UNSW Business School

FINS3630
Lecture 05

Interest Rate Risk II

(Chapter 9)
 Topics for discussion
We will discuss

Features of duration

Use duration to immunize a single security

Duration of a portfolio of assets

Use duration to immunize the whole balance sheet

Convexity.

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 Calculating Duration: Zero-Coupon Bond
Zero-coupon bonds, also called as pure discount bond
do not pay interim coupons and only pay the face value at maturity.
thus sell at discount (Deep Discount Bond)
Assume that you are investing in a zero-coupon bond with a face value of $1000
with a remaining time to maturity of two years. The annual yield to maturity is 12%.
What is the duration of the zero-coupon bond?

D = 2 years = time to maturity. Why?

2
 Calculating Duration: Consol Bond
Consol bonds have no maturity, i.e. they are a perpetuity.
Mc =
The duration formula of a consol bond:
Dc = 1 + 1/R
Exercise:
Consider a consol bond with a face value of $10,000. R = 10% p.a. What is the duration?
Dc = 1 + 1/0.1 = 11 years.
While the consol bonds maturity is infinite, its duration is finite.
The duration of a consol bond is independent of coupon rates and face values.
As interest rates rise (fall), the duration of consol bonds falls (rises).
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 Duration Model and Modified Duration
Duration is the proportional constant that relates percentage change in to a small change in
in the equation above.
If we know the duration of a debt instrument, we can calculate change in for a small change
in by:

=
When compounding frequency is times per period, then the duration relation becomes

=

We can define a modified duration to relate a percentage change in directly to a change in

interest rate, .

= =
Where = is called the Modified Duration

4
 Features of Duration
Duration increases with maturity but at a decreasing rate.
# #*
#$
> 0 '() #$*<0

This is the case for the vast majority of securities.

It needs to be noted, however, that for bonds selling below par, duration increases at a
decreasing rate up to a point. At long maturities (e.g., 50 years) duration starts to decline.
Few bonds in the market have a maturity long enough to see this decline.
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 Features of Duration
Duration decreases with yield
Duration increases as yield decreases, and decreases as yield increases.
+
<0
+
Intuitively, higher yields discount later cash flows more heavily and the relative
importance, or weights, of those later cash flows decline when compared with
earlier cash flows on an asset or liability.
Duration decreases with coupon rate
+
<0
+-
The higher coupon rate a bond pays, the lower its duration, and the more
frequent a bond pays coupons, the lower its duration.

6
 Duration and Immunizing a Single Security
Insurance company and pension fund managers face the risk that interest rates may
fall in the future so that the accumulated returns on the investment are insufficient to
meet the promised payment in the future.

Suppose we are in 2016 and an insurer has to make a guaranteed payment to a

policy holder in 2021. Assume this target guaranteed payment is $1,469, a lump-sum
payout on retirement, equivalent to investing $1,000 at an annually compounded rate
of 8% over five years.

To immunize, or protect, itself against interest rate risk, the insurer needs to
determine which investments would produce a cash flow of exactly $1,469 in five
years regardless of what happens to interest rates in the immediate future.

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 Buy Five-Year Maturity Discount Bonds
Suppose a 5-year discount bond has a face value of $1000 and the current market
yield is 8 percent with annual compounding. Then the current price per 5-year
discount bond would be
$ ///
=( = $680.58
./2)4

If the insurer bought 1.469 of these bonds at a total cost of $1,000 in 2016, these
investments would produce exactly $1000 (1.08)9 =$1,469 on maturity in fives
years.
Intuitively, since no intervening cash flows or coupons are paid by the issuer
of the discount bonds, future changes in interest rates have no reinvestment
income effect. Thus, the return would not be affected by intervening interest
rate changes.
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 What About Buying Coupon Bonds?
Sometimes, zero-coupon bonds may not be available.
What kind of coupon bonds should the insurer buy to immunize it against
change in interest rates?
The insurer should buy a coupon bond with duration that equals to the
length of the investment horizon.
In this example, the insurer should buy a coupon bonds with 5-year duration.
In general, matching the duration of a coupon bond or, any other fixed-
interest rate instruments to the FIs investment horizon immunizes the FI
against instantaneous shock to interest rates.

9
 Buy 5-Year Duration Coupon Bonds
Suppose there is a six-year maturity bond paying 8 percent coupons with an 8 percent yield to
maturity. The face value is $1,000. We can show that the duration of the bond is 4.993 years,
which is approximately 5 years.

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 Buy 5-Year Duration Coupon Bonds
If the insurer buys this bond in 2016 and hold it for five years, until 2021, at the same time, reinvests all
coupon payments at the market rate, the cash flow generated at the end of the five years will be $1,469
whether interest rates stay at 8 percent or instantaneously rise or fall.

If the interest rate stays at 8 percent, then

Coupons plus reinvestment income, >;?/ $80(1.08); = $469
$ /2/
Bond sale proceeds, 9 = = $1000
./2

If the interest rate immediately rises to 9 percent, then

Coupons plus reinvestment income, >;?/ $80(1.09); = $478
$ /2/
Bond sale proceeds, 9 = = $991
./A

If the interest rate immediately falls to 7 percent, then

Coupons plus reinvestment income, >;?/ $80(1.07); = $460
$ /2/
Bond sale proceeds, 9 = ./B
= $1009

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 Duration of the Asset and Liability Portfolios of an FI
For a FI, the durations of the asset and liability portfolio can be calculated as:

C =D C C + DFC FC+ + DHC HC

I =D I I + DFI FI + + DHI HI
where D;J is the market value proportion of each asset or liability held in the respective asset or liability
portfolios. H;? D;J = 1 for K=L MN O.

L=O+P where E is the net worth.

The FI is insolvent if E<0

Changes in interest rates causes changes in net worth

P = L O
How to immunize E against changes in interest rates, i.e. to make P =0 for small changes in
interest rates?
This is called immunization of the balance sheet.

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 Duration and Immunizing the Whole Balance Sheet (Cont.)
Calculate changes in the market values of assets and liabilities based on durations
R A RL
A = DA A L = DL L
(1 + R A ) (1 + RL )

Changes in equity values: R A RL

E = DA A DL L
(1 + R A ) (1 + RL )

Assuming the level of interest and expected shock to interest rates are the same for both
assets and liabilities, then: R
E = (D A D L k ) A
(1 + R )
Where k = L / A (a firms leverage measured in market values)
Important: every variables are market values rather than accounting ones
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 Duration and Immunizing the Whole Balance Sheet (Cont.)
R
E = (D A D L k ) A
(1 + R )
C IQ is called the leverage adjusted duration gap

Determinants of Interest rate exposure:

E = (Leverage adjusted duration gap) asset size interest rate shock
Generally the objective of risk management is to minimize the effect of interest rate changes on
firm value.
E = 0
I
Immunization requires C = I C

Note: setting C = I does not immunize P against interest rate changes because L>O. This is
also why leverage R matter for immunization.
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 Duration and Immunizing the Whole Balance Sheet
Suppose C = 5 years, I = 3 years and rates are expected to rise from 10% to 11%. (Rates
change by 1%). Also, the market value of A = $100 million and L = $ 90 million. Find the
change in E for the change in interest rate.
A/ ./
P = 5 3 100 =$2.09million
// .

The FI could lose $2.09 million in net worth if rate rises 1 percent
How can the FI manager immunize the net worth from interest rate risk in the above example?
Reduce C to 2.7
Reduce C and increase I

increase leverage (k )
There are infinite number of combinations to immunize the balance sheet.

15
 Immunization and Regulatory Considerations
Regulators usually set minimum target ratios for an FIs capital to assets. The simplest is the
ratio of FI capital to its assets, or:
X
-'TUV'W 'VUM =
C

FI managers may be more interested in immunizing against change in the capital ratio
X
(i.e. ) due to interest rate risk rather than changes in the level of capital (P).
C

To immunize the capital ratio, the FI manager needs to set

C= I
X I
Proof: =1 .
C C
X C I
To make = 0 when 0, we need = for any . This requires C = I.
C C I
X
The FI manager cannot immunize both P and ) simultaneously.
C

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 Difficulties in Applying The Duration Model
Duration matching can be costly.
Restructuring the balance sheet of a large and complex FI can be both time-consuming the
costly.
However, the growth of purchased funds, asset securitization, loan sales market has
considerably eased the speed and lowered the transaction costs of major balance sheet
restructurings.
Managers can get many of the same results of direct duration matching by taking hedging
positions in the market for derivative securities.

Immunization is a dynamic process.

Large interest rate changes and convexity.

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Immunization is a Dynamic Process
Duration of a bond changes as time passes and it changes at a different rate than
does real or calendar time.
For example, in the insurance company example, if interest rate remains at 8% at the end of
year 1, the duration of the six-year maturity coupon bond with 5 years remaining is 4.31
years rather than 4 years.

Duration of a bond also changes with interest rates.

For example, in the insurance company example, if interest rate falls immediately to 7%
after the insurance company purchasing the bond, the duration of the bond increases from
4.993 years to 5.018 years.
If an FI manager has chosen C I Q = 0, a change in interest rate will make C IQ
0 and the balance sheet is no longer immunized.

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 Immunization is a Dynamic Process (cont.)
In the insurance company example, if the interest rate has fallen to 7% at the end of year 1,
the duration of the bond will be 4.33 years, which exceeds the remaining target horizon of 4
years.
This means that the insurance company is no longer hedged against further changes in
interest rate. As a result, the manager has to restructure the bond portfolio to remain
immunized.
One way to do so is for the insurer to sell the five-year coupon-bearing bonds and invested
the proceeds in 4-year zero-coupon bonds.
The coupon payment at the end of year 1 is $80 and the five-year bond can be sold for $1041 (based on
the 7% annual yield).
Investing this $80+$1041=$1121 in a four-year zero-coupon bond will generate a payoff of $1469 in four
years.

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 Immunization is a Dynamic Process (cont.)
Alternatively, the insurer could sell 50 percent of the five-year bonds and invested the
proceeds in 3.67-year duration zero-coupon bonds.
C = 0.5 4.33 + 0.5 3.67 = 4 Z['N\
In theory, the strategy requires the portfolio manager to rebalance the portfolio continuously to
ensure that the duration of the investment portfolio exactly matches the investment horizon at
any time.
Because continuous rebalancing may not be easy to do and involves costly transaction fees,
most portfolio managers seek to be only approximately dynamically immunized against
interest rate changes by rebalancing at discrete intervals.
That is, there is a trade-off between being perfectly immunized and the transaction costs of
maintaining an immunized balance sheet.

20
 Large Interest Rate Changes and Convexity
Duration accurately measures the price sensitivity of fixed-income securities for
small changes in interest rates of the order of one basis point.
For large changes, such as an interest rate shock of the order of 2 percent,
duration becomes a less accurate predictor of how much the prices of securities
will change and therefore a less accurate measure of interest rate sensitivity.
Duration will be constant if the relation between price and yield, i.e., R is linear. In
reality, this relation is convex.
The actual relation between bond price and interest rate exhibits convexity (i.e.
curvature). The larger the convexity (i.e curvature), the larger the approximation
error in using duration.

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Large Interest Rate Changes and Convexity

For large rate increases, duration overpredicts the fall in bond prices, while for large
interest rate decreases, it underpredicts the increase in bond prices.
 A Graphic Illustration of Duration Approximation

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 Solutions

Breaking down a discrete change in interest rate into numerous semi-continuous ones, and
calculating the price changes in every step with the continuously updated interest rates
Duration is continuously updated with every small change in interest rate (and thus duration will
change very little), and as such the approximation error will be very small

OR, taking into account of the curvature of the price-yield curve and discrete interest rate
changes
Predicting price changes using both duration and convexity

1 F
= + -D
1+ 2
or,
1 F
= + -D
2

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 Convexity
F F
= + -D or, = + -D
F F

CX = convexity measure, measuring degree of curvature of price -yield relationship.

Mathematically, (modified dollar) duration is the first derivative of price with respect to interest rate:
measures the slope of price-yield curve.
(Dollar) Convexity is the second derivative of price with respect to interest rate: measures the curvature of
price-yield curve.
To be exact, even the above equation is not complete, because CX also changes with interest rate (just as
D does).
So higher orders (up to infinity) of derivatives and interest rate changes should be added, which should
remind you of Taylor expansion in your advanced mathematics course.
However, we typically ignore higher orders of approximation errors because they are typically trivial how
big could be ( )H be if n >= 3?
Note: The exact calculation of CX wont be required in the assessments you will be given information
related to CX if needed for calculating price changes or returns.

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Convexity

One desirable feature of convexity in the price-yield relation is that the capital gain
effect of a rate decrease exceeds the capital loss effect of a rate increase of the same
magnitude.
Hence, buying a bond or a portfolio of assets that exhibits a lot of convexity, or
curvature, in the price-yield curve relationship, is similar to buying partial interest rate
risk insurance.
Specifically, high convexity means that for equally large changes in interest rates up
and down, the capital gain effect of a rate decrease more than offsets the capital loss
effect of a rate increase.

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