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RISK MANAGEMENT MODULE A

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RISK MANAGEMENT MODULE A Asset Liability Management AND MODULE B Risk Management A PRESENTATION BY K ESWAR MBA XLRI, CAIIB CHIEF MANAGER, SPBT COLLEGE. – PowerPoint PPT presentation

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Title: RISK MANAGEMENT MODULE A


1
RISK MANAGEMENT MODULE A Asset Liability
Management AND MODULE B Risk Management
  • A PRESENTATION BY
  • K ESWAR MBA XLRI, CAIIB
  • CHIEF MANAGER, SPBT COLLEGE.

2
BANKS TYPICALLY FACE THREE KINDS OF RISK
Example
Type of Risk
Stocks
Daily price change ()
  • Risk of loss due to unexpected re-pricing of
    assets owned by the bank, caused by either
  • Exchange rate fluctuation
  • Interest rate fluctuations
  • Market price of investment fluctuations
  • Risk of loss due to unexpected borrower default
  • Risk of loss due to a sudden reduction in
    operational margins, caused by either internal or
    external factors viz Process failure, systems
    failure, human error, frauds but does not cover
    reputational risk/strategic risk.

Unexpected price volatility
Market
Time
Default rate ()
Loans with credit rating 3
Unexpected default
Avg. default
Credit
Time
Monthly change of revenue to cost ()
Business unit A
Unexpected low cost utilization
Operational
Time
3
The Current Capital Accord
  • Focused on credit risk but formula based
  • Partially amended in 1996 to include market risk
  • Operational risk not addressed
  • Simple in its application
  • Produced an easily comparable and verifiable
    measure of banks soundness

4
Need for a new frame-work
  • Financial innovation and growing complexity of
    transactions
  • Categorised banks assets into one of only four
    categories each representing a risk class
  • Made no allowance for the effect portfolio
    diversification
  • Requirement of more flexible approaches as
    opposed to one size fits all Approach
  • Requirement of Risk sensitivity as opposed to a
    broad- brush Approach
  • Operational Risk not covered

5
Basle Accord I II - Differences
  • Talks of Credit Risk only
  • Capital Charge for Credit Risk 8
  • Does not mention separate Capital charge for
    Market and Operational Risk
  • No mention about market Discipline
  • No effort to quantify Market and Operational Risk
  • Talks of Credit, Market and Operational Risks
  • Capital Charge dependant on Risk rating of assets
  • Capital Charge to include risks arising out of
    Credit, Market and Operational risks. Not a broad
    brush approach
  • Quantitative approach for calculation of Market
    and Operational risks as for Credit Risk.

6
Three pillars of the Basel II framework
Minimum Capital Requirements
Supervisory Review Process
Market Discipline
  • Credit risk
  • Operational risk
  • Market risk
  • Banks own capital strategy
  • Supervisors review
  • Enhanced disclosure

7
Pillar I Credit Risk
Pillar 1 Credit Risk stipulates three levels of
increasing sophistication. The more sophisticated
approaches allow a bank to use its internal
models to calculate its regulatory capital. Banks
who move up the ladder are rewarded by a reduced
capital charge
Advanced Internal Ratings Based Approach
Increase Sophistication
Foundation Internal Ratings Based Approach
Banks use internal estimations of PD, loss given
default (LGD) and exposure at default (EAD) to
calculate risk weights for exposure classes
Standardized Approach
Banks use internal estimations of probability of
default (PD) to calculate risk weights for
exposure classes. Other risk components are
standardized.
Risk weights are based on assessment by external
credit assessment institutions
Reduce Capital requirements
8
Pillar I Minimum Capital Requirements
The new Accord maintains the current definition
of total capital and the minimum 8 requirement
Total capital
Banks capital ratio (minimum 9)
Credit risk Market risk Operational risk
Total capital Tier 1 Tier 2 Tier 1
Shareholders equity disclosed reserves Tier 2
Supplementary capital (e.g. undisclosed reserves,
provisions)
Total Capital
Credit Risk
The risk of loss arising from default by a
creditor or counterparty
Market Risk
The risk of losses in trading positions when
prices move adversely
Operational Risk
The risk of loss resulting from inadequate or
failed internal processes, people and systems or
from external events
The revisions affect the denominator of the
capital ratio - with more sophisticated measures
for credit risk, and introducing an explicit
capital charge for operational risk
9
Internal Ratings Based Approach
  • Exposures in five categories because of different
    risk characteristics
  • Sovereigns
  • Banks
  • Corporates
  • Retail
  • NPA

10
Pillar I Credit Risk
Pillar 1 Credit Risk stipulates three levels of
increasing sophistication. The more sophisticated
approaches allow a bank to use its internal
models to calculate its regulatory capital. Banks
who move up the ladder are rewarded by a reduced
capital charge
Advanced Internal Ratings Based Approach
Increase Sophistication
Foundation Internal Ratings Based Approach
Banks use internal estimations of PD, loss given
default (LGD) and exposure at default (EAD) to
calculate risk weights for exposure classes
Standardized Approach
Banks use internal estimations of probability of
default (PD) to calculate risk weights for
exposure classes. Other risk components are
standardized.
Risk weights are based on assessment by external
credit assessment institutions
Reduce Capital requirements
11
Capital Requirement What New?
12
Framework
13
Claims on Banks is 20 subject to the fact that
CRAR of borrowing Bank is 9 and above. And it
is scheduled Bank.
14
Claims on corporates
Credit assessment by domestic rating agencies AAA AA A BBB BB and below Unrated
Risk weight 20 30 50 100 150 100
Unrated exposure of Rs.50(Rs.10 crores) will
attract 150 risk weight.
15
Mapping process draft guidelines
Short term ratings Short term ratings Short term ratings Short term ratings Risk weights
CARE CRISIL FITCH ICRA
PR1 P1 F1 A1 20
PR1 P1 F1 A1 30
PR2 P2 F2 A2 50
PR3 P3 F3 A3 100
PR4/PR5 P4/P5 B/C/D AR/A5 150
UNRATED UNRATED UNRATED UNRATED 100
16
Retail Portfolio - Criteria
  • Orientation criterion - exposure to individual
    person or persons or to a small business.
  • Product criterion - revolving credit, line of
    credit, personal term loan and lease small
    business facilities and commitments.
  • Granularity criterion- regulatory retail
    portfolio is sufficiently diversified to a degree
    that reduces the risk in the portfolio no
    aggregate exposure to one counterpart can exceed
    0.2 of the overall regulatory retail portfolio
  • Low value of individual exposures- the maximum
    aggregate retail exposure to one counterpart
    cannot exceed an absolute threshold of euro 1
    million.( Rs. 5 Crores for our Bank)
  • Turnover Rs.50 Crores.(AVERAGE FOR LAST 3 YEARS)

17
Capital charge for Credit risk contd
  • Past due loans
  • The unsecured portion of any loan that is past
    due for more than 90 days, net of specific
    provisions, to be given higher risk weight
  • 150 if specific provision lt20 o/s
  • 100 if provision gtor 20
  • if provision or gt 50 with supervisory
    discretion for 50 weight
  • 100 if provision gt or 15 if fully secured

18
Exclusion in Regulatory Retail.
  • Mortgage loans to the extent they qualify for
    treatment as claims secured by residential
    property Margin 25 RW upto Rs.20 lakhs 50
    and Rs.20 lakh and above 75 Margin less than 25
    RW 100
  • Consumer credit, credit card exposure etc.
    RW125
  • Capital market exposure and NBFCs RW125
  • Commercial Real Estate RW 150
  • Staff loans 20 if covered by superanuation
    funds or mortgage.
  • Other staff loans 75 RW

19
Operational Risk
  • Explicit charge on capital
  • Basic Indicator approach 15 of gross income
  • Gross income net interest income plus net non
    interest income

20
GROSS INCOME
  • GROSS INCOME NET PFORIT PROVISIONSOPERATING
    EXPENSES-PROFIT ON SALE OF INVSTEMENT-INCOME FROM
    INSURANCE-EXTRA ORDINARY ITEM OF INCOME LOSS ON
    SALE OF INVESTMENT

21
Operational Risk
  • Standardised Approach- Capital charge is
    calculated as a simple summation of capital
    charges across 8 business lines

Business lines of gross income
Corporate finance 18
Trading sales 18
Retail Banking 12
Commercial Banking 15
Payment Settlement 18
Agency Services 15
Asset Management 12
Retail Brokerage 12
22
  • CREDIT RISK MITIGATION
  • HAIR CUT TO EXPOSURE
  • HAIR CUT TO FINANCIAL COLLATETAL.

23
  •  
  • Q. Net Interest Margin NIM is defined as
  • a. Net interest income divided by total earning
    assets.
  • b. Interest income interest expenses.
  • c. total interest income divided by total assets.
  • d. None of above.
  •  
  • Q..Ratio of share holders funds to total assets
    is called as
  • a. Debt equity ratio.
  • b. TOL/TNW ratio.
  • c. Economic equity ratio.
  • d. No ne of above.

24
  •  
  • Q The institution is in a position to benefit
    from rising interest rates when assets are
    than liabilities.
  • Lower.
  • Greater
  • Equal
  • Half.
  • Q. The liquidity risk arising out of
    unanticipated withdrawal or non renewal of
    deposits is called as
  • a. Funding Risk.
  • b. Time risk.
  • c. Market Risk
  • d. Operational risk.

25
  •  
  • Q. The liquidity risk arising out of non
    receipt of expected in flow of funds due to
    accounts turning as NPA is known as
  • a. Time Risk.
  • b. Call Risk.
  • c. Operational Risk.
  • d. Funding risk.
  •  
  • Q. The liquidity risk arising out of
    crystallization of liabilities and conversion
    of non fund based limits to fund based limits
    is known as
  • a. Call risk.
  • b. Time risk.
  • c. Operational risk.
  • d. Market risk.
  •  

26
  •  
  • Q. Stock approach of measuring and managing
    liquidity risk and funding requirements is
    based on
  • a. level of assets and liabilities and balance
    sheet exposure on a particular date.
  • b. based on stocks pledged to Bank in Cash
    Credit Account
  • c. Stock of Investments of bank.
  • d. None of above.
  •  
  • Q. Flow approach to measuring and managing
    liquidity consist of
  • a. Measuring and managing net funding
    requirements.
  • b. Managing market access.
  • c. Contingency planning.
  • d. All the above.

27
  •  
  • Q. Under gap method the net funding
    requirement is calculated based on
  • a. residual maturities of assets and
    liabilities.
  • b. Actual maturities of assets and liabilities
  • c. Both the above.
  • d. None of above.
  •  
  • Q. Cash inflows arise from mainly
  • a. Maturing assets.
  • b. Maturing liabilities.
  • c. Maturing off balance sheet exposure.
  • d. Maturing time deposits.

28
  •  
  • q. Cash outflows arise out of mainly.
  • a. Maturing liabilities.
  • b. Maturing assets.
  • c. Maturing T Bills.
  • d. Maturing CPs.
  •  
  • Q. Different between the cash in flow and cash
    out flow will result into.. if the cash
    inflows are lower than the cash outflows
  • a. deficit.
  • c. Surplus
  • d. None of above.
  • e. No impact.

29
  •  
  • Q. If there is significant deficit observed say
    after 30 days period the option available for
    bank is to
  • a. acquire an asset maturing on that day.
  • b. renew or roll over a 30 day liability.
  • c. Acquire a liability maturing after 30
    days.
  • d. None of above.
  •  
  • Q. In the year 2007 RBI has for the purpose of
    measurement of liquidity risk split the first
    time bucket of 1-14 days in its structural
    liquidity in
  • a. Four time buckets.
  • b. Three time buckets
  • c. Five time buckets.
  • d. None of above.

30
  • Q the net cumulative negative mismatch during
    the next day, 2-7 days, 8-14 days and 15-28 days
    buckets should not exceed
  • a.5,10, 15 and 20 of cumulative cash inflows
    in respective time bucket.
  • b. 20,15,10 and 5 of cumulative cash inflows.
  • c.10,5,25 and 30 of cumulative cash inflows.
  • Q. Frequency of structural liquidity position
    is
  • a. fortnightly
  • b. Weekly.
  • c. Monthly
  • d. Quarterly.

31
  •  
  • Capital , Reserves and Surplus are slotted in
    which time bucket in Structural Liquidity
    Statement
  • Over 5 years.
  • Over 3 Years.
  • Over 1 Year.
  • Over 6 months.
  • Q. Saving and Current deposit may be treated as
    volatile portion upto
  • a. 10 and 15 respectively.
  • b.20 and 30 respectively.
  • c. 30 and 40 respectively.
  • d. None of above

32
  • Q. Placement of volatile portion and core
    portion of Saving and current deposit may be done
    as under
  • a. volatile portion in day 1 time bucket and core
    portion in 1-3 year bucket.
  • b. Volatile portion in 7 day time bucket and
    core portion in 5 year bucket.
  • c. Volatile portion in 2-7 days time bucket and
    core portion in 1 year time bucket.
  • d. none of above.
  •  
  • Q. Cash should be shown under which time bucket
    for inflow
  • a. 1 day.
  • b. 2-7 days.
  • c. 8-14 days.
  • d. One year.

33
  •  
  • Q. Investment in shares and mutual fund (open
    ended) should be shown in
  • a. Over 5 year bucket
  • b. Over 1 year bucket.
  • c. Over 2 year Bucket.
  • D. None of above.
  •  
  • Q. Investment in subsidiaries and joint ventures
    to be shown
  • a. In over 5 year bucket.
  • b. In over 3 year bucket.
  • c. In over 1 year bucket.
  • d. None of above.

34
  •  
  • Q. Core portion of Cash credit advances may be
    shown undera. 1-3 year time bucket.
  • b. over 3 year time bucket.
  • c. Over 5 years time bucket.
  • d. None of above.
  •  
  • Q. Term Loans to be shown under
  • a. Interest and principal of the loan under
    residual maturity bucket.
  • b. Principal under residual maturity bucket.
  • c. all in 5 year and above bucket.
  • d. None of above.

35
  •  
  • Q. Sub Standard loans to be shown under
  • a. Over one year bucket.
  • b. Over 2 year bucket.
  • c. Over 3 years bucket.
  • d. Over 3-5 year bucket.
  •  
  • Q. Fixed Assets
  • a. Over 5 year bucket.
  • b. Over 2 year bucket.
  • c. Over 1 year bucket.
  • d. none of above.

36
  •  
  • Q. The net cumulative negative mismatches
    during the day 1, 2-7, 8-14 and 15-28 days
    buckets if exceed the prudential limits may be
    financed from market by
  • a. Market borrowings ( call /term)
  • b. Bills discounting
  • c. Repo
  • d. All above.

37
  • Q. Market Value of an asset is conceptually equal
    to
  • a. Present value of current and future cash flows
    from that asset and liability.
  • b. future value of current and future cash
    flows from that asset and liability.
  • c. None of above.
  • d. all the above.
  •  
  • Q. There fore rising interest rates increase the
    discount rates on those cash flows and thus
  • a. Decrease the market value of asset or
    liability.
  • b. Increase the market value of asset or
    liability.
  • c. No impact is caused.
  • d. None of above.
  •  

38
  • Q. Falling interest rate decrease the discount
    rates on these cash flows and thus
  • a. Increase the market value of an asset or
    liability.
  • c. Decrease the market value of an asset or
    liability.
  • d. No Impact.
  • e. None of above.
  •  
  • Q. What is basis risk
  • a. risk that interest rate of different assets
    and liabilities may change in different
    magnitudes is called basis risk.
  • b. Risk relating to basis on which loan is
    sanctioned.
  • c. Risk related to yield curve.
  • d. None of above.

39
  • Q. Yield Curve Risk is known as
  • a. Risk owing to altering of yields across
    maturities and its impact on NII
  • b. Risk owing to wrong drawing of yield curve
    by Bank staff.
  • c. risk of lower current yield .
  • d. None of above.
  •  
  • Q. Gap method is basically used for
  • a. measuring banks interest rate risk exposure.
  • b. measure maturity mismatch
  • c. Measure potential losses from off balance
    sheet exposure.
  • d. None of above.

40
  •  
  • Q. In a given time band a negative or liability
    sensitive gap occurs when
  • a. Rate sensitive liabilities exceed rate
    sensitive assets.
  • b. Rate sensitive assets exceed rate sensitive
    liabilities.
  • c. None of above.
  • d. All the above.
  •  
  • Q. with a negative gap , an increase in market
    interest rates could cause a
  • a. decline in net interest income.
  • b. Increase in net interest income.
  • c. None of above.
  • d. All above.
  •  

41
Market Value with interest at 8
42
Interest Rate
  • Suppose that current expectation of yield is 10.
    What will be the market price?

43
Interest Rate
  • Suppose that current expectation of yield is 6.
    What will be the market price?

44
  •  
  • Q. Higher the duration implies that a given
    change in the level of interest rates will have
  • a. larger impact on economic value.
  • b. smaller impact on economic value.
  • c. No Impact.
  • d. None of above.
  •  
  • Q. Duration will be higher ifa. longer the
    maturity date or smaller the payments that occur
    before maturity ( coupon payments)
  • b. shorter the maturity and higher the payments
    that occur before maturity ( coupon payments)
  • c. None of above.
  • d. all the above.

45
  •  
  • Q. One of the strategies for reducing the asset
    or liability sensitivity could be
  • a. Increase floating rate instruments.
  • b. Increase fixed rate instruments.
  • c. None of above.
  • d. all the above.
  •  
  • Q. The Duration of Zero coupon bond would be
  • a. Greater than its maturity.
  • b. Shorter than its maturity.
  • c. Equal to its maturity.
  • d. None of above.

46
  • None of above.
  • Q. Under Put option the buyer has
  • a. Right to sell but not obligation to sell
  • b. Right to buy but not obligation to buy
  • c. Right to receive interest payments.
  • d. None of above.
  • Q. Under Call option the buyer has
  • a. Right to buy but not obligation to buy
  • b. right to sell but not obligation to buy
  • c. None of above.

47
  • ..
  •  
  • Q. American option
  • a. Permit the holder to exercise any time before
    the expiration date.
  • b. Does not permit to exercise any time before
    the expiration date.
  • c. None of above.
  • d. all above.
  •  
  • Q. European option means
  • a. Which permit holder to exercise any time
    before expiration date.
  • b. Does not permit holder to exercise any time
    before expiration date.
  • c. all above.
  • d. none of above.

48
  •  
  • Q. In India only
  • a. European option are allowed.
  • b. Only American option are allowed.
  • c. Both are allowed.
  • d. None are allowed.
  •  
  • Q. Futures are
  • a. Over the counter products.
  • b. Exchange traded.
  • c. None of above.
  • d. all the above.

49
  •  
  • Q. Which of the following is true
  • a. A swap has invariably two legs of transaction.
  • b. A swap only one leg of transaction.
  • c. None of above.
  • d. All the above.
  •  
  • Q. Futures are marked to market on
  • a. Daily basis and margin is adjusted.
  • b. Weekly basis.
  • c. Monthly basis.
  • d. None of above.

50
  •  
  • Q. Short term dynamic liquidity statement
    relate to
  • a. monitoring liquidity on dynamic basis over a
    time horizon of 1-90 days.
  • b. monitoring liquidity on dynamic basis over a
    time horizon of 7-90 days.
  • c. monitoring liquidity on dynamic basis over a
    time horizon of 28-90 days.
  • d. None of above.
  •  
  • Q. In statement of interest rate sensitivity
  • a. Only rupee assets and liabilities and off
    balance sheet positions should be reported.
  • b. All assets and liabilities should be
    reflected.
  • c. Only foreign currency assets and liabilities
    should be reflected.
  • d. None of above.

51
  •  
  • Q. Gap is the difference between
  • a. Rate Sensitive Assets and Rate Sensitive
    Liabilities for each time bucket.
  • b. Rate Sensitive Liabilities and Rate Sensitive
    Assets for each time bucket.
  • c. None of above.
  • d. all above.
  •  
  • Q If positive gap of RSA gt RSL, Bank will
  • A.Benefit from rising interest rate.
  • B.Lose from rising interest rate.
  • C.None of above.
  • D.All of above.

52
  • Q. If negative gap of RSL gt RSA will benefit
    from
  • a. declining interest rate.
  • b. Rising interest rate.
  • c. None of above.
  • d. No impact.
  •  
  • Q. Capital , Reserves and Surplus are
  • a. Non interest rate sensitive.
  • b. Interest Rate Sensitive.
  • c. None of above.

53
  •  
  • Q. Provisions and inter office adjustments are
  • a. Rate sensitive.
  • b. Rate non sensitive.
  • c. None of above.
  • d. all of above.
  •  
  • Q. Current account balance is
  • a. Rate sensitive.
  • b. Rate non sensitive.
  • c. None of above.
  • d. All of above.

54
  • . Banking Book relates to assets which are
  • A held till maturity and reflected in
    Balancesheet at acquisition cost.
  • b. held till maturity and reflected in Banking
    book at market cost.
  • c. None of above.
  • d. all of above.
  •  
  • Q. Trading book includes
  • a. assets a which normally not held till
    maturity and mark to market system is followed.
  • b. assets which are held till maturity.
  • c. assets which are purchased in market.
  • d. none of above.

55
  •  
  • Q..which book is exposed to market risk.
  • a. Banking book.
  • b. trading book
  • c. None of above.
  • d. Both a and b.
  •  
  • Q. Which is true
  • a. Risk associated with portfolio is always
    less than the weighted average of risks of
    individual items in portfolio.
  • b. Risk associated with portfolio is always more
    than the weighted average of risks of individual
    items in portfolio.
  • c. Risk associated with portfolio is equal to
    weighted average of risks of individual items in
    a portfolio.
  •  

56
  •  
  • Q. Daily volatility of stock is 1. What is 10
    day volatility?
  • a. 3
  • b.10
  • c.1
  • d.4

57
  • Q. Systemic risk can be diversified
  • a. True.
  • b. False
  • c. Partly true
  • d. partly false.
  •  
  • Q. Basel Committee (BCBS) possess formal super
    national supervisory authority and its
    conclusions have legal force
  • a. True.
  • b. False.

58
  •  
  • q..Bond prices changes can be estimated using
    modified duration using following relationship
  • a. modified duration yield change.
  • b. Mculay duration yield change.
  • c. Maturityyield change.
  • d. None of above.
  •  
  • Q.VaR is
  • a. potential worst case loss at a specific
    confidence level over a certain period of time.
  • b. potential worst case loss over indefinite
    period of time.
  • c. none of above.
  •  

59
  •  
  • 1 day VaR of portfolio is Rs.5,00,000 with 95
    confidence level in a period of six months ( 125
    days) how many times the loss on the portfolio
    may exceed Rs.5,00,000
  • 4 days. B. 5 days. 3. 6 days 4. 7 days.
  •  
  • Q. RAROC stands for
  • a. Risk Adjusted Return on capital
  • b. Risk adjusted return on cost.
  • c. Return adjusted risk on credit.
  • D none of above.

60
  •  
  • Q.Credit Default swaps are
  • a. One of credit derivatives.
  • b. a kind of Bank guarantee
  • c. a kind of line of credit.
  • d. stand by credit.
  •  
  • Q. The beta factor for calculating operational
    risk under standardized approach for retail
    banking is
  • a. 12
  • b.18
  • c.15
  • D. None of above.

61
  •  
  • Q. Probability of occurrence 4
  • Potential financial impact 4
  • Impact of internal control 0
  •  
  • a. What is estimated level of operational risk?
  • 1. 3
  • 2. 2
  • 3 0
  • 4. 4

62
Interest Rates
63
Yield Curve Parallel Shifts
64
Yield Curve Stiffening Flattening
65
  • Duration Analysis

66
DURATION
  • A methodology is required for following purposes
  • To assess ALM mis-matches between assets and
    liabilities
  • To compare two portfolios - Both can be assets /
    liabilities or one asset and one liability
    portfolio
  • To decide between various options for contracting
    assets or liabilities
  • DURATION ANALYSIS

67
DURATION
  • In financial analysis, any intermittent cash flow
    earned from a financial asset is presumed to be
    reinvested at current interest rates.
  • Thus, when current interest rates go up, price of
    a bond falls while the reinvestment income will
    go up for period to maturity. Thus capital loss
    and higher income occur together.
  • At some point of time in the life of the asset,
    the capital loss will equal the rise in
    reinvestment income This point of time is defined
    as Duration of the Asset.

68
DURATION
  • Duration is also termed as effective life of an
    asset / liability or as weighted average life.
  • Duration can be applied to any asset / liability
    that is of fixed income type. It cannot be
    applied to floating rate instruments.
  • Duration is a direct outcome of maturity (to
    term) and interest rates.
  • Hence Duration is also viewed as primary
    measurement of price sensitivity.
  • Duration measure (D) is expressed in years.

69
DURATION ANALYSIS An Example
70
Duration
  • Duration in expressed in years and is comparable
    across portfolios.
  • Duration of a Zero Coupon Bond is equal to its
    maturity.
  • Duration is additive. Hence, Duration of a
    portfolio is the weighted average duration of all
    instruments of the portfolio.
  • Duration of a coupon paying bond / asset is less
    than its maturity.
  • Longer the maturity of a bond, longer is
    Duration.
  • Duration is inversely related to Coupon.

71
Duration
  • Duration is directly related to market interest
    rates / Yield.
  • Higher the frequency of coupons, lower the
    Duration.
  • Duration of a Floating Rate bond is equal to its
    interest reset period or the period remaining to
    next reset of interest.
  • For small changes in yield, Duration multiplied
    by percentage change in yield gives percentage
    change in price for bonds.

72
Duration Price Change
  • If current price of a bond is Rs 98.50, its
    Duration is 2.7613 and yield is likely to change
    from 6.00 to 5.80, then the likely price of the
    bond is computed as under
  • change in Price D(percentage change in
    Yield)
  • 2.7513 (6.00 - 5.80)
  • 0.55226
  • Absolute change in Price 98.50 0.55226
  • 0.54398.
  • As Yield has come down, price will increase and
    therefore, expected bond price will be
    Rs 99.04398.

73
Modified Duration
  • Duration is not preferred to compute price
    changes when change in yield is large. For this
    purpose, Modified Duration (MD) is used.
  • MD Duration / (1Yield)
  • In our Bond example, D2.76129 and yield is
    6.00. Therefore, MD 2.76129/(10.06) or
    2.60500. Let current market price be Rs 98.50.
  • If yield changes from 6.00 to 5.80, percentage
    change in price will be 0.52100 and absolute
    change in price will be 0.51318.
  • Hence changed price will be Rs 99.01318.

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Duration Interest Rate Risk
  • In a banks balance sheet, If DA DL, there is
    no IRR faced by the bank. IRR manifests itself if
    DA gt DL or DA lt DL, depending on the direction of
    movement of interest rates.
  • Hence, the strategy for containing IRR will be to
    aim at a mix of assets and liabilities in such a
    way that their Duration matches.
  • Duration Gap is the difference between the
    Duration of Assets less the effective Duration of
    Liabilities.

75
Duration Interest Rate Risk
  • If a bank has Asset Duration of 3 years, Assets
    of Rs 200 crore and Liabilities (excluding
    Equity) of Rs 150 crore, the bank should target
    Liability Duration of 4 years (2003/150).
  • In that case, Duration of Equity will be
  • (3200) (4150) 0.
  • In other words, banks net worth is immunized
    against changes in interest rates.
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