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# DURATION MATCHING with a SWAP TO IMMUNIZE INTEREST

RATE RISK

## Consider a bank with the following balance sheet:

First the asset side:

## Assets Value Duration

of the
Asset
Cash \$200 0
3yr loan @7% \$1000 2.20
7yr loan @8% \$800 4

## Total Value of Assets, as you can see, is \$200+\$1000+\$800=\$2000

• Duration of a financial security is the extent of its exposure to interest
rate risk. For example, the duration of the 3yr loan @7% in this
example is 2.20. This means that if interest rates go up by 1%, the
value of this loan, which is \$1000 now, will go down by 2.20 %. Of
course, if interest rates go down by 1%, then the value of this loan will
go up by 1%.

## • Duration of the total assets is just the weighted average of the

component durations on the asset side.

## • Duration of Assets = DA = (200/2000)*0 + (1000/2000)* 2.20 +

(800/2000)*4 = 2.7

• This means that the total value of the assets will go DOWN by 2.7% if
interest rates go UP by 1%. Remember again that duration is a
measure of interest rate risk. It tells us the sensitivity of the value of
an asset or portfolio to changes in interest rates. Also note that cash
always has zero duration.
Now let’s look at the liability side of the bank’s balance sheet:

## Liabilities Value Duration of

the Liability
5yr loan \$750 1.5
@ Libor +0.1%
5yr loan @6% \$150 3
7yr loan @8% \$300 6

## • Total Value of Liabilities, as you can see, is \$750+\$150+\$300=\$1200

• Duration of the total liabilities is again just the weighted average of
the component durations on the liability side.
• Duration of Total Liabilities= DL = (750/1200)*1.5 + (150/1200)* 3 +
(300/1200)*6 = 2.8125
• This means that the total value of the liabilities will go DOWN by
2.8125% if interest rates go UP by 1%.

## • Now, what is the COMPLETE situation here in terms of interest rate

risk? Recall that DA = 2.7, therefore the total value of the assets will
go DOWN by 2.7 % if interest rates go down by 1%. But DL =
2.8125, therefore the total value of the liabilities will DOWN by
2.8125% if interest rates go UP by 1%.

• In other words, the bank’s net worth (assets minus liabilities) may be
exposed to a loss in case interest rates go up, because if that happens,
value of assets may decrease more than the value of liabilities. To
check whether this is the case in our example, we quantify this interest
rate risk exposure as follows:

## Duration Gap = DA – {Total Liabilities/Total Assets}* DL

= 2.7– (1200/2000)* 2.8125 =1.0125
• Since duration gap is positive, this means the bank’s net worth (assets
minus liabilities) will suffer if interest rates go up. In our case,
duration gap is 1.0125. This says that if interest rates go up by 1%,
then the net worth of the bank’s balance sheet (which is now \$2000-
\$1200=\$800) will go down by 1.0125%.
• Now, we will discuss how we can immunize this interest rate risk.
This practice of interest rate risk management is called duration
matching. The purpose of duration matching, which is a hedging
method, is to decrease the duration gap to zero, because if the duration
gap is zero, then this means that the net worth of the balance sheet is
immune to changes in interest rate, i.e. the net worth (value of assets
minus the value of liabilities) do not change if interest rate changes. (It
becomes immune). To see how one can achieve this, consider the
duration gap equation again:
Duration Gap = DA – {Total Liabilities/Total Assets}* DL
At the moment, this is positive, it is equal to 1.0125 and we want to
decrease it to zero. We can concentrate on the liability side and
increase the duration of liability side just enough to make Duration
gap zero.

• Now, look at the floating rate loan on the liability side, that’s a 5yr
loan @ Libor +0.1%. The face value of this loan is \$750. Suppose you
swap part of this loan in exchange of paying a fixed interest rate of
7.25%. Since this is a liability, you are at the moment paying Libor
+0.1% on a value of \$750 over the course of next 5 years. Say you
swap \$x out of this \$750, i.e. the other party pays you Libor +0.1%
over the notional principal of \$x (i.e. she assumes your liability) and
you pay her a fixed rate of 7.25% over the next 5 years. After this
swap, your liability side will look as follows:

## Liabilities Value Duration of

the Liability
5yr loan \$750-x 1.5
@ Libor +0.1%
5yr loan \$x 4.3
@7.25%
7yr loan @8% \$300 6
5yr loan @6% \$150 3

All we have to decide now is the value of x such that Duration Gap = 0 (see
the solution in class).
Practice Questions on Duration Matching:

## Assets Value Duration of

the Asset
Cash \$1500 0
3yr loan @6% \$3000 3
5yr loan @8% \$3000 4

## Liabilities Value Duration of

the Liability
5yr loan @ Libor \$2000 2
4yr loan @6% \$1000 3
5yr loan @6% \$2000 4.9

a) Find the duration of the asset side. If interest rate goes up by 1%, what will
happen to the total value of the assets?
Find the duration of the liability side. If interest rate goes up by 1%, what
will happen to the total value of the liabilities?

## Answer: Duration of Assets = 2.8

Duration of Liabilities = 3.36

b) Find the duration gap. If interest rate goes up by 1%, what will happen to
the net worth of the bank’s balance sheet?

c) Suppose the portfolio manager wants to reduce the duration gap to zero and
thus immunize all interest rate risk. For that purpose he wants to swap \$x of
the 5yr loan @ Libor with a 5yr loan at 8% fixed rate. The duration of the
fixed rate 5yr loan at 8% is 4.5
What is the size \$x of the swap such that duration gap becomes zero?

Question 2 (Reducing Duration Gap To Zero)

## Assets Value Duration of

the Asset
Cash \$3000 0
6yr loan @5% \$1500 5.3
5yr loan @6% \$1500 4.2

## Liabilities Value Duration of

the Liability
4yr loan @ Libor \$1000 1
4yr loan @5% \$1000 3
5yr loan @6% \$2000 4

a) Find the duration gap. If interest rate goes up by 1%, what will happen to
the net worth of the bank’s balance sheet?

b) Suppose the portfolio manager wants to reduce the duration gap to zero and
thus immunize all interest rate risk. For that purpose he wants to swap \$x of
the 4yr loan @ Libor with a 4yr loan at 7% fixed rate. The duration of the
fixed rate 4yr loan at 7% is 3.5. What is the size of the swap \$x so that
duration gap becomes 0?