TOPIC 17 BONDS PORTFOLIO AND RISK MANAGEMENT

Bond portfolio concepts, measures of interest rate risk duration, modified

duration, DV01, Convexity, taylor series approximations

Bond price changes as yield (= constant discount rate) changes

- Duration = slope of line
This slope or rate of change is not constant; it changes as the yield changes
- Convexity
The behaviour of the price of the bond as interest rates change is one way to
characterise the interest rate risk of a bond (or bond portfolio)

DURATION

As the discount rate goes up, the price of the bond goes down
By how much? Duration answers this
Two types of duration
- Macaulays duration
- Modified duration
If a trader is talking about duration he/she probably means modified duration
(the more useful of the two concepts)
Rule 1 for duration: the duration of a zero-coupon bond equals its time to
maturity. A coupon bond is lower than a zero with equal maturity because
coupons early in the bonds life lower the bonds weighted average time until
payments.
Rule 2 for duration: holding maturity constant, a bonds duration is lower when
the coupon rate is higher

MACAULAYS DURATION

Macaulays duration definition:

- Roughly: it is the average time of cash flows
- Precisely: it is the weighted average of cash flow time where the
weights used for each time is equal to the present value of the cash
flow at that time
Intuition: imagine a ruler where distance corresponds to time. Put a weight equal
to the PV of a cash flow on each time along the ruler for each cash flow. The
Macaulays duration is simple the balancing point of this ruler.

TOPIC 17 BONDS PORTFOLIO AND RISK MANAGEMENT

MODIFIED DURATION

Modified duration definition

Alternative definition:

Suggests that modified duration is the partial derivative of the bond

price with respect to yield, scaled by the bond price, times -1

TOPIC 17 BONDS PORTFOLIO AND RISK MANAGEMENT

-

Derivative B0 / y is the slope of the price of the bond plotted against

the discount rate
The slope is often negative (since y when B 0 ); the formula
multiplies by -1 so that modified duration is usually a positive number
Modified duration is measuring the sensitivity of the bond to a
(infinitesimally) small change in yield
for a small change in yield y.
Rearrange to get
B0 D B0 y
Useful for predicting change in bond price for a given change in yield
An APPROXIMATION that will become increasingly inaccurate as y gets
bigger
IMPORTANT: the accuracy of this approximation can be improved by
including the effect of convexity

DV01 (aka PV01)

dollar value of a basis point

Meaning: how much does the price of the bond change if the yield increases by
1bp (=0.01%=0.0001)
DV 01 D B0 0.0001
Since 1 basis point is quite small, this approximation should be close enough
for most practical purposes
In trading applications DV01 is usually calculated directly by just bumping the
curve up 1bp and recording the change in bond price that results

CONVEXITY

Convexity Is related to the slope of duration plotted against yield

using maths we can express convexity in terms of modified duration
While duration is scaled slope of the bond price plotted against yield, convexity is
the scaled curvature of the slope.
You dont need to calculate convexity in this paper; but you should be able to
explain, interpret and use it
Refer to 519 BKM
Bonds normally exhibit positive convexity; and that is a good thing if you are a
bond holder
The more volatile yields are, the more valuable positive convexity is.
Why? (refer to original graph) say youre stuck @ 5%, $100. Consider 2
scenarios: where the discount rate goes down 3% and where it goes up 3%.
Down 3% means you end up at 2%, $170 -> you make $70 if it goes down
If interest rates go up 3%, you dont lose $70, but you lose $30.
Go either direction, on average you are going to get money if interest rates are
moving. Also you prefer big changes in interest rate rather than small changes.
This is convexity of the curve.

TAYLOR APPROXIMATION AND ESTIMATING BOND PRICE CHANGES

TOPIC 17 BONDS PORTFOLIO AND RISK MANAGEMENT

Convexity is useful for predicting changes in bond prices (or bond portfolios)
We do this using the Taylor series approximation

BOND PORTFOLIOS
Concepts such as duration and convexity are equally applicable to individual
bonds as well as porfolios of bonds
If you have a bond portfolio with several (eg.1,562) bonds, need to manage
aggregate risk exposure.
- Portfolio duration and convexity
- If you have portfolio and convexity measures for your portfolio, you can
estimate the impact of changes in interest rates quickly
Immunization and hedging
Immunization: basically cash flow matching what is your portfolio duration and
convexity if all cash flows are exactly matched (and so = 0)?
Hedging
- In trading it is common to aggregate various types of risk and then
manage or hedge them at the portfolio level
- Duration, convexity would be good candidates for a bond portfolio
EXAMPLE

Bond portfolio = $100m, duration = 2.8, convexity = 40

how do you hedge risk?

TOPIC 17 BONDS PORTFOLIO AND RISK MANAGEMENT

2 equations, 2 unknowns
Solving eq 1 and eq 2 simultaneously yields a 49.03 and b 29.68 (I just used
Excel solver...but it can also be done with algebra)