AdvancedRiskManagement FNC615 MBAII Finance

DrNawazish Mirza nawazish@nmirza.com

AdvancedRiskManagement FNC615 MBAII Finance

AdvancedRiskManagement

LahoreSchoolofEconomics

AdvancedRiskManagement FNC615 MBAII Finance

MarketRiskManagement Bonds
Price Sensitivity and Maturity
I general, the l In l h longer the term to maturity, the h i h greater the sensitivity to interest rate changes. Example: Suppose the zero coupon yield curve is flat at 12%. Bond A pays $1762.34 in five years. Bond B pays $3105.85 in ten years. What will be current price of these bonds?
A Assume th t i t that interest rate i t t increases b 1% E ti t th by 1%. Estimate the marked to market value

LahoreSchoolofEconomics

AdvancedRiskManagement FNC615 MBAII Finance

DrNawazish Mirza nawazish@nmirza.com

AdvancedRiskManagement FNC615 MBAII Finance

MarketRiskManagement Bonds
PriceSensitivityandMaturity
B d A P $1000 $1762 34/(1 12)5 BondA:P=$1000=$1762.34/(1.12) BondB:P=$1000=$3105.84/(1.12)10

Nowsupposetheinterestrateincreasesby1%.
BondA:P=$1762.34/(1.13)5 =$956.53 BondB:P=$3105.84/(1.13)10=$914.94 The longer maturity bond has the greater drop in price because the payment is discounted a greater number of times.
LahoreSchoolofEconomics

AdvancedRiskManagement FNC615 MBAII Finance

MarketRiskManagement Bonds
PriceSensitivityandCoupon
PriceSensitivityof6%CouponBond
N 20 10 5 1 FV 1000 1000 1000 1000 Coupon (Annual) 6% 6% 6% 6%

PriceSensitivityof8%CouponBond
N 20 10 5 1 FV 1000 1000 1000 1000 Coupon (Annual) 8% 8% 8% 8%

YTM

8%,6%,4%

YTM

10%,8%,6%

(AssumeSemiAnnualCompounding)

(AssumeSemiAnnualCompounding)

EstimateMarkedtoMarketValue

EstimateMarkedtoMarketValue

LahoreSchoolofEconomics

AdvancedRiskManagement FNC615 MBAII Finance

DrNawazish Mirza nawazish@nmirza.com

AdvancedRiskManagement FNC615 MBAII Finance

MarketRiskManagement Bonds
PriceSensitivityandCoupon
PriceSensitivityof6%CouponBond PriceSensitivityof8%CouponBond

N 40 20 10 2

8% $802 $864 $919 $981

6% $1,000 $1,000 $1,000 $1,000

4% $1,273 $1,163 $1,089 $1,019

Range $471 $299 $170 $37

N 40 20 10 2

10% $828 $875 $923 $981

8% $1,000 $1,000 $1,000 $1,000

6% $1,231 $1,149 $1,085 $1,019

Range $403 $274 $162 $38

Therangeofpricesisgreaterwhenthecouponislower. The6%bondshowsgreaterchangesinpriceinresponsetoa2%changethan the8%bond.Thefirstbondhasgreatermarketrisk.

LahoreSchoolofEconomics

AdvancedRiskManagement FNC615 MBAII Finance

MarketRiskManagement Bonds
Duration
Weighted average time to maturity using the relative present values of the cash flows as weights. Combines the effects of differences in coupon rates and differences in maturity. Based on elasticity of bond price with respect to interest rate.

LahoreSchoolofEconomics

AdvancedRiskManagement FNC615 MBAII Finance

DrNawazish Mirza nawazish@nmirza.com

AdvancedRiskManagement FNC615 MBAII Finance

MarketRiskManagement Bonds
Duration
Dm = (t wt )
t =1 T

PV (CFt ) CFt /(1 + y ) t wt = = PV ( Bond ) P

t w

w
t =1

=1

= =

1
T

t = 1

t = 1

PV ( C t PV(Bond) PV(B d)

C N + ... + N (1 + y ) N C N + ... + N (1 + y )
LahoreSchoolofEconomics

C 1 (1 + y ) 1 C (1 +

C 2 + 2 (1 + y )2 C 2 1 1 + 2 y) (1 + y )

AdvancedRiskManagement FNC615 MBAII Finance

MarketRiskManagement Bonds
DurationandModifiedDuration
PriceInterestRelationship
P =

t=1

Ct (1 + y )t

1 P = 1 + y y

Ct t t (1 + y ) t=1
N

Dm P = P = y 1 + y 1 P * = Dm P y

Dm P
*

P * 100 = Dm y 100 P
* Delta= (Dm P) /100
LahoreSchoolofEconomics

AdvancedRiskManagement FNC615 MBAII Finance

DrNawazish Mirza nawazish@nmirza.com

AdvancedRiskManagement FNC615 MBAII Finance

MarketRiskManagement Bonds
Convexity
The duration measure is a linear approximation of a nonlinear function. If there are large changes in R, the approximation is much less accurate. Duration involves only the first derivative of the price function. We can improve on the estimate using an expansion th t rarely goes b i i that l beyond second d d order (using the second derivative).

LahoreSchoolofEconomics

AdvancedRiskManagement FNC615 MBAII Finance

MarketRiskManagement Bonds
Convexity
N CFt 2P 1 = (t 2 + t) 2 2 y (1 + y) t =1 (1+ y)t

Convexity =

1 2 P P 2 y

P 1 * 2 100 = ( Dm y 100 ) + Convexity (y) 100 2 P

LahoreSchoolofEconomics