08 2 - 1

M. Jahangir Alam Chowdhury

Department of Finance, DU
Chapter 08
Interest Rate Risk
The Maturity Model

08 2 - 2
M. Jahangir Alam Chowdhury
Department of Finance, DU
The Maturity Model

Financial Institutions reports their Balance Sheet using the Book
Value Accounting
But assets, which are expected to be sold, are reported according to
Market Values

The Maturity Model: An Example

Coupon Rate : 10%
Face Value: Tk. 100
Yield to Maturity (YTM): 10%

Price of the one Year Bond:

Govt. tightens the monetary policy, YTM goes up from 10% to 11%

Market Price of the bon falls to



(

=
+
=
+
+
= 100
1 . 1
0 100
) 1 (
1
R
C F
P
B
(

=
+
=
+
+
= 10 . 99
11 . 1
0 100
) 1 (
1
R
C F
P
B

08 2 - 3
M. Jahangir Alam Chowdhury
Department of Finance, DU
Currently,

Book Value : Tk. 100.00
Market Value : Tk. 99.10



This example simply demonstrates the fact that:


Rise in the required YTM reduces MP of fixed income securities

YTM MP

Rise in the required YTM is bad for FIs in the case of Assets, but
it is good for FIs in the case of Liabilities.

% 90 . 0 100 10 . 99
1
= = AP
0 <
A
A
R
P

08 2 - 4
M. Jahangir Alam Chowdhury
Department of Finance, DU
Because, in the same way, the Market Price of a liability (face
value Tk. 100.00) reduces to Tk. 99.10.



In a Market Value Accounting framework, rising interest rates
generally lower the market values of both assets and liabilities on
the FIs balance sheet.

Falling Market Interest Rates (YTM) have reverse (negative )
effect on both Assets and Liabilities.

The extent of the negative effect depends on the maturity period
of Assets and Liabilities.


(

=
+
=
+
+
= 100
1 . 1
0 100
) 1 (
1
R
C F
P
D
(

=
+
=
+
+
= 10 . 99
11 . 1
0 100
) 1 (
1
R
C F
P
D

08 2 - 5
M. Jahangir Alam Chowdhury
Department of Finance, DU
For Example




Marginal effect of an increase in YTM on Market Prices of Assets
and Liabilities decreases with the increase in the Maturity Period


(

=
+
=
+
+
= 100
1 . 1
100 10
) 1 (
1
n
B
R
C F
P
(

=
+
=
+
+
= 29 . 98
11 . 1
100 10
) 1 (
2
2
n
B
R
C F
P
R
P
R
P
R
P
R
P
A
A
<
A
A
<
A
A
<
A
A
30 3 2
..... ..........
% 73 . 0 %) 171 . 0 ( % 44 . 2
81 . 0 %) 9 . 0 ( % 71 . 1
2 3
1 2
= = A A
= = A A
P P
P P

08 2 - 6
M. Jahangir Alam Chowdhury
Department of Finance, DU










Maturity of the Bond
Capital Loss
0 1 2 3

08 2 - 7
M. Jahangir Alam Chowdhury
Department of Finance, DU
Three Characteristics of the effect of YTM on the Market
Prices of Assets and Liabilities:

1. A rise (fall) in interest rates generally leads to a fall (rise) in
the market value of an asset or liability.

2. The longer the maturity of a fixed-income asset or liability, the
greater the fall (rise) in market value for any given interest rate
increase (decrease).
3. The fall in the value of longer-term securities increases at a
diminishing rate for any given increase in interest rates.




08 2 - 8
M. Jahangir Alam Chowdhury
Department of Finance, DU
The Maturity Model with a Portfolio of assets and
Liabilities
Portfolio of Assets and Liabilities

M
i
= W
i1
M
i1
+ W
i2
M
i2
+ .. + W
in
M
in


M
i
= The weighted average maturity of an FIs assets (liabilities),
i=A or L
W
ij
= The importance of each asset (liability) in the asset (liability)
portfolio as measured by the market value of that asset (liability)
position relative to the market value of all the asset and (liabilities)
M
ij
= The amturity of the jth asset (or liability), j=1 n

The maturity of a portfolio of assets and liabilities is a weighted
average of the maturities of assets and liabilities


08 2 - 9
M. Jahangir Alam Chowdhury
Department of Finance, DU
The above mentioned three principles of YTM and Market
Prices also prevails in the Portfolio context.

The net effect of rising or falling interest rates on an FIs balance
sheet depends on the extent and direction in which the FI
mismatches the maturities of its assts and liabilities.

That is, whether its maturity gap, M
A
M
L
, is greater than, equal
to, or less than zero.

M
A
M
L
= 0, M
A
M
L
> 0, M
A
M
L
< 0



08 2 - 10
M. Jahangir Alam Chowdhury
Department of Finance, DU
E = A L
E = Net Worth A = Assets L = Liabilities


Maturity mismatch and its effect on Net-worth of
an FI.
Example:
Maturity of the Portfolio of Assets (Bonds) 3 Years
Maturity of the Portfolio of Liabilities (Deposits) 1 Year

Maturity Gap M
A
M
L
= 2 Years
L A E A A = A

08 2 - 11
M. Jahangir Alam Chowdhury
Department of Finance, DU
If Market Interest Rates rise by 1 percent from 10 to 11 percent,

the value of the three year bond falls by 2.44 percent (Table 6-3)
the value of the one-year deposits fall by 0.9 percent (Table 6-3)



Table 6-2: Initial Values of a Banks Assets and Liabilities
Assets Liabilities
A = 100 L = 90
E = 10
Table 6-3: Values after a rise in interest rates of 1%
Assets Liabilities
A = 97.56 L = 89.19
E = 8.37

08 2 - 12
M. Jahangir Alam Chowdhury
Department of Finance, DU
Because of the mismatch in the maturity of portfolio of assets
and liabilities:

The value of assets have fallen more than the value of liabilities
The net worth of the bank declines from Tk. 10 to Tk. 8.37, i.e. a
loss of Tk.1.63 or 16.3% (Table 6-3)
If interest rates rises from 10% to 17% (7% rise), the FI becomes
economically insolvent (Equity falls just over Tk.10) (Table 6-4)

Immunization against the Interest Rate Risk

The best way for an FI to immunize or protect itself from interest
rate risk would be for its managers to match the maturities of its
assets and liabilities, that is, to construct its balance sheet so that
its maturity gap is zero.
M
A
M
L
= 0


08 2 - 13
M. Jahangir Alam Chowdhury
Department of Finance, DU
Maturity Matching and Interest Rate Risk
Exposure

Does the Strategy of matching maturity always
eliminate all interest rate risk?

The immunization against interest rate risk requires banks to take
into account the following points:

(1) The duration or average life of assets (liability) or cash
flows, rather than the maturity of assets and liabilities.

(2) The degree of leverage in the banks balance sheet; that is, the
proportion funded by liabilities (such as deposits) rather than equity.

08 2 - 14
M. Jahangir Alam Chowdhury
Department of Finance, DU










Bank Borrows Tk. 100
Pays Principal plus Interest Tk. 115
Loan
Tk. 100
Receive 50 principal + Interest 3.75 +
interest on reinvestment of the cash
flow received in the middle of the year
Receive 50 Principal + 7.5
interest

08 2 - 15
M. Jahangir Alam Chowdhury
Department of Finance, DU











Table 6-7: Cash flow on a loan with a 15% interest rate
Cash flow at year
Principal
Interest
Cash flow at 1 year
Principal
Interest
Reinvestment Income (Tk. 57.5 x x 15%)

Tk. 50.00
7.50

Tk. 50.00
3.75
4.3125
Total cash inflow on a loan Tk. 115.5635

08 2 - 16
M. Jahangir Alam Chowdhury
Department of Finance, DU










Table 6-8: Beginning interest rate 15% falls to 12%
Cash flow at year
Principal
Interest
Cash flow at 1 year
Principal
Interest
Reinvestment Income (Tk. 57.5 x x 12%)

Tk. 50.00
7.50

Tk. 50.00
3.75
3.45
Total cash inflow on a loan Tk. 114.70

08 2 - 17
M. Jahangir Alam Chowdhury
Department of Finance, DU
The reduction in the market interest rates (in the middle of the
year) reduces the reinvestment income from Tk. 4.3125 (Tk. 57.5
x x 15%) to Tk. 3.45 (Tk. 57.5 x x 12%).





Bank incurs a loss of Tk. 0.3 (Table 6-6) rather than making a
profit of Tk. 0.5625 (Table 6-7)


Despite the matching of maturities, the FI is still exposed to
interest rate risk because the timing of the cash flows on the
deposit and loan are not perfectly matched.
Interest Rate Unchanged Interest Rate Changes
Payment on CD Tk. 115.00
Income from Loan Tk. 115.5625
Payment on CD Tk. 115.00
Income from Loan Tk. 114.70