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Duration as an effective risk management tool for interest rate risk

By Michael Vincent

26 December, 2006

Interest rate risk is one of the five major risk groups a financial institution is exposed to on an on-going basis, the others are credit risk, liquidity risk, market risk and foreign exchange risk.  Interest rate risk is the risk of adverse price movements of a security due to changes in interest rates.  Duration is a measure of a security's exposure to interest rate risk. It measures the time flow of cash from a security.

In other words duration is the effective maturity of a security because it can account for the interim cash flows.  Traditionally duration as a risk management tool has focused on bond portfolios, however Melanie Ferger, an exchange student from Germany looked at the tool in relation to asset and liability management from a financial institution's viewpoint.  The theme of her project sought to validate her hypothesis that duration could be used as an effective interest rate management tool for the liability side of a financial institution's balance sheet.

Melanie undertook experimentation by developing a model balance sheet, which could then be subjected to the effects of various scenarios with various duration values.  She indeed found that duration is an effective tool for the management of a balance sheet of a financial institution.

In recent years, risk has become a vital issue for financial institutions management; its successful identification and mitigation will more and more separate the market leaders from the also-rans. In the context of financial institutions, risk is defined as "the adverse impact of profitability of several distinct sources of uncertainty." 

Duration is an instrument to measure interest rate risk.  Frederick Macaulay first developed it in 1938, originally it was seen as a better way to summarise the timing of bond flows than the measure of term to maturity.  Duration relates the percentage price change of a security to a single property of the income stream.   Today, duration is widely applied to the asset and liability scenarios of financial institutions, effectively it is seen as an alternative to gap management, (the monitoring of interest rate sensitivities and maturities of assets and liabilities.)

Comparing the balance sheets of various Australian banks, assets in general have a duration much longer than the average liabilities.  Accordingly long terms assets are financed by short terms liabilities.  This is due to the inherent characteristics of individual securities, i.e. the predominant assets are loans and mortgages, which have long durations. On the other side of the balance sheet the majority of liabilities are comparatively short term.  This can be an advantage in a falling interest rate environment, however if interest rates rise the market value tends to decrease, financial institutions are exposed to volatility in a way that can lead to large accumulated losses.

The lesson is, if financial institutions have a certain idea of the direction of movements in interest rates, it can apply duration strategies to optimize the asset and liability portfolios according to the expected changes.

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