12. Interest rate risk

Question 1

Interest rate risk
* Mismatch in …
* Induces variations of …
* Shareholder value = Value assets – Value liabilities (debt).
* If …, then it affect shareholder value.
* Maturity/duration mismatches

Answer 1

maturities between assets and liabilities.

bank value due to changes in interest rates.

interest rate changes affect the value of assets differently than the value of liabilities

Question 2

Duration
* Maturity of a fixed income instrument (i.e., bond) does not….
– Different coupon payments through time
* Duration of a bond is the…, where the weight attached to each payment reflects the relative contribution of that payment to the value of the bond.
– A measure of the effective maturity of a bond; it is the …

Answer 2

give all the information about price volatility of the bond

weighted average of the time to arrival of all future payments

average time taken by the bond, on a discounted basis, to pay back the original investment.

Question 3

Duration formulae

Answer 3

make a formula sheet of slides 6-9

Question 4

Duration: Key Points
* Higher duration, …
* Duration is a measure of the “weighted average life” of an asset
* Longer maturity assets …, ceteris paribus
* For zero-coupon bonds, …
* For non-zero-coupon bonds, …
* Duration of a portfolio = the …

Answer 4

greater bond price sensitivity to interest rate changes

have longer durations

duration = maturity; thus, they are most price sensitive (longest duration)

duration < maturity; an increase in the coupon decreases duration

weighted average of the durations of all the assets in the portfolio

Question 5

Duration and bank equity value

Answer 5

E = -[ADA - LDL] x (i/1+i)

Question 6

• Change in the shareholder value depends on:
• Bank can eliminate interest rate risk by immunization:

Answer 6

1. Shock on interest rates (di/1+i); duration of Assets/Liabilities (Da/DL), bank’s leverage (L/A)
2. A * Da = L * DL

Question 7

Why take on interest rate risk?
* Bank can completely eliminate interest rate risk by immunizing, but then it…
* Risk premium in the structure of interest rates invites more risk tolerant (such as banks and other depository FIs) to …
* It is not about a bank not taking interest rate risk, but rather that…

Answer 7

forgoes a potentially profitable type of service.

hold long-term assets and fund these assets with short-term liabilities.

such risk must be carefully assessed and managed.

Question 8

SVB: Term structure of interest rates
Typically, longer maturities have …
Deposits have lower returns because of …
Banks make profits by taking on …

Answer 8

higher yields

payment and storage services

duration risk