7 views

Uploaded by afrahamed

- Corporate Finance Companion
- 2010_FRM_Part_I_AIM
- Understanding Fixed-Income Risk and Return
- Valuation of Fixed Income Securities
- Bond Mini Case
- Emad A Zikry - Immunized Portfolios - Alternative to GICs 2
- ch17
- Problem Set 3 Solution
- Ohio v. Frank, 103 U.S. 697 (1881)
- 20140115 Investment Outlook_EN by FM
- fabozzi_BMAS9_IM_24.docx
- Time Value of Money
- Sinclair Company
- Go Study Level 1 - Time Value of Money
- Credit Default Swap Handout
- Chapter 4 Notes
- Chapter 5 Exploration Answer
- Demeter Presentation
- Glossary of Investment Terms.doc
- Exam 2 Notes

You are on page 1of 37

McGraw-Hill/Irwin

Overview

This chapter discusses a market valuebased model for assessing and managing interest rate risk:

Duration Computation of duration Economic interpretation Immunization using duration *Problems in applying duration

9-2

In general, the longer the term to maturity, the greater the sensitivity to interest rate changes Example: Suppose the zero coupon yield curve is flat at 12%. Bond A pays $1790.85 in five years. Bond B pays $3207.14 in ten years, and both are currently priced at $1000.

9-3

Example continued...

Bond A: P = $1000 = $1790.85/(1.06)10 Bond B: P = $1000 = $3207.14/(1.06)20

Bond A: P = $1762.34/(1.065)10 = $954.03 Bond B: P = $3105.84/(1.065)20 = $910.18

The longer maturity bond has the greater drop in price because the payment is discounted a greater number of times.

9-4

Coupon Effect

Bonds with identical maturities will respond differently to interest rate changes when the coupons differ. This is easily understood by recognizing that coupon bonds consist of a bundle of zero-coupon bonds. With higher coupons, more of the bonds value is generated by cash flows which take place sooner in time. Consequently, it is less sensitive to changes in R.

9-5

In general, longer maturity bonds experience greater price changes in response to any change in the discount rate The range of prices is greater when the coupon is lower

A 6% bond will have a larger change in price in response to a 2% change than an 8% bond The 6% bond has greater interest rate risk

9-6

Consider two ten-year maturity instruments:

A ten-year zero coupon bond A two-cash flow bond that pays $999.99 almost immediately and one penny ten years hence

Small changes in yield will have a large effect on the value of the zero but almost no impact on the hypothetical bond Most bonds are between these extremes

The higher the coupon rate, the more similar the bond is to our hypothetical bond with higher value of cash flows arriving sooner

9-7

Duration

Duration

Weighted average time to maturity using the relative present values of the cash flows as weights Combines the effects of differences in coupon rates and differences in maturity Based on elasticity of bond price with respect to interest rate The units of duration are years

9-8

Macaulay Duration

Macaulay Duration

Where

D = Macaulay duration (in years) t = number of periods in the future CFt = cash flow to be delivered in t periods N= time-to-maturity DFt = discount factor

9-9

Duration

Since the price (P) of the bond equals the sum of the present values of all its cash flows, we can state the duration formula another way:

Notice the weights correspond to the relative present values of the cash flows

9-10

It is important to see that we must express t in years, and the present values are computed using the appropriate periodic interest rate. For semiannual cash flows, Macaulay duration, D is equal to:

9-11

For a zero-coupon bond, Macaulay duration equals maturity since 100% of its present value is generated by the payment of the face value, at maturity For all other bonds, duration < maturity

9-12

Computing duration

Consider a 2-year, 8% coupon bond, with a face value of $1,000 and yieldto-maturity of 12% Coupons are paid semi-annually Therefore, each coupon payment is $40 and the per period YTM is (1/2) 12% = 6% Present value of each cash flow equals CFt (1+ 0.06)t where t is the period number

9-13

t 1 2 3 4 years CFt 0.5 1.0 1.5 2.0 40 40 40 PV(CFt) 37.736 35.600 33.585 P = 930.698 Weight W years (W) 0.041 0.020 0.038 0.036 0.885 1.000 0.038 0.054 1.770 D=1.883 (years)

9-14

1,040 823.777

Special Case

Maturity of a consol: M = . Duration of a consol: D = 1 + 1/R

9-15

Features of Duration

Duration and maturity

D increases with M, but at a decreasing rate

D decreases as yield increases

D decreases as coupon increases

9-16

Economic Interpretation

Duration is a measure of interest rate sensitivity or elasticity of a liability or asset: [P/P] [R/(1+R)] = -D Or equivalently, P/P = -D[R/(1+R)] = -MD R where MD is modified duration

9-17

Economic Interpretation

To estimate the change in price, we can rewrite this as: P = -D[R/(1+R)]P = -(MD) (R) (P)

9-18

Dollar Duration

Dollar duration equals modified duration times price Dollar duration = MD Price Using dollar duration, we can compute the change in price as P = -Dollar duration R

9-19

With semi-annual coupon payments the percentage change in price is P/P = -D[R/(1+(R/2)]

9-20

Immunization

Matching the maturity of an asset investment with a future payout responsibility does not necessarily eliminate interest rate risk Matching durations will immunize against changes in interest rates

9-21

Consider three loan plans, all of which have maturities of 2 years. The loan amount is $1,000 and the current interest rate is 3%. Loan #1 is a two-payment loan with two equal payments of $522.61 each. Loan #2 is structured as a 3% annual coupon bond. Loan #3 is a discount loan, which has a single payment of $1,060.90.

An Example

9-22

Yield Loan Value 2% 3% P N D Equal $1014.68 $1000 $14.68 2 1.493 Payment 3% Coupon $1019.42 $1000 $19.42 2 1.971 Discount $1019.70 $1000 $19.70 2 2.000

9-23

Duration is a measure of the interest rate risk exposure for an FI If the durations of liabilities and assets are not matched, then there is a risk that adverse changes in the interest rate will increase the present value of the liabilities more than the present value of assets is increased

9-24

Duration Gap

Suppose that a 2-year coupon bond is the only loan asset (A) of an FI. A 2-year certificate of deposit is the only liability (L). If the duration of the coupon bond is 1.8 years, then: Maturity gap: MA - ML = 2 -2 = 0, but Duration Gap: DA - DL = 1.8 - 2.0 = -0.2

Deposit has greater interest rate sensitivity than the bond, so DGAP is negative FI exposed to rising interest rates

9-25

Duration Gap:

From the balance sheet, E=A-L. Therefore, DE=DA-DL. In the same manner used to determine the change in bond prices, we can find the change in value of equity using duration.

DE = -[DA - DLk]A(DR/(1+R))

9-26

The formula shows 3 effects:

Leverage adjusted D-Gap The size of the FI The size of the interest rate shock

9-27

An Example

Suppose DA = 5 years, DL = 3 years and rates are expected to rise from 10% to 11%. (Rates change by 1%). Also, A = 100, L = 90 and E = 10. Find change in E. DE = -[DA - DLk]A[DR/(1+R)]

= -[5 - 3(90/100)]100[.01/1.1] = - $2.09.

Adjust DA , DL or k.

9-28

Regulators set target ratios for an FIs capital (net worth):

Capital (Net worth) ratio = E/A

DA = DL

But, to set DE = 0:

DA = kDL

9-29

Limitations of Duration

Immunizing the entire balance sheet need not be costly Duration can be employed in combination with hedge positions to immunize Immunization is a dynamic process since duration depends on instantaneous R Large interest rate change effects not accurately captured

Convexity

9-30

Convexity

The duration measure is a linear approximation of a non-linear function. If there are large changes in R, the approximation is much less accurate. All fixed-income securities are convex. Convexity is desirable, but greater convexity causes larger errors in the duration-based estimate of price changes.

9-31

*Convexity

Those who are familiar with calculus may recognize that duration involves only the first derivative of the price function. We can improve on the estimate using a Taylor expansion. In practice, the expansion rarely goes beyond second order (using the second derivative). This second order expansion is the convexity adjustment.

9-32

DP/P = -D[DR/(1+R)] + (1/2) CX (DR)2 or DP/P = -MD DR + (1/2) CX (DR)2 Where MD implies modified duration and CX is a measure of the curvature effect. CX = Scaling factor [capital loss from 1bp rise in yield + capital gain from 1bp fall in yield] Commonly used scaling factor is 108

9-33

*Calculation of CX

Example: convexity of 8% coupon, 8% yield, six-year maturity Eurobond priced at $1,000 CX = 108[DP-/P + DP+/P] = 108[(999.53785-1,000)/1,000 + (1,000.46243-1,000)/1,000)] = 28

9-34

Default risk Floating-rate loans and bonds Duration of demand deposits and passbook savings Mortgage-backed securities and mortgages

Duration relationship affected by call or prepayment provisions

9-35

*Contingent Claims

Interest rate changes also affect value of off-balance sheet claims

Duration gap hedging strategy must include the effects on off-balance sheet items such as futures, options, swaps, caps, and other contingent claims

9-36

Pertinent Websites

Bank for International Settlements Securities Exchange Commission The Wall Street Journal www.bis.org www.sec.gov

www.wsj.com

9-37

- Corporate Finance CompanionUploaded bycmtinv
- 2010_FRM_Part_I_AIMUploaded byabhisheksundar
- Understanding Fixed-Income Risk and ReturnUploaded byHassan
- Valuation of Fixed Income SecuritiesUploaded byVikrant Verma
- Bond Mini CaseUploaded byRottenDinkle
- Emad A Zikry - Immunized Portfolios - Alternative to GICs 2Uploaded byEmad-A-Zikry
- ch17Uploaded bysumihosa
- Problem Set 3 SolutionUploaded byMax
- Ohio v. Frank, 103 U.S. 697 (1881)Uploaded byScribd Government Docs
- 20140115 Investment Outlook_EN by FMUploaded byFrancesco Maggioni
- fabozzi_BMAS9_IM_24.docxUploaded byasdasd
- Time Value of MoneyUploaded byneha_baid_1
- Sinclair CompanyUploaded byVictor Lim
- Go Study Level 1 - Time Value of MoneyUploaded byjojo
- Credit Default Swap HandoutUploaded byshashi
- Chapter 4 NotesUploaded byMatt Courchaine
- Chapter 5 Exploration AnswerUploaded byJenny Varela
- Demeter PresentationUploaded byspeedenquiry
- Glossary of Investment Terms.docUploaded bypapu
- Exam 2 NotesUploaded byRachel Deinhart
- 120958_TUTORIAL 5 ANSWER.docxUploaded bySyuhaidah Binti Aziz Zudin
- Finance FundaUploaded bySathish Kumar
- ch8 individuUploaded bydiah123
- Dorchester SolutionUploaded byJoe Mixon
- 11. Derivatives and HedgingsUploaded byHuynh Le Kim Ha
- HDFC Long Term Advantage Fund SID Apr 17Uploaded byAnkur Khanna
- Financial Functions .Uploaded byKaran Bhansali
- BA322 GA Notes Ch 6 - Accountng for Capital Projects and Debts ServiceUploaded byZebedee Taltal
- En - Dictionary of Financial and Business TermsUploaded byMuhammad Ali Jawed
- FM JUL07Uploaded byvineetjogalekar

- History of BullionismUploaded byrony7sar
- Milk Collection ProjectUploaded byDipendraKumarShah
- The Uttar Pradesh Trade Tax ActUploaded byIndu Gupta
- Nero's Pasta Case Study Analysis - Group 9Uploaded byajaxor
- A Tariff Acts as an Added Cost of TransportationUploaded bydestiny710
- MY BPCLUploaded byMohit Agarwal
- Value Presentation April 2018Uploaded byAnkur
- ACCA F9 Lecture 3Uploaded byFathimath Azmath Ali
- AITR-2003-005.pdfUploaded byoscar
- marketing plan to launch a car in pakistanUploaded bySMZHZ
- Chap5_2011_SCMUploaded bytaekwonolive
- a186a PDF EngUploaded byerickpa
- Silent RiskUploaded bymicha424
- 3414 3 Beau Vorm Gym StrengthUploaded byAashika Shah
- Religare-Capital Goods - Sector Report - June 2010Uploaded bybombayaddict
- Commodity MarketUploaded byPrakash Sudvesa
- Chap07 GM6e TIFUploaded byradislamy
- Indian Downstream Natural Gas SectorUploaded byhakr5
- sld01Uploaded byNekta Pincha
- Factory VGSoM, IIT Kgp KrushersUploaded byArchana Singhal
- mdbl-chapter5Uploaded byDilbagh Singh
- BLADES Chuong 4Uploaded byMỹ Trâm Trương Thị
- Tax Incidence Analysis - Taxation - Lecture Notes PDFUploaded byAman Machra
- Marking Scheme -Strategic Management 2015Uploaded bySaad Ali
- 6.2014ImpactofDividendAnnouncementonthestockPricesofIndianCompaniesAnEmpiricalEvidencesUploaded bySumitas
- Ballack Carpets ParveenUploaded byMohit kolli
- Sample Purchase OrderUploaded byArif Reza Maharama
- Global Question Answer.Uploaded byIftekhar Ahmed
- Jpm Circle of LifeUploaded byjonnywinchester
- Food Service Facts 2007Uploaded bysytlui