Scribd
Upload
141 views5 pages

Bond Valuation and Duration Analysis

The document discusses interest rate risk management concepts such as duration, interest rate gaps, and sensitivity of assets and liabilities to interest rate changes. It provides examples of calculating duration for individual bonds and weighted average duration for a portfolio. It also demonstrates how to calculate the impact of interest rate changes on the value of assets and liabilities and the resulting change in net worth using duration figures. The key ideas are that duration measures interest rate sensitivity and can be used to estimate the price impact of small yield changes, and that differences in asset and liability durations create exposure to interest rate risk for a bank or other financial institution.

Uploaded by

Rakib Ahmed
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
141 views5 pages

Bond Valuation and Duration Analysis

The document discusses interest rate risk management concepts such as duration, interest rate gaps, and sensitivity of assets and liabilities to interest rate changes. It provides examples of calculating duration for individual bonds and weighted average duration for a portfolio. It also demonstrates how to calculate the impact of interest rate changes on the value of assets and liabilities and the resulting change in net worth using duration figures. The key ideas are that duration measures interest rate sensitivity and can be used to estimate the price impact of small yield changes, and that differences in asset and liability durations create exposure to interest rate risk for a bank or other financial institution.

Uploaded by

Rakib Ahmed
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

7FNCE026W

Seminar 4: Interest rate gap and


duration

1. Suppose that a bank has $5 billion of one-year loans and $20 billion of five-year
loans. These are financed by $15 billion of one-year deposits and $10 billion of five-
year deposits. Explain the impact on the bank’s net interest income of interest
rates increasing by 1% every year for the next three years.

In this case, the interest rate mismatch is $10 billion. The bank’s net interest income
declines by $100 million each year for the next three years.

2. What does duration tell you about the sensitivity of a bond portfolio to interest
rates? What are the limitations of the duration measure?

Duration provides information about the effect of a small parallel shift in the yield curve on
the value of a bond portfolio. The percentage decrease in the value of the portfolio equals
the duration of the portfolio multiplied by the amount by which interest rates are increased
in the small parallel shift. Its main limitation is that it applies only to parallel shifts in the
yield curve that are small.

3. A five-year bond with a yield of 11% pays an 8% coupon at the end of each year.
(a) What is the bond’s price?
(b) What is the bond’s duration and modified duration?
(c) Use the modified duration to calculate the effect on the bond’s price of a 0.2%
decrease in its yield.
(d) Recalculate the bond’s price on the basis of a 10.8% per annum yield and verify
that the result is in agreement with your answer to (c).

(a) The bond’s price is:

8 8 8 8 108
P 0= + + + + =88.91
( 1.11) (1.11) (1.11) (1.11) (1.11)5
2 3 4
(b) Duration:

8 ×1 8× 2 8× 3 8 × 4 108 ×5
+ + + +
(1.11) (1.11) (1.11) (1.11)4 (1.11)5
2 3
D= =4.27
P0

Modified duration:

−4.27
V= =−3.84
1.11

(c) When the yield decreases by 0.2% the bond’s price increases by 0.68:

∆P ∆i ⇒
=V ×∆ i=−D× =0.768 % ❑ ∆ P=0.68
P ( 1+i )

(d) recomputing the bond’s price with a yield of 10.8% gives a price of 89.60, which is
approximately consistent with (a) and (c).

4. When is a firm asset sensitive? Liability sensitive?

A firm is asset sensitive when it has more interest-rate sensitive assets maturing or subject
to repricing during a specific time period than rate-sensitive liabilities. A liability sensitive
position, in contrast, would find the institution having more interest-rate sensitive deposits
and other liabilities than rate-sensitive assets for a particular planning period.

5. Suppose Carroll Bank and Trust reports interest-sensitive assets of $570 million
and interest-sensitive liabilities of $685 million. What is the bank’s dollar interest-
sensitive gap? Its relative interest-sensitive gap and interest-sensitivity ratio?

Dollar Interest-Sensitive Gap = Interest-Sensitive Assets – Interest Sensitive Liabilities


= $570 mill. − $685 mill. = − $115 mill.

Relative Gap = IS Gap = − $115 = − 0.2018


Total assets $570

ISR = Interest-Sensitive Assets = $570 = 0.8321

Interest-Sensitive $685
Liabilities
6. New Comers State Bank has recorded the following financial data for the past
three years (dollars in millions):

Current Previous Year Two Years Ago


Year
Interest revenues $82 $80 $78
Interest expenses 64 66 68
Loans 450 425 400
Investments 200 195 200

a. Calculate the bank’s net interest margin for the past three years.
b. What do you think caused the changes you observe?
c. Do you have any recommendations for New Comers’ management team?

Net interest margin (NIM) = Net interest income/Total earning assets


Net interest income = Net interest revenues - Net interest expenses
Total earning assets = Loans + Investments

NIM (Current) = ($82-64)/ (450 + 200) = 18/650 = 0.028 or 2.77%


NIM (Previous) = ($80-66)/ (425 + 195) = 14/620 = 0.0226 or 2.26%
NIM (Two years ago) = ($78-68)/ (400 + 200) = 10/600 = 0.0167 or 1.67%

The net interest margin has been increasing over the years. As interest revenues and
expenses as well as the bank’s assets have increased consistently over the years, there has
been a constant increase in the net interest margin. If the bank can further cut down on its
interest expenses and increase its assets in the next years, the net interest margin will
increase at a higher rate.

7. A government bond currently carries a yield to maturity of 6% and a market price


of $1,168.49. If the bond promises to pay $100 in interest annually for five years,
what is its current duration?

The duration of the bond is computed as follows:

= 4.23 years
8. Blue Moon National Bank holds assets and liabilities whose average durations and
dollar amounts are as shown in this table:

Avg. Duration
Asset and Liability Items (years) Dollar Amount (millions)

Investment Grade Bonds 15.00 $65.00


Commercial Loans 3.00 $400.00
Consumer Loans 7.00 $250.00
Deposits 1.25 $600.00
Nondeposit Borrowings 0.50 $50.00

a. What is the weighted average duration of Blue Moon’s asset portfolio and
liability portfolio?
b. What is the leverage-adjusted duration gap?

The weighted average duration of Blue Moon’s asset portfolio is calculated as follows:

The weighted average duration of the liability portfolio is calculated as follows:

9. Carter National Bank holds $15 million in government bonds having a duration of
12 years. If interest rates suddenly rise from 6% to 7%, what percentage change
should occur in the bonds’ market price?

The percentage change in market price is computed as follows:

10. Conway Thrift Association reports an average asset duration of 7 years and an
average liability duration of 4 years. In its latest financial report, the association
recorded total assets of $1.8 billion and total liabilities of $1.5 billion.
a. If interest rates began at 5% and then suddenly climbed to 6%, what change
will occur in the value of Conway’s net worth?
b. By how much would Conway’s net worth change if, instead of rising,
interest rates fell from 5% to 4.5%?

The key formula is: Change in net worth NW =

a) For the change in interest rates from 5 to 6%, change in net worth will be:

[
¿ −7 ×
0.01
( 1+0.05 ) ][
×1.8 − −4 ×
0.01
( 1+ 0.05 )
×1.5
]
= – $0.12 billion – (–$0.05714 billion) = – $0.06286 billion

b) On the other hand, if interest rates decline from 5 to 4.5%, change in net worth will
be:

[
¿ −7 ×
−0.005
( 1+0.05 ) ][
×1.8 − −4 ×
−0.005
( 1+ 0.05 )
×1.5
]
= + $0.06 billion – $0.02857 billion = + $0.03143 billion

Common questions

Powered by AI

The interest-sensitive gap measures the dollar amount difference between interest-sensitive assets and liabilities, indicating potential net interest income changes due to rate fluctuations. A negative gap suggests potential losses if rates rise. The interest sensitivity ratio, reflecting the proportion of sensitive assets to liabilities, indicates the extent of exposure. A lower ratio suggests higher vulnerability .

New Comers State Bank's net interest margin increased from 1.67% to 2.77% over three years. This increase is attributed to rising interest revenues outpacing interest expenses and an increase in the total earning assets, suggesting improved asset management and interest income generation .

To improve financial performance and manage interest rate risks, New Comers State Bank should consider extending the duration of its liabilities to better match its assets, ensuring more active monitoring and adjustment of interest-sensitive gaps, and potentially diversifying its portfolio with variable rate instruments to hedge against fluctuations .

A firm is asset sensitive if more interest-rate sensitive assets mature or reprice during a specific period compared to rate-sensitive liabilities, leading to potential income increase when rates rise. Conversely, it is liability sensitive if it has more interest-rate sensitive liabilities than assets, making it vulnerable to income decreases when rates rise .

The leverage-adjusted duration gap assesses a bank's exposure to interest rate changes, measuring the difference between the durations of assets and liabilities adjusted by the bank's capital leverage. A positive gap implies potential losses if rates rise, and it is calculated using the weighted average durations and dollar amounts of the assets and liabilities, factoring in the bank's leverage ratio .

The modified duration can be used to estimate a bond's price change by multiplying it with the change in yield. For example, if a bond with a modified duration of -3.84 experiences a yield decrease of 0.2%, the bond's price would increase by approximately 0.768% . However, this estimation is only accurate for small changes in yield and assumes a parallel shift in the yield curve, which may not always be the case .

An increase in interest rates by 1% every year for the next three years results in a $100 million decline in the bank's net interest income each year. This occurs due to an interest rate mismatch of $10 billion, where the bank's longer-term loans are financed by a mix of short-term and medium-term deposits .

If interest rates increase from 6% to 7%, given the bond's duration is 12 years, the bond's market price would decrease by approximately 12% due to the inverse relationship between bond prices and interest rates .

The main limitation of duration as a measure of bond portfolio sensitivity to interest rates is that it only applies to small parallel shifts in the yield curve. Duration does not account for non-parallel shifts or large interest rate changes .

For Conway Thrift Association, a 1% increase from 5% to 6% in interest rates decreases its net worth by approximately $0.06286 billion. This is calculated using the difference in average asset and liability durations, impacting the value of assets and liabilities differently .

You might also like