FINA 481 - Ch. 9 Interest Rate Risk II

In most countries, FI’s report their balance sheets using _________ accounting

Book Value

Type of accounting used to reflect current market conditions

Market value accounting, marking to market

In general, the longer the term to maturity, the ________ the sensitivity to the interest rate changes

greater

The longer maturity bond has the greater drop in price because the payment is discounted a _______ number of times

greater

Duration equals the bond’s ______ since there are no intervening cash flows bewteen issue and maturity

maturity

For all other bonds, duration is _______ than maturity because there are intervening cash flows between issue and maturity

smaller

Consol bond

Bond that pays a fixed coupon each year indefinitely (not issued in the USA)

The maturity of a consol bond is _____

Infinity

Duration of a consol

D = 1 + 1/r

Duration ________ with maturity of a fixed-income asset/liability, but at a _________ rate

increases, decreasing

Duration ________ as yield ________

decreases, increases

Duration ________ as coupon __________

decreases, increases

Dollar value change in the price of a security to a 1 percent change in the return on the security

Dollar duration = MD x Price

Change in price

ΔP = -Dollar duration x ΔR

Duration Gap

Measure of the interest rate risk exposure for an FI

Change in Equity (ΔE)

ΔE = ΔA - ΔL

Difficulties in applying the duration model

1. Duration Matching can be costly

2. Immunization is a Dynamic Problem

3. Large Interest Rate Changes and Convexity

Convexity

The degree of curvature of the price-yield curve around some interest-rate level

Duration

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

If durations of liabilities and assets are not matched, then

There is a risk that adverse changes in the interest rate will increase the present value of the liabilities more than the present value of assets is increased

Convexity is desirable, but greater convexity causes __________ in the duration-based estimate of price changes

larger errors