“Managing a Duration

Gap”
&
“Duration and Convexity”
The Purpose of Duration Gap
Analysis
• The purpose of DGAP analysis is to provide a measure of the
impact of unexpected interest rate changes on the market
value of a bank’s owners’ equity, i.e. net worth.

• Interest sensitive GAP analysis does not consider the impact

of changing interest rates on the market value of a bank’s
owners’ equity.
 Two Interest Rate Theorems
Central to DGAP Analysis
n
CFt
Market Price  t
t 1 (1  YTM)
I.Market yields and market prices move in opposite directions.
A rise in market rates of interest will cause the market value of both fixed-rate
assets and liabilities to decline.
II.
The longer the maturity of a fixed rate financial instrument, the greater
will be the change in market value for a given change in market interest
rates.
The longer the duration of a bank’s assets and liabilities, the more they will
decline in market value when market interest rates rise.
Duration and
Convexity
Duration and Convexity
Duration and Convexity is used calculate the magnitude
of change in the price of bond with change in interest
rate.
Difference between Duration and Convexity is that, the
Duration is used to Calculate the magnitude of change for
short term period whereas, the Convexity is used to
calculate the magnitude of change for long term period.
As the Maturity increases the result of Duration is
getting worse and Convexity is getting closer to actual
change.
Duration
T
D = Macaulay’s Duration= D  t wt
t 1

*(Calculate through Table)

D* = Modified Duration = D/(1 + i)

Duration Effect=P/P = -D*( i)

 Convexity
1 n
 CFt 
Convexity 
P (1  y ) 2  2
 (1  y ) t (t  t )
t 1  

P 1 2
 D y  [Convexity (y ) ]
P 2
Data
Assume that a company issues 6 year bond with
the face value of 500 each at the coupon rate of
10% currently the market rate is 11%. Keeping
this information , you are required to calculate
the duration effect and convexity effect
 If interest rate is increased by 1%
 If interest rate is decreased by 1%
Let’s Start
Calculation
First Calculate Duration
Year
1 1st Column:
2 Write Total Numbers of
3 Years in given data.
4
5
6
First Calculate Duration
Year Cash flow
2nd Column:
1 50 Cash flow during each year and on
2 50 bond the cash flow is coupon
3 50 payment and in last year coupon
payment plus face value.
4 50
5 50 To Calculate Coupon Payment (CP):
6 550 CP=Face Value * Coupon Rate
First Calculate Duration
Year Cash flow PV cash flow
3rd Column:
1 50 45.045 Calculate Present Value
2 50 40.5811 of each Cash flow
3 50 36.5595
4 50 32.9365 To Calculate Present
5 50 29.6725 Value:
6 550 294.0524
478.847
PV=Amount(1+YTM)^-
n
 First Calculate Duration
Year Cash flow Pv cash flow Wt

1 50 45.045 0.09406
4th Column:
Calculate Weight of
2 50 40.5811 0.08474
PV of Cash flow
3 50 36.5595 0.07634

4 50 32.9365 0.06878 To Calculate Weight:

5 50 29.6725 0.06196
W=PVi divided by
6 550 294.0524 0.61408 total of PV Column
478.847 1
 First Calculate Duration
Year Cash flow Pv cash flow Wt Wt*t 5th Column:
1 50 45.045 0.09406 0.09406 Multiply Weight
2 50 40.5811 0.08474 0.16948 with years.
3 50 36.5595 0.07634 0.22902 Sum of 5th
4 50 32.9365 0.06878 0.27512 Column will be
5 50 29.6725 0.06196 0.3098 the Maculay
Duration
6 550 294.0524 0.61408 3.68448
478.847 1 4.76196
Now Calculate
Duration Effect
Duration Effect
 D = Macaulay’s Duration= 4.76196

 *(Calculate through Table)

 -D* = Modified Duration = D/(1 + i)= 4.76196/(1.11)

 -D*= -4.29005

 Duration Effect=P/P = -D*( i)

Duration Effect
Continue…
Now Calculate Duration Effect with increase in interest
rate by 1%

Duration Effect=P/P = -D*( i)

P/P= -4.29005*(0.01)= -4.29005%

It means with the increase in YTM by 1% the Price will be

decreased by -4.29005%
Duration Effect
Continue…
Now Calculate Duration Effect with decrease in interest
rate by 1%

Duration Effect=P/P = -D*( i)

P/P= -4.29005*(-0.01)= 4.29005%

It means with the decrease in YTM by 1% the Price will

be increased by 4.29005%
 Now Calculate
Convexity and
Convexity Effect
 To Calculate we will
Continue the Duration Table
Calculate Convexity
Year Cash flow Pv cash flow Wt Wt*t
1 50 45.045 0.09406 0.09406
2 50 40.5811 0.08474 0.16948
3 50 36.5595 0.07634 0.22902
4 50 32.9365 0.06878 0.27512
5 50 29.6725 0.06196 0.3098
6 550 294.0524 0.61408 3.68448
478.847 1 4.76196
 Calculate Convexity
Year Cash flow Pv cash flow Wt Wt*t t2
1 50 45.045 0.09406 0.09406 1
2 50 40.5811 0.08474 0.16948 4
3 50 36.5595 0.07634 0.22902 9
4 50 32.9365 0.06878 0.27512 16
5 50 29.6725 0.06196 0.3098 25
6 550 294.0524 0.61408 3.68448 36
478.847 1 4.76196

6th Column:
Take a Square of Year (t2)
 Calculate Convexity
Year Cash flow Pv cash flow Wt Wt*t t2 (t2 + t)
1 50 45.045 0.09406 0.09406 1 2
2 50 40.5811 0.08474 0.16948 4 6
3 50 36.5595 0.07634 0.22902 9 12
4 50 32.9365 0.06878 0.27512 16 20
5 50 29.6725 0.06196 0.3098 25 30
6 550 294.0524 0.61408 3.68448 36 42
478.847 1 4.76196

7th Column:
Add t2 Column with Year (t2 + t)
 Calculate Convexity
Year Cash flow Pv cash flow Wt Wt*t t2 (t2 + t) PV*(t2+t)
1 50 45.045 0.09406 0.09406 1 2 90.09
2 50 40.5811 0.08474 0.16948 4 6 243.4866
3 50 36.5595 0.07634 0.22902 9 12 438.714
4 50 32.9365 0.06878 0.27512 16 20 658.73
5 50 29.6725 0.06196 0.3098 25 30 890.175
6 550 294.0524 0.61408 3.68448 36 42 12350.2008
478.847 1 4.76196 14,671.40

8th Column:

Multiply (t2 + t) with PV of Cash Flow

 Now Calculate
Convexity and
Convexity Effect
 Convexity
1 n
 CFt 
Convexity 
P (1  y ) 2  2
 (1  y ) t (t  t )
t 1  

Convexity= 1 / 500(1.11)^2 x [14671.40]

Convexity= 23.81527
P= Price of Bond
n
 CFt 
Y=
 (1 YTM
y)
2
(t  t )
t
t 1  

= Calculated Through Table

 Convexity Effect
Now Calculate Convexity Effect with Increase in interest rate by 1%
P
 D  y  1 [Convexity (y ) 2 ] x100
P 2
P/P= -4.29005 + ½ [23.81527x(0.01)^2]x100

P/P= -4.29005+0.1191

P/P= -4.17095%

It means with the increase in YTM by 1% the Price will be

decreased by -4.17095%
 Convexity Effect
Now Calculate Convexity Effect with decrease in interest rate by 1%
P
 D  y  1 [Convexity (y ) 2 ] x100
P 2
P/P= 4.29005 + ½ [23.81527x(-0.01)^2]x100

P/P= 4.29005+0.1191

P/P= 4.40915%

It means with the decrease in YTM by 1% the Price will be increased by

4.40915%
Results
A) With increase in Interest Rate by 1%:
Duration Effect = -4.29005%
Convexity Effect = -4.17095%

B) With the decrease Interest Rate by 1%:

Duration Effect = 4.29005%
Convexity Effect = 4.40915%
Practice Data
Assume that a company issues 5 year bond with
the face value of 1,500 each at the coupon rate
of 8% currently the market rate is 9%. Keeping
this information , you are required to calculate
the duration effect and convexity effect
 If interest rate is increased by 1%
 If interest rate is decreased by 1%
Duration Gap
Analysis
The Duration Gap
DGAP = DA - {DL (TL\TA)}
DGAP = Duration Gap
DA = Dollar Weighted Duration of the Asset Portfolio
DL = Dollar Weighted Duration of the Bank’s Liabilities
TL = Total Market Value of the Bank’s Liabilities
TA = Total Market Value of the Bank’s Assets

DGAP is measured in years and is a measure of the mismatch

in the average duration of the assets and the liabilities. The larger
the mismatch, the greater the impact of unexpected interest rate
changes on the market value of the net worth of the bank.
Positive Duration GAP
Interest Rates Increase

Assets have a higher duration so they will

decrease more in value than liabilities. This
causes the Net Worth to decrease.
Interest Rates Fall

Assets have a higher duration so they will

increase more in value than liabilities. This
causes the Net Worth to increase.
Negative Duration
GAP
Interest Rates Increase

Assets have a lower duration so they will

decrease less in value than liabilities. This
causes the Net Worth to increase.
Interest Rates Fall

Assets have a lower duration so they will

increase less in value than liabilities. This
causes the Net Worth to decrease.
Zero Duration GAP
If the DGAP = 0 over the planning period,
the bank is immunized against changes in the
value of its net worth.

In other words, the market value of the bank’s

equity will be stable in the event of unexpected
interest rate changes, either up or down.
The Calculation of the Duration of
a Portfolio of Assets
Assets MV of Assets Duration Duration x
MV Weight
U. S. T. Sec. $ 90 7.49 (90/300) 7.49
Mun. Sec. 20 1.50 (20/300) 1.50
Commer. 100 0.60 (100/300) .60
Lns.
Consum. 50 1.20 (50/300) 1.20
Lns
RE Loans 40 2.25 (40/300) 2.25
Total 300 3.047

DA = 3.047 years
 Computation of the DGAP

Composition of Assets Market Yield to Average

Value $ Maturity % Duration
U. S. Treasury Sec. 90 10.00 7.490
Municipal Bonds 20 6.00 1.500
Commercial Loans 100 12.00 0.600
Consumer Loans 50 15.00 1.200
Real Estate Loans 40 13.00 2.250

Total Assets 300

Average in Years 3.047

Composition fo Lia. And EC

Negotiable CD's 100 6.00 1.943

Other Time Deposits 125 7.20 2.750
Subordinated Notes 50 9.00 3.918
Total Liabilities 275
Equity Capital 25

Total Liabilities and EC 300

Average in Years 2.669

Duration of the Assets =

[( 90/300) x 7.49] + [(20/300) x 1.50] + [(100/300) x 0.60] + [(50/300) x 1.20] + [(40/300) x 2.25] =
3.047

Duration of the Liabilities =

[(100/275) x 1.943] + [(125/275) x 2.750] + [(50/275) x 3.918] =
2.669

DGAP = D(A) - {D(L)[TL/TA]} = 3.047 - {2.669 x (275/300)} = 0.60 years