125.364 Week 05

SCHOOL OF ECONOMICS & FINANCE
Week 05
Interest Rate Risk part 2 : Duration Model
Textbook Chapter 09
1
Introduction
• The major weakness of repricing model is its reliance on book values.
• Duration gap model solve the problem by taking into account:

– Market values
– Timing of cash flows
– Asset’s or liability’s maturity
– Degree of leverage on B/S
• It is a more complete measure of interest rate sensitivity compared to

the maturity gap.
2
Duration
• The weighted-average time to maturity of a series of cash flows,
using the relative present values of the cash flows as weight.
• Annual coupon bond:
N N CFt  t N
Total time-weighted
 CFt  DFt  t t 1 1  R 
t  PVt  t PV of cash flows
D N t 1
 N  t 1N
CFt
 CFt  DFt   PVt
t 1 1  R 
t Total PV of cash
t 1 t 1
where: flows
D = duration measured in years
N = the last period in which the cash flow is received
CFt = cash flow received on the security at the end of period t
DFt = the discount factor = 1/(1+R)t
PVt = present value of cash flow at the end of period n = CFt × DFt
3
Duration (cont.)
• Semi-annual coupon bond:
N CFt  t

t
D N
1
1 R2
2  2t

CFt

t 1 R
1 2
2  2t

For all other bonds, duration < maturity
• Zero coupon bond:

– Duration = maturity, since 100% of its PV is generated by the
payment of the face value at maturity.
• Consol1 bond (perpetuity, M=∞):
D 1
R
4
Duration (cont.)
• Assumptions for the duration model:
– Yield curve or term structure of interest rates is
flat.
– When rates change, the yield curve shifts in a
parallel fashion.
– No default risk.
5
Example 1
Consider a security with annual cash flows of $10 000 and a time to maturity
of three years. The current interest rate is 8 per cent p.a.
1) What is the security's duration?
t CFt CFt / (1+R)t CFt / (1+R)t ×t Weight

1 $10 000 $9 259 $9 259
2 $10 000 $8 573 $17 146
3 $10 000 $7 938 $23 814
∑ = $25 770 ∑ = $50 219
D = 50,219/25,770 = 1.95 years 6

t CFt CFt / (1+R)t CFt / (1+R)t ×t Weight

1 $10 000 $9 259 $9 259 0.36
2 $10 000 $8 573 $17 146 0.33
3 $10 000 $7 938 $23 814 0.31
∑ = $25 770 ∑ = $50 219 1
2) Why the duration of the security is shorter than its maturity?
Duration is less than maturity because heavier weight is placed on

earlier cash flows.
D = (9259/25770×1) + (8573/25770×2) + (7938/25770×3) = 1.95
years 7
Example 2
Refer to Example 1. Assume now that instead of paying
$10,000 annually, the security pays semi-annual cash flows of
$5,000 each year for 3 years. What is the duration in this case?
t CFt CFt / (1+R)t CFt / (1+R)t ×t Note now R is the semi-
0.5 $5,000 $4 808 $2 404 annual rate and t is the
number of 6-months.
1 $5,000 $4 623 $4 623
1.5 $5,000 $4 445 $6 668
2 $5,000 $4 274 $8 548
D = 44374/26212 =
2.5 $5,000 $4 110 $10 275
1.69 years, shorter
3 $5,000 $3 952 $11 856 than D in last
∑ = $26 212 ∑ = $44 374 example.
8
Features of Duration
• Duration and yield
– Duration decreases as yield increases, and vice versa.
– Higher yield discount later cash flows more heavily and the
weighting of those later cash flows decline when compared
to earlier cash flows.
• Duration and maturity
– Duration increases as maturity of a fixed income asset or
liability increases.
– However, it increases at a decreasing rate.
9
Features of Duration (cont.)

• Duration and coupon interest
– The higher the coupon rate, the lower the duration, and
vice versa.
– The larger the coupon payment, the quicker cash flows are
received and the higher the present value weights of those
cash flows in the duration calculation.
10
Economic Meaning of Duration

• Duration directly measures the interest sensitivity of an asset or
liability: P  R 
 D     MD  R
P 1R 
Bond prices move in an
Where: inversely proportional fashion
according to the size of
∆P = the price change of assets or liabilities duration (for small changes in
∆R = the change of interest rate interest rate).
MD = modified duration = D/(1+R)
• For semi-annual coupon bond:
P  R 
 D   
P 1 2R 
1
11
Economic Meaning of Duration (cont.)

• Duration measure the percentage change in the price
of a security for a change in the return on security.
• Dollar duration is the dollar value change in the
price of a security for a change in the return on
security.
– Dollar duration = MD × P
• Total value change in the value of security:
– ΔP =  dollar duration × ΔR
12
Example 3
Refer to Example 1. The price of the bond is
$25,770, its duration is 1.95 years and the
interest rate is 8% p.a.
13
1) What happens to the price of the bond if interest rate increases by 1% p.a.?
P  0.01 
 1.95   0.0181  1.81%
P  1  0.08 
P  1.81%  25770  $466
 1.95
or , MD   1.81
1.08
dollar duration  MD  P  1.81 25770  $46,644
P  46,644  0.01  $466
Check: What is the accurate price change?

1
3 1 
10000 1 .09 3
Decrease in price predicted by
P'    10000   $25,313
t 1 1 .09 0 .09 duration model is over-
P  25313  25770  $457 estimated.
14
2) What happens to the price of the bond if the interest decreases

by 1% p.a.?
P   0.01 
 1.95   0.0181  1.81%
P  1  0.08 
P  1.81%  25770  $466
Check: what is the accurate price change?

1
1 3
P'  10000  1 .07  $26,243
0.07
P  26243  25770  $473 Increase in price predicted by
duration model is under-estimated.
15
3) What do you find from the answers above?
• The gains and losses under the duration model are

symmetrical. Any percentage change in the price would be
proportionate with change in duration.
• However, the actual gain and loss are not symmetrical. We’ll
come back to this issue later.
16
Duration and Immunising Future Payments
• To provide a certain amount of future

payments no matter what happens to interest
rates in immediate future:
– Matching the maturity of zero-coupon bonds to
investment horizon, or
– Matching the duration of coupon bonds to
investment horizon.
• The gains (losses) on reinvestment income are exactly
offset by the losses (gains) from bond proceeds on sales.
17
Example 4
Suppose you purchase a 5-year, 15% annual coupon bond that
is prices to yield 9%. The face value of the bond is $1000.
1)t What
CF ($) is the PV
duration
of CF ($)of this
PV ofbond?
CF × t ($)
1 150 137.62 137.62
2 150 126.25 252.50
3 150 115.38 347.48
4 150 106.26 425.06
5 1150 747.42 3737.10 Duration =
4899.76/1233.38 = 3.97 ≈
$1233.38 $4899.76 4 years
18
2) Show that if interest rates rise to 10% within the next year and your investment
horizon is 4 years from today, you will still earn a 9% yield on your investment.
Value of bond at end of year 4:

PV = (150+1000)/1.1 = $1045.45
1.14  1
Future value of interest payment at end of year 4: FV  150   $696.15
0.1
Future value of all cash flows at end of year 4:

(1) Coupons = $150×4 = $600
(2) Reinvestment income = $96.15
(3) Bond sale proceeds = $1045.45
Total income = $1741.6
Yield:
r = (1741.6/1233.38)1/4 – 1 = 0.09 = 9% 19
3) Show that a 9% yield also will be earned if interest rates fall next year to 8%.
Value of bond at end of year 4:

PV = (150+1000)/1.08 = $1064.81
Future value of interest payment at end of year 4:

1.08 4  1
FV  150   $675.92
0.08
Future value of all cash flows at end of year 4:

(1) Coupons = $150×4 = $600
(2) Reinvestment income = $75.92
(3) Bond sale proceeds = $1064.81
Total = $1740.73
Yield:
r = (1740.73/1233.38)1/4 – 1 = 0.09 = 9% 20
Duration and Immunising Balance Sheet

• Duration can be used to measure an FI’s duration
gap.
• Duration of the asset or liability portfolio is the
market value weighted-average of the individual
duration of the assets or liabilities on the B/S:
– Asset portfolio: DA  X 1 AD1A  X 2 AD2A  ...  X nADnA
DL  X 1LD1L  X 2LD2L  ...  X nLDnL
– Liability portfolio:
• Duration gap = DA - DL
21
• We know: A R
 DA 
ALE A 1  R 
A  L  E L R
 DL 
E  A  L L 1  R 
• The change in FI’s market value of equity for a change in interest rates:
 R   R 
E   DA  A   
  L D  L 
 (1  R )   (1  R) 
If the level of interest rate and expected shock to interest rates are the
same for both assets and liabilities, then:
R
E  DA  DL k  A 
(1  R)
Where k = L/A (a measure of FI’s leverage)

22
Duration and Immunising Balance Sheet (cont.)
• The effect of interest rate changes on the market value

of an FI's net worth breaks down into three effects:
– Leverage adjusted duration gap = [DA – kDL]. It measures
the degree of duration mismatch in B/S.
– Size of FI = A. It measures the dollar size of the potential
net worth exposure from interest rate shock.
– Size of interest rate shock = ΔR/(1+R).
• ΔE = (leverage adjusted duration gap) × asset size ×
interest rate shock
23
Example 5
Consider the following B/S:
Assets Liabilities
A = $100 L = $80
E = $20
TA = $100 TL + E = $100
Assume that the average duration of assets is 7 year, while the average duration
of liabilities is 4 years. The current interest rate is 10%, but is expected to
increase to 11% in the future. What is the expected change in FI’s net worth?
ΔE = –(7 – 4×80/100) × 100 × (0.01/1.1) = -$3.45

FI could loss $3.45 in net worth if interest rate increase by 1%.
24
Duration and Immunising Balance Sheet (cont.)
• Potential strategies for FI to immunise the B/S (i.e. to

make ΔE = 0, i.e. to set DA = kDL):
– Reduce DA (equal to kDL)
– Reduce DA and increase DL
– Change k and DL
• If the goal is to immunise against change in capital
ratio (ΔE/A) instead of change in net worth (ΔE), then
the strategy is to set DA = DL.
25
Example 6
The balance sheet for Gotbuck Bank Inc. (GBI), is presented below
($million): Assets Liabilities and equity
Cash $30 Core deposits $20
Interbank lending 20 Interbank borrowing 50
Loans (floating) 105 Euro CDs 130
Loans (fixed) 65 Equity 20
Total assets $220 Total liabilities and equity $220
• Interbank cash rate: 8.5%

• Floating loan rate: BBR+4% (current BBR: 11%)
• Fixed rate loans: 5-year maturity, priced at par, pay 12% annual interest,
principal is repaid at maturity.
• Core deposits: fixed rate for 2 years at 8% paid annually, principal is repaid
at maturity. 26
1) What is the duration of the fixed-rate loan portfolio?
Par=$65, coupon rate=12%, annual payment=$7.8,

R=12%, maturity=5 years
t CF PV of CF PV of CF×t
1 $7.8 $6.964 $6.964
2 7.8 6.218 12.436
3 7.8 5.552 16.656
4 7.8 4.957 19.828
5 65+7.8 41.309 206.543
$65 $262.427
Duration = 262.427/65 = 4.0373 years 27

Example 6
2) If the duration of the floating-rate loans and
interbank lending is 0.36 year, what is the duration of
GBI’s assets? Note the duration of cash is zero.
30 20 105 65
DA  0   0.36   0.36   4.0373
220 220 220 220
30  0  20  0.36  105  0.36  65  4.0373

220
 1.3974 years
28
Example 6
3) What is the duration of the core deposits if they are priced at par?
Par=$20, coupon rate=8%, annual payment=$1.6,

R=8%, maturity=2 years
1 $1.6 $1.481 $1.481
2 20+1.6 18.519 37.037
$20 $38.519
Duration = 38.519/20 = 1.9259 years

29
Example 6
4) If the duration for the Euro CDs and interbank
borrowing is 0.401 year, what is the duration of GBI’s
liabilities?
20 50 130
DL   1.9259   0.401   0.401
200 200 200
20  1.9259  50  0.401  130  0.401

200
 0.5535years
30
5) What is GBI’s leverage adjusted duration gap?
Leverage adjusted duration gap

= 1.3974 – 0.5535(200/220) = 0.8942 years
6) What is the impact on the market value of equity if the relative

change in all interest rates is an increase of 1% (100 basis points)?
Note that the relative change in interest is ΔR/(1+R) = 0.01.
ΔE = -[1.3974 – 0.5535(200/220)]×220m×0.01 = -$1.9673 million

E’ = 20,000,000 – 1,967,280 = $18.0327m
31
Example 6
7) What is the impact on the market value of equity if
the relative change in all interest rates is a decrease of
0.5% (-50 basis points)?
ΔE = -[1.3974 – 0.5535(200/220)]×220m×-0.005 =
$983,647
E’ = 20,000,000 + 983,647 = $20,983,647
32
8) How can GBI immunise the bank? How much would each variable need to
change to achieve the immunisation goal?
Immunisation requires GBI to have a leverage adjusted duration gap of 0.
a. Change duration of assets: 200

DA   0.5535  0
220
 DA  0.5035
200
b. Change duration of liabilities: 1.3974   DL  0
220
 DL  1.5371
c. Change leverage (L/A ratio): 1.3974  k  0.5535  0

 k  2.5247 Not feasible
Or other combination which makes DGAP=0. 33

Example 6
9) Assume that a goal is to immunise the ratio of equity
to total assets, that is, Δ(E/A) = 0. How would you
answer in last question change if it was the goal?
In this case, the duration of the assets and liabilities

should be equal, so either reduce the duration of assets
to 0.5535 year, or increase duration of liability to
1.3974 year.
34
Difficulties of Applying the Duration Model
1. Duration matching can be costly

– Other techniques (e.g. using derivatives) can be
used instead of rebalancing whole portfolio to
immunise against interest rate risk.
2. Immunisation is a dynamic problem
– It requires continuous rebalancing to match the
duration of investment portfolio with investment
horizon; there is trade-off between being perfectly
immunised and transaction costs.
35
Example 7
A FI has an investment horizon of two years 9.33
months (or 2.777 years). The FI has converted
all assets into a portfolio of 8%, $1,000 3-year
annual coupon bonds that are trading at a yield
to maturity of 10%.
36
Example 7
1) Is the portfolio immunised at the time of bond purchase? What is
the duration of the bonds?
1 $80 $72.73 $72.73
2 80 66.12 132.23
3 1080 811.42 2434.26
$950.26 $2639.22
Duration = 2639.22/950.26 = 2.777 years.

The bond investment horizon was immunised at the time of
purchase.
37
Example 7
2) Will the portfolio be immunised one year later?
1 $80 $72.73 $72.73
2 1080 892.56 1785.12
$965.29 $1857.85
Duration = 1857.85/965.29 = 1.9247 years.

After one year the investment horizon will be 1.777 years. At this
time the bonds will have a duration of 1.9247 years. Thus the
bonds will no longer be immunised.
38
Example 7
3) Assume that one-year, 8% zero-coupon bonds are available in one year.
What proportion of the original portfolio should be replaced in these bonds
to rebalance the portfolio?
Recall for zero coupon bond duration equals to maturity.
If we want to immunise the investment horizon of 1.777 years:

1.777 = x(1) + (1-x)(1.9247)
x=0.1597
Thus, 15.97% of the bond portfolio should be replaced with the zero-
coupon bonds after one year. 39
Difficulties of Applying the Duration Model

(cont.)
3. Large interest rate change and convexity
– Bond’s price-yield relationship is convex rather than linear as
assumed by duration model.
– For large interest rate increase (decrease), duration over-predict
(under-predict) the fall (increase) in bond price. That is, the capital
gain effect and capital loss effect is not symmetric as predicted by
duration model.
40
Duration model predicts symmetric effects for

rate increase and decrease on bond price.
The actual effects are not symmetric;

Capital gain effect > capital loss effect.
41

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SCHOOL OF ECONOMICS & FINANCE

• Duration gap model solve the problem by taking into account:

• It is a more complete measure of interest rate sensitivity compared to

• Zero coupon bond:

1) What is the security's duration?

t CFt CFt / (1+R)t CFt / (1+R)t ×t Weight

D = 50,219/25,770 = 1.95 years 6

t CFt CFt / (1+R)t CFt / (1+R)t ×t Weight

2) Why the duration of the security is shorter than its maturity?

Duration is less than maturity because heavier weight is placed on

Features of Duration (cont.)

Economic Meaning of Duration

Economic Meaning of Duration (cont.)

Check: What is the accurate price change?

2) What happens to the price of the bond if the interest decreases

Check: what is the accurate price change?

3) What do you find from the answers above?

• The gains and losses under the duration model are

Duration and Immunising Future Payments

• To provide a certain amount of future

Value of bond at end of year 4:

Future value of all cash flows at end of year 4:

Value of bond at end of year 4:

Future value of interest payment at end of year 4:

Future value of all cash flows at end of year 4:

Duration and Immunising Balance Sheet

Where k = L/A (a measure of FI’s leverage)

Duration and Immunising Balance Sheet (cont.)

• The effect of interest rate changes on the market value

ΔE = –(7 – 4×80/100) × 100 × (0.01/1.1) = -$3.45

Duration and Immunising Balance Sheet (cont.)

• Potential strategies for FI to immunise the B/S (i.e. to

• Interbank cash rate: 8.5%

1) What is the duration of the fixed-rate loan portfolio?

Par=$65, coupon rate=12%, annual payment=$7.8,

Duration = 262.427/65 = 4.0373 years 27

Par=$20, coupon rate=8%, annual payment=$1.6,

Duration = 38.519/20 = 1.9259 years

5) What is GBI’s leverage adjusted duration gap?

Leverage adjusted duration gap

6) What is the impact on the market value of equity if the relative

ΔE = -[1.3974 – 0.5535(200/220)]×220m×0.01 = -$1.9673 million

Immunisation requires GBI to have a leverage adjusted duration gap of 0.

a. Change duration of assets: 200

c. Change leverage (L/A ratio): 1.3974  k  0.5535  0

Or other combination which makes DGAP=0. 33

In this case, the duration of the assets and liabilities

Difficulties of Applying the Duration Model

1. Duration matching can be costly

Duration = 2639.22/950.26 = 2.777 years.

Duration = 1857.85/965.29 = 1.9247 years.

Recall for zero coupon bond duration equals to maturity.

If we want to immunise the investment horizon of 1.777 years:

Difficulties of Applying the Duration Model

Duration model predicts symmetric effects for

The actual effects are not symmetric;

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