Module 9– Managing interest risk part 2
In the previous module, we examined how changes in interest rates affect the net interest revenue earned, and how, based
on expected future rates, an FI could structure its balance sheet to take advantage of this. The repricing GAP focuses on the
effect of interest rate changes on cash flows – although it does not use discounting.
However, interest rate changes affect more than revenue earned; they affect the value of assets and liabilities,
and hence the market value (or net asset value) of an FI. We examine the impact of interest rate changes on the
value of assets and liabilities by measuring ‘Duration’.
Duration takes account of values and also involves discounting of cash flows.
In this module we focus on changes in stockholders’ equity given potential changes in interest rates
Duration GAP analysis compares the price sensitivity of a bank’s total assets with the price sensitivity of its total
liabilities to assess the impact of potential changes in interest rates on stockholders’ equity.
GAP and Earnings Sensitivity versus Duration GAP and EVE Sensitivity
9.2 Duration
Duration is a measure of the effective maturity of a security.
1. Duration incorporates the timing and size of a security’s cash flows: It shows the weighted average time for receipt of
cash flows.
Duration =
cf df t
cf df
Where: cf = cash flow, df = discount factor, t = period
2. Duration also measures how price sensitive a security is to changes in interest rates. The greater (shorter) the
duration, the greater (lesser) the price sensitivity. From an economic viewpoint, duration is an ‘elasticity’.
P D
r
P 1 r
Where: P = the price (or market value) of the asset, r = the interest rate or yield, D = the duration of the asset
Example 4.8 of the Hogan text involves a 10 year, 6% coupon bond with annual payments. Face value is 1000, and the
current market yield is 7%. Note: Table 4.6 says yield = 9%. This is a typo. It should be 7%.
Based on the formula, what is the duration? D = 7167.84/929.76 =7.71 years which looks reasonable compared to the
diagram (figure 4.7) above.
Estimating price change
Note that price changes based on duration are approximations. The larger the interest rate change, the less accurate they
will be. We can simplify our interest elasticity formula by using a modified form of duration. See below:
D Hence, P
D mod - D mod r
1 r P
If we know the duration, we can calculate the expected change in asset price that will occur for a given change in interest
rate: ∆P = - Dmod ∆r P
Example: modified duration of a zero-coupon bond
A ten-year zero-coupon bond has a par value of $10,000, current price of $6139.13, and a market rate of interest (spot
rate) of 5% p.a. What is the expected change in the bond’s price if interest rates fall by 25 basis points?
Since the bond is a zero-coupon bond, Macaulay’s Duration equals the time to maturity, 10 years.
With a market rate of interest, the Modified
Duration is: 10/(1.05) = 9.5238 years.
If rates fall by 0.25% (0.0025), the bond’s price will increase by approximately:
∆P = - Dmod ∆r P = -9.5238 × -.0025 × $6,139.13 = $146.17
Duration of asset and liability portfolios
We can also calculate duration for a portfolio of assets or liabilities. It is the weighted average of the individual durations.
n
Asset duration: DA= D
i 1
i i
Where: ωi = weighting of asset I, Di = duration of asset I, n = number of assets
n
Liability duration: DL=
j 1
j Dj
Where: ωj = weighting of liability j, Dj = duration of liability j, n = number of liabilities
Example
Calculate the: average duration of assets; and average duration of liabilities; for FIN3109 bank.
Category Value ($) Duration (yr)
Tnotes 100 0.5
CDs 150 1.2
Tbonds 250 4
variable loans 2000 0.1
fixed loans 1500 5.5
current accounts 1400 0.2
Investment deposits 500 0.49
fixed term deposits 900 3
debentures 800 6
equity 400
There are 2 ways you could approach this question.
Approach 1: apply the formula
100 150 250 2000 1500
DA 0.5 1.2 4 0.1 5.5 2.42 years
4000 4000 4000 4000 4000
1400 500 900 800
DL 0 .2 0.49 3 6 2.23 years
3600 3600 3600 3600
Approach 2: extend the table
Category Value ($) Duration (yr) V*D
Total Assets 4000
Tnotes 100 0.5 50
CDs 150 1.2 180 Total liabilities 3600
Tbonds 250 4 1000 Equity 400
variable loans 2000 0.1 200
fixed loans 1500 5.5 8250 50 180 1000 200 8250
DA 2.42 years
current accounts 1400 0.2 280 4000
Investment deposits 500 0.49 245
fixed term deposits 900 3 2700
debentures 800 6 4800 280 245 2700 4800
DL 2.23 years
equity 400 3600
Duration of a perpetuity
1
The duration of a perpetuity can be calculated as shown: DP 1
r 1
Therefore, for a bond paying 5% per annum in perpetuity, the duration is: DP 1 21 years
0.05
Hence, while in the case of a perpetuity, maturity is infinite, duration is finite and measurable.
9.3 Duration Gap and economic value of equity
Duration GAP Model focuses on managing the market value of stockholders’ equity.
The bank can protect EITHER the market value of equity or net interest income, but not both.
Duration GAP analysis emphasizes the impact on equity and focuses on price sensitivity.
Steps in Duration GAP Analysis
Forecast interest rates
Estimate the market values of bank assets, liabilities and stockholders’ equity.
Estimate the weighted average duration of assets and the weighted average duration of liabilities.
Incorporate the effects of both on & off-balance sheet items. These estimates are used to calculate duration gap.
Forecasts changes in the market value of stockholders’ equity across different interest rate environments.
Calculating the duration gap
Dgap = DA – kDL
Where: k = L/A
where: L = market value of liabilities, A = market value of assets
Dgap = DA – (L/A)*DL
Example
Calculate the Duration Gap for FIN3109 bank.
DA= 2.42 years; DL=2.23 years; A=4000; L = 3600
Impact 3600
D gap 2of.42
Dgap
on economic
2.23 0value of equity (EVE)
.413 years
The sign and size4000
of DGAP provides information about whether rising or falling rates are beneficial or harmful and how
much risk the bank is taking.
If DGAP is positive, an increase in rates will lower EVE, while a decrease in rates will increase EVE
If DGAP is negative, an increase in rates will increase EVE, while a decrease in rates will lower EVE
The closer DGAP is to zero, the smaller is the potential change in EVE for any change in rates
A bank can control its equity exposure to an interest rate change by setting the DGAP to zero (or close to zero).
This process is called immunisation.
Estimating the change in EVE
If the Dgap is not zero, then the change in equity brought about by a change in interest rate can be found by the following
equation. r
E - D gap A
1 r
Note: The Hogan text uses the symbol ‘E’ for economic value of equity, while the Koch and MacDonald text uses ‘EVE’.
Example
Given the duration gap calculated for FIN3109 bank, what will happen to equity if rates rise? Assume rates are currently
10% and they rise to 11%. Equity currently = 400. r
E - D A
gap 1 r
Hence, according to the duration gap model, FIN3109 bank 0.01
- 0.413 4000
is currently exposed to a rate rise, because a rate rise will 1.10
reduce the economic value of its equity. $15.02
The new level of equity 400 - 15.02 $384.98
Duration GAP Summary
Immunising the bank
If DGAP > 0, reduce interest rate risk by:
Shortening asset durations: Buy short-term securities and sell long-term securities, make floating-rate loans, and
sell fixed-rate loans.
Lengthening liability durations: Issue longer-term CDs, borrow via longer-term FHLB advances, Obtain more core
transactions accounts from stable sources.
If DGAP < 0, reduce interest rate risk by:
Lengthening asset durations: Sell short-term securities and buy long-term securities, sell floating-rate loans, and
make fixed-rate loans, Buy securities without call options.
Shortening liability durations: Issue shorter-term CDs, borrow via shorter-term FHLB (Federal home loan bank)
advances, use short-term purchased liability funding from federal funds and repurchase agreements.
Strengths of DGAP
Duration analysis provides a comprehensive measure of interest rate risk.
Duration measures are additive. This allows for the matching of total assets with total liabilities rather than the
matching of individual accounts.
Duration analysis takes a longer-term view than static GAP analysis.
Weaknesses of DGAP
It is difficult to compute duration accurately.
“Correct” duration analysis requires that each future cash flow be discounted by a distinct discount rate.
A bank must continuously monitor and adjust the duration of its portfolio.
It is difficult to estimate the duration on assets and liabilities that do not earn or pay interest.
Duration measures are highly subjective.
A Critique of Strategies for Managing Earnings and EVE Sensitivity
GAP and DGAP Management Strategies
It is difficult to actively vary GAP or DGAP and consistently win.
Interest rates forecasts are frequently wrong.
Even if rates change as predicted, banks have limited flexibility in changing GAP and DGAP.
REVISION QUESTIONS