RATE RISK
• This means that the total value of the assets will go DOWN by 2.7% if
interest rates go UP by 1%. Remember again that duration is a
measure of interest rate risk. It tells us the sensitivity of the value of
an asset or portfolio to changes in interest rates. Also note that cash
always has zero duration.
Now let’s look at the liability side of the bank’s balance sheet:
• In other words, the bank’s net worth (assets minus liabilities) may be
exposed to a loss in case interest rates go up, because if that happens,
value of assets may decrease more than the value of liabilities. To
check whether this is the case in our example, we quantify this interest
rate risk exposure as follows:
• Now, look at the floating rate loan on the liability side, that’s a 5yr
loan @ Libor +0.1%. The face value of this loan is $750. Suppose you
swap part of this loan in exchange of paying a fixed interest rate of
7.25%. Since this is a liability, you are at the moment paying Libor
+0.1% on a value of $750 over the course of next 5 years. Say you
swap $x out of this $750, i.e. the other party pays you Libor +0.1%
over the notional principal of $x (i.e. she assumes your liability) and
you pay her a fixed rate of 7.25% over the next 5 years. After this
swap, your liability side will look as follows:
All we have to decide now is the value of x such that Duration Gap = 0 (see
the solution in class).
Practice Questions on Duration Matching:
a) Find the duration of the asset side. If interest rate goes up by 1%, what will
happen to the total value of the assets?
Find the duration of the liability side. If interest rate goes up by 1%, what
will happen to the total value of the liabilities?
b) Find the duration gap. If interest rate goes up by 1%, what will happen to
the net worth of the bank’s balance sheet?
c) Suppose the portfolio manager wants to reduce the duration gap to zero and
thus immunize all interest rate risk. For that purpose he wants to swap $x of
the 5yr loan @ Libor with a 5yr loan at 8% fixed rate. The duration of the
fixed rate 5yr loan at 8% is 4.5
What is the size $x of the swap such that duration gap becomes zero?
Answer : x = $1680
Question 2 (Reducing Duration Gap To Zero)
a) Find the duration gap. If interest rate goes up by 1%, what will happen to
the net worth of the bank’s balance sheet?
b) Suppose the portfolio manager wants to reduce the duration gap to zero and
thus immunize all interest rate risk. For that purpose he wants to swap $x of
the 4yr loan @ Libor with a 4yr loan at 7% fixed rate. The duration of the
fixed rate 4yr loan at 7% is 3.5. What is the size of the swap $x so that
duration gap becomes 0?