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• Suppose a bank finds that it holds a Treasury
$1000 par bond with 10 years to final
maturity, bearing a 10% coupon rate with a
current price of $900.
• Calculate duration.
period cf pv pv*p
1 100 90.9 90.91
2 100 82.6 165.29
3 100 75.1 225.39
4 100 68.3 273.21
5 100 62.1 310.46
6 100 56.4 338.68
7 100 51.3 359.21
8 100 46.7 373.21
9 100 42.4 381.69
10 1100 424 4240.98
1000 6759.02
Duration 7.51
Example 2
A 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. Calculate the Duration of
the CDs.
period cf pv pv*p
1 6 5.66 5.66
2 6 5.34 10.68
2 100 89.00 178.00
100.00 194.34
Duration 1.943
Problems with InterestSensitive Gap
Management
• Interest Paid on Liabilities Tend to Move Faster than
Interest Rates Earned on Assets
• Interest Rate Attached to Bank Assets and Liabilities
Do Not Move at the Same Speed as Market Interest
Rates
• Point at Which Some Assets and Liabilities are
Repriced is Not Easy to Identify
• InterestSensitive Gap Does Not Consider the Impact
of Changing Interest Rates on Equity Position
The Concept of Duration
Duration is the Weighted Average
Maturity of a Promised Stream of Future
Cash Flows. It is a direct measure of price
risk.
Duration gap measurement
• It is the difference between the duration of a bank’s
assets and the duration of its liabilities
• The duration of the banks assets can be determined
by taking the weighted average of the duration of all
assets in the portfolio
• The weight is the dollar amount of a particular type
of asset out of the total amount of assets
• The duration of liabilities can be determined in a
similar way
To Calculate Duration
¿
¿
=
=
+
+
=
n
1 t
t
t
n
1 t
t
t
YTM) (1
CF
YTM) (1
CF * t
D
To Calculate Duration
¿
¿
=
=
+
+ +
+
+
+
+
×
+ +
+
×
+
+
×
=
n
1 t
n
n
2
2
1
1
n
n
2
2 2
n
1 t
1
1 1
YTM) (1
CF
...
YTM) (1
CF
YTM) (1
CF
YTM) (1
CF
...
YTM) (1
CF
YTM) (1
CF
D
n
t t t
ice ket CurrentMar
t t t
n
Pr
YTM) (1
CF
...
YTM) (1
CF
YTM) (1
CF
D
n
n
2
2 2
n
1 t
1
1 1
+
×
+ +
+
×
+
+
×
=
¿
=
Using Duration to Hedge against
Interest Rate Risk
Dollar
weighted
duration of
the asset
portfolio
Dollar
weighted
duration of
liabilities
≈
Using Duration to Hedge against
Interest Rate Risk
Dollar
Duration
gap
0
≈
Using Duration to Hedge against
Interest Rate Risk
Dollar
Duration
gap
Dollar
weighted
duration of
the asset
portfolio
=

Dollar
weighted
duration of
liabilities
Dollar Wt. Avg. Asset Portfolio
Duration
Dollar
Wt. Avg.
Duration
Duration
of each
asset in
portfolio
=
×
Market Value
of each asset
in the
portfolio
¿
=
n
i 1
Total Market Value of all
assets
Duration of an Asset portfolio
i
w × =
¿
=
n
1 i
A A
i
D D
Where:
w
i
= the dollar amount of the ith asset divided by total assets
D
Ai
= the duration of the ith asset in the portfolio
Duration of a Liability Portfolio
¿
=
× =
n
1 i
L L
i
D D
i
w
Where:
w
i
= the dollar amount of the ith liability divided by total liabilities
D
Li
= the duration of the ith liability in the portfolio
Example
Assets held
Actual or Estimated
Market Values of Assets ($
millions)
Assets
Duration
(years)
Treasury Bonds 90.0 7.49
Commercial Loans 100.0 0.6
Consumer Loans 50.0 1.2
Real estate Loans 40.0 2.25
Municipal Bonds 20.0 1.5
Calculate dollar weighted average asset portfolio.
w D
Assets held
Actual or Estimated
Market Values of
Assets ($ millions)
Assets Duration
(years)
W*D
Treasury Bonds 90.0 7.49 674.1
Commercial Loans 100.0 0.6 60.0
Consumer Loans 50.0 1.2 60.0
Real estate Loans 40.0 2.25 90.0
Municipal Bonds 20.0 1.5 30.0
300.0
914.1
Dollar Wt. Avg. Asset duration 3.047
Leverage Adjusted Leverage Gap
• Volume of assets usually exceeds the volume
of liabilities.
• Otherwise, the financial institution would be
insolvent.
• Leverage should be adjusted to minimize the
effects of interest rate fluctuations.
Leverage Adjusted Duration Gap
Leverage
adjusted
Duration
gap
Dollar
weighted
duration
of the
asset
portfolio
=

Dollar
weighted
duration
of
liabilities
×
Total
Liabilities
Total
Assets
Duration Gap
TA
TL
D  D D
L A
× =
Duration gap calculation
• Asset duration is 2.5 years, liability duration is 3
years, total assets = $560 million and total liabilities =
$467 million
Solution
Duration gap = DA –DL × TL/TA
= 2.5 yrs – 3 yrs × (467/560)
= 2.5 – 2.5018
=  .018 years
Price Sensitivity of a Security
i) (1
i
D 
P
P
+
A
× ~
A
Where,
• ΔP/P = %change in market price of an asset,
• Δi/(1+i) = relative change in interest rate associated with
the assets or liabilities,
• D = duration,
• Negative sign = market price and interest rate on
financial instruments move in opposite directions.
• Interest rate risk of financial instruments is directly
proportional to their duration.
Example
Suppose, a bond carrying a duration of 4 years
has a current market value (price) of $ 1000.
Market interest rate attached to the bond is 10
percent currently, but recent forecast suggests
that market rates may rise to 11 percent. If this
forecast turns out to be correct, what
percentage change will occur in the bond’s
market value?
Solution
• Duration= 4, and interest rates go up from 10
to 11 pct
• Change in price % = D x Δ i/1+I
• 4 x .01/1+.10 =  3.64%
• If rate go down from 10 to 9 pct then
• 4 x .01/1+.10 = + 3.64%
Change in the Value of Bank’s Net Worth
NW = A – L
ΔNW = ΔA – ΔL (i)
We Know,
ΔP/P = D × (Δi/(1+i))
Or
ΔA/A = D × (Δi/(1+i))
Change in the Value of Bank’s Net Worth
ΔA/A = D × (Δi/(1+i))
Or
ΔA = D × (Δi/(1+i))× A
Similarly,
ΔL = D × (Δi/(1+i))× L
Change in the Value of Bank’s Net Worth
Replacing the value of ΔA and ΔL in
equation (i),
ΔNW= [D×(Δi/(1+i))×A][D×(Δi/(1+i))×L]
or
(
¸
(
¸
×
+
A
×
(
¸
(
¸
×
+
A
× = A L
i) (1
i
D   A
i) (1
i
D  NW
L A
Duration gap calculation
• Asset duration is 3.25 years and liability
duration is 1.75 years. The liabilities amount
to $485 million while assets total $512 million.
Interest rates rise form 7 to 8 per cent.
• Calculate duration gap. What happens to the
net worth.
solution
• First calculate duration gap.
• Duration gap = 3.25 yrs – 1.75 yrs *485/512 =
+ 1.5923
• The change in net worth due to the increase in
interest rates is = {3.25yrsx .01/(1+.07) x
$512} – {1.75 yrs x .01/(1+.07) x $485 mill } =
7.62
Example
Assets
Market
value ($)
Interst
Rate (%)
Average
Duration
(Yrs)
Treasury bills 90.0 10.00 7.490
Municipal bonds 20.0 6.00 1.500
Commercial loans 100.0 12.00 0.600
Consumer loans 50.0 15.00 1.200
Real estate loans 40.0 13.00 2.250
Total 300.0
Liabilities
Market
value ($)
Interst
Rate (%)
Average
Duration
(Yrs)
Negotiable CDs 100.0 6.00 1.9430
Other time deposits 125.0 7.20 2.7500
Subordinated notes 50.0 9.00 3.9180
Total Liabilities 275.0
Equiti capital 25.0
Total 300.0
Calculation of Wt. Average Duration of
Assets
Assets
Market
value ($)
Average
Duration
(Yrs)
Wt.*P
Treasury bills 90.0 7.490 2.247
Municipal bonds 20.0 1.500 0.100
Commercial loans 100.0 0.600 0.200
Consumer loans 50.0 1.200 0.200
Real estate loans 40.0 2.250 0.300
Total 300.0 3.047
Wt. Average
Duration of Assets 3.047
Calculation of Wt. Average Duration
of Liabilities
Liabilities
Market
value ($)
Average
Duration
(Yrs)
Wt.*P
Negotiable CDs 100.0 1.9430 0.707
Other time deposits 125.0 2.7500 1.250
Subordinated notes 50.0 3.9180 0.712
Total Liabilities 275.0 2.669
Wt. Average Duration
of Liabilities 2.669
Change in Value of Net Worth
(
¸
(
¸
×
+
A
×
(
¸
(
¸
×
+
A
× = A L
i) (1
i
D   A
i) (1
i
D  NW
L A
Suppose interest rate on both assets and liabilities rise
from 8 to 10 percent. The filling in the asset and
liabilities figures from the example above gives this
result.
(
¸
(
¸
×
+
+
×
(
¸
(
¸
×
+
+
× = A $275m
0.08) (1
) 02 . 0 (
2.669yrs.   $300m
) 08 . 0 (1
) 02 . 0 (
3.047yrs.  NW
= $3.34 million
Interpretation: Net worth would fall by $3.34 million if interest rate
increase by 2 percent points.
Suppose interest rate on both assets and liabilities fall
from 8 to 6 percent. What would happen to the value of
the above example?
Substituting the value in the same formula:
(
¸
(
¸
×
+
÷
×
(
¸
(
¸
×
+
÷
× = A $275m
0.08) (1
) 02 . 0 (
2.669yrs.   $300m
) 08 . 0 (1
) 02 . 0 (
3.047yrs.  NW
= +$3.34 million
Interpretation: Net worth would rise by $3.34 million if interest rate
fall by 2 percent points.
Calculation of leverage adj. Duration Gap
TA
TL
D  D D
L A
× =
=3.047 yrs  2.669 yrs X$275/$300
= +0.60 years
Interpretation:
The positive duration gap of +0.60 years means that the bank’s net
worth will decline if interest rates rise and increase if interest rates
fall.
Impact of Changing Interest Rates on a
Bank’s Net Worth
If the FIs’ Leverage Adj.
Duration Gap is:
If Interest
Rate
NW will
Positive (DA>DL×L/A)
Rise Decrease
Fall Increase
Negative (DA<DL×L/A) Rise Increase
Fall Decrease
Zero (DA=DL×L/A) Rise No Change
Fall No Change
Limitations of Duration Gap
Management
• Finding assets and liabilities of the same duration can
be difficult
• Some assets and liabilities may have patterns of cash
flows that are not well defined
• Customer prepayments may distort the expected cash
flows in duration
• Customer defaults may distort the expected cash flows
in duration
period 1 2 3 4 5 6 7 8 9 10
cf 100 100 100 100 100 100 100 100 100 1100
pv 90.9 82.6 75.1 68.3 62.1 56.4 51.3 46.7 42.4 424 1000 Duration
pv*p 90.91 165.29 225.39 273.21 310.46 338.68 359.21 373.21 381.69 4240.98 6759.02 7.51
Example 2
A 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. Calculate the Duration of the CDs.
00 Duration 194.00 5.34 1.00 100.66 5.68 178.period cf pv pv*p 1 2 2 6 6 100 5.34 89.66 10.943 .
Problems with InterestSensitive Gap Management • Interest Paid on Liabilities Tend to Move Faster than Interest Rates Earned on Assets • Interest Rate Attached to Bank Assets and Liabilities Do Not Move at the Same Speed as Market Interest Rates • Point at Which Some Assets and Liabilities are Repriced is Not Easy to Identify • InterestSensitive Gap Does Not Consider the Impact of Changing Interest Rates on Equity Position .
It is a direct measure of price risk. .The Concept of Duration Duration is the Weighted Average Maturity of a Promised Stream of Future Cash Flows.
Duration gap measurement • It is the difference between the duration of a bank’s assets and the duration of its liabilities • The duration of the banks assets can be determined by taking the weighted average of the duration of all assets in the portfolio • The weight is the dollar amount of a particular type of asset out of the total amount of assets • The duration of liabilities can be determined in a similar way .
To Calculate Duration t * CFt (1 YTM) t t 1 D n CFt (1 YTM) t t 1 n .
.. (1 YTM) n t 1 n CFn t n CF1 t1 CF2 t 2 (1 YTM)1 (1 YTM) 2 . (1 YTM) n D t 1 CurrentMarket Pr ice n .....To Calculate Duration CFn t n CF1 t1 CF2 t 2 (1 YTM) 1 (1 YTM) 2 . (1 YTM) n D t n1 CF1 CF2 CFn (1 YTM) 1 (1 YTM) 2 .
Using Duration to Hedge against Interest Rate Risk Dollar weighted duration of the asset portfolio ≈ Dollar weighted duration of liabilities .
Using Duration to Hedge against Interest Rate Risk Dollar Duration gap ≈ 0 .
Using Duration to Hedge against Interest Rate Risk Dollar weighted duration of the asset portfolio Dollar Duration gap =  Dollar weighted duration of liabilities .
Avg. Duration = i 1 n Duration of each asset in portfolio × Market Value of each asset in the portfolio Total Market Value of all assets . Avg. Asset Portfolio Duration Dollar Wt.Dollar Wt.
Duration of an Asset portfolio D A D A i wi Where: n i 1 wi = the dollar amount of the ith asset divided by total assets DAi = the duration of the ith asset in the portfolio .
Duration of a Liability Portfolio n D L D Li wi Where: i 1 wi = the dollar amount of the ith liability divided by total liabilities DLi = the duration of the ith liability in the portfolio .
25 1.Example Assets held Actual or Estimated Market Values of Assets ($ millions) Assets Duration (years) Treasury Bonds Commercial Loans Consumer Loans Real estate Loans Municipal Bonds 90.0 7.2 2.0 40.0 50. .0 100.6 1.5 Calculate dollar weighted average asset portfolio.49 0.0 20.
0 20.5 3.0 90.0 0.1 Dollar Wt.w Assets held D W*D Actual or Estimated Assets Duration Market Values of (years) Assets ($ millions) 90.0 50.25 1.0 7. Avg.1 Commercial Loans Consumer Loans Real estate Loans Municipal Bonds 100.49 Treasury Bonds 674.0 914. Asset duration .0 60.0 40.6 1.2 2.0 30.0 300.047 60.
the financial institution would be insolvent. • Otherwise. • Leverage should be adjusted to minimize the effects of interest rate fluctuations.Leverage Adjusted Leverage Gap • Volume of assets usually exceeds the volume of liabilities. .
Leverage Adjusted Duration Gap Dollar weighted duration of the asset portfolio Dollar weighted duration of liabilities Total Liabilities Total Assets Leverage adjusted Duration gap =  × .
DL TA .Duration Gap TL D DA .
5 years.Duration gap calculation • Asset duration is 2. liability duration is 3 years. total assets = $560 million and total liabilities = $467 million .
.5018 = .5 – 2.018 years .Solution Duration gap = DA –DL × TL/TA = 2.5 yrs – 3 yrs × (467/560) = 2.
Price Sensitivity of a Security P i D P (1 i) Where. . • D = duration. • Interest rate risk of financial instruments is directly proportional to their duration. • Negative sign = market price and interest rate on financial instruments move in opposite directions. • Δi/(1+i) = relative change in interest rate associated with the assets or liabilities. • ΔP/P = %change in market price of an asset.
Example Suppose. a bond carrying a duration of 4 years has a current market value (price) of $ 1000. If this forecast turns out to be correct. but recent forecast suggests that market rates may rise to 11 percent. what percentage change will occur in the bond’s market value? . Market interest rate attached to the bond is 10 percent currently.
64% • If rate go down from 10 to 9 pct then • 4 x .64% .10 = . and interest rates go up from 10 to 11 pct • Change in price % = D x Δ i/1+I • 4 x .Solution • Duration= 4.01/1+.3.01/1+.10 = + 3.
Change in the Value of Bank’s Net Worth NW = A – L ΔNW = ΔA – ΔL (i) We Know. ΔP/P = D × (Δi/(1+i)) Or ΔA/A = D × (Δi/(1+i)) .
Change in the Value of Bank’s Net Worth ΔA/A = D × (Δi/(1+i)) Or ΔA = D × (Δi/(1+i))× A Similarly. ΔL = D × (Δi/(1+i))× L .
DL L (1 i) (1 i) .. ΔNW= [D×(Δi/(1+i))×A][D×(Δi/(1+i))×L] or i i NW .Change in the Value of Bank’s Net Worth Replacing the value of ΔA and ΔL in equation (i).DA A .
25 years and liability duration is 1. What happens to the net worth. Interest rates rise form 7 to 8 per cent. . • Calculate duration gap.Duration gap calculation • Asset duration is 3. The liabilities amount to $485 million while assets total $512 million.75 years.
07) x $512} – {1. • Duration gap = 3.62 .25yrsx .01/(1+.75 yrs *485/512 = + 1.solution • First calculate duration gap.07) x $485 mill } = 7.01/(1+.75 yrs x .5923 • The change in net worth due to the increase in interest rates is = {3.25 yrs – 1.
0 50.0 100.200 2.0 300.00 6.00 15.Example Assets Treasury bills Municipal bonds Commercial loans Consumer loans Real estate loans Total Average Market Interst Duration value ($) Rate (%) (Yrs) 90.00 7.500 0.0 10.00 13.250 .490 1.0 20.00 12.0 40.600 1.
0 125.20 9.00 1.Liabilities Average Market Interst Duration value ($) Rate (%) (Yrs) Negotiable CDs Other time deposits Subordinated notes Total Liabilities Equiti capital Total 100.0 275.9430 2.0 50.7500 3.9180 .0 25.0 6.00 7.0 300.
0 50.300 3.500 0.250 Wt.047 .490 1.200 2.0 Average Duration (Yrs) 7.*P 2.200 0.0 40.0 20.0 300. Average Duration of Assets Market value ($) 90. Average Duration of Assets Assets Treasury bills Municipal bonds Commercial loans Consumer loans Real estate loans Total Wt.200 0.100 0.047 3.0 100.600 1.247 0.Calculation of Wt.
9180 0.707 1.9430 2.7500 3.712 2.669 .0 1.250 0.*P Negotiable CDs Other time deposits Subordinated notes Total Liabilities Wt.0 50. Average Duration of Liabilities 100.0 125.669 2. Average Duration of Liabilities Liabilities Market value ($) Average Duration (Yrs) Wt.Calculation of Wt.0 275.
02) NW .DL L (1 i) (1 i) Suppose interest rate on both assets and liabilities rise from 8 to 10 percent.3. $275m (1 0. . (0. The filling in the asset and liabilities figures from the example above gives this result..08) (1 0.Change in Value of Net Worth i i NW .047yrs..DA A .02) (0.08) = $3.2. $300m .669yrs.34 million if interest rate increase by 2 percent points.34 million Interpretation: Net worth would fall by $3.
08) (1 0.2.34 million Interpretation: Net worth would rise by $3.Suppose interest rate on both assets and liabilities fall from 8 to 6 percent. $300m . What would happen to the value of the above example? Substituting the value in the same formula: (0..3. $275m (1 0.02) NW .08) = +$3.34 million if interest rate fall by 2 percent points.047yrs.669yrs. .02) (0.
047 yrs . .2.669 yrs X$275/$300 = +0.DL TA =3. Duration Gap D DA TL .Calculation of leverage adj.60 years Interpretation: The positive duration gap of +0.60 years means that the bank’s net worth will decline if interest rates rise and increase if interest rates fall.
Duration Gap is: Positive (DA>DL×L/A) Negative (DA<DL×L/A) If Interest Rate Rise Fall Rise Fall Zero (DA=DL×L/A) Rise Fall NW will Decrease Increase Increase Decrease No Change No Change .Impact of Changing Interest Rates on a Bank’s Net Worth If the FIs’ Leverage Adj.
Limitations of Duration Gap Management • Finding assets and liabilities of the same duration can be difficult • Some assets and liabilities may have patterns of cash flows that are not well defined • Customer prepayments may distort the expected cash flows in duration • Customer defaults may distort the expected cash flows in duration .
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