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Finance 465 Chapter 9
Terms in this set (18)
-Used by small financial institutions
-Used by large financial institutions
-Takes market value risk into account
-Much more accurate than maturity because it takes into account time of arrival of all cash flows as well as maturity
-Units of duration are YEARS
Zero Coupon Bond
-For all other bonds, duration < maturity
-pay coupons annually
-last period has both coupon and principal repaid
U.S. Treasury Bonds
-Pay coupons semi annually
-Pays a fixed coupon each year forever
and doesn't pay back principle
-Never been issued in U.S.
-Issued by British govt in 1890s to finance Boer Wars in S. Africa, still being paid
Duration and yield to maturity:
D decreases as yield increases since the discounting factor of future cash flows increases
Duration and coupon payment:
D decreases as coupon increases, since the higher the coupon rate, the faster the investor recoups the initial investment
When interest rates increase....
price of bond goes down
For small changes in interest rates....
P moves in an inversely proportional fashion according to size of D
For any given ichange in interest rates....
longer duration securities suffer larger capital loss
If assets have a longer duration than liabilities......
Rising interest rate will cause a capital loss
In order to immunize from interest rate risk, if a FI issues a liability, it must.....
-buy an asset with same duration
Limitations of duration:
-immunizing entire balance sheet used to be very costly
-large interest rate change effects not accurately captured
-Shortens duration because typically the last payments that are not made
-Delays in payment lengthen duration
Duration of demand deposits and passbook savings
Generally not rate sensitive, but depositors sometimes do react to interest rate changes
Mortgage backed securities
-Duration relationship affected by call provisions
-Duration much shorter than maturity on mortgages b/c people often prepay when they move or interest rates fall
How interest rate changes also affect value of off-balance sheet claims:
duration gap hedging strategy must include effects of off balance sheet items such as futures, swops, and options
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