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)