Casual observers of the savings and loan industry identify the basic cause of current industry problems as the fact that interest rates have risen substantially in the last few years. This statement is true but somewhat of an over simplification. There are benefits which accrue to savings and loans when interest rates rise. Unfortunately, the disadvantages from the rise far outweigh the advantages.
For these reasons, an examination of the consequences of interest rate changes for savings and loans is in order. One of the best tools for this examination is a statistic referred to as duration. The emphasis of the discussion is on the intuitive concept, so any reader unfamiliar with the mathematics of the various formulas should nonetheless be able to grasp their significance. Once the meaning, significance, and limitations of duration have been clarified, we proceed to the concept of "immunization," which refers to the process of reducing or eliminating the effects of interest rate changes on the net worth of SLAs.
One of the most important features about duration is that no value is unique to a single bond. In other words, there is an infinite number of combinations of yield-to-maturity, term-to-maturity, and coupon rate that will produce the same duration number. Hence a bond with some particular yield-to-maturity, termto-maturity, and coupon rate can be described as having price risk equal to that of another bond whose yield-to-maturity, term-to-maturity, and coupon rate are all different from those of the first bond.
For every combination of bonds which have the same duration, there is always one easily identifiable bond. It is the one referred to as a zero-coupon bond. A zero-coupon bond is one which provides no interest payments but has a redemption value, and it is sometimes referred to as a pure discount bond.
The duration of a zero-coupon bond is equal to its term-to-maturity. The validity of this last statement is easily demonstrated algebraically.
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