© Jie Dai

Lecture 4.2
Interest Rate Risk
Duration Gap Analysis

Dollar Gap analysis provides a table of numbers. Duration analysis provides a

single number. Both concerns about an FI’s exposure to interest rate changes, due to A/L
mismatch.

 Definition of Duration of a Security:

C1 C2 C3 ……. Ct …… CT

0 1 2 3 t T
R R R

C1 C2 C3 CT
P0     ... 
1  R (1  R) 2
(1  R) 3
(1  R) T

C1 C2 C3 CT
 (1)   (2)   (3)  ...   (T )  PV  t
T

(1  R) 1
(1  R) 2
(1  R) 3
(1  R) T t
D  t 1 ---- (1)
C1 C2 C3 CT P0
   ... 
(1  R) (1  R) 2
(1  R) 3
(1  R) T

Intuition:
- Duration is a weighted average of time to arrival of all cash flows, where the
weights are the present values of cash flows.
- Duration is the average time it takes for a security to return its present value to
the owner.

 Another Interpretation of Duration

To know how present value or price (P) of the security changes with interest rate
(R), take the first-order derivative of P with respect to R, and use expression of (1), we
get:
P
D  ( ) P ---- (2)
R
1 R
Intuition:
- Duration is the interest rate elasticity or sensitivity of a security’s price to
interest rate change, i.e. how much price will change, given a R .
- The larger the |D|, the more sensitive of the price of the security to changes in
interest rate.

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 Calculations of Durations of Different Types of Financial Securities

o International bonds:
feature: annual coupon payments
e.g. coupon rate = 8%, face value = $1,000
yield = 8%, maturity = 2 years
duration = ?

o Canada bonds
feature: semi-annual coupon payments
e.g. coupon rate = 8%, face value = $1,000
annual yield = 12% (quoted, not effective!)
(the effective yield for 6-month is
12%/2 = 6%, due to the way to quote yield!)
maturity = 2 years
duration = ?

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o Pure discount bonds (Zero coupon bonds):

feature: all cash flows occur at maturity. e.g. T-Bill
Dzero coupon =

o Consol bonds (perpetuity)

feature: cash flows occur over infinite time period

Dperpetuity =

o Duration of Floating–Rate Securities

feature: rates are not constant throughout securities’ lives, but are reset/
rolled over periodically after their issuances.

As in dollar gap analysis, we are interested in the duration to the time of next
repricing:
Duration: time to repricing (not time to maturity)
e.g. quarterly roll over (whether finite or perpetual maturity) of annual R:

o Duration of Cash, Property, Equity/Retained earnings, Demand deposits:

Since these items are not subject to repricing, technically speaking, their durations
are zero – either insensitive to interest rate changes or time to repricing is zero.

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 Duration of a Portfolio

B/S
A
A1 D 1 L1 D1L
A
A2 D 2 L2 D2L
   
   
 

Cash Demand deposit

Property Equity
A DA L DL

A = A1 + A2 + … + Cash + Property
L = L1 + L2 + … + Demand deposit (no Equity!)

The duration of an asset or liability portfolio is a market value-weighted average of

the individual durations of the assets or liabilities in the portfolio:

DA = x1A D1A + x2A D2A +... + xnA DnA

DL = x1L D1L + x2L D2L +... + xnL DnL

where: x = proportion/weight of each asset or liability in the portfolio

A1 A
xiA   i
A1  A2  ...  An  Cash  Property A

L1 L
xiL   i
L1  L2  ...  Ln  Demand deposit L

 Hedging Interest Rate Risk based on Duration

o Balance sheet identity for a typical FI:

B/S
Assets (A) Liabilities (L)
Equity (E)

A: market value of assets

L: market value of liabilities

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A=L+E ---- B/S Identity

A  L  E ---- (3)

o From elasticity/sensitivity interpretation of duration in eq. (2):

A
R
A  A   DA A
DA  ( ) 1 R
R
1 R

L
 R
DL  ( ) L L   DL L
R 1 R
1 R

Substituting these expressions of A and L into (3):

  L  R R
E    D A  DL   A  () DG  A  ---- (4)
  A  1  R 1 R

where:
L : leverage, the amount of borrowed funds (liabilities), rather than own capital
A
(equity), used to fund the assets.

  L 
DG   D A  DL   : leverage-adjusted Duration Gap
  A 

Note: the A includes all assets (such as cash and property), and L includes all
liabilities (such as demand deposits) but excludes equity/retained earnings!

 If DG is positive, duration of assets exceeds duration of liabilities, implying that

liabilities reprice earlier than assets. Thus, a rise in interest rate will decrease
equity value, and we say that banks having positive duration gaps are exposed to
rising interest rates.

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 If DG is negative, duration of liabilities exceeds duration of assets, implying

that assets reprice before liabilities. Thus, a fall in interest rate will decrease equity
value, and we say that banks having negative duration gaps are exposed to falling
interest rates.

 If DG = 0, the durations of A and L are matched (but DA  DL!), then equity value
will not be affected by any interest rate changes, we say that banks having zero
duration gaps are not exposed to interest rate risk. The equity value is perfectly
hedged or immunized.

When durations of A/L are matched (after adjusting for leverage) such that DG = 0,
L and A have the same effective time to repricing, or the interest rate sensitivities of
loans and deposits are identical. Thus, all changes in earnings from assets due to
interest rate changes are offset exactly by changes in the costs of liabilities.

By perfect hedging or immunization, the bank not only eliminates downside risk,
but it also eliminates upside potential.

To allow for upside potential, restructure A and L through direct refinancing so that
duration gap DG is negative (positive) if you predict a rise (fall) in interest rate (the
same intuition as with Dollar Gap analysis)

 Direct Refinancing to Modify the Duration Gap, DG

If DG > 0, then if R increases, loss on equity. So we should reduce DA or increase

DL. To do this, we can simply sell long-term assets and buy short-term assets with the
proceeds; or repurchase (i.e. retire) short-term liabilities and finance the repurchase by
selling (i.e. issuing) long-term liabilities.

 Dollar Gap vs. Duration Gap

- Similarity: both analyze the impacts of interest rate changes on interest earning FIs
such as banks and look at two sides of balance sheets.

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- Differences: Dollar gap analysis measures impact of interest rate change on net
interest income; whereas duration gap analysis looks at impact of interest rate change on
net equity value.

 Problems with duration:

- Require dynamic rebalancing of A/L since, as time passes, duration changes.

- Error in sensitivity prediction with large interest rate change: due to convexity of
all fixed-loan securities. A more precise measure of duration that accounts for
convexity includes the second-order derivative of price with respect to R as well, not
only the first-order derivative.

price

Linear approximation to a quadratic curve gives error

interest rate
- Flat term structure of interest rate (same R for different maturities).

- Deferral, default, and prepayment in payments change duration, making it

difficult to predict timing of cash flows.