Immunization- Immunization is an aspect of the duration model that is not well understood.

Lets go back to the earlier immunization example in which an insurer sought to buy bonds to provide an accumulated cash flow of $1,469 in five years no matter what happened to interest rates. We showed that buying a six-year maturity, 8 percent coupon bond with a five-year duration immunizes the insurer against an instantaneous change in interest rates. Interest rate immunization is a strategy that ensures that a change in interest rates will not affect the value of a portfolio. Similarly, immunization can be used to ensure that the value of a pension fund's or a firm's assets will increase or decrease in exactly the opposite amount of their liabilities, thus leaving the value of the pension fund's surplus or firm's equity unchanged, regardless of changes in the interest rate. FI managers may be most interested in immunizing against changes in the capital ratio ((E/A)) due to interest rate risk rather than changes in the level of capital (E). For example, suppose the FI manager is close to the minimum regulatory required E/A (or capital) ratio (e.g., 4 percent for depository institutions) and wants to immunize the FI against any fall in this ratio if interest rates rise.20 That is, the immunization target is no longer E = 0 when rates change but (E/A) = 0. Convexity (ESSAY)- The degree of curvature of the priceyield curve around some interest rate level. A measure of the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes. Convexity is used as a risk-management tool, and helps to measure and manage the amount of market risk to which a portfolio of bonds is exposed.

In the example above, Bond A has a higher convexity than Bond B, which means that all else being equal, Bond A will always have a higher price than Bond B as interest rates rise or fall. As convexity increases, the systemic risk to which the portfolio is exposed increases. As convexity decreases, the exposure to market interest rates decreases and the bond portfolio can be considered hedged. In general, the higher the coupon rate, the lower the convexity (or market risk) of a bond. This is because market rates would have to increase greatly to surpass the coupon on the bond, meaning there is less risk to the investor.

Convexity relationships: -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 Duration or Modified duration to capture risk

Definition of Duration 1. The weighted-average time to maturity on a security. 2. The interest elasticity of a securitys price to small interest rate changes. Features of Duration 1. Duration increases with the maturity of a fixed-income security, but at a decreasing rate. 2. Duration decreases as the yield on a security increases. 3. Duration decreases as the coupon or interest payment increases. Risk Management with Duration 1. Duration is equal to the maturity of an immunized security. 2. Duration gap is used by FIs to measure and manage the interest rate risk of an overall balance sheet. What are the two different general interpretations of the concept of duration, and what is the technical definition of this term? How does duration differ from maturity? 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 assets value to changes in the interest rate. 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. Technically, duration is the weighted-average time to maturity using the relative present values of the cash flows as the weights. A 10-year, 10 percent annual coupon, $1,000 bond trades at a yield to maturity of 8 percent. The bond has a duration of 6.994 years. What is the modified duration of this bond? What is the practical value of calculating modified duration? Does modified duration change the result of using the duration relationship to estimate price sensitivity? Modified duration = Duration/(1+ R) = 6.994/1.08 = 6.4759. Some practitioners 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. Using modified duration will not change the estimated price sensitivity of the asset. Modified duration- Duration divided by 1 plus the interest rate.

The duration equation can be rearranged, combining D and (1 + R) into a single variable D/(1 + R), to produce what practitioners call modified duration (MD). How come the 5 day VAR is not the sum of the 5 years? Ch10

Hedging Routine hedging: reduces interest rate risk to lowest possible level. Low risk - low return. Selective hedging: manager may selectively hedge based on expectations of future interest rates and risk preferences. VAR AND DEAR (ESSAY) DEAR or Daily Earnings at Risk is defined as the estimated potential loss of a portfolio's value over a one-day period as a result of adverse moves in market conditions, such as changes in interest rates, foreign exchange rates, and market volatility. DEAR is comprised of (a) the dollar value of the position, (b) the price sensitivity of the asset to changes in the risk factor, and (c) the adverse move in the yield. The product of the price sensitivity of the asset and the adverse move in the yield provides the price volatility component. DEAR = ($ value of position) x (price volatility) = $1,000,000 x 0.009252 = $9,252 Value at risk or VAR is the cumulative DEAR over a specified period of time and is given by the formula VAR = DEAR x [N]. VAR is a more realistic measure when it requires a longer period for an FI to unwind a position, that is, if markets are less liquid. The value for VAR in problem 4 above is $9,252 x [10] = $29,258. According to the above formula, the relationship assumes that yield changes are independent. This means that losses incurred one day are not related to losses incurred the next day. Recent studies have indicated that this is not the case, but that shocks are auto correlated in many markets over long periods of time. Impact of Basis Risk (ESSAY) Basis risk- A residual risk that arises because the movement in a spot (cash) assets price is not perfectly correlated with the movement in the price of the asset delivered under a futures or forward contract. It is an unhedgable risk. Computing Historical Volatility annualized. VAR formula Micro hedging with futures and funds

Forward Compounds pure expectations

Good Friend (ESSAY) INTEREST RATE POLICY AND THE INFLATION SCARE PROBLEM

Key Issues 1. Fed funds rates is a key policy instrument fed funds is the rate at which banks borrow from each other overnight. 2. Inflation scares occur when long term rates rise relative to short term rates remaining steady. a. Fisher theory: nominal rate = real rate + expected inflation. 3. Inflation scares are costly because they require the Fed to raise short term rates which may reduce economic growth. 4. Hesitation is also costly because it may signal that the Fed will allow higher inflation, which increases the cost of doing business. 5. In order to manage the dilemma the Fed must maintain its credibility as a fighter of expected inflation. Conclusions: Fed has shifted from a reactive stance to a proactive stance on fighting expected inflation. Inflation scares occur when the fed funds rate stays relatively steady but long term rates are rising indicating increasing inflation expectations. Fed fights inflation scares by raising the fed funds rate aggressively. Fed funds rate short term rates In short run: Long term rates rise choking off expected inflation. In long run Long term rate falls due to falling expected inflation. (credibility attained)

Interest rate risk (PROBLEM) Gap if it is positive what happens with cash flow. ARTICLE (INTEREST RATE RISK 1) The duration gap is a financial and accounting term and is typically used by banks, pension funds, or other financial institutions to measure their risk due to changes in the interest rate. This is one of the mismatches that can occur and are known as asset liability mismatches. Another way to define Duration Gap is: it is the difference in the sensitivity of interest-yielding assets and the sensitivity of liabilities (of the organization ) to a change in market interest rates (yields).The duration gap measures how well matched are the timings of cash inflows (from assets) and cash outflows (from liabilities).When the duration of assets is larger than the duration of liabilities, the duration gap is positive. In this situation, if interest rates rise, more assets than liabilities will lose value, thus

reducing the value of the firms equity. If interest rates fall, more assets than liabilities will gain value, thus increasing the value of the firms equity. Conversely, when the duration of assets is less than the duration of liabilities, the duration gap is negative. If interest rates rise, more liabilities than assets will lose value, thus increasing the value of the firms equity. If interest rates fall, more liabilities than assets will gain value, thus reducing the value of the firms equity. By duration matching, that is creating a zero duration gap, the firm becomes immunized against interest rate risk. Duration has a double-facet view. This can be as risky as gambling or playing bingo. It can be beneficial or harmful depending on where interest rates are headed.

NIM-RSARSL NIInet interest income =NIMnet interest margin EA=earnings asset Coupon rate (PROBLEM) Bond (PROBLEM) convexity and risk (PROBLEM) Modified duration (CHAPTER 9 ANSWERS) Modified Duration, systemic risk connects to capital. Value risk, VAR and DEAR definitions VAR (problem) VAR and CAPITAL VAR lecture VAR CASE (ESSAY) Value-at-risk: for a given level of confidence and a given time horizon VAR gives an estimate of the losses that can accrue Another way of putting VAR: the dollar loss associated with an extremely bad outcome from the distribution of returns VaR gives a solid foundation for assessing the amount of capital that should be held by a bank to protect it in the case of losses arising from market risks There are three reasons for analyzing the capital consumed by market risks Complying with industry regulations Calculating economic capital to control the bank's default probability Measuring Risk-Adjusted Profitability

DEAR AND VAR DIFFERANTIATE

MICRO HEDGE CONCEPT AND BASIS RISK CONCEPT(ESSAY) Microhedging Using a futures (forward) contract to hedge a specific asset or liability. An FI is micro hedging when it employs a futures or a forward contract to hedge a particular asset or liability risk. An example of micro hedging asset-side portfolio risk, where an FI manager wanted to insulate the value of the institutions bond portfolio fully against a rise in interest rates. An example of micro hedging on the liability side of the balance sheet occurs when an FI, attempting to lock in a cost of funds to protect itself against a possible rise in short-term interest rates, takes a short (sell) position in futures contracts on CDs or T-bills. In micro hedging, the FI manager often tries to pick a futures or forward contract whose underlying deliverable asset is closely matched to the asset (or liability) position being hedged. Basis Risk is a residual risk that arises because the movement in a spot (cash) assets price is not perfectly correlated with the movement in the price of the asset delivered under a futures or forward contract. Residual unhedgable risk termed basis risk.

MACRO HEDGE EXTRA CREDIT Macro hedging hedging the entire duration gap of an Financial Institution. Macro hedging occurs when an FI manager wishes to use futures or other derivative securities to hedge the entire balance sheet duration gap. This contrasts to micro hedging, where an FI manager identifies specific assets and liabilities and seeks individual futures and other derivative contracts to hedge those individual risks. Note that macro hedging and micro hedging can lead to quite different hedging strategies and results. In particular, a macro hedge takes a whole portfolio view and allows for individual asset and liability interest sensitivities or durations to net each other out. This can result in a very different aggregate futures position than when an FI manager disregards this netting or portfolio effect and hedges individual asset and liability positions on a one-to-one basis. What is duration, modified duration and convexity? Computing historical volatility:Annualization