Chapter 9: Interest Rate Risk II

Question 1

Difference between book value accounting and market value accounting?

Answer 1

• Book value accounting reports assets and liabilities at original issue values.
• Market Value accounting reports assets and liabilities at current market values.
• FIs generally report their balance sheets using book value accounting methods.However, if deposits or loans have to be refinanced, then market value accounting presents a better picture of the condition of the FI.

Question 2

What is marking to market?

Answer 2

The process by which changes in the economic value of assets and liabilities are accounted.

Question 3

How does duration differs from maturity?

Answer 3

Duration differs from maturity as a measure of interest rate sensitivity because duration takes into account the time of arrival and the rate of reinvestment of all cash flows during the assets life.

Question 4

What is the technical definition of Duration?

Answer 4

Weighted-average time to maturity using the relative present values of the cash flows as the weights.

Question 5

What are the two different general interpretations of the concept of duration?

Answer 5

Duration measures the weighted-average life of an asset or liability in economic terms. As such, duration has economic meaning as the interest sensitivity (or interest elasticity) of an asset’s value to changes in the interest rate.

Question 6

How does the change in the current yield to maturity affect the duration of a coupon bond?

Answer 6

Increasing the yield-to-maturity decreases the duration of the bond.

Question 7

Why does the change in the yield to maturity affect the coupon bond differently than the zero-coupon bond?

Answer 7

Increasing the YTM on the coupon bond allows for a higher reinvestment income that more quickly recovers the initial investment. The zero-coupon bond has no cash flow until maturity.

Question 8

What conclusions can you reach about the relationship between duration and the time to maturity?

Answer 8

As maturity decreases, duration decreases at a decreasing rate.

Question 9

What is the relationship of duration to the relative frequency of interest payments?

Answer 9

Duration decreases as the frequency of payments increases. This relationship occurs because (a) cash is being received more quickly, and (b) reinvestment income will occur more quickly from the earlier cash flows.

Question 10

What is a consol bond?

Answer 10

A consol is a bond that pays a fixed coupon each year forever.

Question 11

What is the relationship between duration and the amount of coupon interest that is paid?

Answer 11

Duration decreases as the amount of coupon interest increases.

Question 12

What is the relationship between duration and the amount of coupon interest that is paid?

Answer 12

Duration decreases as the amount of coupon interest increases.

Question 13

What is modified duration?

Answer 13

Modified duration = Duration/(1+ R).

Question 14

What is the practical value of calculating modified duration?

Answer 14

Some find this value easier to use because the percentage change in value can be estimated simply by multiplying the existing value times the basis point change in interest rates rather than by the relative change in interest rates.

Question 15

Does modified duration change the result of using the duration relationship to estimate price sensitivity?

Answer 15

Using modified duration will not change the estimated price sensitivity of the asset.

Question 16

What is dollar duration?

Answer 16

Dollar duration is the dollar value change in the price of a security to a one percent change in the return on the security.

Question 17

How is dollar duration different from duration?

Answer 17

Duration is a measure of the percentage change in the price of a security for a one percent change in the return on the security. The dollar duration is intuitively appealing in that we multiply the dollar duration by the change in the interest rate to get the actual dollar change in the value of a security to a change in interest rates.

Question 18

Identify and discuss three criticisms of using the duration model to immunize the portfolio of an FI.

Answer 18

1. Immunization is a dynamic problem because duration changes over time. Thus, it is necessary to rebalance the portfolio as the duration of the assets and liabilities change over time.
2. Duration matching can be costly because it is not easy to restructure the balance sheet periodically, especially for large FIs.
3. Duration is not an appropriate tool for immunizing portfolios when the expected interest rate changes are large because of the existence of convexity.

Question 19

What is convexity?

Answer 19

Convexity is a property of fixed-rate assets that reflects nonlinearity in the reflection of price-rate relationships.

Question 20

Why is convexity a desirable feature to be captured in a portfolio of assets?

Answer 20

This characteristic is similar to buying insurance to cover part of the interest rate risk faced by the FI. The more convex is a given asset, the more insurance against interest rate changes is purchased.

Question 21

Why is convexity a desirable feature to be captured in a portfolio of assets?

Answer 21

This characteristic is similar to buying insurance to cover part of the interest rate risk faced by the FI. The more convex is a given asset, the more insurance against interest rate changes is purchased.

Question 22

What are the principles of interest rate-price relationships for fixed-rate financial assets?

Answer 22

Rule 1. Interest rates and prices of fixed-rate financial assets move inversely.
Rule 2. The longer is the maturity of a fixed-income financial asset, the greater is the change in price for a given change in interest rates.
Rule 3. The change in value of longer-term fixed-rate financial assets increases at a decreasing rate.
Rule 4. For a given percentage change in interest rates, the increase in price for a decrease in rates is greater than the decrease in value for an increase in rates.

Question 23

What are the Convexity relationships?

Answer 23

Given the same yield-to-maturity, a zero-coupon bond with the same maturity as a coupon bond will have more convexity.
Given the same yield-to-maturity, a zero-coupon bond with the same duration as a coupon bond will have less convexity.