Jennifer McAfee recently received her university Master’s degree and has decided

Question

Jennifer McAfee recently received her university Master’s degree and has decided to enter the mortgage brokerage business. Rather than work for someone else, she has decided to open her own shop. Her cousin Finn has approached her about a mortgage for a house he is building. The house will be completed in 3 months, and he will need the mortgage at that time. Finn wants a 25-year, fixed-rate mortgage for the amount of £500,000 with monthly payments. Jennifer has agreed to lend Finn the money in 3 months at the current market rate of 8 per cent. Because Jennifer is just starting out, she does not have £500,000 available for the loan, so she approaches Ian MacDuff, the president of IM Insurance, about purchasing the mortgage from her in 3 months. Ian has agreed to purchase the mortgage in 3 months, but he is unwilling to set a price on the mortgage. Instead, he has agreed in writing to purchase the mortgage at the market rate in 3 months. There are Treasury bond futures contracts available for delivery in 3 months. A Treasury bond contract is for £100,000 in face value of Treasury bonds.

7. IM Insurance wish to hedge themselves against interest rate risk by ensuring that the average duration of their assets equals the average duration of their liabilities. This strategy is known as duration matching or portfolio immunization. Explain how duration matching can protect a portfolio of assets and liabilities against a shift in interest rates.

8. Describe a situation when the duration of assets doesn’t match the duration of liabilities. When do you make a profit (loss) on your portfolio?

9. In which situation does duration matching fail to perfectly immunize a portfolio?

Explanation / Answer

8) Consider a bank with a $100 asset(with a duration of 2 years and a $100 liability with a duration of 1 year.

If the interest rate increases at the end of the year, the outflow on the liability will increase with no change to the inflows from the asset. Hence the total returns of the bank will decrease with a rise in interest rates when the duration of the asset> duration of the liability.
On the other hand, if interest rates were to fall, it will result in the bank's total returns
increasing. In this case, the outflows would reduce and the net interest income would increase.

9 Duration matching does not immunize a portfolio against non parallel shifts in yield curve ie when the change in rates impacts maturities differently. For example, given a yield curve for bonds with one-year, five-year, and 10-year maturities, the yield for the one-year bond may increase 10 basis points, the five-year may stay the same, and the 10-year may decrease 20 basis points. It is also affected by pre-payments and defaults.In such cases, duration matching will fail and the firm will have to use other methods to reduce their interest rate exposure

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