Chapter 09
Interest Rate Risk II
The Duration Model
AS: PP 234 – PP 248
DR. MD. MONZUR MORSHED BHUIYA
PROFESSOR, DEPT. OF FINANCE, JNU
9–1-1
Duration: Definition
The average life of an asset or liability, or more technically, the
weighted average time to maturity using the relative present values
of the asset or liability cash flows as weights.
✔ Duration is a more complete measure of an asset or liability’s
interest rate sensitivity than maturity because it takes into
account the time of arrival of all cash flows as well as the asset
and liability’s maturity.
✔ In the duration analysis, we weight the time at which cash flows are
received by the relative importance in present value terms of the
cash flows arriving at each point in time.
DR. M. MONZUR MORSHED BHUIYA
9–1-2
PROFESSOR, DEPT. OF FINANCE, JNU
Present Value of Cash Inflows
CF1/2 = Tk. 57.50 PV1/2 = Tk. 57.50/(1.075) = Tk.
CF1 = Tk. 53.75 53.49 PV1 = Tk. 53.75/(1.075)2 =
CF1/2 + CF1 = Tk. 111.25 + PV1 Tk. 46.51
= Tk.
PV 100.00
1/2
PV = Tk. 53.49
1/2
PV1 = Tk. 46.51
0 ½ Year 1 Year
Time (t) Weight (x)
½ Year X1/2=PV1/2/(PV1/2+PV 53.49/10 0.5349 53.49%
1
) 0
1 Year X1 =PV1/(PV1/2+PV1) 46.51/10 0.4651 46.51%
0
1.0 100%
DR. M. MONZUR MORSHED BHUIYA
9–1-3
PROFESSOR, DEPT. OF FINANCE, JNU
✔ By Definition, the sum of the (present value) cash flow weights
must equal 1
X + X1 = 1 0.5349 + 0.4651 = 1
1/2
✔ The duration or the average life of the loan using the present value
of its cash flows as weights:
DL = X1/2(1/2) + X1(1)
= 0.5349 (1/2) + 0.4651 (1) = 0.7326 years
Maturity of the Loan 1 year
Duration of the Loan (Cash Flow Sense) 0.7326 years
✔ Duration is different from the maturity is because of the cash
flows in the middle of the year.
Present value of CD: CF1 = Tk. 115, PV1 = 115/1.15 = Tk. 100
Weight of CD: X1 = Tk. 100/100 = 1
Duration: DD= X1 X (1) DD = 1 X (1) = 1 year
Maturity of CD 1 year
Duration/Average Life of CD (Cash Flow Sense) 1 year
DR. M. MONZUR MORSHED BHUIYA
9–1-4
PROFESSOR, DEPT. OF FINANCE, JNU
Maturity Gap: ML – MD = 1 – 1 = 0 year
Duration Gap: DL – DD = 0.7326 – 1 = - 0.2674 years
✔ In spite of matching maturity, the bank is still exposed to interest
rate risk, because duration gap is greater than zero.
✔ Duration equals maturity when all cash flows are
paid or received at the end of the period with no intervening
cash flows.
✔ The bank needs to manage its duration gap rather than maturity gap
to hedge or immunize interest rate risk.
DR. M. MONZUR MORSHED BHUIYA
9–1-5
PROFESSOR, DEPT. OF FINANCE, JNU
A General Formula for Duration
Formula N N
D ∑ CF × DF × = ∑ PV ×
t t t
t =1 t =1
N N
t t
CF ×
∑ ∑
t t t
t t
=1 =1
DF PV
D = Duration measured in years
CF1 = Cash flow received on the security at end of period t
N = Last period in which the cash flow is recived
DF1= Discount factor = 1/(1+R)t, where R is the yield or current
leN vel of interest rates in the
∑
market
t
=1
= Summation sign for addition of all terms t = 1 to t = N
PVt= Present value of the cash flow at the end of the period to,
which equals CFt X DFt
DR. M. MONZUR MORSHED BHUIYA
9–1-6
PROFESSOR, DEPT. OF FINANCE, JNU
The Duration of a Six-Year Eurobond
Coupon Rate: 8%
Face Value: Tk. 1000
Yield to Maturity 8%
Table 7-1: The Duration of a 6-Year Eurobond with 8% Coupon and Yield
t CFt DFt CFt X DFt CFt X DFt X t
1 80 0.9259 74.07 74.07
2 80 0.8573 68.59 137.18
3 80 0.7938 63.51 190.53
4 80 0.7350 58.80 235.20
5 80 0.6806 54.45 272.25
6 1080 0.6302 680.58 4083.48
1,000.00 4,992.71
D = 4.992.71/1,000.00 = 4.993 years
DR. M. MONZUR MORSHED BHUIYA
9–1-7
PROFESSOR, DEPT. OF FINANCE, JNU
Table 7-2: The Duration of a 2-Year US Treasury Bond with 8%
Coupon and 12% Yield
t CFt DFt CFt X DFt CFt X DFt X t
½ 40 0.9434 37.74 18.87
1 40 0.8900 35.60 35.60
1½ 40 0.8396 33.58 50.37
2 1040 0.7921 823.78 1647.56
930.78 1752.40
D = 1752.40/930.78 = 1.88 years
✔ The duration is equal to the maturity ofa Zero-Coupon
Bond, because it doesn't have any intervening cash flows.
D =M
ZCB zcb
DR. M. MONZUR MORSHED BHUIYA
9–1-8
PROFESSOR, DEPT. OF FINANCE, JNU
The Duration of a Consol Bond (Perpetuities)
A consol bond is a bond that pays a fixed coupon each year. The novel
feature of this bond is that it never matures; that is, it is perpetuity.
Mc=∞
While its maturity is theoretically infinity, the formula for the duration of a
consol bond is: Dc =1+ 1
R
When R=5%, 1
D =1+ .05= 21years
c
When R rise to 20%, then 1
D = 1 +.2 = 6
c
years
DR. M. MONZUR MORSHED BHUIYA
9–1-9
PROFESSOR, DEPT. OF FINANCE, JNU
Features of Duration
✔ Duration increase with the maturity of a fixed-income asset or liability,
but at a
∂D
decreasin g rate:
∂ D ∂M > 2
<
∂M 2
0 0
Duration
Maturity
DR. M. MONZUR MORSHED BHUIYA
9 – 1 - 10
PROFESSOR, DEPT. OF FINANCE, JNU
∂D
<
Duration decreases as yield increases: 0
∂R
For Example: R = 8% D = 13.50
R = 9% Negative D = 12.11
The higher the coupon or promised interest payment on the
security, the lower its duration.
∂D
∂C <
The Economic Meaning of Duration 0
Duration is a direct measure of the interest rate sensitivity or
elasticity of an asset or liability.
The larger the numerical value of D that is calculated for an asset
or liability, the more sensitivity the price of that asset or liability is
to changes or shocks in interest rates.
DR. M. MONZUR MORSHED BHUIYA
9 – 1 -11
PROFESSOR, DEPT. OF FINANCE, JNU
Consider the following equation on the current price of a bond:
C C C+F
P= + + .............. + (1)
(1 + R) (1 + R) (1 + R)
2 N
We would like to derive a direct measure of the size of the effect of
the market interest rate change on price of a bond, i.e. the degree
of price sensitivity.
Taking the derivative of the bond’s price with respect to the yield to
the yield to maturity (R), we get:
dP − C − 2C − N(C + F)
= + + .....................+
dR (1+ R) (1+ R) (1+ R)
2 3 N +1 (2)
By rearranging, we get:
2C
dP 1 ⎡ + N (C + F ⎥) (3)
=− ⎢ (1 + + ....... + (1 +
C 1 + R (1⎣ + R)
dR ⎦
R)2 ⎤ R)N
DR. M. MONZUR MORSHED BHUIYA
9 – 1 -12
PROFESSOR, DEPT. OF FINANCE, JNU
We have shown that the duration (D) equation is the
weighted average time to maturity using the present
value of cash flows as weights is, by definition
C C
1× (C + F )
R)+ N(1
(1 + R) + 2(1++... 2 × + R) C
N
D= (4)
C (C + F
+ + ... +
(1 + R) (1 + R) (1 +) R)
2 N
Since the denominator of the duration equation (4) is simply the price
(P) of the bond that is equal to the present value of the cash on
the bond, then:
C C
1×(1+R) +2×
(1+R) 2
D (5
(1+R) C+FP
+...+N×
N
)
=
Multiplying both sides of this equation by P, we get:
C C C+F
P × D = 1× +2× + ... + N × (6)
(1 + R) (1 + R) (1 + R) 2 2
DR. M. MONZUR MORSHED BHUIYA
9 – 1 -13
PROFESSOR, DEPT. OF FINANCE, JNU
The term on the right hand side of Equation (6) is the same term as
that in square brackets in equation (3). Substituting equation (6) into
Equation (3), we get:
dP 1
=− [P × D] (7)
By cross multiplying: dR (1 + R)
× ( 8)
dP1+R dR=−
PdP
or, alternatively:
(9)
P
dR=
(1−
+R
In Equation (8) and (9),
) D is the interest elasticity, or sensitivity of
the security’s price to small interest rate changes. That is, it
describes the percentage price fall of the bond (dP/P) for any given
(present value) increase in required interest rates or yields
(dR/1+R).
DR. M. MONZUR MORSHED BHUIYA
9 – 1 -14
PROFESSOR, DEPT. OF FINANCE, JNU
Equation (8) and (9), can be rearranged in
another useful way for interpretation regarding
interest sensitivity:
dP dR
= −D⎢⎡ (10)
Price
P 1+R
Changes ⎥⎤ ⎣ ⎦ Figure 7-5
(dP/P) -D
Yield Changes (dR/1+R)
Equation (10) and figure 7-5, its graphic presentation show that for
small changes in interest rates, bond prices move in an inverse
proportional fashion according to the size of D
DR. M. MONZUR MORSHED BHUIYA
9 – 1 -15
PROFESSOR, DEPT. OF FINANCE, JNU
The Six-Year Eurobond
C = 8% YTM = 8% D = 4.99 (Table 7-1) FV = Tk. 1000
YTM increases by 1 basis point (1/100th of 1%) i.e. increase to 8.00% to
8.01%
dP ⎡0.0001⎤
= −(4.99) = −0.000462 = −0.0462%
⎢ ⎥
P 1.08
⎣ ⎦
Under the above scenario, the bond price will fall to Tk. 999.538 from Tk.
1000.00 (Tk. 1000.00 X (100% - 0.0462%).
dP ⎡0.0001⎤
= −(13.5) = −0.00125 = −0.125% Price fall
⎢ ⎥
P 1.08
⎣ ⎦
The Consol Bond
C = 8% YTM = 8% D = 13.5 dR (Change in YTM) = 1 basis point (0.0001)
DR. M. MONZUR MORSHED BHUIYA
9 – 1 -16
PROFESSOR, DEPT. OF FINANCE, JNU
Semi-annual Coupon, Two-Year Maturity, Treasury Bond
dR ⎤
dP ⎡
=⎢−D ⎥
P 1 + 1/ 2R
⎣ ⎦
C = 8%, YTM = 8%, D = 1.88 (Table 7-2) dR = 1 basis point
(0.01%)
dP ⎡0.0001⎤
= −1.88 = −0.00018 = −0.018% Price fall
⎢ ⎥
P 1.04
⎣ ⎦
DR. M. MONZUR MORSHED BHUIYA
9 – 1 -17
PROFESSOR, DEPT. OF FINANCE, JNU