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Chapter 9

Interest Rate Risk
II

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

9-2
Overview

 This chapter discusses a market value-
based model for assessing and managing
interest rate risk:
 Duration
 Computation of duration
 Economic interpretation
 Immunization using duration
 * Problems in applying duration

9-3
Price Sensitivity and Maturity
 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 $1762.34
in five years. Bond B pays $3105.85 in ten
years, and both are currently priced at
$1000.

13) 10 = $914..12)10  Now suppose the interest rate increases by 1%..13)5 = $956. .12)5  Bond B: P = $1000 = $3105.34/(1.84/(1.53  Bond B: P = $3105. 9-4 Example continued.94  The longer maturity bond has the greater drop in price because the payment is discounted a greater number of times.34/(1.  Bond A: P = $1762.84/(1.  Bond A: P = $1000 = $1762.

With higher coupons. This is more readily understood by recognizing that coupon bonds consist of a bundle of “zero-coupon” bonds. more of the bond’s value is generated by cash flows which take place sooner in time. Consequently. less sensitive to changes in R. 9-5 Coupon Effect  Bonds with identical maturities will respond differently to interest rate changes when the coupons differ. .

163 $299 10 $919 $1.000 $1.089 $170 2 $981 $1. 9-6 Price Sensitivity of 6% Coupon Bond r 8% 6% 4% Range n 40 $802 $1.019 $37 .273 $471 20 $864 $1.000 $1.000 $1.000 $1.

000 $1.000 $1.149 $274 10 $923 $1.231 $403 20 $875 $1.019 $38 .000 $1.085 $162 2 $981 $1. 9-7 Price Sensitivity of 8% Coupon Bond r 10% 8% 6% Range n 40 $828 $1.000 $1.

 The range of prices is greater when the coupon is lower. longer maturity bonds experience greater price changes in response to any change in the discount rate.  The 6% bond shows greater changes in price in response to a 2% change than the 8% bond. 9-8 Remarks on Preceding Slides  In general. . The first bond has greater interest rate risk.

9-9 Extreme examples with equal maturities  Consider two ten-year maturity instruments:  A ten-year zero coupon bond  A two-cash flow “bond” that pays $999.  Small changes in yield will have a large effect on the value of the zero but essentially no impact on the hypothetical bond.99 almost immediately and one penny. . the more similar the bond is to our hypothetical bond with higher value of cash flows arriving sooner.  Most bonds are between these extremes  The higher the coupon rate. ten years hence.

 Based on elasticity of bond price with respect to interest rate.  Combines the effects of differences in coupon rates and differences in maturity. . 9-10 Duration  Duration  Weighted average time to maturity using the relative present values of the cash flows as weights.

. 9-11 Duration Duration D = SNt=1[CFt• t/(1+R)t]/ SNt=1 [CFt/(1+R)t] Where D = duration t = number of periods in the future CFt = cash flow to be delivered in t periods N= time-to-maturity R = yield to maturity.

we can state the duration formula another way: D = SNt=1[t  (Present Value of CFt/P)]  Notice that the weights correspond to the relative present values of the cash flows. 9-12 Duration  Since the price (P) of the bond must equal the present value of all its cash flows. .

at maturity. duration equals maturity since 100% of its present value is generated by the payment of the face value. 9-13 Duration of Zero-coupon Bond  For a zero coupon bond.  For all other bonds: duration < maturity .

9-14 Computing duration  Consider a 2-year.  Therefore. .  Present value of each cash flow equals CFt ÷ (1+ 0. each coupon payment is $40 and the per period YTM is (1/2) × 12% = 6%. with a face value of $1. Coupons are paid semi-annually.000 and yield-to-maturity of 12%. 8% coupon bond.06)t where t is the period number.

9-15 Duration of 2-year.5 40 37.0 1.040 823.5 40 33.777 0.054 4 2. YTM = 12% t years CFt PV(CFt) Weight W × years (W) 1 0.000 D=1.038 3 1.585 0. 8% bond: Face value = $1.736 0.883 (years) .600 0.036 0.698 1.770 P = 930.020 2 1.0 40 35.885 1.038 0.000.041 0.

9-16 Special Case  Maturity of a consol: M = .  Duration of a consol: D = 1 + 1/R .

885 . funded by a 2-year certificate of deposit (D).DD = 1.115  Deposit has greater interest rate sensitivity than the loan.2.  Maturity gap: ML .0 = -0.MD = 2 -2 = 0  Duration Gap: DL . so DGAP is negative. 9-17 Duration Gap  Suppose the bond in the previous example is the only loan asset (L) of an FI. .  FI exposed to rising interest rates.

9-18 Features of Duration  Duration and maturity:  D increases with M.  Duration and yield-to-maturity:  D decreases as yield increases.  Duration and coupon interest:  D decreases as coupon increases . but at a decreasing rate.

ΔP/P = -D[ΔR/(1+R)] = -MD × ΔR where MD is modified duration. . 9-19 Economic Interpretation  Duration is a measure of interest rate sensitivity or elasticity of a liability or asset: [ΔP/P]  [ΔR/(1+R)] = -D Or equivalently.

we can rewrite this as: ΔP = -D[ΔR/(1+R)]P = -(MD) × (ΔR) × (P)  Note the direct linear relationship between ΔP and -D. . 9-20 Economic Interpretation  To estimate the change in price.

9-21 Semi-annual Coupon Payments  With semi-annual coupon payments: (ΔP/P)/(ΔR/R) = -D[ΔR/(1+(R/2)] .

61 each. The loan amount is $1. 9-22 An example:  Consider three loan plans. .90.  Loan #2 is structured as a 3% annual coupon bond. which has a single payment of $1. is a two-payment loan with two equal payments of $522.  Loan #1.060. all of which have maturities of 2 years.000 and the current interest rate is 3%.  Loan # 3 is a discount loan.

000 .42 2 1.68 $1000 $14.70 2 2. 9-23 Duration as Index of Interest Rate Risk Yield Loan Value 2% 3% ΔP N D Equal $1014.971 Discount $1019.70 $1000 $19.68 2 1.42 $1000 $19.493 Payment 3% Coupon $1019.

In the same manner used to determine the change in bond prices. DE=DA-DL.DLk]A(DR/(1+R)) . 9-24 Immunizing the Balance Sheet of an FI  Duration Gap:  From the balance sheet. E=A-L. Therefore.  DE = [-DAA + DLL] DR/(1+R) or  DE = -[DA . we can find the change in value of equity using duration.

9-25 Duration and Immunizing  The formula shows 3 effects:  Leverage adjusted D-Gap  The size of the FI  The size of the interest rate shock .

3(90/100)]100[. . 9-26 An example: Suppose DA = 5 years.$2.  DE = -[DA . Find change in E.  Adjust DA . A = 100. Also.  Methods of immunizing balance sheet.DLk]A[DR/(1+R)] = -[5 . (Rates change by 1%).1] = . DL = 3 years and rates are expected to rise from 10% to 11%.01/1.09. L = 90 and E = 10. DL or k.

9-27 Immunization and Regulatory Concerns  Regulators set target ratios for an FI’s capital (net worth):  Capital (Net worth) ratio = E/A  If target is to set D(E/A) = 0:  DA = DL  But. to set DE = 0:  DA = kDL .

Duration can be employed in combination with hedge positions to immunize.  Large interest rate change effects not accurately captured. .  Immunization is a dynamic process since duration depends on instantaneous R.  Convexity  More complex if nonparallel shift in yield curve. 9-28 *Limitations of Duration  Immunizing the entire balance sheet need not be costly.

If there are large changes in R. . Convexity is desirable. but greater convexity causes larger errors in the duration-based estimate of price changes. 9-29 *Convexity  The duration measure is a linear approximation of a non-linear function. the approximation is much less accurate. All fixed-income securities are convex.

In practice. We can improve on the estimate using a Taylor expansion. the expansion rarely goes beyond second order (using the second derivative). 9-30 *Convexity  Recall that duration involves only the first derivative of the price function. .

9-31 *Modified duration & Convexity  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. 8 . CX = Scaling factor × [capital loss from 1bp rise in yield + capital gain from 1bp fall in yield]  Commonly used scaling factor is 10 .

000.53785-1.000)] = 28.000. 9-32 *Calculation of CX  Example: convexity of 8% coupon. .000)/1.000)/1. CX = 108[DP-/P + DP+/P] = 108[(999. 8% yield.000 + (1.46243-1. six-year maturity Eurobond priced at $1.

. 9-33 *Duration Measure: Other Issues  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.

. and other contingent claims. options. swaps. caps.  Duration gap hedging strategy must include the effects on off-balance sheet items such as futures. 9-34 *Contingent Claims  Interest rate changes also affect value of off- balance sheet claims.

com .wsj.bis.gov The Wall Street Journal www. 9-35 Pertinent Websites Bank for International Settlements www.sec.org Securities Exchange Commission www.