264 Par Two Measuring Risk

Questions 1. What is the difference between book value accounting and market value
assets and
and Problems accounting? How do interest rate changes affect the value of bank
liabilities under the two methods? What is marking to market?
2. What are the two different general interpretations of the concept of duration
and what is the technical definition of thisterm? How does duration difo
from maturity?
3. A one-year, $100,000 loan carries a
couponrate and a market interest rate of
interest and one-half of the
accrued
12 percent. The loan requires payment ofremaining principal and the accrued
principal at the end of six months. The
interest are due at the end of the year. end of th
What willbe the cash flows at the end of six months and at the
a.
year? of each cash flow discounted at the market rate?
b. What is the present value
What is the total present value? end
What proportion of the total present value of cash flows occurs at the
c. occurs at the end of the year?
of six months? What proportion
of this loan?
d. What is the duration bond
bonds are available for purchase in the financial markets. The first
4. Two The sec
pays an annual coupon of 10 percent.
is a two-year, $1,000 bond that zero-coupon bond.
ond bond is a two-year, $1,000
coupon bond if the current yield to maturitya
a. What is the duration of the percent? (Hint: You may wish to create
(R) is 8 percent? 10 percent? 12
calculations.)
spreadsheet program to assist in the this
does the change in the yield to maturity affect the duration of
b. How
coupon bond?
Calculate the duration of the zero-coupon bond with a yield to maturity of
c. percent.
8 percent, 10 percent, and 12 to maturity affect the duration of the zero
d. How does the change in the yield
coupon bond? bond differ
Why does the change in the yield to maturity affect the coupon
e.
ently than it affects the zero-coupon bond?
CoupKon a t e ?

duration of a five-year, $1,000 Treasury bond with a 10 percent V

What is the 12 per
Selling with a yield to maturity ofbetween
semiannual coupon selling at par?conclude about the relationship
cent? 14 percent? What can you relationship. Why does this relation
duration and yield to maturity? Plot the
ship exist?
three Treasury bonds each of which has a 10 percent semiannual
BConsider
cOupon and trades at par.
that has a maturity of four years(three
a. Calculate the dkration for a bond
years) antwo years.
þ. What concusions can you reach
abòut the relationship between duration
and the time to maturity? Plot the relationship.
intereskannuallyand has a 6 percent
six-year, $10,000 CD pays 6 percent
A CD? What would be the duration
yield to maturity. What is the duration of the relationship of duration to the
if interest were paid semiannually? What is the
relative frequency of interest payments?
 10. 0
(16,pöints)?
n(50basis (15/ 14. 13/ 12. b. coupon ata zield What
b. a. at aYou b. a.
percent. bonds
12 measure
10 An under
a.only yearMaximum
c B.What a. nual The changeCalculate pon What bond?theyiofeldSecuri You ty? What How (10percent)
Explain What thchoi percent,insurance est What Whatmaturities and yield to is
Whiponts)?
at basincrease
(2s0 bond? he have
e ce can est What What
th at in its
duration of is to is is end obtain that differ is isthat bond maturity a
Whatcoupon th e
duration is of is is of management. Pension maturity to consol
percent
the
in 10thedollar maurity discovered th e the and of ()
paid?
is the the only haveinterest paid? isthe th¹ the
trading
)would 0.10 wil the is
duration paying
the relationship a duration companyrelationshipduration coupons
of bond?
relationshipdifference
and duration $10,in000 of
the percent thebe modified selling an price and duration? fell related principalsecond loan the rate Pl o t trade Fund at of 8
petcenl?
ngactual 11-jear, from t h at the of the
f estimated of of
trades $100,000 for amount for are
at The is the 10 What
the th e a How the between to in of inyearinterest
between each par analyzing
risk. isbetween
relationship. each attermpting
a
percenthave
same
pri ce (10 duration pa$1,r at000 9.75 the th e the equal
or All percent, 7 fund
al bond at istwo-year, price lean values, bond? yield 10the is
basis bas t w o (i) (10 at five-year of three
of price
of a dollar percent durationinterest under payments
anortizing aduration arnnual duration to has yield percent? duration
the Treasury
heen ifyield of results. percentXeach rate three
points)? the interest $1,0duration 00 a and bonds 9
identified to
ent bond change bond? estimated of tobond elasticity bot h of bond? coupon bonds
percent,maturity balance togreater a
maturity? 12
bond 14 9.25 rose and each 10 and have an d percent? of Chapter
be If methods the percent trade of
alu under rafes on What ratespercent. bonddifferent percent.
fro m the of year. loan, the interest five and the and three duration consol a
the payiat ng that price a year n 9 one 9
band each is 6.7 63 decl in e fixed-incomé The for amount years at isamount percent.
11 Why? Would
decrease bond the $975 that and two a
yield using of Interest
a Whatis pays from What th ey
of paynent? ofloan percent. bonds the than bond
icing rate 10 to the
if dollat years. percent by an
is $995 paying
is
is, the years. of toduration The bond
th at a Rate
change interest 0.20 the duration?
annual the fixed-income pric ed to t a l coupon pay:
maturity. to coupon of consol
a thát
ues? 0.50 maturity bonds
difer 20-year
duration semiar percentexpected duration when security? principal You 8, portfolios
have sells Risk
situa percent interest
at have inter 10, trading
rates cou the pat an d Th e as inter
five 2 at 265 l
of of the a
 20.
c b. rmaturity. If
a. at 8.275 rity
zeTO-COupon Joan a Two 19,
iesVerifyequity What whatmarket 10 ofseTsitivity d. c. b. horizn
a. yer
market percent. 1010-year with probl If
e rm.
Recalulate is What If Consider Shuwthat . b. athat
(principal)
percent percent. is banks return,eithe
hel d
original'required inteTest tharn
whpercenut yi
investmet e ld hww huypose
/byhuw 9
accounts
yourbetween wi l financed his Show is thunwinvustment huw
of values
be The $1 why
or fo r wil th e m prieed
achresults interest the that that
the coupon bond million theirofare calculatin her al happer rates duratiim yns yns thut hat hat
the fo r of lo an valu e Bank with being would parts cass if th e
nk, net with investnent fiv e haninminterest purehase to s9 duratuai if the
above two the efect the rates and B balance rise, in eet
invetmeTt duratin yield hrizaa
assets $1/000,00 of has laoanexarnined arn in years, (b ) torate whi peet interest
and differences
banks? increase $1,9 t
76,h e 3 62. B 8. a1-year an d t he wi l ofch is
te by on current with investor part of the yie d
CDs assets to realized
(c) return? th e four rates perert y a ia
calcula the and sheets. horizun? () verify bamd, f five yield five rates Mmdthrisof
market $1 a by return irrvetn als years ris e t h is
liabilities
in percent 1 pay (rmarket)
face composed coupon
million ever is problernof als years tise
the ting
the interest The val ue regulators
Bank greater yonur Expl
return ain . th at wi l tobrd The yea,
es try that froan 10 fare 15 wil ftnn o
the changes value CD rate A is,holds 10
of
points),
basis
(100 CDbond value tothar ansWers 18 if is lnger be peeTt ispercent he
ration of each arnually, with solely with and has to match above, interest earned a
earned tday, equal vale earred tday,perert eal is
in the is of assets
deternine the bond of
lue in bank financed
$894,006.20 of yield
a to thar if yoswitti tocoupm within geats.frveto
th equity
e a coupon t
orignalhe parts rates exceed irterest f a n the if yn
for assjurning the for wil
for market change? That with yield 7-year, acomposed of duration a the years. tond interest wil the
the the for towith (a)decrease? ororiginalperid still nent bond
assets each principal
howthdo and rate 12 the required
and fall rat e s earrn
is rates shil rext
ed e maturity percent. that year $1,/00.(paid
value a 12and interest of short of fal l earn year
bank? 10-yeat, percent a solely an (b) the
Explain. investment a fallrext
and of tite next 9and
anrualy a9rd
of is, due of matu yield The rate asset rate bond of percert percent
of of this the lor year your year yoT
 2 21.
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Wha t al isthe What the rertly changes woul d your th e rate s rate s the
is the is7.25 InstitutionXY the only
coupon
est relatiivneterest What What the duraistion is gield rate ,and and theto of duratorion percent at net
duration
atlon dur a t io n the for sheet assumi 30 n g i n format io n is im l
pact
is e verage 9.94
ales tchange
is theisduraisdur pay balánce
ntiy the basis answerdecrease. AR/ ( 1 a worth
he irates GB>'s tion the ofduration percent. 9yeartwoscure12 Asset s for n gap Ireasury
ation GBI's of percentt8LBOR sheet: Got bucks imarduratket iónpóints. that to for decrease adjsemi onu st e adrnual years. has of to
the
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arnual The the part a in
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decrease inon GBI'S Euro¹ asset $ The bond assetfinancial
65105 2030
ofs?' theof percentinterest isI1fed $220
paid percent hnds
ttheerienstcreaseanfhon floating-rate of
interest ofrelative (ç) financial parts of
rate Bank, the by =-0. 0 020. 20durationcoupon assets
val ú e sel in g
The
ttolable of rätes e lgaiapbi? lities? CDs cothree annual l y .
mar k et market fi x ed- ra te rates?assets calculating (a) basi s are institution your
e perGBItocent0.5 value isof1 What is deposi and ts prinFiThcie xpedral ate 8.5is Total Equity EurFederal Cor
CDso fudeposi
nds t
es In c. change i n stitu ti o n an d if
to to AR/per (1 cent value its fed loans loan principal isloperanscentl,iabilities (GBI) need (b),
points? the gapcapifitanlanced pa:.atlion porttolio,
Chapter
repaid have the LiabliEquitieasntdy is in the rel a t iv e of inThvest
e ed
is to
get (-50 of + inof t e rest flo at ing
at if what Not e: Fi n anci al note when
funds theyif and
muni (10equity pr e sent e d be achange l wi th 9
GAP ze basequiis ty R) = are
porfed tfolio rematpaldufriivtye-.year loan and
tomarket in what Interest
interest can The seling equidurat ion interest
tothe theif0.01. basis ifrate liabilities priced funds of maturitymat,atCourreities, rate equity change t y
is i mmuni ze in a three
equal points)r?elative points)? the risk is Gotisbucks bel o w interest the rate s be rel ati v e Inst it u tio n 30-year,
Burdeposi
os s areLIBOR said atand of Rate
zeo?bank? relaexpos
tive ure? 0.401 par?at 0.36 ($ mar k et are in par. this ratesfactors
How change Note year , cuare pricd +4$220 20130 50 $
20 al a 10 Risk
change year, Ba n k? mi lo ns) . the rates expected about change
market XY? $900, 0 00, bondpercentchange? Il
that wha t what equity is
value aflect 267
much ain l the in is an the in has
 million, one-year note at 8percent
wo MeasuringRisk
issued a $90 the year) or with
Hands Insurance Company one coupon at the end of
24. interest (paying fund a$100 million, two-year
add-onannual proceeds were used to
yield. The percent.çouponrate and a 10 percentmarket; tyield. Imme
an 8percent a10 simultaneously closed, all tinterest
commercialloan with transactions were
diately afterthesepercent(150-basispoints). investment and-
the liability after
ratesincreased1.5 market value of the loan
true
a. What is the interest rates? the market value
thechàngein changes in m¡rket valuehave on
did these
b. Whatimpact
of the FI'sequity? loan investment and the liability at thetime
of the
the duration
c. What was value of
ofissuance?
the expected change in the
calculate
d. Use these duration
values to
predicted increase of 1.5percent in interest
for the
the loan and the liability
rates.
Hands Insurance Company after the issuance
duration gap of
e. What is the note?
of the asset and forecasted by this duration gap for the
equity value
f. What is the change ininterest rates of 1.5 percent?
predicted increase in available during the time period
in
prediction h¡d been
g. If the interest rate were being negotiated, what suggestions
which the loan and the liability
reduce the possible effecton the equity of the
to
would you have offereddifficulties in implementing your ideas?
company? What are the available (amounts in thousands of
sheet information is
25. Thefollowing balance yars) for a financialinstitution:
dollars and duration in

Amount Duration

$ 90 0.50
T-bills
55 0.90
T-notes
Fbonds 176 X

Loans 2,724 7.00

Deposits 2,092 1.00
Federal funds 238 0.01
Equity 715

Treasury bonds are five-year maturities paying 6percent semiannually and

seling at par.
a. What is the duration of the T-bond portfolio?
b. What is the average duration of all the assets?
c.What is the average duration of all the liabilities?
d. What is the leverage adjusted duration gap? What is the interest rate risk
exposure?
e. What is the forecasted impact on the market value of equity caused
by a relative upward shift in the entire yield curve of 0.5
Le, AR/(1 +R) =0.0850]? percent
 Chapter 9 Interest Rate Ask l 269

{. Ifthe yield curve shifts downward 0.25 percent [ie, 4R/(1 +R) - 0.025|,
what is the forecasted impact on the market value of equity?
8 What variables are available to the financial institutlon to immunize the bal
ance sheet? How much would each variable necd to change to get DGAP
to equal 0?
26. Assume that a goal of the regulatory agencies of financial institutions is to
immunize the ratio of equity to total assets, that is, A(E/A) »0. Exþlain how
this goal changes the desired duration gap for the institution. Why does this
differ from the duration gap necessary to immunize the total equity? How
would your answers to part (h) in problem 23 and part (g) in problem 25
change if immunizing equity to total assets was the goal?
27. Identify and discuss three criticis1ths of using the duration model to imimunize
the portfolio of afinancial institution.
28. In general, what changes have occurred intheir the financial markets that would
allow financial institutions to restructure balance sheets more rapidly
.and efficiently to meet desired goals? Why is it critical for an investment man
desired investment horizon
ager who has a portfolio immunized to match a
is convexity? Why is convexity a
to rebalance the portfolio periodically? Whatassets?
desirable feature to capture in aportfolio of
investment horizon of two years 9.33 months
29. A financial institution has an converted all assets into a portfolio of
(or 2.777 years). The institution has trading at a yield to maturity of
$1,000 three-year bonds that are
8percent, annually. The portfolio manager believes
10 percent. The bonds pay interest
against interest rate changes.
that the assets are immunized
portfolio immunized at the time of the bond purchase? What is the
a. Is the
duration of the bonds?
immunized one year later?
b.Will the portfolio be zero-coupon bonds are available in one
percent
c. Assume that one-year, 8 original portfolio should be placed in these
year. What proportion of the
bonds to rebalance the portfolio?
based on material in Appendix 9A,
at
questions and problems are
The following (www.mhhe.con/saunders7e).
the book's Web site of
12-year, 12 percent arnual coupon bond witha required return
30. Consider a has aface value of$1,000.
10 percent. The bond
the bond?
a. What is the price of percent, what is the price of the bond?
11
b. If interest rates rise to
change in price?
c. What has been the percentagefor a16-year bond.
and (c)
d. Repeat parts (a), (b), changesin bondprices indicate?
e. What do the respectivepercent annual coupon bond with a face value of
15
31. Consider a five-year, trading at ayieldto m¡turity of 12 percent.
$1,000. The bond is
ofthe bond?:
a. Whatis theprice increases1percent, what will be the bond's new price?
b. Iftheyield to matutity (a) and (b), wh¡t is the percentage change
in
taparts interest rates?
c. Using yor answers a result of he 1percent increa[e in
the bond's price as
 270
Part
Two

4. Measuring
3chapter.
. the The
at
Estimate a 12 1 10 10 10
price c. b. a. 8MLK following thchange an R:ule atRule isRule Rule b. 8 32.
yield Diagraim
a amount four
th e of
prices The by percent
What a the "
a. Risk
Githatven error immediately
the decreasing 3. 2. 1. ships Use (YTM) e. d.
th e duration +/-0.10 Bank in
4. change
The Complete matuConsider
rity price
to of in l
wicoupon decrease Although The
Irterest for this 10 10 10 10 10 1010% Coupon
Rate Change
WhatRepeat
rity a nd cases between each interest of
onvexity errorconvexity be has questions change longer fixed-rate 10 (N) a do
label using by the an rate. in information relationships
in th e
of ofpercent?
the these +/- $1,000 in not price rates percent.
the $1,000
of the parts
bonds' asset rates, in
offclearly
four 11 11 11 10
8 or these the duration is and valuementioned value for theisand 9 9%YTM
following years.10bonddifferences (b)
ent predictions?
each duration 212.4, casesbonds 2.00 What bonds for the maturity prices
financial to of and
the percent? new portfolio problems giofven a verify
of is increase with
Thefixed-rate (c)
and the results prediction
what using12.1608 wilpricos th at an longer-term
ofassets. Price table. in
assuming
be increase ofa the
llowing
have pl u s arthe sell th at are in the
in changefixed-rate bond a your
fixed-rate
in the the if at principles s?
face partsconvexity duration and years. nemarket
w consists par. based Appendix, price
in
fixed-income in currently assetanswers a
bond rates. fixed-rateinterest financial Change $ 10 l
ues three (a), the What prices on for fromPar percent
(b), values!
market
actual rule? yields ofmaterial a of percent ratabout
e
is indicate
bonds, relationship? $100 decrease for rates. interest in trading
of and are if financial financial assets decrease
000. predi c t io ns What market change a Price arnual
al (c). the given:
million in in at
of predictedis yields Appendix rates assets asset, move rate-price a in
which What the immediately percentage from
PricePar yicoupon the
eld rate interestinterest
inamount of the Change in
change 30-year, is increases inversely. to
trade iseach bond 9B greater greater relation rates.
the maturity
of to (:) and
a-
 Chapter 9 Interest Rate Risk II 271

A7year, zero-coupon bond.

Ayear, 10 percent annual coupon bond.
A10year, 10 percent annual çoupon bond that has a duration value of 6.994
years (i.e., approximately 7 years).
Rank the bonds in terms of convexity, and express the convexity relation
ship between zeros and coupon bonds in terms of maturity and duration
equivalencies.
35. A10year, 10 percent annual coupon $1,000 bond trades at a yield to matu
rity of 8percent. The bond has a duration of 6.994 years. What is the modi
fied duration of this bond? What is the practical value of calculating modified
duration? Does modified duration change the result of using the duration
relationship to estimate price sensitivity?

Integrated MiniCase