Question

Assume you manage a bank’s asset portfolio with average duration of 10. If you think that next month the Central Bank will increase the interest rates by 0.25% estimate the potential % gain or loss in the value of the bank’s portfolio.

Answer 1

Duration is the risk measure for interest rate sensitive instruments like bonds, loan portfolio of a bank etc. It is an elasticity measure and changes at every point of interest rate.

If average duration is 10, it means if interest rate changes by 1% then value of bond portfolio or value of loan portfolio is expected to change by 10% in the opposite direction ignoring convexity effect.

So if central bank is expected to increase the interest rates by 0.25%, then bank will suffrer to the tune of 2.5% which is duration * % change in interest rates.

So if value of bank portfolio is $100bn, it will fall by $2.5bn due to 0.25% rise in rates.