Week 6 - Interest Rate Risk Management

Business & Finance Finance Assignment

PBF-Assessment 3  

[Topic 6- Interest Rate Risk Management]

Question 1 - Macaulay Duration of Bond Portfolio + Modified Duration [8 marks]

(a) An investor decides to construct a bond portfolio made up of $10,000 in the 4-year 5% coupon bond and $30,000 in a 3-year zero coupon bond. Assume the par value of bond is $1000 and the market interest rate = 4%. What is the Macaulay duration of this bond portfolio? (4 marks)

(b) Estimate, using modified duration, the change in the price of the 4-year 5% coupon bond if the market interest rate decreases from 4% to 3%. (4 marks)

Question 2- Income Gap + Overall Duration Gap [17 marks]

(a) Consider the following balance sheet of Banco Credit: Assumptions - Fixed rate mortgages repaid in the coming year = 25% - Savings deposits that become rate sensitive in the coming year = 20% - All commercial loans are rate sensitive - All money market deposits are rate sensitive Using income gap analysis, calculate the change in net interest income over the coming year if interest rates increase by 1% from 4% to 5% (4 marks)

(b) What is the duration gap for Banco Credit? (4 marks)

(c) What is the estimated change in the value of equity (in $s) for Banco Credit if interest rates increase by 1% from 4% to 5%? (4 marks)

(d) Explain why a bank with a positive duration gap is estimated to see a fall in the value of its equity when interest rates increase. (5 marks)