Duration

Management
What is Duration?
Duration (D) is a value and time weighted measure of maturity
that considers the timing of all cash inflows from earnings
assets and all cash outflows associated with liabilities.
It measures the average maturity of a promised stream of
future cash payment.
In effect D measures the average time needed to recover the
funds committed to an investment.
The standard formula for calculating the duration (D) of an
individual financial instrument, such as a loan, security,
deposit, or non-deposit borrowing, is

⇒ D stands for the instrument’s duration in years;

⇒ t represents the period of time in which each flow of cash off the
instrument, such as interest or dividend income, is to be received;
⇒ CF indicates the volume of each expected flow of cash in each time
period (t); and
⇒ YTM is the instrument’s current yield to maturity.
For example, suppose that a bank grants a loan to one of its
customers for a term of five years. The customer promises
the bank an annual interest payment of 10 percent (that is,
$100 per year). The face (par) value of the loan is $1,000,
which is also its current market value (price) because the
loan’s current yield to maturity is 10 percent. What is this
loan’s duration?
The formula with the proper figures entered would be this:
 100∗1 100∗2 100∗3 100∗4 100∗5 1000∗5
+ + + + +
(1+𝑌𝑇𝑀)1 (1+𝑌𝑇𝑀)2 (1+𝑌𝑇𝑀)3 (1+𝑌𝑇𝑀)4 (1+𝑌𝑇𝑀)5 (1+𝑌𝑇𝑀)5
𝐷𝐿𝑜𝑎𝑛 =
1 000

90.91+165.29+225.39+273.21+310.46+3104.61
𝐷𝐿𝑜𝑎𝑛 =
1000

𝐷𝐿𝑜𝑎𝑛 = 4.17 𝑦𝑒𝑎𝑟𝑠

We know,
As market interest rates change, the value of both a financial
institution’s assets and its liabilities will change, resulting in a
change in its net worth (the owner’s investment in the
institution).
Because, 𝑁𝑊 = 𝐴 − 𝐿
Portfolio theory teaches us that
1. A rise in market rates of interest will cause the market
value (price) of both fixed-rate assets and liabilities to
decline.
2. The longer the maturity of a financial firm’s assets and
liabilities, the more they will tend to decline in market
value (price) when market interest rates rise.
Thus, a change in net worth due to changing interest rates will
vary depending upon the relative maturities of a financial
institution’s assets and liabilities.
Because duration is a measure of maturity, a financial firm with
longer-duration assets than liabilities will suffer a greater
decline in net worth when market interest rates rise.
By equating asset and liability durations, management can
balance the average maturity of expected cash inflows from
assets with the average maturity of expected cash outflows
associated with liabilities.
Thus, duration analysis can be used to stabilize, or immunize, the
market value of a financial institution’s net worth (NW).
Show different relationships between the market value of bank
assets and their maturity when interest rates change? And
what will be the bank's strategy to reduce risk against such
interest rate changes?
The important feature of duration from a risk-management
point of view is that it measures the sensitivity of the market
value of financial instruments to changes in interest rates.

The percentage change in the market price of an asset or a

liability is equal to its duration times the relative change in
interest rates attached to that particular asset or liability.
That is
𝜟𝑷 𝜟𝒊
≈ −𝑫 ×
𝑷 𝟏+𝒊
where
𝜟𝑷
represents the percentage change in market price and
𝑷
𝜟𝒊
is the relative change in interest rates associated with
𝟏+𝒊
the asset or liability.
𝑫 represents duration, and the negative sign attached to it
reminds us that market prices and interest rates on
financial instruments move in opposite directions.
For Example:
Duration = 4 years (bond),
Current market value of bond = $1000,
𝑖 = 10% (Current market Interest rate)
But market rates may rise to 11% (Forecast),
If the forecast turns out to be correct, what % change will occur
in the bonds market value?

Here 𝑫 = 𝟒, 𝒊 = 𝟏𝟎% 𝜟𝒊 = 𝟏𝟏% − 𝟏𝟎% = 𝟎. 𝟎𝟏, 𝑷 = 𝟏𝟎𝟎𝟎

𝜟𝑷 𝟎.𝟎𝟏
So, ≈ −𝟒 × = −𝟎. 𝟎𝟑𝟔𝟒 = −𝟑. 𝟔𝟒%
𝑷 𝟏+.𝟏𝟎
Bond value will be decrease by 3.64%, bond value will be 963.60
when interest rate increase by 1% and duration is 4 years.
Again if D=2, then,
𝜟𝑷 𝟎. 𝟎𝟏
≈ −𝟐 × = −𝟎. 𝟎𝟏𝟖𝟐 = −𝟏. 𝟖𝟐%
𝑷 𝟏+. 𝟏𝟎
Value of the bond will be 981.8
And when D=8, then,
𝜟𝑷 . 𝟎𝟏
≈ −𝟖 × = −𝟎. 𝟎𝟕𝟐𝟕 = −𝟕. 𝟐𝟕%
𝑷 𝟏+. 𝟏𝟎
Value of the bond will be 927.27
Considering the above situations, if bankers believe that, in near
future interest will rise then they try to decrease duration of
assets.
To decrease the assets duration, ease the terms and condition
on short-term loans and other securities (like decrease
interest rate on short term loans etc.).
And vice versa in case of decrease interest rates.
Using Duration to Hedge against Interest Rate Risk
A financial-service provider interested in fully hedging against
interest rate fluctuations wants to choose assets and liabilities
such that
The dollar-weighted The dollar-weighted
duration of the asset ≈ duration of liabilities
portfolio
So that the duration gap is as close to zero as possible
Because the dollar volume of the bank assets usually exceeds
the dollar volume of bank liabilities (otherwise the bank
would be insolvent), a financial institution seeking to
minimize the effects of interest rate fluctuations would need
to adjust for leverage:
The dollar−weighted
The dollar−weighted Total Liabilities
duration 𝒐𝒇
= duration of ×
𝒂𝒔𝒔𝒆𝒕𝒔 𝒑𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 liabilities portfolio Total Assets
Suppose assets duration exceeds liability duration we then have a
positive duration Gap,
So,
𝑷𝒐𝒔𝒊𝒕𝒊𝒗𝒆 𝒅𝒖𝒓𝒂𝒕𝒊𝒐𝒏 𝑮𝒂𝒑 =
𝑻.𝑳
$ 𝒘𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑨. 𝑫. −$ 𝒘𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑳. 𝑫.∗ >𝟎
𝑻.𝑨
In this case, a rise in Interest rates will tend to lower the market value
of the bank’s net worth as assets values fall further than the value
of liabilities.
On the other hand,
𝑵𝒆𝒈𝒂𝒕𝒊𝒗𝒆 𝒅𝒖𝒓𝒂𝒕𝒊𝒐𝒏 𝑮𝒂𝒑
𝑻. 𝑳
= $ 𝒘𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑨. 𝑫. − $ 𝒘𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝑳. 𝑫.∗ <𝟎
𝑻. 𝑨
If Interest rates fall, the bank’s liabilities will increase more in value
than its assets and owner’s equity will decline.
Changes of bank’s net worth due to change of interest rates.
Or,
Using Duration to Hedge against Interest Rate Risk

We can calculate the change in the market value of a financial

institution’s net worth if we know
its dollar-weighted average asset duration,
its dollar-weighted average liability duration,
the original rate of discount applied to the institution’s
cash flows, and
how interest rates have changed during the period we
are concerned about.
The relevant formula is based upon the balance-sheet
relationship
𝜟𝑵𝑾 = 𝜟 𝑨 − 𝜟 𝑳
Because ∆A/A is approximately equal to the product of asset
duration times the change in interest rates

Δ𝐴 Δ𝑖
= −𝐷𝐴 ×
𝐴 1+𝑖
Δ𝑖
∴ ∆𝐴 = −𝐷𝐴 × ∗𝐴
1+𝑖
and ∆L/L is approximately equal to liability duration times the
change in interest rates
Δ𝐿 Δ𝑖
= −𝐷𝐿 ×
𝐿 1+𝑖
Δ𝑖
∴ Δ𝐿 = −𝐷𝐿 × ∗𝐿
1+𝑖

So,
𝜟𝒊 𝜟𝒊
𝜟𝑵𝑾 = −𝑫𝑨 × × 𝑻𝑨 − −𝑫𝑳 × × 𝑻𝑳
𝟏+𝒊 𝟏+𝒊
In words,
For example, suppose that a financial firm has an average duration
in its assets of three years, an average liability duration of two
years, total liabilities of $100 million, and total assets of $120
million. Interest rates were originally 10 percent, but suddenly
they rise to 12 percent. Find the change in the value of net worth
In this example:
Let’s consider an example of how duration can be calculated
and used to hedge a financial firm’s asset and liability
portfolio.
We can start by
(1) calculating the duration of each loan, deposit, etc.
(2) weighting each of these durations by the market
values of the instruments involved; and
(3) adding all value-weighted durations together to derive
the duration of a financial institution’s entire portfolio.
For example, suppose management of a bank finds that it holds a
U.S. Treasury $1,000 par bond with 10 years to final maturity,
bearing a 10 percent coupon rate with a current price of $900.
Based on the formula shown in previously, this bond’s duration is
7.49 years (calculate by yourself).
Suppose the bank holds other assets with durations and market
values as follows:
Weighting each asset duration by its associated dollar volume,
we calculate the duration of the asset portfolio as follows:
The calculation of duration for liabilities proceeds in the same
way as asset durations are calculated.
For example, suppose this same bank has $100 million in
negotiable CDs outstanding on which it must pay its customers
a 6 percent annual yield over the next two calendar years.
The duration of these CDs will be determined by the distribution
of cash payments made over the next two years in present-
value terms.
Thus:
In summary, the impact of changing market interest rates on net
worth is indicated by entries in the following table:
The Limitations of Duration Gap Management
For one thing, finding assets and liabilities of the same duration
that fit into a financial-service institution’s portfolio is often
a frustrating or tough task.
Some accounts held by depository institutions, such as
checkable deposits and passbook savings accounts, may
have a pattern of cash flows that is not well defined, making
the calculation of duration difficult.
Customer prepayments distort the expected cash flows from
loans and so do customer defaults (credit risk) when
expected cash flows do not happen.
Duration gap models assume that a linear relationship exists
between the market values (prices) of assets and liabilities
and interest rates, which is not strictly true.
If there are major changes in interest rates and different interest
rates move at different speeds, the accuracy and effectiveness
of duration gap management decreases somewhat.
Duration itself can shift as market interest rates move, and the
durations of different financial instruments can change at
differing speeds with the passage of time.
Q. Suppose that a thrift institution has an average asset duration
of 2.5 years and an average liability duration of 3.0 years. If the
thrift holds total assets of $560 million and total liabilities of
$467 million, does it have a significant leverage-adjusted
duration gap? If interest rates rise, what will happen to the
value of its net worth?
𝑻.𝑳 𝟒𝟔𝟕
Ans: 𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏 𝑮𝒂𝒑 = 𝑫𝑨 − 𝑫𝑳 ∗ = 𝟐. 𝟓 − 𝟑. 𝟎 ∗
𝑻.𝑨 𝟓𝟔𝟎
= 𝟐. 𝟓 − 𝟐. 𝟓𝟎𝟏𝟕𝟖 = −. 𝟎𝟎𝟏𝟖 𝒚𝒆𝒂𝒓𝒔
This bank has a very slight negative duration gap; so small in fact
that we could consider it insignificant.
If interest rates rise, the bank's liabilities will fall slightly more in
value than its assets, resulting in a small increase in net
worth.
Q. Stilwater Bank and Trust Company has an average asset
duration of 3.25 years and an average liability duration of 1.75
years. Its liabilities amount to $485 million, while its assets
total $512 million. Suppose that interest rates were 7 percent
and then rise to 8 percent. What will happen to the value of
the Stilwater Bank's net worth as a result of a rise in interest
rates?
Ans: First, we need an estimate of Stilwater's duration gap. This
is:
𝑻. 𝑳 𝟒𝟖𝟓
𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏 𝑮𝒂𝒑 = 𝑫𝑨 − 𝑫𝑳 ∗ = 𝟑. 𝟐𝟓 − 𝟏. 𝟕𝟓 ∗
𝑻. 𝑨 𝟓𝟏𝟐
= +𝟏. 𝟓𝟗𝟐𝟑 𝒚𝒆𝒂𝒓𝒔
Then, the change in net worth if interest rates rise from 7
percent to 8 percent will be:

𝜟𝒊 𝜟𝒊
𝜟𝑵𝑾 = −𝑫𝑨 × × 𝑨 − −𝑫𝑳 × ×𝑳
𝟏+𝒊 𝟏+𝒊

+.𝟎𝟏 +.𝟎𝟏
𝜟𝑵𝑾 = −𝟑. 𝟐𝟓 × × 𝟓𝟏𝟐 − −𝟏. 𝟕𝟓 × 𝟒𝟖𝟓
𝟏+.𝟎𝟕 𝟏+.𝟎𝟕

= −𝟏𝟓. 𝟓𝟓 + 𝟕. 𝟗𝟑 = −$𝟕. 𝟔𝟐 𝒎𝒊𝒍𝒍𝒊𝒐𝒏

Some Problems:
1. Leland Thrift Association reports an average asset duration of
4.5 years, an average liability duration of 3.25 years. The
bank has total assets of $1.8 billion and liabilities totaling
$1.5 billion. (i) If interest rates rise from 7 percent to 9
percent, how will Leland's net worth change? (ii) What if
interest rates fall from 7 to 5 percent?

Ans: (i) -$60.28 million, (ii) + $60.28 million.

2. A bank holds a bond in its investment portfolio whose
duration is 5.5 years. Its current market price is $950. While
market interest rates are currently at 8 percent for
comparable quality securities, an increase to 10 percent is
expected in the coming weeks. What changes (in percentage
terms) will the bond’s price experience if market interest
rates change as anticipated?

Ans: This bond’s price will decrease by 10.19 percent or its price
will decline to $853.
3. Commerce National Bank holds assets and liabilities whose
average duration and dollar amount are shown as below:

What is the dollar-weighted duration of the bank’s asset

portfolio and liability portfolio? What is the duration gap?
Ans: 𝑫𝑨 = 𝟒. 𝟑𝟓 𝒚𝒆𝒂𝒓𝒔, 𝑫𝑳 = 𝟏. 𝟎𝟔𝟏𝒚𝒆𝒂𝒓𝒔,
𝑫𝒖𝒓𝒂𝒕𝒊𝒐𝒏 𝑮𝒂𝒑 = 𝟑. 𝟑𝟏𝒚𝒆𝒂𝒓𝒔