# BEC 3322 Financial Economics Session 6

2/28/2013

1

Lecture Outline
• Interest Rate and Bond • Measuring Interest-Rate Risk • Duration and Gap Analysis
– Bank – Nonbanking Financial Institution

2/28/2013

2

Interest Rate and Bond
• We saw that when interest rates change, a bond with a longer term to maturity has a larger change in its price and hence more interest rate risk than a bond with a shorter term to maturity (bond prices and interest rates are negatively related).

2/28/2013

3

Bond Price at Different interest Rate Time to Maturity 1 year 10 years 20 years • 30 years • • • • 4% 6% 8% 10% 12% 1038 1029 1000 981 963 1327 1148 1000 875 770 1547 1231 1000 828 699 1695 1277 1000 810 676 • 8% Coupon rate 2/28/2013 4 .

You tied up your money earning at 8% when alternative investments offer higher returns. T-Bills are considered as safest.Cont. • This is reflected in a capital loss on the bond – (decrease in the market price of bond). and market interest rate subsequently rise. This is why. 2/28/2013 5 . • If you buy the bond at par with an 8% coupon rate. then you suffer a loss.

• Prices and returns for long-term bonds are more volatile than those for shorter term bonds.Rate of Capital Gain • Example 1 • Calculate the rate of capital gain or loss on a ten-year zero-coupon bond for which the interest rate has increased from 10% to 20%. The bond has a face value of \$1. 2/28/2013 6 .000.

385.54 = 49.81 • Pt = 1000 / (1+0.1)10 = 385.2)9 = 193. • G = (Pt+1 – Pt) / Pt • Pt+1 = 1000/ (1+0.Cont.81.54 • G = (193.7 % 2/28/2013 7 .54) / 385.

• Changes in interest rates make investments in long-term bonds quite risky • The riskiness of an asset’s return that results from interest-rate changes has been given a special name. 2/28/2013 8 . interest-rate risk • Dealing with interest-rate risk is a major concern of managers of financial institutions and investors.Cont.

2/28/2013 9 . • The change in interest rates can then have no effect on the price at the end of the holding period for these bonds.Cont. and the return will therefore be equal to the yield to maturity known at the time the bond is purchased. • There is no interest-rate risk for any bond whose time to maturity matches the holding period.

• Interest-rate risk is especially important for long-term bonds. • Changes in interest rates lead to capital gains and losses that produce substantial differences between the return and the yield to maturity known at the time the bond is purchased. This is why long-term bonds are not considered to be safe assets with a sure return over short holding periods. where the capital gains and losses can be substantial. Bonds whose term to • maturity is longer than the holding period are subject to interest-rate risk. 2/28/2013 10 . • Bond is a good investment when the holding period and the maturity of the bond are identical.Cont.

Measuring Interest-Rate Risk • To calculate the duration or effective maturity on any debt security. it makes sense to define its effective maturity as equal to its actual term to maturity 2/28/2013 11 . a researcher at the National Bureau of Economic Research. Frederick M. • A zero-coupon bond makes no cash payments before the bond matures. invented the concept of duration.

2/28/2013 12 . the longer its duration. when interest rates rise. • Example 2 • Calculate the duration for an 11-year 10% coupon bond when the interest rate is again 10% • All else being equal. • Thus we have reached the flowing conclusions: All other factors being equal. the longer the term to maturity of a bond. the duration of a coupon bond falls (see Table 3).Duration of an Individual Security • Duration is a weighted average of the maturities of the cash payments (see Table 1).

• Example 4 • A manager of a financial institution is holding 25% of a portfolio in a bond with a five year duration and 75% in a bond with a ten-year duration. • All else being equal. • Example 3 • Consider a ten-year 20% coupon bond when the interest rate is 10%. the shorter the bond’s duration. What is the duration of the portfolio? 2/28/2013 13 .Cont. the higher the coupon rate on the bond.

2/28/2013 14 .Duration of a Portfolio • The duration of a portfolio of securities is the weighted average of the durations of the individual securities. the proportion of the portfolio invested in each. with the weights reflecting.

Find the approximate change in the bond price when the interest rate increases from 10% to 11%. What loss would the fund be exposed to if the interest rate rises to 11% tomorrow? • Example 6 • Now the pension manager has the option to hold a ten-year coupon bond with a coupon rate of 20% instead of 10%. the duration for this 20% coupon bond is 5. 2/28/2013 15 .Interest Rate Risk-Examples • Example 5 • A pension fund manager is holding a ten-year 10% coupon bond in the fund’s portfolio and the interest rate is currently 10%.98 years when the interest rate is 10%. As mentioned earlier.

the greater the percentage change in the market value of the security for a given change in interest rates. • Examples 5 and 6 have led the pension fund manager to an important conclusion about the relationship of duration and interest-rate risk: • The greater the duration of a security. Therefore.Cont. 2/28/2013 16 . the greater its interest-rate risk. the greater the duration of a security.

• Duration is a useful concept because it provides a good approximation of the sensitivity of a security’s market value to a change in its interest rate 2/28/2013 17 .Cont.

the riskiness of earnings and returns that is associated with changes in interest rates.Gap Analysis • With the increased volatility of interest rates that occurred in the 1980s. banks and other financial institutions became more concerned about their exposure to interest rate risk. 2/28/2013 18 .

2/28/2013 19 .Cont. • The sensitivity of bank profits to changes in interest rates can be measured more directly using gap analysis. in which the amount of ratesensitive liabilities is subtracted from the amount of rate-sensitive assets.

a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits. 20 2/28/2013 .Cont. • Gap = the amount of rate-sensitive assets the amount of rate-sensitive liabilities (Example 7) • If a bank has more rate-sensitive liabilities than assets.

• Duration analysis and gap analysis are thus useful tools for telling a manager of a financial institution its degree of exposure to interest-rate risk 2/28/2013 21 .Duration Analysis for Banks • An alternative method for measuring interest-rate risk. examines the sensitivity of the market value of the bank’s total assets and liabilities to changes in interest rates. called duration analysis.

2/28/2013 22 .Cont. • Duration analysis involves using the average (weighted) duration of a financial institution’s assets and of its liabilities to see how its net worth responds to a change in interest rates.

9 million = \$1.Examples • Example 8 • The bank manager wants to know what happens when interest rates rise from 10% to 11%. • The result is that the net worth of the bank would decline by \$1.6 million).5 million \$0. 2/28/2013 23 . The total asset value is \$100 million.6 million (\$2. and the total liability value is \$95 million.

determine the duration gap for First National Bank and calculate the change in the market value of net worth as a percentage of assets as a result of change in interest rates. • Example 9 • Based on the information provided in Example 8. what will happen to the net worth of the bank 2/28/2013 24 .Cont. • Example 10 • If interest rates fall from 10% to 5%.

we have seen that a rise in interest rates from 10% to 11% will cause the market value of net worth to fall by \$1. Thus the bank manager realizes that the bank faces substantial interest-rate risk because a rise in interest rates could cause it to lose a lot of its capital.6 million.Conclusion of Duration Gap Analysis • Duration gap analysis indicate that the Bank will suffer from a rise in interest rates. In this example. which is one-third the initial amount of bank capital. 2/28/2013 25 . this analysis is useful tools for understanding a manager of the financial institution to degree of exposure to interest rate risk. Clearly.

2/28/2013 26 . so that when interest rates rise.Nonbanking Financial Institution and Duration Gap Analysis • Some financial institutions have and duration gaps that is opposite in sign to those of banks. net worth rise rather than fall.

• The reason that the company has benefited from the interest-rate rise. whose profits suffer from the rise in interest rates. the manager finds that company’s income will rise by 120.Cont. the Friendly Finance Company has a positive income gap because it has more ratesensitive assets than liabilities. in contrast to the Bank. • In the finance company. On the other hand.000 when interest rates rise by 1%. 2/28/2013 27 .

the company will suffer a fall in income and market value of net worth.Cont. • Thus the finance company manager. • Even though the income and duration gap analysis indicates that the Friendly Finance Company gains from a rise in interest rates. realizes that the institution is subject to substantial interest-rate risk. like the bank manager. 2/28/2013 28 . the manager realizes that if interest rates go in the other direction.

Conclusion • Duration gap analysis. examines the sensitivity of the market value of the financial institution’s net worth to changes in interest rates 2/28/2013 29 .

You have done the duration and income gap analysis for this bank.Strategies for Managing InterestRate Risk • Assume that you are a manager of the First National Bank. and you must decide which alternative strategies to pursue under the following conditions • interest rates will fall in the future • interest rates will rise in the future 2/28/2013 30 .

Question 1 • Suppose that you are the manager of a bank that has \$15 million of fixed-rate assets. and show what will happen to bank profits if interest rates rise by 5 percentage points. What actions could you take to reduce the bank’s interest-rate risk? 2/28/2013 31 . Conduct a gap analysis for the bank. and \$20 million of rate-sensitive liabilities. \$30 million of rate sensitive assets. \$25 million of fixed-rate liabilities.

and show what will happen to the net worth of the bank if interest rates rise by 2 percentage points.Question 2 • Suppose that you are the manager of a bank whose \$100 billion of assets have an average duration of four years and whose \$90 billion of liabilities have an average duration of six years. What actions could you take to reduce the bank’s interest-rate risk ? 2/28/2013 32 . Conduct a duration analysis for the bank.

Thank you 2/28/2013 33 .