Topic 7:

Managing Interest Rate Risk (the

changes of the IR) interest rate
(borrowing/ investment) up and
down
if the IR up good for investment/
no good for borrowing
if the IR down no good for
investment/ good for borrowing

6-1
Interest Rate Risk
• Firms that borrow must pay interest on their debt
(borrowing/financing). An increase in interest rates raises
firms’ borrowing costs (interest payment) and can reduce their
profitability.---via impact on interest income or expense
• On the other hand, an increase in interest rates reduces the
present value of these liabilities in the balance sheet and can
increase the net asset/worth of the firm. (higher IR, security
price is lower; lower IR, security price is higher) ---via impact
on capital gain or loss
• When interest rate increases a debt security investor faces an
increase in interest income and a capital loss.
• When interest rate decreases a debt security investor faces a
decrease in interest income and a capital gain.
• Thus, the impact of interest rate changes to the firm’s profit
can be positive or negative, it acts like a double-edged sword.
6-2
Interest Rate Risk (cont’d)
Bank
Assets (Billion USD) Liabilities (Billion USD)
Interest-rate-sensitive assets: Interest-rate-sensitive
E.g. Variable rate & short-term liabilities:
loans and short-term securities, Variable rate Certificates of Deposit
$10 (investment, bank will get (CDs) and Money market deposit
the return 7%) accounts (MMDAs), $20 (bank
has to pay the interest 3%)
Fixed-rate assets: Fixed-rate liabilities:
E.g. reserves, long-term loans and E.g. Fixed rate CDs and equity
securities, $50 capital, $40
• If interest rates increase, the bank’s gross
interest profits (the difference between what it
pays for its liabilities and earns on its assets) will
decline.

6-3
Interest Rate Risk (cont’d)
• For example, the Bank pays today 3% for its rate-
sensitive liabilities of $20 bil and receives 7% on its
rate-sensitive assets of $10 bil. Thus, it is paying $0.6
bil ($20 bil x 3%) to earn $0.7 bil ($10 bil x 7%) and
earns $0.1 billion in gross.
• IF interest rates increase 1% on each side of the balance
sheet, the Bank will pay $0.8 bil ($20 bil x 4%) to earn
$0.8 bil ($10 bil x 8%) and earned nothing.
• IF interest rates increase another 1% on each side of the
balance sheet, it will have to pay $1 bil ($20 bil x 5%) to
earn $0.9 bil ($10 bil x 9%) and have another $0.1 billion
loss, with a total loss of $0.2 billion. (+0.1 to – 0.1)
• Thus, ceteris paribus, its gross profits would decrease
from $0.1 bil profit to $0.1 bil loss, with a total loss
of $0.2 billion during that period.
6-4
Interest Rate Risk (cont’d)
• On the other hand, the Bank would also suffer
loss if the interest rates decrease.
• For instance, a Bank has $10 bil in interest rate-
sensitive assets at 8%, and only $1 billion in
interest rate-sensitive liabilities at 5%. It’s earning
$0.8 bil ($10 bil x 0.08) while paying $0.05 bil ($1
bil x 0.05) and earned $0.75 billion.
• If interest rates decreased 3%, it might earn only
$0.5 bil ($10 bil x 0.05) while paying $0.02 bil ($1
bil x 0.02) and earned $0.48 billion.
• Thus, ceteris paribus, its gross profits would
decrease from $0.75 billion to $0.48 billion, a
total loss of $0.27 billion during that period.
6-5
Interest Rate Risk (cont’d)
Asset Liabilities Gross Profit
($ bil) ($ bil) ($ bil)
Now pay 7% x $10 = 0.7 3% x $20 = 0.6 0.7-0.6 = 0.1
+1% 8% x $10 = 0.8 4% x $20 = 0.8 0.8-0.8 = 0
Another 9% x $10 = 0.9 5% x $20 = 1.0 0.9-1 = -0.1
+1%
Total Gain/Loss -0.1-0.1 = -0.2

Asset Liabilities Gross Profit

($ bil) ($ bil) ($ bil)
Now pay 8% x $10 = 0.8 5% x $20 = 1 0.8-1 = -0.20
-3% 5% x $10 = 0.5 2% x $20 = 0.4 0.5-0.4 = 0.1
Total Gain/Loss +0.1-(-0.2)=
=0.3

6-6
Interest Rate Risk (cont’d)
Asset Liabilities Gross Profit
($ bil) ($ bil) ($ bil)
Now pay 7% x $10 = 0.7 3% x $20 = 0.6 0.7-0.6 = 0.1
+1% 8% x $10 = 0.8 4% x $20 = 0.8 0.8-0.8 = 0
Another 9% x $10 = 0.9 5% x $20 = 1.0 0.9-1 = -0.1
+1%
Total Gain/Loss -0.1-0.1 = -0.2

Asset Liabilities Gross Profit

($ bil) ($ bil) ($ bil)
Now pay 8% x $10 = 0.8 5% x $1 = 0.05 0.8-0.05 = 0.75
-3% 5% x $10 = 0.5 2% x $1 = 0.02 0.5-0.02 = 0.48
Total Gain/Loss 0.48-0.75 = -0.27

6-7
Interest Rate Risk (cont’d)
• When interest rates are volatile (up and down),
interest rate risk is a concern for many firms. Thus,
before the firms can manage interest risk, the firm
must be able to measure it.
• As the interest rate sensitivity of a cash flow
depends on its maturity (how long is loan/ bond),
the interest rate sensitivity of a security with
multiple cash flows depends on their value-
weighted maturity (duration).
• Duration estimates the sensitivity of a security or
a portfolio market value to the interest rate
changes.

6-8
 Interest Rate Risk (cont’d)
• A bond is a debt-based instrument that represents a loan made by an
investor to a borrower (bond issuer). Bond details include the end
date when the principal of the loan is due to be paid to the investor
and usually includes the terms for variable or fixed interest payments
(coupon) made by the borrower.
• The duration of a bond can be defined as below for interest rate
risk measurement:

where,
i = Bond yield (rate) or required return rate; (Interest rate)
C = Annual coupon paid by the bond; (coupon payment)
M = Par value paid at maturity;
P = Total present value of the bond’s cash flows;
T = The year in which respective payment is made.
• Duration is value-weighted maturity
• The duration weights each maturity t by the percentage contribution
of its cash flow to the total present value, PV(Ct ) ∕ P.

6-9
Example 6.1

a) What is the duration of a 10-year, zero-coupon

bond trading at $100 par value?

b) What is the duration of a 10-year bond with 10%

annual coupons trading at $100 par value?
Coupon ($) = par value x coupon rate
= 100 x 10%
= 10
At the maturity in 10th year = investor will
receive a coupon payment + principal (par
value)

6-10
Table 6.1a Computing the duration of a 10-year
zero coupon bond traded at $100 par value
t Interest Cash flow PV (Ct) PV (Ct)/P [PV (Ct)/P] x t
1 0% $ - $ - 0.00 0.00
2 0 $ - $ - 0.00 0.00
3 0 $ - $ - 0.00 0.00
4 0 $ - $ - 0.00 0.00
5 0 $ - $ - 0.00 0.00
6 0 $ - $ - 0.00 0.00
7 0 $ - $ - 0.00 0.00
8 0 $ - $ - 0.00 0.00
9 0 $ - $ - 0.00 0.00
10 0 $ 100 $ 100 100/100=1.00 1.00x10=10
Bond price Duration
1.00
=100 = 10 years

6-11
Table 6.1b Computing the duration of a 10-year
bond with 10% annual coupons trading at $100 par
T Interest (1)Cash flow (2)PV(Ct) (3)PV(Ct)/P (4)[PV(Ct)/P] x
(%) ($) ($) ($) t($)
1 10% $100x10%=$10 10/(1.1)^1=9.09 9.09/100=0.09 0.09x1=0.09
2 10% $10 10/(1.1)^2=8.26 8.26/100=0.08 0.08x2=0.16
3 10% $10 10/(1.1)^3=7.51 7.51/100=0.075 0.08x3=0.23
4 10% $10 $6.83 0.07 0.27
5 10% $10 $6.21 0.06 0.31
6 10% $10 $5.64 0.06 0.34
7 10% $10 $5.13 0.05 0.36
8 10% $10 $4.67 0.05 0.37
9 10% $10 $4.24 0.04 0.38
10 10% $100+$10=$110 110/(1.1)^10 42.41/100 0.424x10
=$42.41 =0.424 =4.24
Sum=100 Sum=1.0 (5)Duration
= 6.76 years

6-12
Table 6.1c Computing the duration of a 10-year
bond with 20% annual coupons trading at $100 par
T Interest (1)Cash (2)PV(Ct) (3)PV(Ct)/P (4)[PV(Ct)/P] x
(%) flow ($) ($) ($) t($)
1 20% $100x20% 20/(1.2)^1=16.67 16.67/100=0.17 0.17x1=0.17
=$20
2 20% $20 20/(1.2)^2=13.89 13.89/100=0.14 0.14x2=0.28
3 20% $20 20/(1.2)^3=11.57 11.57/100=0.12 0.12x3=0.35
4 20% $20 $9.65 0.10 0.39
5 20% $20 $8.04 0.08 0.40
6 20% $20 $6.70 0.07 0.40
7 20% $20 $5.58 0.06 0.39
8 20% $20 $4.65 0.05 0.37
9 20% $20 $3.88 0.04 0.35
10 20% $100+$20 120/(1.2)^10 19.38/100 0.19x10
=$120 =$19.38 =0.19 =1.94
Sum=100 Sum=1.0 (5)Duration
= 5.03 years
The higher the coupon rate, the lower the duration

6-13
Solution - Example 6.1
• For a zero-coupon bond, there is only one single cash flow.
Thus, PV(C10), present value in year 10 = P, principal =
$100, and the duration is equal to the bond’s maturity
of 10 years.
• Meanwhile, for the coupon bond, because the bond trades
at par, its yield to maturity (buy then hold it until
maturity) equals to 10% as its coupon rate.
• From Table 6.1a-6.1c, we can find that the higher the
coupon rate, the more weight is put on the earlier cash
flows, and the shorter the duration of the bond.
• Besides, because the bond pays coupons prior to
maturity, its duration should be shorter than its 10-
year maturity.
• As shown in next slide, the interest rate sensitivity of a
stream of cash flows increases with its duration.
6-14
Interest Rate Risk(cont'd)

• If the annual interest rate (r) that is used to

discount a stream of cash flows of a bond increases
to (r+e) where e is a small change, then the
present value of the cash flows changes by
approximately:
𝜀
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶h𝑎𝑛𝑔𝑒 𝑖𝑛 𝑉𝑎𝑙𝑢𝑒 ≈ − 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 ×
𝑟
1+( )
𝑘
where,
– k is the number of compounding periods per
year; k=1 for annual coupon payment.
– k=2 for semiannual coupon payment
– k=4 for quarterly coupon payment
– r is the annual interest rate.
6-15
Example 6.2

Suppose the yield of a 10-year bond with 10% annual

coupons increases from 10% to 10.25%.
Use duration to estimate the percentage price change
of the bond. How does it compare to the actual price
change?

6-16
 Solution - Example 6.2

• In Example 6.1, we found that the duration of the 10-

year bond with 10% annual coupons is 6.76 years.
interest
Suppose the coupon rate increases from 10% to
10.25%.

• Percentage of bond price change:

, k=1 as annual coupon payment
≈ 6.76 x
≈ 1.54% (with theinterest
coupon rate increases from
10% to 10.25%, the % of bond price change will
be -1.54%)

6-17
Duration-Based Hedging

• A firm’s market capitalization (equity value) is

determined by the difference in the market value of
its assets and its liabilities.
• If changes in interest rates affect its assets and
its liabilities, they will affect the firm’s equity
value.
• Thus, we can measure a firm’s sensitivity to
interest rates by computing the duration of its
assets and liabilities on its balance sheet.
• By restructuring the balance sheet to reduce its
duration, we can hedge the firm’s interest rate
risk.

6-18
Duration-Based Hedging (cont’d)
• Consider a typical Savings and Loans (S&L) case.
Banks hold short-term deposits (checking and
savings accounts, certificates of deposit, etc.). They
also make long-term loans (car loans, home
mortgages, etc.).
• Most S&L cases face a problem of the duration of
the loans is generally longer than the duration of
their deposits.
• When the durations of a firm’s assets and
liabilities are significantly different, the firm has
a duration mismatch.
This duration mismatch causes the S&L case at
risk if the interest rates change significantly.
6-19
 Duration-Based Hedging (cont'd)
• The duration of an investment portfolio is the
value-weighted average of the durations of
each investment in the portfolio.
• A portfolio with two assets of market values A
and B and its durations DA and DB respectively,
has the following Duration of Portfolio, DA+B :

𝐴 𝐵
𝐷 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜= 𝐷 𝐴 +𝐵 = × 𝐷 𝐴+ × 𝐷𝐵
𝐴+ 𝐵 𝐴+ 𝐵
𝐴 𝑠𝑠 𝐿 𝑖𝑎𝑏
𝐷 𝐸𝑞𝑢𝑖𝑡𝑦 =𝐷 𝐴𝑠𝑠𝑒𝑡 − 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 𝐷 𝐴𝑠𝑠𝑒𝑡 − 𝐷 𝐿 𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐴 𝑠𝑠− 𝐿𝑖𝑎𝑏 𝐴 𝑠𝑠− 𝐿𝑖𝑎𝑏

6-20
Example 6.3: Market-Value Balance Sheet for
Acorn Savings and Loan
The following slide shows the market-value balance sheet for
Acorn company Savings and Loan.
Modified

6-21
Duration-Based Hedging (cont'd)
• The duration of Acorn’s assets is

• The duration of Acorn’s liabilities is

6-22
 Duration-Based Hedging (cont'd)
• The duration of Acorn’s equity , :

• Thus, if interest rates increase by 1%, the value

of Acorn’s equity will decrease by about 40.67%,
or,
• If interest rates decrease by 1%, the value of
Acorn’s equity will increase by about 40.67%.
6-23
 Duration-Based Hedging (cont'd)
Why? When interest rate increases by 1%, the decline in the
equity value occurs as a result of:
• Acorn’s assets value decreases by $16 million,
• Acorn’s liabilities value decreases by $9.9 million,
• Acorn’s equity value declines = ($16.0mil - $9.9mil)
=$6.1 million, which equals to 40.67% x 15 million =$6.1
mil. (Not favorable for equity value to be decreased)

Estimation steps:
• Assets value decrease = 5.33% x $300mil = $16mil
• Liabilities value decrease =3.47% x $285mil= $9.9mil
• Acorn’s equity value decrease = (-$16–(-$9.9))mil ∕
$15mil = $6.1mil ∕ $15mil = 40.67%

6-24
 Duration-Based Hedging (cont'd)
• To fully protect its equity value fluctuate from an
overall increase or decrease in the level of interest
rates, Acorn needs to achieve an equity duration
of zero.
• A portfolio with a zero duration is called a
duration-neutral portfolio or immunized
portfolio, which means that for small interest rate
fluctuations, the value of equity should remain
unchanged.
• Adjusting a portfolio to make its duration zero is
referred to as immunizing the portfolio.

6-25
Duration-Based Hedging (cont'd)

• To make its equity duration neutral, Acorn

company must decrease the duration of its
assets , OR increase the duration of its
liabilities.

• The firm can lower the duration of its assets, by

selling some of its mortgages in exchange for
cash.

𝐶h𝑎𝑛𝑔𝑒𝑖𝑛𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛×𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜𝑉𝑎𝑙𝑢𝑒
𝐴𝑚𝑜𝑢𝑛𝑡𝑡𝑜 𝐸𝑥𝑐h𝑎𝑛𝑔𝑒=
𝐶h𝑎𝑛𝑔𝑒𝑖𝑛 𝑨𝒔𝒔𝒆𝒕 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛

6-26
Example 6.3: Market-Value Balance Sheet for
Acorn Savings and Loan

Reduce assets duration

5.33

Or, increase liability duration

3.47
So that Equity value immunized by
achieve zero duration. 40.7

6-27
Duration-Based Hedging (cont'd)
• Suppose Acorn would like to reduce the duration
of its equity from 40.7 to 0.
• The duration of the mortgages will change
from 8 to 0 if Acorn sells all mortgages for cash.

• Thus, Acorn must sell $76.3 million worth of

mortgages for cash.

6-28
Example 6.3: Market-Value Balance Sheet for
Acorn Savings and Loan

Plus $76.3 mil

Minus $76.3 mil

5.33

3.47

𝐶h𝑎𝑛𝑔𝑒𝑖𝑛𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛×𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜𝑉𝑎𝑙𝑢𝑒
𝐴𝑚𝑜𝑢𝑛𝑡𝑡𝑜 𝐸𝑥𝑐h𝑎𝑛𝑔𝑒=
𝐶h𝑎𝑛𝑔𝑒𝑖𝑛 𝑨𝒔𝒔𝒆𝒕 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
6-29
 Duration-Based Hedging (cont'd)
Proof:
• If Acorn does so, the duration of its assets will
decline to
Increase cash balance Decrease mortgage holdings
10+76.3 120 170 − 76.3
𝐷 𝐴= ×0 + × 2+ × 8=𝟑 .𝟑𝟎 𝒚𝒆𝒂𝒓𝒔
300 300 300

• Hence, the equity duration will fall to

300 285
𝐷𝐸= ×3.30 − × 3.47=𝟎 𝒚𝒆𝒂𝒓𝒔
(300 − 285) ( 300 − 285 )

6-30
Example 6.3 Market-Value Balance Sheet for
Acorn Savings and Loan After Immunization

5.33

40.7

6-31
Duration-Based Hedging (cont'd)
Duration matching has three important limitations:
1) The duration of a portfolio depends on the current
interest rate. Thus, maintaining a duration-
neutral portfolio will require constant adjusting
when interest rates change.
2) A duration-neutral portfolio is protected only
against parallel shifts in the asset yield curve,
which means the interest rates with different
maturity dates change at the same rate.
3) A duration-neutral portfolio is protected only
against assets that have same credit risks.

6-32
Hedging interest cash flows

• Forward rate agreement

• Interest rate swap

• Examples in tutorial questions

6-33
Forward rate agreement

• An FRA is a forward agreement on interest rates relating to

a notional loan or deposit. The loan or deposit is for a
stated period, such as two months, three months, six
months and so on, starting at a specified time in the future.
• In the terminology of the markets, an FRA on a notional
three-month loan/deposit starting in five months time is
called a “5X8 FRA” (or “5v8 FRA”). Loan period

0 5 8
FRA origination date FRA settlement date End of FRA

• When an FRA reaches its settlement date (usually the start

of the notional loan or deposit period), the buyer and seller
must cash settle the contract.
• Only the difference in interest rates is paid. The principal is
not exchanged.
6-34
Forward rate agreement (cont.)

• Borrowing (hence concerned about interest rate rises)

– The firm will borrow the required sum on the target date and will thus
contract at the market interest rate on that date.
– Separately the firm will buy a matching FRA from a bank or other
market maker and thus receive compensation if rates rise.
– If FRA rate>market interest rate, buyer of FRA makes a cash payment
to the seller; or, vice versa.
• Depositing (hence concerned about a fall in interest rates)
– The firm will deposit the required sum on the target date and will thus
contract at the market interest rate on that date.
– Separately the firm will sell a matching FRA to a bank or other market
maker and thus receive compensation if rates fall.
– If market interest rate>FRA rate, seller of FRA makes a cash payment
to the buyer; or, vice versa.
• In each case this combination effectively fixes the rate.
6-35
Interest rate swap

• An interest rate swap is an agreement whereby the parties agree

to swap a floating stream of interest payments for a fixed stream
of interest payments and vice versa. There is no exchange of
principal.
• The companies involved are termed “counter-parties”.
• Swaps can be used to hedge against an adverse movement in
interest rates. Say a company has a $200m floating loan and the
treasurer believes that interest rates are likely to rise over the
next five years. He could enter into a five-year swap with a
counter party to swap into a fixed rate of interest for the next
five years. From year six onwards, the company will once again
pay a floating rate of interest.
• A swap can be used to obtain cheaper finance. A swap should
result in a company being able to borrow what they want at a
better rate under a swap arrangement, than borrowing it directly
themselves.
6-36
THE END

6-37