FIN 430 – Risk Management
Interest Rate Risk: Measurement
Prof. Ramona Dagostino
What we learnt during last class
Main Role of Financial Institutions? Reallocate savings to fund projects
Services provided by FIs? Asset Transformation, Diversification, Scale up &
transaction costs, solve Information Asymmetries
Main types of Risk? Interest Rate, Market, Credit, Liquidity
Why need for Risk Management? Financial distress costs, Taxation, Agency
& Self-interest
Where financial instruments are traded? Exchange vs OTC, Role of CCP
Which instruments & How are they different? Forwards & future, Swaps,
Options
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Agenda for today
Measuring interest rate sensitivity: duration models
Measuring interest rate exposure of FI
Limitations of the duration model
To Do: Read HBS case BancOne.
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How does interest rate risk arise?
Interest rate risk stems from uncertainty about interest rate
changes affecting the value of assets & liabilities
Mismatch of assets & liabilities:
revenues and costs are adjusted at different frequencies (net
income effect) –rolling over liabilities/reinvest assets
market values of assets and liabilities vary differently with interest
rate change (discount rates effect) - even if same maturity, can still
have basis if rates imperfectly correlated.
as macro rates move, market value of liabilities might go up
Ideally assets value (same maturity) goes up
However instruments do not move 1-for-1 (imperfect correlation)
Basis spread risk
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Challenges of Managing IRR
Many different interest rates in any given currency
they may move together, but not perfectly correlated
Balance sheet exposed to movement in many rates
Need more than one number to describe interest rate
environment
yield curve (a function) describing the variation of interest
rates with maturity
Example:
a US treasury bond trader’s portfolio may consist of many
bonds with different maturities, exposed to movements in
one-year, two-year rates, and so on..
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Type of Rates
Treasury rates
rates for a government to borrow in domestic currency, risk-free,
artificially low
LIBOR
unsecured borrowing rates between banks for 5 currencies and 7
periods (from a day to a year)
Overnight indexed swap (OIS) rate
fixed-rate swapped for a pre-determined published index of a daily
overnight reference rates
Repo rates
secured borrowing rates in a repurchase agreement
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Strategy for Measurement
Given the complexity in rates & exposure, how to
quantify asset-liability mismatch?
Basic models that measure the gap exposure of a FI
repricing (income/book value change – SC#8)
duration (market value change – SC#9)
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Basic Idea
• For fixed-income assets and liabilities:
- how do interest rate changes affect market values?
- how are maturity and payments linked to this effect?
Recall bond pricing…
C1 C2 CN + F
P= + +... +
1+ R (1+ R) 2
(1+ R)N
- P--bond price, Ct--coupon, F--face value, N--time to maturity, R--
yield.
- recall: yield is the discount rate that sets the PV of bonds cash
flows equal to its price.
• How will changes in R affect P?
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Basic Idea
Rate goes up, price goes __
Values of fixed payments far in the future are affected more
strongly by changes in the interest rate [PV = C/(1+R)t ].
Interest rate change usually affects a sequence of cash
flows including both coupons and principal.
values of floating rate securities are usually less susceptible to
interest rate shocks.
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Maturity Effect
The longer the term to maturity, the greater the sensitivity to interest
rate changes
Example. Zero coupon bonds with 12% yield: bond A pays $1762.34 in
five years; B pays $3105.85 in ten years. Their prices are:
A: $1000 = $1762.34/(1.12)5
B: $1000 = $3105.84/(1.12)10
Now suppose yield increases to 13%. New prices are:
A: $1762.34/(1.13)5 = $956.53
B: $3105.84/(1.13)10 = $914.94
Longer maturity greater price drop.
intuition larger discount applied for longer
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Maturity Effect
Maturity of portfolio is the weighted average of
maturities of individual components.
For most traditional banks: maturity gap NA - NL > 0
If rates rise, both assets and liabilities have lower value.
But NA - NL > 0 , hence NA > NL so asset more sensitive
assets decreases more than liabilities lose $
If rates fall, reverse the logic make $
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Maturity Effect
Does maturity fully describe the timing of cash flows?
Extreme Example:
Consider a 1-year zero coupon bond with face value $100
Compare it with 1-year loan, which pays back $99.99 the day after
after origination, and 1¢ at the end of the year
Both have maturity of 1 year..
Yet, do they look the same to you?
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Coupon Effect
Bonds with identical maturities will respond differently to
interest rate changes when the coupons differ
With higher coupons, more of the bond’s value is generated by
cash flows occurring sooner in time. So bond value is less
sensitive to changes in R.
- E.g an 8% coupon bond shows smaller change in price in response to a
1% yield change than a 6% coupon bond
- the 8% coupon bond has smaller interest rate risk.
Reverse the logic: bond with lower coupon is more sensitive
to interest rate change.
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Coupon Effect
Let’s go back to the extreme example:
A: ten-year zero coupon bond;
B: two cash flow “bond” that pays $999.99 almost immediately and one
penny in ten years.
A and B have same maturity. Small changes in yield will have a
large effect on the value of A, but essentially no impact on the
hypothetical bond B.
Most bonds are between these two extremes.
bonds paying higher coupon is more similar to B (ie less sensitive).
Need a better measure of timing than maturity =>
duration
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Duration
• Duration (D): weighted average time to maturity using the
relative present values of the cash flows as weights
N
PV (cft )
D=å ´t
t=1 P
• Combines the coupon effect and the maturity effect.
• Allows us to better estimate the interest rate exposure.
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Duration
Duration: N
PV (cft )
D=å ´t
t=1 P
Consider a 3 year 10% coupon bond.
PV (C1 ) 1 PV (C2 ) 2 PV (C3 F ) 3
D
P P P
Suppose interest rates are 5% (don’t confuse coupon rate and
discount rates)
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Duration
Is duration bigger or smaller than maturity?
For a zero coupon bond, duration equals maturity since 100%
of its present value is generated by the payment of the face
value, i.e. at maturity
For all other bonds:
duration < maturity
Duration of a perpetuity is:
D=1 + 1/R
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Duration
Duration allows us to approximate the expected change in bond
prices in response to changes in interest rates
D
DP = -DR ´ P ´
1+ R
duration is the interest elasticity (sensitivity) of bond price.
if coupon is semi-annual, the price change becomes:
D
DP = -DR ´ P ´
1+ R / 2
This relation is a good first order approximation when:
yield is flat over time;
small and parallel change in interest rate;
coupon fixed.
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Duration: Example
Duration allows to better estimate how an asset and/or
liability of a FI will respond to interest rate changes
Consider three loan plans, all have $1000 face value and
2 years maturity. Suppose current yield is 3%.
#1: two equal payments of $522.61 each.
#2: 3% annual coupon bond.
#3: a single payment of $1,060.90.
How will loan values change for different bonds if yield
drops to 2%? Let’s use the formula..
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Duration: Example
All three loans have maturity of 2 years. At 3% yield,
all loans have PV of $1,000 (at par). Their respective
durations are:
#1: D = [1*522/1.03 + 2*522/1.032] / 1000
#2: D = [1*30/1.03 + 2*1030/1.032] / 1000
#3: D = [1*0/1.03 + 2*1061/1.032] / 1000
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Duration: Example
Loan Value
Loans 3% y 2% y N D ΔP
Equal Pay $1000 $1014.68 2 1.49 $14.68
3% Coup $1000 $1019.42 2 1.97 $19.42
Discount $1000 $1019.70 2 2.00 $19.70
• y: yield D D
• N: maturity P R P DP = -DR ´ P ´
• D: duration 1 R 1+ R / 2
• P: price Formula for annual payments Formula for semi-annual payments
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Features of Duration
Duration and maturity (+)
D increases with maturity: D/N > 0
Duration and coupon interest (-)
D decreases as coupon increases: D/C < 0
Duration and yield-to-maturity (-)
D decreases as yield increases: D/R < 0
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Modified Duration
Define D
MD =
1+ R
• Using our previous formula:
D Dp
Dp = -DR * p * = -DR * MD
1+ R p
• MD measures the % change in price in response to interest
rate changes:
- In the previous example of 2 year 3% coupon bonds:
MD = 1.97 / 1.03 = 1.91
- if interest rates go up by 1%, bond price will fall by 1.91%.
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Interest Rate Exposure
So, Duration is an effective measure of the interest rate
risk exposure for an FI (D says change in price in dollar
terms, MD tells the % change in prices)
If the durations of liabilities and assets are not matched,
then FI will be exposed to risk due to adverse changes in
the interest rate.
• In the same manner used to determine the change in bond
prices, we can find the change in the values of Assets &
Liabilities of FI:
DA DL
DA = -DR * A * DL = -DR * L *
1+ R 1+ R
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Interest Rate Exposure
If there are multiple assets (liabilities), we can treat the
asset (liability) side of the balance sheet as a portfolio.
Portfolio duration is:
DA = X D + X D +.. + X D
1
A
1
A A
2
A
2
A
n
A
n
the weights are: Xi = (value of asset i / portfolio value)
X 1A +... + X nA = 1 X 1A,...., X nA ³ 0
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Interest Rate Exposure
Accounting identity:
E = A- L DE = DA - DL
Effect of interest rate change on net worth (equity):
Recall: DA DL
DA = -DR * A * DL = -DR * L *
1+ R 1+ R
DR
Therefore: DE = -[DA A - DL L]*
1+ R
DR
Rewrite it as: DE = -[DA - DL k]* A *
1+ R
- where k=L/A is the leverage ratio
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Interest Rate Exposure
DR
DE = -[DA - DL k]* A *
1+ R
Three channels affecting interest rate sensitivity:
leverage adjusted duration gap: DA-DLk (recall k=L/A is
the leverage ratio) (+)
size of FI as measured by its assets: A (+)
size of interest rate shock: ΔR/(1+R) (+)
Larger (leverage adjusted D gap) / (asset size) /
(interest rate shock) increases FI interest rate
exposure.
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Interest Rate Exposure
Suppose a FI has $100mln asset and $90mln
liabilities. We calculate their portfolio durations as
DA = 5years, DL = 3years. Interest rate is expected to
rise from 10% to 11%. What is the risk exposure the
FI as a whole? (Recall k=L/A)
DR
DE = -[DA - DL k]´ A ´
1+ R
0.01
= -[5 - 3´ 0.9]´100 ´ = -2.09
1.1
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Limitations of Duration
Duration is good only under these assumptions:
interest rate shifts are small and parallel;
fixed coupon;
flat yield curve;
no default risk.
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Convexity
Duration uses local linear approximation of the price-yield
relationship (ie the relation btw P and R can be approx. by a
straight line)
But fixed-income securities exhibit convex price-yield relationship.
Not a straight line:
Bond price P is a convex (nonlinear) function of interest rate R. A curve.
If there are large changes in R, the duration measure is much less
accurate.
Actual relation
P
Duration
model
R
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Convexity
Greater convexity causes larger errors in the duration-based estimate of
price changes, i.e the bigger the convexity, the more the formula is a bad
approximation.
For large interest rate increases, duration over-predicts the fall in bond
prices.
For large interest rate cuts, under-predicts increase in bond prices
Actual relation
P
Duration
model
R
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Convexity
Convexity can be desirable
If rates expected to drop, try to have more convexity in assets than
in liabilities.
Extreme example:
Loans in asset side have a lot of convexity
Liabilities have zero convexity, so linear relationship
If interest rates drop, value of assets will increase by more than value
of the liabilities
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Default Risk
Restructuring of coupon and principle payments affects
bond duration.
A borrower might have difficulty paying back his loan,
so the bank restructures the payments, eg. delays some
interest payments, or reduces them
delay in scheduled payments will increase duration
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Other Issues: Early Repayment
• Duration may be affected by call or prepayment provisions
- Mortgages have pre-payment options, another eg. are callable/putable
bonds
Example
a firm issues a 10-year callable bond which is priced at par and has fixed
coupon payments. At 5 years from issue, the firm may call the bond (i.e.
buy back the bond) at its face value. If the bond is not called, the payments
continue as planned until maturity. The firm is long the call.
Suppose a FI bought that bond. From the bond holder’s perspective (i.e the
FI), the FI has a short position in the call option on top of a vanilla coupon
bond.
If the firm calls the bond, it means the firm pays down immediately all the
value of the bond- it pre-pays the bond
In such case, duration of FI asset changes
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Other Issues: Early Repayment
When will the option be exercised?
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Other Issues: Early Repayment
When will the option be exercised?
when interest rate is low
Compared with a 10-year vanilla bond paying the same
coupon, what is the callable bond price?
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Other Issues: Early Repayment
When will the option be exercised?
when interest rate is low
Compared with a 10-year vanilla bond paying the same
coupon, what is the callable bond price?
price is lower
FI is long (buy) the bond, and short (sold) the call:
Price of Callable = P(Vanilla Bond) – P(call)
What is the duration of the callable bond?
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Other Issues: Early Repayment
When will the option be exercised?
when interest rate is low
Compared with a 10-year vanilla bond paying the same
coupon, what is the callable bond price?
price is lower
FI is long (buy) the bond, and short (sold) the call:
Price of Callable = P(Vanilla Bond) – P(call)
What is the duration of the callable bond?
duration is shorter
When would the callable and non-callable bonds have the
same price? How would these bonds differ?
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Other Issues: Early Repayment
When will the option be exercised?
when interest rate is low
Compared with a 10-year vanilla bond paying the same coupon,
what is the callable bond price?
price is lower
FI is long (buy) the bond, and short (sold) the call:
Price of Callable = P(Vanilla Bond) – P(call)
What is the duration of the callable bond?
duration is shorter
When would the callable and non-callable bonds have the same
price? How would these bonds differ?
It must be that the callable bond has higher coupon payments, shorter
duration
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Takeaways
The difference between maturity and duration
Calculations regarding duration and bond price
change
Apply the duration model to measure interest rate
exposure
Applications & limitations of duration model
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