BFC5280 Institutional asset and liability management

The Duration Model - Tutorial questions

Source: Prescribed text (Saunders and Cornett, 2018)
Priority Questions: 3, 4, 5, 10

1. What are the two different general interpretations of the concept of duration, and what
is the technical definition of this term? How does duration differ from maturity?

2. A one-year, $100,000 loan carries a coupon rate and a market interest rate of 12
percent. The loan requires payment of accrued interest and one-half of the principal at
the end of six months. The remaining principal and accrued interest are due at the end
of the year.

a. What will be the cash flows at the end of six months and at the end of the year?

b. What is the present value of each cash flow discounted at the market rate? What is
the total present value?

c. What proportion of the total present value of cash flows occurs at the end of six
months? What proportion occurs at the end of the year?

d. What is the duration of this loan?

3. Two bonds are available for purchase in the financial markets. The first bond is a two-
year, $1,000 bond that pays an annual coupon of 10 percent. The second bond is a two-
year, $1,000, zero-coupon bond.

a. What is the duration of the coupon bond if the current yield to maturity (R) is 8
percent? 10 percent? 12 percent? (Hint: You may wish to create a spreadsheet
program to assist in the calculations.)

b. How does the change in the yield to maturity affect the duration of this coupon bond?

c. Calculate the duration of the zero-coupon bond with a yield to maturity of 8 percent,
10 percent, and 12 percent.

d. How does the change in the yield to maturity affect the duration of the zero-coupon
bond?

e. Why does the change in the yield to maturity affect the coupon bond differently
than it affects the zero-coupon bond?

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4. Consider three Treasury bonds each of which has a 10 percent semiannual coupon and
trades at par.

a. Calculate the duration for a bond that has a maturity of four years, three years, and two
years.

b. What conclusions can you reach about the relationship between duration and the
time to maturity? Plot the relationship.

5. Maximum Pension Fund is attempting to manage one of the bond portfolios under its
management. The fund has identified three bonds that have five year maturities and
trade at a yield to maturity of 9 percent. The bonds differ only in that the coupons are 7
percent, 9 percent, and 11 percent.

a. What is the duration for each bond?

b. What is the relationship between duration and the amount of coupon interest that is
paid? Plot the relationship.

6. What is dollar duration? How is dollar duration different from duration?

7. The duration of an 11-year, $1,000 Treasury bond paying a 10 percent semiannual

coupon and selling at par has been estimated at 6.763 years.

a. What is the modified duration of the bond? What is the dollar duration of the bond?

b. What will be the estimated price change on the bond if interest rates increase 0.10
percent (10 basis points)? If rates decrease 0.20 percent (20 basis points)?

c. What would the actual price of the bond be under each rate change situation in part
(b) using the traditional present value bond pricing techniques? What is the amount
of error in each case?

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8. Suppose you purchase a six-year, 8 percent coupon bond (paid annually) that is priced
to yield 9 percent. The face value of the bond is $1,000.

a. Show that the duration of this bond is equal to five years.

b. Show that if interest rates rise to 10 percent within the next year and your
investment horizon is five years from today, you will still earn a 9 percent yield on
your investment.

c. Show that a 9 percent yield also will be earned if interest rates fall next year to 8
percent.

9. If an FI uses only duration to immunize its portfolio, what three factors affect changes
in the net worth of the FI when interest rates change?

10. Financial Institution XY has assets of $1 million invested in a 30-year, 10 percent

semiannual coupon Treasury bond selling at par. The duration of this bond has been
estimated at 9.94 years. The assets are financed with equity and a $900,000, two-year,
7.25 percent semiannual coupon capital note selling at par.

a. What is the leverage adjusted duration gap of Financial Institution XY?

b. What is the impact on equity value if the relative change in all market interest rates
is a decrease of 20 basis points? Note: The relative change in interest rates is
∆R/(1+R/2) = -0.0020.

c. Using the information calculated in parts (a) and (b), what can be said about the
desired duration gap for the financial institution if interest rates are expected to
increase or decrease.

d. Verify your answer to part (c) by calculating the change in the market value of
equity assuming that the relative change in all market interest rates is an increase of
30 basis points.

e. What would the duration of the assets need to be to immunize the equity from
changes in market interest rates?

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11. The balance sheet for Gotbucks Bank, Inc. (GBI), is presented below ($ millions):

Assets Liabilities and Equity

Cash $30 Core deposits $20
Federal funds 20 Federal funds 50
Loans (floating) 105 Euro CDs 130
Loans (fixed) 65 Equity 20
Total assets $220 Total liabilities and equity $220

Notes to the balance sheet: The fed funds rate is 8.5 percent, the floating loan rate is LIBOR
+ 4 percent, and currently LIBOR is 11 percent. Fixed rate loans have five-year maturities,
are priced at par, and pay 12 percent annual interest. The principal is repaid at maturity. Core
deposits are fixed rate for two years at 8 percent paid annually. The principal is repaid at
maturity. Euro CDs currently yield 9 percent.

a. What is the duration of the fixed-rate loan portfolio of Gotbucks Bank?

b. If the duration of the floating-rate loans and fed funds is 0.36 year, what is the
duration of GBI’s assets?

c. What is the duration of the core deposits if they are priced at par?

d. If the duration of the Euro CDs and fed funds liabilities is 0.401 year, what is the
duration of GBI’s liabilities?

e. What is GBI’s duration gap? What is its interest rate risk exposure?

f. What is the impact on the market value of equity if the relative change in all interest
rates is an increase of 1 percent (100 basis points)? Note that the relative change in
interest rates is ∆R/(1+R) = 0.01.

g. What is the impact on the market value of equity if the relative change in all interest
rates is a decrease of 0.5 percent (-50 basis points)?

h. What variables are available to GBI to immunize the bank? How much would each
variable need to change to get DGAP equal to zero?

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No reproduction or distribution without the prior written consent of McGraw-Hill Education.