CHAPTER 9

Interest Rate Risk II

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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
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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 $1790.85 in five years. Bond B pays $3207.14 in ten years, and both are currently priced at $1000.
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Example continued...
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).

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.

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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.
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Remarks on Preceding Slides

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

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Extreme Examples With Equal Maturities

Consider two ten-year maturity instruments:
A ten-year zero coupon bond A two-cash flow bond that pays $999.99 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
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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
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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

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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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Semiannual Cash Flows

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:

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Duration of Zero-coupon Bond

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

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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

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Duration of 2-year, 8% bond: Face value = $1,000, YTM = 12%

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)
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1,040 823.777

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

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Features 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

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

Note the direct linear relationship between P and -D

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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

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Semi-annual Coupon Payments

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

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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

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 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

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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 $1019.70 $1000 $19.70 2 2.000

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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
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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
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Immunizing the Balance Sheet of an FI

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 = [-DAA + DLL] DR/(1+R) or

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

The formula shows 3 effects:
Leverage adjusted D-Gap The size of the FI The size of the interest rate shock

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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%). 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.

Methods of immunizing balance sheet.

Adjust DA , DL or k.
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Immunization and Regulatory Concerns

Regulators set target ratios for an FIs 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
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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

More complex if nonparallel shift in yield curve

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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.
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*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.
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*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. CX = Scaling factor [capital loss from 1bp rise in yield + capital gain from 1bp fall in yield] Commonly used scaling factor is 108
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*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
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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 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

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

www.wsj.com

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