AF6007 Theme 1

Interest Rate Risk Lecture 3

The Duration Model
Learning Outcomes
Specifically for this lecture, we will be examining the principal
models for measuring Interest Rate Risk, and by the end you
will be able to:
• Explain and analyse the Duration Model
• Understand Modified Duration
• Understand the role of Convexity
• Explain the concept of Balance sheet Immunization
 The Duration Model
The Duration Model (more properly the Macauley Duration
Model) is a Market value based average life model, that examines
the interest rate sensitivity of an FI/Bank based on the timing of
the cashflows it is due to receive/pay. It is the
• Most complete – it takes into account the timing of all cash
flows as well as the maturity.
• Uses the weighted average time to maturity using the present
values of the cash flows as weights.
• Combines the effects of differences in coupon rates and
differences in maturity
• The unit of Duration (D or DYears) is years.

Importantly, Duration is the model preferred by BIS

 The Duration Model – A Simple Example
Consider a one-year loan (an Asset):
o Principal : £ 100
o Interest Rate : 15% per annum
o Requirement to repay 50% of principal at 6 mths, balance at end.

0 Six One
Months Months Year
Time →
Cashflow Cashflow
Principal : £ 50.00 Principal : £ 50.00
Interest : £ 7.50 Interest : £ 3.75
£ 57.50 £ 53.75
Present Value Discount Factor : 1 / (1+(15%/2))^1
£ 53.49

Present Value Discount Factor : 1 / (1+(15%/2))^2

£ 46.51
 The Duration Model – A Simple Example
Consider a one-year loan (an Asset):
o Principal : £ 100
o Interest Rate : 15% per annum
o Requirement to repay 50% of principal at 6 mths, balance at end.

0 Six One
Months Months Year
Time →
Cashflow Cashflow
Principal : £ 50.00 Principal : £ 50.00
Interest : £ 7.50 Interest : £ 3.75
£ 57.50 £ 53.75
Present Value Discount Factor : 1 / (1+(15%/2))^1
CF6Mths + CF12 Mths = £ 57.50 + £ 53.75
£ 53.49 = £ 111.25

Present Value Discount Factor : 1 / (1+(15%/2))^2 PV6Mths + PV12 Mths = £ 53.49 + £ 46.51
£ 46.51 = £ 100.00
 The Duration Model – A Simple Example
Consider a one-year loan (an Asset):
o Principal : £ 100
o Interest Rate : 15% per annum
o Requirement to repay 50% of principal at 6 mths, balance at end.

To find the duration for the one

year loan the weights for each
cashflow need to be determined
with which the weighted average
duration of the loan will be
established.
 The Duration Model – A Simple Example
Consider a one-year loan (an Asset):
o Principal : £ 100
o Interest Rate : 15% per annum
o Requirement to repay 50% of principal at 6 mths, balance at end.

Duration (D) is the Consequently, for our one-year loan :

weighted-average
time to maturity of
the loan cashflow
payments using the
PV of each cashflow
for the weightings.
 The Duration Model – A Simple Example
Consider a one-year Certificate of Deposit (a Liability):
o Principal : £ 100
o Interest Rate : 15% per annum
o Requirement for one payment at maturity.

0 One
Months Year
Time →
Cashflow
Principal : £ 100.00
Interest : £ 15.00
£ 115.00

Present Value Discount Factor : 1 / (1+15%)^1

£ 100.00
 The Duration Model – A Simple Example
Consider a one-year Certificate of Deposit (a Liability):
o Principal : £ 100
o Interest Rate : 15% per annum
o Requirement for one payment at maturity.

0 One
Months Year
Time →
Cashflow
Principal : £ 100.00
Interest : £ 15.00
£ 115.00
CF12 Mths = £ 100.00 + £ 15.00
= £ 115.00

Present Value Discount Factor : 1 / (1+15%)^1 PV12 Mths = £ 100.00

£ 100.00
 The Duration Model – A Simple Example
Consider a one-year Certificate of Deposit (a Liability):
o Principal : £ 100
o Interest Rate : 15% per annum
o Requirement for one payment at maturity.

Just as for the asset, to find the

duration for the one year CoD
the weights for each cashflow
need to be determined, with
which the weighted average
duration of the loan will be
established.
 The Duration Model – A Simple Example
Consider a one-year Certificate of Deposit (a Liability):
o Principal : £ 100
o Interest Rate : 15% per annum
o Requirement for one payment at maturity.

Duration (D) is the Consequently, for our one-year CoD :

weighted-average
time to maturity of
the CoD cashflow
payments using the
PV of each cashflow
for the weightings.
 The Duration Model – A Simple Example
So for this single asset/liability FI, what is the Maturity Gap
(Lecture 2) between the Loan (Asset) and the Certificate of Deposit
(Liability)?
o Maturity of the Loan (MLoan) : 1 Year
o Maturity of the CoD Maturity Gap = M - M
(MCoD) : 1 Year Loan CoD

o Maturity Gap : 0 Years

However, the Duration Gap (given by the Duration Model) is

negative:
o Duration of the Loan (DLoan) : 0.7326 Years
o Duration of the CoD (DCoD) : 1 Year Duration = D Loan - DCoD
Gap
o Duration Gap : -0.2674 Years
 The Duration Model
• Frederick Macaulay suggested in 1938 that the price volatility of fixed
income instruments could be determined by using Duration.
• Duration may be defined as:
o The Average Life of a fixed income instrument*
o The Weighted Average Time before Repayment

of an asset or liability that uses the relative present values of the

future cash flows as weights
o The Weighted Average Term to Maturity

of an asset or liability that uses the relative present values of the

future cash flows as weights
• The weightings applied to each of the cashflows are calculated based
on the relative size of each cashflow compared to
(relative to) all of the other cashflows in the portfolio.
* The Duration Model may only be applied to fixed period cashflows (fixed income
instruments or to measure duration to the first roll-date of a floating rate instrument.
 The Duration Model - ‘Rules’ of Duration
The method of calculation implies some ‘rules’ or conclusions that
we can draw :
Di < Mi : If a fixed income instrument pays a coupon prior
to maturity, they Duration will always be less
than Maturity. The Average Life of a Bond
NOTE :
The only exception is a zero coupon instrument
for which Di = Mi because the entire payment is
made at maturity
Di ↑ as Ci ↓ : The Duration of a fixed income instrument ↑ as
and the coupon the instrument pays decreases. This
Di ↓ as Ci ↑ is because a greater proportion of the payments
due (e.g. principal) will be paid at maturity
 The Duration Model - ‘Rules’ of Duration
The method of calculation implies some ‘rules’ or conclusions that
we can draw :
Di ↑ as Mi ↑ : The Duration of a fixed income instrument ↑ as
the maturity of the instrument ↑. This is because
the longer the maturity, the longer it will take to
get to receive all of the cashflows the fixed
income instrument will pay.
NOTE :
The longer the maturity, the greater the duration,
therefore the more sensitive the instrument will
be to interest rate changes and so the more
volatile the price will be.
Whilst Duration increases with Maturity the rate
of increase slows as M gets larger.
 The Duration Model - Annotated
Mathematically, the Duration Model (Macaulay Duration) may be
expressed as:

Where
D = Macaulay Duration (in years)
t = Period in the Future
CFt = Cashflow to be Delivered at Time = t
N = Time-to-Maturity (Years)
DFt = Discount Factor at Time = t
 The Duration Model - Annotated
Since the Price (P) of a fixed income instrument equals the sum of
the present values of all its cash flows, the Duration formula can
also be expressed as:

Where
D = Macaulay Duration (in years)
PVt = Present Value of the Cashflow to be Delivered at Time = t
t = Period in the Future
P = Price of the Fixed Income Instrument
The Duration Model - Annotated An Example
A £100 2-year redeemable bond paying 15% per annum coupon is
priced at £108.34 and is, therefore, showing a yield to maturity of
10%. What is the Duration?

Where
PVt = For time t = 1 (£ 15.00 x 1) / (1 + 10%)^1 = 13.64
For time t = 2 (£ 15.00 x 2) / (1 + 10%)^2 = 24.79
(£ 100.00 x 2) / (1 + 10%)^2 = 165.29
Total = 203.72
P= 108.34
D= 203.72/108.34
1.88
The Duration Model - Annotated Semi-Annual Payments

Since the Price (P) of a fixed income instrument equals the sum of
the present values of all its cash flows, the Duration formula can
also be expressed as:

Where
D = Macaulay Duration (in years)
t = Period in the Future
CFt = Cashflow to be Delivered at Time = t
N = Time-to-Maturity (Years)
R = Discount Rate (Yield to Maturity) [an annualised figure]
 The Duration Model
So what does the Duration Model tell us?
• Duration is the gap in the average life (duration) of assets and
liabilities given the timing of their cashflows
Note:
Contrastingly, the maturity model is the gap in the average maturity
the market value of each of the instruments
• Duration is more complex than the Funding Gap or Maturity models
– it takes into account the time of arrival of all associated cash flows as well as
the maturity
• Di < Mi unless the fixed income instrument is a zero-coupon variant
(see slides above)
• Matching cash inflows/outflows the bank can manage interest rate
risk
 The Modified Duration Model - Annotated
The formula for the Duration Model can be restated so that rather
than measuring the average (cashflow weighted) term to maturity
of a bond, you can measure the sensitivity of a bond to
movements in interest rates.
This is called Modified Duration and the calculation is:
DM
MD =
Where (1 + (Y / n))

MD= Modified Duration

DM = Macauley Duration
Y = Yield to Maturity
n = Number of Discounting Periods in a Year
e.g. For semi-annual payments n = 2
The Modified Duration Model An Example
A £100 2-year redeemable bond paying 15% per annum coupon is
priced at £108.34 and is, therefore, showing a yield to maturity of
10%. What is the Duration?

We established that:
P = 108.34
DM = D = 203.72 / 108.34
1.88

Therefore the Modified Duration for this Bond would be:

MD= 1.88 / (1 + (10%/1)) DM
MD =
(1 + (Y / n))
= 1.71
 The Modified Duration Model - Annotated
Modified Duration provides an estimate of the price sensitivity of a
fixed income instrument to a change in the interest rate (also
known as interest rate elasticity).
Based on a derivation of the change in price given
the change in interest rates (shown on the right)
this relationship may be calculated as:
% Price Change = -1 x Modified Duration x Yield Change

In the example given above, where MD = 1.71 this means that:

o For every 1% ↑ in the IR (YTM) : Price should ↓ by
1.71%
o For every 1% ↓ in the IR (YTM) : Price should ↑ by
1.71%
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 The Modified Duration Model - Annotated
The expected change in the absolute price of the fixed income
instrument may also be found.
Based on a derivation of the change in price given
the change in interest rates (shown on the right)
this relationship may be calculated as:
PriceRevised = PriceCurrent + ( -1 x Modified Duration x Yield Change x PriceCurrent )

In the example given above, where MD = 1.71 this means that:

o If the IR (YTM) ↑ 1% (100bps) : Price should be £
106.49
o If the IR (YTM) ↓ 1% (100bps) : Price should be £
110.19
 The Modified Duration Model - Annotated
» The application of the Modified Duration model in this way
provides a linear estimated of the revised pricing based on a
change in the interest rate.
» In reality, the Yield to Maturity curve for a bond is a conves
shape and therefore Modified Duration can only be an estimate
(and that as the ΔY so the scale of the error increases Є↑).

» This can be
shown
Actual Relationship
graphically

Relationship Predicted by
Duration
Macaulay’s Duration Weaknesses
• Assumes that bond prices reacts proportionally to
changes in the Yield to Maturity. However, observe
previously bond prices are convex, and as so, do
not react linearly to changes in the YTM
• Duration does not consider the affect of liquidity
preference theory.
• Macaulay Duration is a valid risk measure only in
the case of a flat yield curve, yields on all bonds, of
all maturities, are equal.
Duration, Modified Duration & Interest Rate Risk
An Example
Consider a situation in which an FI has three loan plans (assets) all
of which have the following characteristics:
o Maturity : 2 years
o Principal : £ 1,000
o Interest Rate : 3% p/a

Asset 1: A two-payment loan with two equal annual

payments of £ 522.61 each.
Asset 2: A fully redeemable 3% annual coupon bond.
Asset 3: A discount loan, which has a single payment of
£ 1,060.90 at maturity.

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Duration, Modified Duration & Interest Rate Risk
An Example
Consider a situation in which an FI has three loan plans (assets) all
of which have the following characteristics:
o Maturity : 2 years
o Principal : £ 1,000
o Interest Rate : 3% p/a

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Duration, Modified Duration & Interest Rate Risk
An Example
Consider a situation in which an FI has three loan plans (assets) all
of which have the following characteristics:
o Maturity : 2 years
o Principal Whilst the Maturity is the same for all three
: £ 1,000
assets, the Duration and so the susceptibility to
o Interest Rate : 3% p/ainterest rate risk is not. This is shown by the
impact of Modified Duration on the scenario of
a change in Yield to Maturity of +1%

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Duration, Modified Duration & Interest Rate Risk
• The Duration / Modified Duration models provide a means by
which interest rate risk may be measured and, thus, managed.
• The measure determines the cashflow based risk of the asset
and liabilities and a measure of:
* Subject to the assumptions
o The scale of the risk
and limitations of the models.
o The sensitivity of the risk to interest rate changes.

• Combined this enables FI’s to put in place measures that will

reduce and potentially eliminate* interest rate risk from the
balance sheet.
• Simply matching the maturity of assets/liabilities will not
eliminate interest rate risk (Week 2), however matching
durations should immunize against changes in interest rates
Balance Sheet Immunization
• Duration is a measure of the interest rate risk exposure.
• 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.

Assets = Liabilities + Owners Equity

(from Lecture 1)

• To maintain this condition Owners Equity would have to be

revalued downwards … which, depending on the scale, would
be an issue for the regulator!
Balance Sheet Immunization An Example
Suppose that the Balance Sheet of an FI is made up of a single asset
and a single liability.
o Asset : A 2-year coupon bond DA = 1.8
o Liability : A 2-year certificate of deposit DL = 2.0
Balance Sheet Maturity Gap (MGAP) : MA – ML = 2.0 - 2.0 = 0.0
Balance Sheet Duration Gap (DGAP) : DA - DL = 1.8 - 2.0 = -0.2

Conclusions :
• The Liability has greater interest rate sensitivity than the Asset (the
duration is longer) so DGAP is negative
• Net Interest Income will fall : liabilities will cost more than assets
• The Value of Equity will rise : ↓ in Asset Value A< =↓ L +Liability Value
OE so if ↓L > ↓A
the value of OE must rise!
 Balance Sheet Immunization
Examining the Accounting Condition once again, it can be
re-stated so that we can determine what the potential impact of
an interest rate change might be on the Value of Equity

Owners Equity = Assets - Liabilities

(from Lecture 1)

Consequently, if we want to examine changes to any of these

items we the formula can be re-stated to show:

ΔE = ΔA - Δ L

We can therefore use this to find the change in value of equity

resulting from a change in interest rates, using duration.
 Balance Sheet Immunization
Examining the Accounting Condition in terms of the change in the
value of Equity and using Duration to examine the change in the
value of (fixed income) Assets and Liabilities, gives us:

ΔE= (-(DA x A) - (DL x L)) x (ΔR / 1 + R)

Where :
ΔE : Change in Equity
DA : Duration of Assets
A : Assets
DL : Duration of Liabilities
L : Liabilities
ΔR : Change in Interest Rates
R : Interest Rate (Yield to Maturity)
 Balance Sheet Immunization
This can also be adjusted to be set out as:

ΔE= -(DA - (DL x k)) x A x (ΔR / 1 + R)

Where :
ΔE : Change in Equity
DA : Duration of Assets
DL : Duration of Liabilities
k : Leverage Ratio Liabilities
A : Assets Assets
ΔR : Change in Interest Rates
R : Interest Rate (Yield to Maturity)
 Duration & Balance Sheet Immunization

These formulae show 3 principal effects when examining balance

sheet immunization in the context of Duration:
• Leverage adjusted D-Gap
• The size of the FI
• The impact of the interest
rate shock on Equity
The Duration Gap multiplied
by the Leverage Ratio
The Net Worth of the FI
What will happen to the
value of equity as a result of
a change in interest rates*

* This is critical for scenario planning

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 Balance Sheet Immunization An Example
Suppose that an FI faces the following metrics:
DA = 5 yrs : Duration of Assets
DL = 3 yrs : Duration of Liabilities
A = 100 : Assets
L = 90 : Liabilities Liabilities
k = 0.90 : Leverage Ratio Assets

Using the equation for ΔE what is the effect on Equity of a 1% rise

in interest rates from 10% to 11%?

ΔR= 1% : Change in Interest Rates

R = 11% : Interest Rate (Yield to Maturity)

ΔE = -(DA - (DL x k)) x A x (ΔR / 1 + R)

 Balance Sheet Immunization An Example
Suppose that an FI faces the following metrics:
DA = 5 yrs : Duration of Assets This means that if IR rise by 1% ΔE is
- £2.09 … of the £ 10.00 the FI holds £2.09
DL = 3 yrs : Duration of Liabilities would be lost meaning that afterwards its
A = 100 : Assets capital would be only £7.91.
FI Equity may be deemed to be susceptible
L = 90 : Liabilities to rising Interest Rates.
k = 0.90 : Leverage Ratio BUT FI Interest Income should rise!

Using the equation for ΔE what is the effect on Equity of a 1% rise

in interest rates from 10% to 11%?
ΔR= 1% : Change in Interest Rates
R = 10% : Interest Rate (Yield to Maturity)
ΔE = -(DA - (DL x k)) x A x (ΔR / 1 + R)
= -(5 - (3 x 0.90)) x 100 x (1% / (1 + 10%))
= - £ 2.09
Balance Sheet Immunization & Regulatory Concerns

• Regulators are interested in ensuring that Fis are viable

institutions and therefore seek to protect the Economic Value
of Equity.
• Regulators therefore set target ratios for an FI’s capital
(The FI’s Net Worth). This is often set as:

Equity
Capital (Net Worth) Ratio =
Assets
To set ΔE = 0 then : DA = k D L where k = Leverage so Liabilities
Assets

• But, if a target is such that Δ(Equity/Assets) = 0 then: DA =

DL The leverage adjustment effect (k) drops out.

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Barclays 100bp Increase Example
The calculations below show the effects of a Total Assets (£m) £ 857,903
100bp interest rate increase on Barclays net Total Liabilities (£m) £ 575,223
worth using Duration GAP Net Worth (£m) £ 282,680

Assuming: Duration of Assets 4 years

Duration of Liabilities 2 years

Then:   1%
ΔE =− [ 4− ( 2∗0.67 ) ] ∗857,903∗ 
1+1%

Exposure = -£22,594 million

The above means that should interest rates rise by 1%, Barclays will lose £22,594m
in their net worth
Quick Duration Recap/Summary
 Limitations of Duration
• Immunizing the entire balance sheet can be, but need not be,
expensive
• Duration can be employed in combination with interest rate
hedging positions to make good the immunization
• Immunization is a dynamic process since duration depends on
instantaneous R (but Balance Sheets are, necessarily a point in
time view … what cost up-to-date information)?
• Duration and Modified Duration are an estimate and do not
accurately capture large interest rate change as a result of:
o Convexity of the Yield to Maturity Curve
o Assumption limitation – this process is far more complex if
there is a no-parallel shift in yield curve
 Limitations of Duration
• What about floating rate instruments?
• What about risk e.g. default risk?
• Does duration consider uncertainty, if so, how?
• How should deposit accounts (on-demand accounts) be
treated?
• How can pre-payment provisions be considered by the model?
• How can off-balance sheet items be considered?:
o Not least because derivatives are a significant tool used for dealing with
interest rate risk.
• Does this manage the tension between shareholders and regulators.
Shareholders would like ↑NII and less Owners Equity (to improve RoE)
whereas regulators would like more OE!

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Duration, Modified Duration and Investing
As an investor, duration and modified duration can be usefully
used to design an investment strategy:
If the investor believes : Set the portfolio mix to include
market yields will ↓ fixed income instruments which
carry higher duration to leverage the increase in
the value of the instrument (bond).
If the investor believes : Set the portfolio mix to include
market yields will ↑ fixed income instruments which
carry lower duration to minimise the negative
effect of falling
prices on the portfolio.
Directed Study
• Read Saunders and Cornett, Chapter 9.
• There are a set of directed study questions
regarding the duration model available on
blackboard.
• Collect balance sheet data from a bank of your
choice to construct your own immunization
example.