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    Interest Rate Risk

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    mailinh1991
    This document discusses interest rate risk management techniques. It covers the term structure of interest rates, duration as a measure of a bond's price sensitivity to interest rates, and how interest rate swaps can be used to manage interest rate risk. Specifically, it explains that swaps allow entities to transform fixed rate liabilities and assets into floating rate ones, or vice versa, through agreements with financial institutions to exchange cash flows.

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    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd

    Interest Rate Risk

    Uploaded by

    mailinh1991
    70 views25 pages
    This document discusses interest rate risk management techniques. It covers the term structure of interest rates, duration as a measure of a bond's price sensitivity to interest rates, and how interest rate swaps can be used to manage interest rate risk. Specifically, it explains that swaps allow entities to transform fixed rate liabilities and assets into floating rate ones, or vice versa, through agreements with financial institutions to exchange cash flows.

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    Lecture about interest rate risk

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    This document discusses interest rate risk management techniques. It covers the term structure of interest rates, duration as a measure of a bond's price sensitivity to interest rates, and how interest rate swaps can be used to manage interest rate risk. Specifically, it explains that swaps allow entities to transform fixed rate liabilities and assets into floating rate ones, or vice versa, through agreements with financial institutions to exchange cash flows.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    70 views25 pages

    Interest Rate Risk

    Uploaded by

    mailinh1991
    This document discusses interest rate risk management techniques. It covers the term structure of interest rates, duration as a measure of a bond's price sensitivity to interest rates, and how interest rate swaps can be used to manage interest rate risk. Specifically, it explains that swaps allow entities to transform fixed rate liabilities and assets into floating rate ones, or vice versa, through agreements with financial institutions to exchange cash flows.

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    Financial Risk Management

    Interest Rate Risk


    Outline
    Term structure of interest rates
    Duration
    Using swaps to manage interest rate risk
    3
    Term Structure of I nterest Rates
    Yield



    Yield curve



    Maturity
    4
    History of interest rates
    5
    (Macauly) duration
    Weighted average term to maturity
    Measure of average maturity of the
    bonds promised cash flows
    Duration formula:


    where:

    t is measured in years
    P
    ) 1 /(
    ) ( PV
    ) ( PV
    t
    t t
    t
    y CF
    Bond
    CF
    w
    +
    = =
    D
    m
    = t w
    t
    ( )
    t =1
    T

    w
    t
    =1
    t =1
    q

    6
    Duration - The expanded equation





    Duration is shorter than maturity for all
    bonds except zero coupon bonds
    Duration of a zero-coupon bond is equal to its
    maturity
    D
    m
    = t w
    t
    t =1
    T

    = t
    PV(C
    t
    )
    PV(Bond)



    (

    (
    t =1
    T

    =
    1
    C
    1
    (1 + y)
    1



    (

    (
    + 2
    C
    2
    (1+ y)
    2



    (

    (
    + ... + N
    C
    N
    (1+ y)
    N



    (

    (
    C
    1
    (1+ y)
    1
    +
    C
    2
    (1 + y)
    2
    +... +
    C
    N
    (1+ y)
    N
    7
    Modified duration (D*
    m
    )



    Direct measure of price sensitivity to interest
    rate changes
    Can be used to estimate percentage price
    volatility of a bond
    y
    D
    D
    m
    m
    +
    =
    1
    *
    AP
    P
    = D
    m
    *
    Ay
    8
    Derivation of modified duration






    So D*
    m
    measures the sensitivity of the %
    change in bond price to changes in yield
    y
    D
    D
    m
    m
    +
    =
    1
    *
    P =
    C
    t
    (1+ y)
    t
    t =1
    N

    cP
    cy
    =
    1
    1 + y
    t
    C
    t
    (1 + y)
    t
    |
    \

    |
    .
    t =1
    N

    cP
    cy
    =
    D
    m
    1 + y
    P = D
    m
    *
    P
    1
    P
    cP
    cy
    = D
    m
    *
    9
    An example
    Compare the price sensitivities of:
    Two-year 8% coupon bond with duration of 1.8853 years
    Zero-coupon bond with maturity AND duration of 1.8853 years
    Semiannual yield = 5%
    Suppose yield increases by 1 basis point to 5.01%



    Upshot: Equal duration assets are equally sensitive to
    interest rate movements
    Original Price New Price % Change
    Coupon bond 964.54 964.19 -.0189
    Zero bond 831.96 831.61 -.0189
    10
    Another example
    Consider a 3-year 10% coupon bond selling at
    $107.87 to yield 7%. Coupon payments are made
    annually.
    87 . 107 79 . 89 73 . 8 35 . 9 bond of Price
    79 . 89
    ) 07 . 1 (
    110
    ) (
    73 . 8
    ) 07 . 1 (
    10
    ) (
    35 . 9
    ) 07 . 1 (
    10
    ) (
    3
    3
    2
    2
    1
    = + + =
    = =
    = =
    = =
    CF PV
    CF PV
    CF PV
    Duration (D
    m
    ) = 1*
    9.35
    107.87
    |
    \
    |
    .
    + 2 *
    8.73
    107.87
    |
    \
    |
    .
    + 3 *
    89.79
    107.87
    |
    \
    |
    .
    = 2.7458
    11
    Another example
    Modified duration of this bond:


    If yields increase to 7.10%, how does the bond price
    change?
    The percentage price change of this bond is given by:

    = 2.5661.0010100
    = .2566
    5661 . 2
    07 . 1
    7458 . 2
    *
    = =
    m
    D
    AP
    P
    100 = D
    m
    *
    Ay 100
    12
    Another example
    What is the predicted change in dollar terms?




    New predicted price: $107.87 .2768 = $107.5932

    Actual dollar price (using PV equation): $107.5966
    AP =
    .2566
    100
    P
    =
    .2566
    100
    $107.87
    = $.2768
    Good
    approximation!
    13
    Nature of Swaps
    A swap is an agreement to exchange
    cash flows at specified future times
    according to certain specified rules
    14
    An Example of a Plain Vanilla
    Interest Rate Swap
    An agreement by Microsoft to receive 6-
    month LIBOR & pay a fixed rate of 5%
    per annum every 6 months for 3 years on a
    notional principal of $100 million
    15
    ---------Millions of Dollars---------
    LIBOR FLOATING FIXED Net
    Date Rate Cash Flow Cash Flow Cash Flow
    Mar.5, 2004 4.2%
    Sept. 5, 2004 4.8% +2.10 2.50 0.40
    Mar.5, 2005 5.3% +2.40 2.50 0.10
    Sept. 5, 2005 5.5% +2.65 2.50 +0.15
    Mar.5, 2006 5.6% +2.75 2.50 +0.25
    Sept. 5, 2006 5.9% +2.80 2.50 +0.30
    Mar.5, 2007 6.4% +2.95 2.50 +0.45
    Cash Flows to Microsoft
    16
    Typical Uses of an
    Interest Rate Swap
    Converting a liability from
    fixed rate to floating rate
    floating rate to fixed rate

    Converting an investment from
    fixed rate to floating rate
    floating rate to fixed rate

    17
    Intel and Microsoft (MS)
    Transform a Liability

    Intel MS
    LIBOR
    5%
    LIBOR+0.1%
    5.2%
    18
    Financial Institution is Involved

    F.I.
    LIBOR
    LIBOR
    LIBOR+0.1%
    4.985%
    5.015%
    5.2%
    Intel MS
    19
    Intel and Microsoft (MS)
    Transform an Asset

    Intel
    MS
    LIBOR
    5%
    LIBOR-0.2%
    4.7%
    20
    Financial Institution is Involved

    Intel
    F.I. MS
    LIBOR LIBOR
    4.7%
    5.015% 4.985%
    LIBOR-0.2%
    21
    Quotes By a Swap Market Maker
    Maturity Bid (%) Offer (%) Swap Rate (%)
    2 years 6.03 6.06 6.045
    3 years 6.21 6.24 6.225
    4 years 6.35 6.39 6.370
    5 years 6.47 6.51 6.490
    7 years 6.65 6.68 6.665
    10 years 6.83 6.87 6.850
    22
    The Comparative Advantage
    Argument

    AAACorp wants to borrow floating
    BBBCorp wants to borrow fixed
    Fixed Floating
    AAACorp 4.0% 6-month LIBOR + 0.30%
    BBBCorp 5.20% 6-month LIBOR + 1.00%
    23
    The Swap

    AAACorp
    BBBCorp
    LIBOR
    LIBOR+1%
    3.95%
    4%
    24
    The Swap when a Financial
    Institution is Involved

    AAACorp
    F.I.
    BBBCorp
    4%
    LIBOR
    LIBOR
    LIBOR+1%
    3.93%
    3.97%
    25
    The Nature of Swap Rates
    Six-month LIBOR is a short-term AA borrowing
    rate
    The 5-year swap rate has a risk corresponding to
    the situation where 10 six-month loans are made
    to AA borrowers at LIBOR
    This is because the lender can enter into a swap
    where income from the LIBOR loans is
    exchanged for the 5-year swap rate

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