate of price changes.H. – If there are large changes in R.H. – All fixed-income securities are convex. • Convexity is desirable. Hauswald 36 . 9/18/2012 Duration and Immunization © Robert B. Hauswald 35 Convexity • The duration measure is a linear approximation of a non-linear function.Limitations of Duration • Immunizing the entire balance sheet need not be costly: why not that expensive for FIs? • Duration can be employed in combination with hedge positions to immunize • Immunization is a dynamic process since duration depends on instantaneous R • Large interest rate changes not accurately captured – Convexity • More complex if nonparallel shift in yield curve – stylized facts on term structure of interest rates (TSIR)? 9/18/2012 Duration and Immunization © Robert B. the approximation is much less accurate.

Hauswald 38 .H. • Improve on the estimate using a second-order Taylor expansion: higher-order approximation – in practice. Hauswald 37 Pricing Error and Convexity Price Pricing error due to ∆P = − DM ∆y P Convexity Duration Yield 9/18/2012 Duration and Immunization © Robert B. the expansion rarely goes beyond second order (using the second derivative). • This second order expansion is the convexity adjustment.Convexity • Remember calculus? linear approximations – notice that duration involves only the first derivative of the price function.H. 9/18/2012 Duration and Immunization © Robert B.

000 (why??) CX = 108[∆P-/P + ∆P+/P] = 108[(999.Modified Duration & Convexity • Second-order approximation using convexity: ∆P/P = -D[∆R/(1+R)] + (1/2) CX (∆R)2 or ∆P/P = -MD ∆R + (1/2) CX (∆R)2 – where MD is modified duration and CX is a measure of the curvature effect.000.000 + (1.53785-1.000)] = 28 9/18/2012 Duration and Immunization © Robert B.000)/1. Hauswald 39 Calculation of CX • Convexity of a 8% coupon.000)/1. Hauswald 40 . – CX = Scaling factor × [capital loss from 1bp rise in yield + capital gain from 1bp fall in yield] • Commonly used scaling factor is 108 9/18/2012 Duration and Immunization © Robert B.H.H. 8% yield. six-year maturity Eurobond priced at \$1.46243-1.

swaps. caps. options. and other contingent claims • In fact: derivatives widely used to adjust duration.. Hauswald 41 Contingent Claims • Interest rate changes also affect value of offbalance sheet claims • Duration gap hedging strategy must include the effects on off-balance sheet items such as – futures.Duration Measure: Other Issues • Default risk • Floating-rate loans and bonds • Duration of demand deposits and passbook savings • Mortgage-backed securities and mortgages – Duration relationship affected by call or prepayment provisions 9/18/2012 Duration and Immunization © Robert B. Hauswald 42 . i. interest-rate exposure 9/18/2012 Duration and Immunization © Robert B.H.e.H.

sec.H.com Duration and Immunization © Robert B. Hauswald 43 Pertinent Websites www.bis. Hauswald 44 .gov www.wsj.Summary • Duration and convexity are market-value DCF based measures of interest exposure – basis for FIs’ risk and balance-sheet management • Adjusting duration gap: – derivatives – product pricing: how to shorten duration? • Tension between shareholders’ and regulators’ objective: apparent conflict of interest – but do shareholders really want to be immunized? 9/18/2012 Duration and Immunization © Robert B.H.org Bank for International Settlements Securities Exchange Commission The Wall Street Journal 9/18/2012 www.