Interest Rate Management

FIN 683
Financial Institutions Management

Measuring and Managing
Interest-Rate Risk
Professor Robert B.H. Hauswald
Kogod School of Business, AU
Cash-Flow Based Interest-Rate

Risk Measurement
Market-value based models for assessing and
managing interest rate risk: beats accounting!
Duration
Computation of duration
Economic interpretation
Immunization using duration: balance-sheet

management for financial institutions
Problems in applying duration
9/18/2012
Duration and Immunization Robert B.H. Hauswald
Price Sensitivity and Maturity

The sensitivity to interest rate changes
rises in the term to maturity: more cash flow(s)
affected by the change in yield (discount rate)
falls in the coupon (interest payment)
Suppose the zero coupon yield curve is flat

at 12%: consider two zero bonds
Bond A pays $1790.85 in five years.
Bond B pays $3207.14 in ten years, and both
are currently priced at $1000.
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The Power of Discounting

Bond A: P = $1000 = $1790.85/(1.06)10
Bond B: P = $1000 = $3207.14/(1.06)20
Now suppose the annual interest rate increases

by 1% (0.5 % semiannually): parallel shift
Bond A: P = $1762.34/(1.065)10 = $954.03
Bond B: P = $3105.84/(1.065)20 = $910.18
The longer bond has the greater drop in price

the payment is discounted a greater number of times.
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Coupon Effect
Different coupons, same maturity
Bonds with identical maturities respond differently
to interest rate changes when the coupons differ.
Notice that any coupon bond simply consists

of a bundle of zero-coupon bonds.
With higher coupons, more of the bonds value is
generated by earlier cash flows
Consequently, it is less sensitive to changes in R
again: the power of discounting
9/18/2012
Fixed-Income Instruments
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
9/18/2012
Hypothetical Example
Consider two ten-year maturity instruments:
Small changes in yield will have
A ten-year zero coupon bond

A two-cash flow bond that pays $999.99 almost
immediately and one penny ten years hence
a large effect on the value of the zero
but almost no impact on the hypothetical bond
Most FI instruments fall between these extremes
the higher the coupon, the more similar it is to our

hypothetical bond
with higher value of cash flows arriving sooner
9/18/2012
Bond Value
Maturity and Bond-Price Sensitivity

Consider two otherwise identical
bonds.
The long-maturity bond will have
much more volatility with respect to
changes in the yield
Par
Short Maturity Bond
C
9/18/2012
Discount Rate
Long Maturity
Bond
8
Duration
Weighted average time to maturity using the
relative present values of cash flows as weights
takes into account the effects of differences in both
coupon rates and differences in maturity
Based on elasticity of bond price with respect to

interest rate: derivative scaled by bond price
simple differentiation of price function wrt yield
The units of duration are years: cash-flow

adjusted maturity
9/18/2012
Macaulay Duration
Formula
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
9-10
9/18/2012
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
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11
Semiannual Cash Flows

Important reminders:
we must express t in years (for consistency)
the present values are computed using the
appropriate periodic interest rate.
For semiannual cash flows, Macaulay

duration, D is equal to:
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12
Duration of Zero = Its Maturity

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

can you see why?
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13
Duration and IR Sensitivity
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14
Example
Consider a 2-year, 8% coupon bond face
value of $1,000 and yield-to-maturity of 12%
coupons are paid semi-annually: how many periods?
Therefore, each coupon payment is $40 and the

per period YTM is (1/2) 12% = 6%
yield already adjusted for semi-annual compounding
Present value of each cash flow equals CFt

(1+ 0.06)t where t is the period number
9/18/2012
15
Duration of 2-Year, 8% Bond:

Face Value = $1,000, YTM = 12%
t
years CFt
PV(CFt)
0.5
40
37.736
Weight W years
(W)
0.041
0.020
1.0
40
35.600
0.038
0.038
1.5
40
33.585
0.036
0.054
2.0
1,040 823.777
0.885
1.770
P = 930.698
1.000
D=1.883
(years)
9/18/2012
16
Duration: Special Cases

Consols (perps in the jargon): perpetual
bonds issued by governments, e.g., UK
if c and y are the coupon and yield: its price?
Maturity of a consol: M = .
Duration of a consol: D = 1 + 1/R
Floating rate note or any other variableinterest fixed-income instrument

duration = length of reset period
inverse floater: tricky and surprising
9/18/2012
17
Properties of Duration
Duration and maturity
D increases with M, but at a decreasing rate
Duration and yield-to-maturity

D decreases as yield increases
Duration and coupon interest

D decreases as coupon increases
Duration is additive: how fortunate!

9/18/2012
18
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
9/18/2012
19
Duration and Yield Sensitivity

dP
= P Modified Duration
dy
$
Duration is related to the rate of change

in a bonds price as its yield changes:
linear (first-order) approximation of
price changes in yield - lets see what the
problem is
y
9/18/2012
20
Predicting Price Changes

1. Find Macaulay duration of bond
2. Find modified duration of bond
3. When interest rates change, the change in a bonds
price is related to the change in yield according to
P
*
100 = Dm y 100
P
Find percentage price change of bond

Find predicted dollar price change in bond
Add predicted dollar price change to original price of bond
Predicted new price of bond (or use XLS)
9/18/2012
21
Predicting Price Changes

To estimate the change in price, we can
express the previous equation as:
P = -D[R/(1+R)]P = -(MD) (R) (P)
Note the direct linear relationship between P and
-D : what does this imply?
9/18/2012
22
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
Allows us to compute the direct price
impact of yield or interest-rate changes
9/18/2012
23
Semi-annual Coupon Payments

With semi-annual coupon payments the
percentage change in price is given by
P/P = -D[R/(1+(R/2)]
As always, for more frequent compounding we
need to adjust
yield
number of (time) periods
9/18/2012
24
Managing Interest-Rate Risk

Measuring interest-rate exposure
duration:
potential problems?
Managing interest-rate exposure:

principle:
implementation?
Overall objective:
9/18/2012
25
Immunization
Matching the maturity of an asset investment
with a future payout responsibility
does not necessarily eliminate interest rate risk
but introduces fundamental principle: match
assets and liabilities along risk sensitivity
Matching durations will immunize against

changes in interest rates
why?
9/18/2012
26
Small Business Lending: in Ks

Consider three loan plans, all of which have
maturities of 2 years.
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.
9/18/2012
27
Duration as Index of Interest Rate Risk

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
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$1019.70 $1000 $19.70 2 2.000
28
Balance-Sheet Immunization
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
Result?
9/18/2012
29
Duration Gap
A simple FI balance sheet:
a 2-year coupon bond is the only loan asset (A)
a 2-year certificate of deposit itsonly liability (L)
If the duration of the 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
9/18/2012
30
Immunizing the Balance Sheet

Duration Gap: the DGAP
From the balance sheet, E = A L; therefore,
E = A L
reflects what management priority?
Like for changes in bond prices, we can find
the change in value of equity using duration.
E = [-DAA + DLL] R/(1+R), or
E = [DA - DLk]A(R/(1+R))
9-31
9/18/2012
Duration and Immunizing

The formula shows 3 effects:
Leverage adjusted D-Gap
The size of the FI
The size of the interest rate shock
How does each factor affect the value of a

financial institution?
leverage:
size:
interest-rate shock:
9/18/2012
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An Example
Suppose DA = 5 years, DL = 3 years and rates
are expected to rise from 10% to 11%.
Rates change by 1%
balance sheet: A = 100, L = 90 and E = 10..
Find change in E
= [DA - DLk]A[R/(1+R)]
= -[5 - 3(90/100)]100[.01/1.1] = - $2.09.
Methods of immunizing balance sheet

simply adjust DA , DL or k: what is least expensive?
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Immunization and Regulation

Regulators set target ratios for an FIs
capital (net worth): immunize capital ratio
Capital (Net worth) ratio = E/A
If target is to set (E/A) = 0: DA = DL
accept without proof
But, to set E = 0:
DA = kDL
Who should managers make happy?

shows what?
9/18/2012
34
Limitations of Duration
Immunizing the entire balance sheet need not be
costly: why not that expensive for FIs?
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 changes not accurately captured
Convexity
More complex if nonparallel shift in yield curve

stylized facts on term structure of interest rates (TSIR)?
9/18/2012
35
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.
9/18/2012
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Convexity
Remember calculus? linear approximations
notice that duration involves only the first
derivative of the price function.
Improve on the estimate using a second-order

Taylor expansion: higher-order approximation
in practice, the expansion rarely goes beyond
second order (using the second derivative).
This second order expansion is the convexity

adjustment.
9/18/2012
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Pricing Error and Convexity

Price
Pricing error due to
P
= DM y
P
Convexity
Duration
Yield
9/18/2012
38
Modified Duration & Convexity

Second-order approximation using convexity:
P/P = -D[R/(1+R)] + (1/2) CX (R)2 or
P/P = -MD R + (1/2) CX (R)2
where MD is 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

9/18/2012
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Calculation of CX
Convexity of a 8% coupon, 8% yield, six-year
maturity Eurobond priced at $1,000 (why??)
CX = 108[P-/P + P+/P]
= 108[(999.53785-1,000)/1,000 +
(1,000.46243-1,000)/1,000)]
= 28
9/18/2012
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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
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Contingent Claims
Interest rate changes also affect value of offbalance 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
In fact: derivatives widely used to adjust

duration, i.e., interest-rate exposure
9/18/2012
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Summary
Duration and convexity are market-value DCF
based measures of interest exposure
basis for FIs risk and balance-sheet management
Adjusting duration gap:

derivatives
product pricing: how to shorten duration?
Tension between shareholders and regulators

objective: apparent conflict of interest
but do shareholders really want to be immunized?
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Pertinent Websites
www.bis.org
Bank for International
Settlements
Securities Exchange
Commission
The Wall Street Journal
9/18/2012
www.sec.gov
www.wsj.com
44

Interest Rate Management

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FIN 683

Financial Institutions Management

Cash-Flow Based Interest-Rate

Immunization using duration: balance-sheet

Duration and Immunization Robert B.H. Hauswald

Price Sensitivity and Maturity

Suppose the zero coupon yield curve is flat

Duration and Immunization Robert B.H. Hauswald

The Power of Discounting

Now suppose the annual interest rate increases

The longer bond has the greater drop in price

Duration and Immunization Robert B.H. Hauswald

Notice that any coupon bond simply consists

Duration and Immunization Robert B.H. Hauswald

Duration and Immunization Robert B.H. Hauswald

Consider two ten-year maturity instruments:

Small changes in yield will have

A ten-year zero coupon bond

Most FI instruments fall between these extremes

the higher the coupon, the more similar it is to our

Duration and Immunization Robert B.H. Hauswald

Maturity and Bond-Price Sensitivity

Duration and Immunization Robert B.H. Hauswald

Based on elasticity of bond price with respect to

The units of duration are years: cash-flow

Duration and Immunization Robert B.H. Hauswald

Duration and Immunization Robert B.H. Hauswald

Notice the weights correspond to the

Duration and Immunization Robert B.H. Hauswald

Semiannual Cash Flows

For semiannual cash flows, Macaulay

Duration and Immunization Robert B.H. Hauswald

Duration of Zero = Its Maturity

For all other bonds, duration < maturity

Duration and Immunization Robert B.H. Hauswald

Duration and IR Sensitivity

Duration and Immunization Robert B.H. Hauswald

Therefore, each coupon payment is $40 and the

Present value of each cash flow equals CFt

Duration and Immunization Robert B.H. Hauswald

Duration of 2-Year, 8% Bond:

Duration and Immunization Robert B.H. Hauswald

Duration: Special Cases

Floating rate note or any other variableinterest fixed-income instrument

Duration and Immunization Robert B.H. Hauswald

Duration and yield-to-maturity

Duration and coupon interest

Duration is additive: how fortunate!

Duration and Immunization Robert B.H. Hauswald

Duration and Immunization Robert B.H. Hauswald

Duration and Yield Sensitivity

Duration is related to the rate of change

Duration and Immunization Robert B.H. Hauswald

Predicting Price Changes

Find percentage price change of bond

Duration and Immunization Robert B.H. Hauswald

Predicting Price Changes

Duration and Immunization Robert B.H. Hauswald

Using dollar duration, we can compute the

Duration and Immunization Robert B.H. Hauswald

Semi-annual Coupon Payments

Duration and Immunization Robert B.H. Hauswald

Managing Interest-Rate Risk