Interest Rate Risk
Class 18
Corporate Finance 6e, Chapter 30, Copyright © Pearson Canada Inc. 1
Overview
Interest Rate Risk
Interest Rate Risk Measurement: Duration
Duration-Based Hedging
Swap-Based Hedging
Corporate Finance 6e, Chapter 30, Copyright © Pearson Canada Inc. 2
Interest Rate Risk
Interest Rate Risk
the risk that changes in market interest rates will
affect the value of financial assets, liabilities, or
cash flows.
Whether you are a bank, investor, firm, or
household, changes in interest rates can directly
impact your earnings, asset values, funding
costs, and overall financial health.
Corporate Finance 6e, Chapter 30, Copyright © Pearson Canada Inc. 3
Interest Rate Risk (1 of 2)
Interest Rate Risk Measurement: Duration
A security’s duration is computed as:
PV (Ct )
Duration t t
P
Where Ct is the cash flow on date t, PV(Ct ) is its present value
(evaluated at the bond’s yield), and P = ΣtPV(Ct ) is the total
present value of the cash flows
Therefore, the duration weights each maturity t by the
percentage contribution of its cash flow to the total present
value, PV(Ct ) ∕ P.
Corporate Finance 6e, Chapter 30, Copyright © Pearson Canada Inc. 4
Example 30.12 The Duration of a
Coupon Bond
Problem
What is the duration of a 10-year, zero-coupon bond? What is the
duration of a 10-year bond with 10% annual coupons trading at par?
Solution
For a zero-coupon bond, there is only a single cash flow. Thus, PV
(C10) = P and the duration is equal to the bond’s maturity of 10 years.
For the coupon bond, because the bond trades at par, its yield to
maturity equals its 10% coupon rate. Table 1 shows the calculation
of the duration of the bond.
Note that, because the bond pays coupons prior to maturity, its
duration is shorter than its 10-year maturity. Moreover, the higher the
coupon rate, the more weight is put on these earlier cash flows,
shortening the duration of the bond.
Corporate Finance 6e, Chapter 30, Copyright © Pearson Canada Inc. 5
Table 1 Computing the Duration
of a Coupon Bond
Corporate Finance 6e, Chapter 30, Copyright © Pearson Canada Inc. 6
Interest Rate Risk (2 of 2)
Interest Rate Risk Measurement: Duration
Duration and Interest Rate Sensitivity: If r, the APR
used to discount a stream of cash flows, increases to r
+ ε, where ε is a small change, then the present value
of the cash flows changes by approximately:
Percent Change in Value Duration
1 r /k
Where k is the number of compounding periods per year of the APR
(Yield of 10% compounded quarterly)
Corporate Finance 6e, Chapter 30, Copyright © Pearson Canada Inc. 7
Example 30.13 Estimating Interest
Rate Sensitivity Using Duration (1 of 2)
Problem
Suppose the yield of a 10-year bond with 10% annual coupons
increases from 10% to 10.25% (yields expressed as effective annual
rates). Use duration to estimate the percentage price change. How
does it compare to the actual price change?
Solution
In Example 30.12, we found that the duration of the bond is 6.76 years.
We can use Eq. to estimate the percentage price change:
0.25%
%Price Change 6.76 = 1.53%
1.10
Corporate Finance 6e, Chapter 30, Copyright © Pearson Canada Inc. 8
Example 2 Estimating Interest Rate
Sensitivity Using Duration (2 of 2)
Indeed, calculating the bond’s price with a 10.25% yield to
maturity, we get
1 1 $100
10 1 10
= $98.48
0.1025 (1.1025) 1.1025 10
which represents a 1.52% price drop.
Corporate Finance 6e, Chapter 30, Copyright © Pearson Canada Inc. 9