Lecture 3: Interest rate risk: the duration model
Introduction
In the US
investment assets: reported in book value
assets in trading: reported in market value
In Australia
assets held by FIs are reported in fair value
held at maturity => reported at historical value
liabilities are recorded at historical cost
Duration model
market value based model (while repricing model based more on book value)
considers the timing of CFs
maturity distribution of FIs assets and liabilities
also takes into account the FI leverage
Duration vs maturity (page 9)
duration is similar to effective maturity
but it used weighted average of the PV of the CFs
duration measures the period of time required to recover the initial investment
duration is a more complete measure of interest rate sensitivity
The economic meaning of duration
Measure average life of cash flows of assets/ liabilities
directly measure the interest rate sensitivity of assets/ liabilities
the higher duration => the greater price changes due to change in interest rate
Using duration to measure FI's interest rate risk
brief outline: p.36
Duration gap = Duration of assets - Duration of liabilities
Calculate the duration gap (p.38)
important formula: p.40
Factors that affect the sensitivity of FI's equity
the leverage adjusted duration gap (reflects the degree of duration mismatch)
the size of FI
the size of interest rate shock
example: page 43
Potential strategies for FIs (p.45 & 46)
Immunization and regulatory considerations (p.47)
Difficulties of applying the duration model
Duration matching can be costly
Immunisation is a dynamic problem
Large interest rate changes and convexity
repricing vs duration gap (p.52)