Duration Duration model Manage single security Manage balance sheet

Interest rate risk

Part 2
Reading: Saunders, chapter 9

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Duration Duration model Manage single security Manage balance sheet

Content

Duration

Duration model

Manage single security

Manage balance sheet

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Duration Duration model Manage single security Manage balance sheet

Duration

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Duration Duration model Manage single security Manage balance sheet

Problem

• The repricing model only measures how interest rate changes

affect net interest income.
• But interest rate changes also impact market values of the
bank’s assets, liabilities, and thus equity → risk
• Example: as discount rate ↑, debt instrument’s price ↓
CF1 CF2 CFn
MV = + 2
+ ... +
1+R (1 + R) (1 + R)n

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Duration Duration model Manage single security Manage balance sheet

Duration

• Objective: measure change to bank’s equity given a change in

market interest rates
• For each asset/liability, we can plug new R in the formula to
get new MV , then get ∆MV → not very convenient for
modeling
• A simpler tool: approximate ∆MV using duration

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Duration Duration model Manage single security Manage balance sheet

Duration

• Duration is the weighted average time to maturity on an

investment
• Takes into account the timing of cash flow arrivals
Xn
PVt × t
t=1
D= n
X
PVt
t=1
Excel file

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Duration Duration model Manage single security Manage balance sheet

Duration

• What is the duration for a zero-coupon bond?

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Duration Duration model Manage single security Manage balance sheet

Duration and maturity

• Duration increases with maturity but at a decreasing rate

δD
> 0;
δM
δ2D
<0
δM 2

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Duration Duration model Manage single security Manage balance sheet

Duration and interest rate

• Duration decreases with interest rate

δD
<0
δR

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Duration Duration model Manage single security Manage balance sheet

Duration and coupon

• Duration decreases with coupon interest

δD
<0
δC

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Duration Duration model Manage single security Manage balance sheet

Duration model

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Duration Duration model Manage single security Manage balance sheet

Economic meaning of Duration

• Duration measures the elasticity of security’s price to a small

change in interest rate (yield to maturity)
∆P ∆R
= −D ×
P (1 + R)

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Duration Duration model Manage single security Manage balance sheet

Economic meaning of Duration

• Rearrange: duration is the percentage change in security price

given a 1% change in interest rate
∆P
D= P
∆R
(1 + R)

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Duration Duration model Manage single security Manage balance sheet

Modified Duration

D
• Call MD =
(1 + R)
• Then
∆P
= −MD × ∆R
P

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Duration Duration model Manage single security Manage balance sheet

Dollar Duration

• Call Dollar Duration = MD × P

• This is the dollar value change in security price given 1%
change in yield

∆P = −Dollar Duration × ∆R

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Duration Duration model Manage single security Manage balance sheet

Manage single security

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Duration Duration model Manage single security Manage balance sheet

Use duration to manage interest rate risk

• Manage interest rate risk of a single security

• Manage interest rate risk of the whole balance sheet

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Duration Duration model Manage single security Manage balance sheet

Interest rate risk: buy a single security

• Objective: earn a certain return on debt security regardless of

interest rate movements during the investment period (e.g., 3
years)
• Simplest solution: buy and hold a zero-coupon bond with
3-year maturity
• Duration is also three years
• No intervening cash flow generated → not subject to
reinvestment risk

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Duration Duration model Manage single security Manage balance sheet

Interest rate risk: buy a coupon bond

• If no zero-coupon bond is available → buy coupon bond

• Interest rate can suddenly change right after investor buys the
bond
• To immunize interest rate risk, buy coupon bond with
duration ≈ 3 years
Excel file

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Duration Duration model Manage single security Manage balance sheet

Manage balance sheet

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Duration Duration model Manage single security Manage balance sheet

Interest rate risk: the whole balance sheet

• Interest rates change → Market values of assets and liabilities

change
∆E = ∆A − ∆L
• Use duration to evaluate the overall interest rate exposure
DA = W1A D1A + W1A D2A + ... + WnA DnA
DL = W1L D1L + W1L D2L + ... + WmL Dm
L

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Duration Duration model Manage single security Manage balance sheet

Interest rate risk: the whole balance sheet

∆R
• ∆A = −DA A
(1 + R)
∆R
∆L = −DL L
(1 + R)
• With k = L/A
∆R
∆E = −(DA − kDL )A
(1 + R)

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Duration Duration model Manage single security Manage balance sheet

What factors affect change in equity

• Adjusted duration gap DA − kDL

• Bank size — total assets A
∆R
• Interest rate shock
(1 + R)

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Duration Duration model Manage single security Manage balance sheet

Immunize interest rate risks

• Make adjusted duration gap DA − kDL ≈ 0

• A bank typically has positive duration gap DA − kDL > 0
(why?), so for gap =0:
• Reduce DA
• Increase DL
• Change k
• A combination of the changes above

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Duration Duration model Manage single security Manage balance sheet

Alternative objective

• Banks have to maintain a minimum capital ratio E /A

• May prefer to immunize interest rate risk to E /A:
∆(E /A) = 0
• Immunize: DA ≈ DL

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Duration Duration model Manage single security Manage balance sheet

Considerations

• Expensive to change DA and DL

• Security duration changes over time → Immunization is a
continuous process
• Large interest rate change makes approximation using
duration less accurate
• Duration model estimates a linear change in security price
• But price-yield relationship is convex, not linear

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Duration Duration model Manage single security Manage balance sheet

Convexity of bond price-yield relationship

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 Problem sets

• Chapter 9: 4, 7, 11, 13, 17, 19, 20, 21, 23, 24, 25, 31

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