FINM7405

Interest Rate Risk Management

Kam Fongg Chan
University of Queensland Business School
Lecture outline:
1 Types of short-term and long-term debt

2 Shapes of interest rates term structure

This is an example text. Go ahead and replace it

3 Theories of interest rates term structure

4 Fundamentals of bond pricing

5 Advanced issues in bond pricing

6 Bond price volatility

7
Duration, DV01 & hedging
Summary:

ƒ There are various short- and long-term debts in

Australia.

ƒ There are 4 main yield curves/term structure

o Normal (upward sloping) curve
o Flat curve
o Inverse (downward sloping) curve
o Humped curve

ƒ The different yield curve shapes can be explained by 3

different theories
o Pure expectation theory
o Liquidity theory
o Market segmentation theory
Summary:

ƒ When we calculate bond price, we obtain clean price.

What investors really pay is the dirty price.

ƒ Yield to maturity (aka internal rate of return) is a constant

rate that makes the ppresent value of the bond equals
q to
its market price

ƒ Duration is a composite measure used to

maximize/minimize bond price volatility. There are 2
duration measures
o Macaulay
M l dduration
ti
o Modified duration
Summary:

ƒ Duration can be used as an approximation to interest

rate sensitivity of a bond (ie how the bond price will react
t a very smallll change
to h iin th
the yield)
i ld)
o How to approximate bond price change? Compute DV01 aka
PV01
o Why
Wh merelyl approximation?
i ti ? B Because off convexity
it effect
ff t

ƒ If we hold (long position) bond B, we can perfectly hedge

it by taking a short position in bond H.
o How? By making the portfolio DV01 = 0
Short-term and long-term debt in Australia

Short-term (maturity up to Long-term (maturity up to 30

12 months) years)

• Bank Accepted Bills (BAB) • Treasury bonds

• Treasury y notes • State bonds
• Certificates of Deposit (CD) • Corporate bonds
• Commercial Papers • Eurobonds
• Interbank deposit
Bank Accepted Bills (BAB)

ƒ Similar to a ‘cheque’, but with fixed maturity of 90, 120

or 180 days
y
ƒ Involve 3 parties: drawer, discounter & acceptor

Drawer Discounter

Acceptor
p

• Sell BAB i.e. borrow cash
• Promise to pay face value of BAB (e.g. 
$100 000) on maturity
$100,000) on maturity 
Bank Accepted Bills (BAB)

ƒ Similar to a ‘cheque’, but with fixed maturity of 90, 120

or 180 days
y
ƒ Involve 3 parties: drawer, discounter & acceptor

Drawer Discounter

Acceptor
p

• Buy BAB i.e. lend cash to drawer
• Can sell (trade) BAB to another discounter  
• Final holder (discounter) receives face value 
( )
at maturity of bill
Bank Accepted Bills (BAB)

ƒ Similar to a ‘cheque’, but with fixed maturity of 90, 120

or 180 days
y
ƒ Involve 3 parties: drawer, discounter & acceptor

Drawer Discounter

Acceptor
p

• The facilitator (i.e. bank)
• Guarantee (‘accept’) the BAB i.e. guarantee the drawer will pay the 
face value on maturity by taking the cash from the drawer and pass it 
y y g p
to the discounter 
Treasury notes

ƒ Issued by the Australia gov. to assist in ‘within-year’

fundingg needs.
ƒ ‘Within-year’ funding needs arise because timing of gov.
revenues does not match expenditure profile.
ƒ Issued by tender and typically mature in 5-26 weeks
Certificates of deposit (CD)

ƒ Usually matures between 1 and 3 months

ƒ Issued byy banks to raise funds to finance their lending
g
activities
ƒ Contain credit risk of the issuing bank
Commercial Papers

ƒ Commercial papers (CP) are unsecured short-term debt

ƒ Usuallyy matures between 2 and 270 days y
ƒ Instead of taking bank loans, companies with high credit
rating issue CP to raise funds to finance projects
ƒ Usually has zero coupon and trades ‘at at discount
discount’ to
reflect interest
Interbank deposit

ƒ Most popular is LIBOR (London Interbank Offer Rate)

o LIBOR is the interest rate at which banks offer to lend

unsecured funds to another bank in the London interbank
market
o Usually matures between 1 and 90 days
o Singapore Interbank Offer Rate (SIBOR) is the LIBOR-
equivalent bank offer rate in Singapore interbank market
o Euribor
E ib is i th
the equivalent
i l tb bankk offer
ff rate
t iin E
Euro iinterbank
t b k
market.
o Daily LIBOR rate is determined by the British Bankers
Association (BBA) at 11am every business day by taking the
average of the rates supplied by member banks (see
http://www.bbalibor.com/bbalibor-explained/the-basics)
o LIBOR can be denominated in USD, GBP, Euro, CAD, AUD,
Yen and Swiss francs.
Interbank deposit

ƒ Most popular is LIBOR (London Interbank Offer Rate)

o Why is LIBOR so popular?

™ Widely used as a reference rate for interest rate swaps etc

™ Commonly used as a proxy for risk-free rate in practice (but

seldom in academic)
Treasury bonds

ƒ Issued by Australia gov.

ƒ Typically
yp y matures in 2 – 10 yyrs
ƒ Has face value and pays coupons, payable every 6
months
ƒ Commonly used as proxy for risk-free rate in academic
(but not in practice)
State bonds

ƒ Semi-gov bonds issued by State Treasury (e.g. QTC) to

meet funding
g needs of state,, local g
gov and g
gov
instrumentalities (to build new port etc).
Corporate bonds

ƒ Issued by companies
ƒ Typically
yp y maturity
y is up
p to 10 yyrs
ƒ Has face value and pays coupons, usually payable
every 6 months
Eurobonds

ƒ Eurobond is a bond issued in a currency (eg. USD)

other than the currencyy of the countryy ((eg.
g Australia)) or
market (eg. Japan) in which it is issued.
ƒ Eurobonds are classified based on currency in which the
issue is denominated e e.g.
g Eurodollar bonds
bonds, Euroyen
bonds
ƒ Example: A Eurodollar bond issued in Japan by an
A t li company iis a E
Australian Eurobond
b d
ƒ Attractive because issuer (eg. Australian company) can
choose the countryy ((eg.
g Japan)
p ) in which to offer its bond
in its preferred currency (eg. USD)
Shapes of interest rates term structure

ƒ The interest rates term structure/yield curve at time t

defines the relationship
p between the level of interest
rates and their time to maturity

ƒ There are 4 main yield curves:

o Normal (upward sloping) curve
o Flat curve
o Inverse (downward sloping) curve
o Humped curve

ƒ The shape of term structure serves as an indicator of

market expectation towards direction of future interest
rates (see Figure 1)
Shapes of interest rates term structure

Normal (upward sloping) curve Yield for 15‐yr = 3.99% p.a.

Yield for 1‐yr = 0.49% p.a.

Figure 1: U.S. treasury curve on June 10, 2010. Source: Bloomberg

Shapes of interest rates term structure

Flat curve, which usually leads to ….

Figure 2: Japanese government yield curve on Nov

Nov. 4
4, 2002
2002. Source: Bloomberg
 Shapes of interest rates term structure

Inverted (downward sloping) curve

Yield for 3‐mth = 6.11% p.a.

Yield for 10‐yr

Yield for 10 yr = 5.31% p.a.
5.31% p.a.

Fi
Figure 3 U.S.
3: U S ttreasury curve on D
Dec. 15
15, 2000
2000. S
Source: Bl
Bloomberg
b
Shapes of interest rates term structure

Humped curve

Fi
Figure 4 U.S.
4: U S ttreasury curve on M
May 26,
26 2000
2000. S
Source: Bl
Bloomberg
b
Shapes of interest rates term structure

Two points to notice:

ƒ Different dates have different shapes of term structure
ƒ Flat term structure leads to inverted term structure

Flat in Aug 2000

Inverted in Feb 2001

Figure 5: U.S. dollar swaps curve between Aug 29, 2000 and Aug 29, 2001. Source: Bloomberg
Shapes of interest rates term structure

ƒ Inverted term structure signals economic recession. Proof:

18
3-month T-bill
16
10-year bond
14

12
ercentage

10

8
Pe

0
Apr/53

Apr/56

Apr/59

Apr/62

Apr/65

Apr/68

Apr/71

Apr/74

Apr/77

Apr/80

Apr/83

Apr/86

Apr/89

Apr/92

Apr/95

Apr/98

Apr/01

Apr/04

Apr/07
Figure 6: 3-month U.S. T-bill vs. 10-year U.S. treasury bond. Source: H.15
database released by U.S. Federal Reserve.
Shapes of interest rates term structure

ƒ Inverted term structure signals economic recession. Proof:

3
Percentage

0
Apr/53

Apr/56

Apr/59

Apr/62

Apr/65

Apr/68

Apr/71

Apr/74

Apr/77

Apr/80

Apr/83

Apr/86

Apr/89

Apr/92

Apr/95

Apr/98

Apr/01

Apr/04

Apr/07
-1

-2

-3

Figure 7: U.S. spread (10-year treasury bond minus 3-month T-bill). The shaded areas
indicate recession periods designated by the U
U.S.
S NBER
NBER. Source: H H.15
15 database
released by U.S. Federal Reserve and NBER.
Theories of interest rates term structure

ƒ The different shapes of interest rates term structure can

be explained
p by
y 3 different theories:
o Pure expectation theory
o Liquidity preference theory
o Market segmentation theory
(See attached reading by Fabozzi F., (2007 2nd ed.), Fixed Income Analysis,
John Wiley & Sons, Inc., pp. 79-81)
Fundamentals of bond pricing

ƒ Standard formula to price BAB:

FV
PBAB = (1)
⎛ t ⎞
1+ ⎜ y × ⎟
⎝ 365 ⎠

where FV = face value of bill

y = yield
t = days to maturity
Fundamentals of bond pricing

ƒ Example:
o On 2 Feb 2010,, HighGear
g issued a $100,000
, 90-dayy
BAB with 9.5% p.a. yield to LowGear. What is the price
of the bill?

$100,000
PBAB = = $97,711
⎛ 90 ⎞
1 + ⎜ 0.095 × ⎟
⎝ 365 ⎠
Fundamentals of bond pricing

ƒ Example (Con’t):
o 30 days have passed. On 4 Mar. 2010, LowGear sold
the BAB to TopGear at a new yield of 8.5% p.a. What
is the price of the bill?

You try over here!

Time 0 30 days later 90 days later

TopGear redeemed the

LowGear lent LowGear sold the BAB from HighGear i.e.
$97,711 to BAB to TopGear HighGear paid $100k to
HighGear at $98,622 TopGear
p

LowGear gained $911 TopGear’s interest (received) = $1378

Fundamentals of bond pricing

ƒ Standard formula to price a coupon-paying bond

assuming
g discrete compounding:
p g

⎡ ⎛ y ⎞−n ⎤
⎢1 − ⎝⎜1 + m ⎟⎠ ⎥
FV C⎣ ⎦
PC = n
+ ( 2)
⎛⎜1 + y ⎞⎟ m y
m
⎝ m⎠

where FV = face value of the bond

C = coupon amount (pa)
y = yield (pa)
n = number of periods
m = compounding frequency
m is usually 2 because:
y
• coupons are paid semi‐annually
• accordingly, yields are 
compounded semi‐annually
Fundamentals of bond pricing

ƒ Example:
o A 5.3% p
p.a. semi-annual couponp Treasury y bond
maturing in 2 years is priced at 6% p.a. compounded
semi-annually. The bond has a face value of $1mil.
Calculate the bond fair price
price.

$1,000,000 $53,000 ⎢⎣
(
⎡1 − 1 + 0.06
2
)
−4
⎤
⎥⎦
PC = + = $986,990
(
1 + 0.06 )
2
4
2 0.06
2
Fundamentals of bond pricing

ƒ Example (con’t):
o A 5.3% p
p.a. semi-annual couponp Treasury y bond
maturing in 2 years is priced at 6% p.a. compounded
semi-annually. The bond has a face value of $1mil.
Calculate the bond fair price
price. − m×t
⎛ y⎞
Assume coupons and face value are  ⎜ 1 + ⎟
stripped into 4 zero‐coupon bonds with  ⎝ m ⎠
different time to maturities
different time to maturities

Time to Cash flow (2) Discount factor (3) Present value (4) =
maturity (1) (2) x (3)
0.5 26500 0.9709 25728
1.0 26500 0.9426 24979
1.5 26500 0.9151 24251
2.0 1026500 0.8885 912032
Sum 986990
Fundamentals of bond pricing

ƒ Example (Con’t):
o 6 months have ppassed i.e. the Treasury y bond now has
1.5 years to maturity. The current yield is 5% p.a.
compounded semi-annually. Calculate the bond fair
price (assume the regular coupon has just been paid)
paid).

You try!
Fundamentals of bond pricing

ƒ Example (Con’t):
o Another 4 months have p passed i.e. the Treasury
y bond
now has 1 year & 2 months to maturity. The current
yield is 4.8% p.a. compounded semi-annually.
Calculate the bond fair price
price.

You try!
Fundamentals of bond pricing

ƒ Example (Con’t):
o Another 4 months have passed i.e. the Treasury bond
now has
h 1 year & 2 months th tto maturity.
t it Th The currentt
yield
 
is 4.8% p.a. compounded semi-annually.
Calculate
 
the bond fair p
price.
t= – 4mths 
  t=2mths t=8mths t=1yr 2mths

 
t $26500
t=$26500 t=$26500 t=$26500+$1mil
 

 
Fundamentals of bond pricing

ƒ Example (Con’t):
o Another 4 months have passed i.e. the Treasury bond
now has
h 1 year & 2 months th tto maturity.
t it Th The currentt
yield
 
is 4.8% p.a. compounded semi-annually.
Calculate
 
the bond fair p
price.
t= – 4mths 
  t=2mths t=8mths t=1yr 2mths

 
t $26500
t=$26500 t=$26500 t=$26500+$1mil
 

 
Fundamentals of bond pricing

ƒ Discrete compounding vs continuous compounding

y=4.8% p.a. 
compounded semi‐
annually

r = m × ln⎛⎜1 + y ⎞⎟ (3)
⎝ m⎠
Fundamentals of bond pricing

ƒ Example (again):
o Another 4 months have p passed i.e. the Treasury
y bond
now has 1 year & 2 months to maturity. The current
yield is 4.8% p.a. compounded semi-annually.
Calculate the bond fair price
price.
df = e − r×t

Time to Cash flow (2) Discount factor (3) Present value (4) =
maturity (1) (2) x (3)
00.166667
166667 26500 00.992126
992126 $ 26
26,291
291
0.666667 26500 0.968873 $ 25,675
1.166667 1026500 0.946165 $ 971,238
Sum $1,023,205
Fundamentals of bond pricing

ƒ Summary:
o The bond pprice is the same regardless
g if yyou use
discrete compounding (eg 4.8% pa compounded semi-
annually) or continuous compounding (eg 4.7433% pa
compounded continuously)
Advanced issues in bond pricing

ƒ Clean price vs. dirty price

o Clean price (quoted in Bloomberg system etc) is like an
‘accounting
accounting price
price’
o What investors actually pay is dirty price:

Dirty price = Accrued interest + clean price
Advanced issues in bond pricing

ƒ Example:
o Another 4 months have passed i.e. the Treasury bond now has 1
year & 2 months to maturity
maturity. The current yield is 4
4.8%
8% p
p.a.
a
 
compounded semi-annually. Calculate the bond fair price.
 

t= 
t=
  – 4mths 
4mths t=2mths t=8mths t=1yr 2mths
t=1yr 2mths

 
t=$26500 t=$26500 t=$26500+$1mil
 

 
now
day diff since last coupon
Accrued interest = C ×
day diff between two coupons
4
= $26500 × = $17,667
6

o Dirty price = $1,023,305 + $17,667=$1,040,872

Advanced issues in bond pricing

ƒ Term structure is not flat

o A coupon-paying bond can be stripped into n zero-coupon bond
o Each nth zero-coupon bond has its own discount rate and time to
maturity
o Thus, discount each zero-coupon bond using its own discount
rate
t & time
ti to
t maturity
t it and
d sum up to
t gett the
th clean
l bond
b d price
i

o Example: A 5.3% p.a. semi-annual coupon Treasury bond

maturing in 2 years has a face value of $1mil
$1mil. The term
term-structure
structure
is upward sloping (see next slide). Calculate the bond fair clean
price.
Advanced issues in bond pricing

− m×t
⎛ y⎞
⎜ 1 + ⎟
⎝ m ⎠

Time to Yield (p.a.) Cash flow (3) Discount factor Present value
maturity (1) (2) (4) (5) = (3) x (4)
0.5 4.6% 26500 0.9775 $ 25,904
1.0 5.6% 26500 0.9463 $ 25,076
1.5 5.8% 26500 0.9178 $ 24,322
2.0 6.0% 1026500 0.8885 $ 912,032

Sum = $987,334
Advanced issues in bond pricing

ƒ Yield to maturity
o Internal rate of return
o A constant rate that makes the present value of future cash flows
equals to the current market price
o Think of it as another way to re-express the bond price

− m×t
What is y that 
⎛ y⎞
solves for bond  ⎜ 1 + ⎟
price = $987,334? ⎝ m ⎠

Time to Cash flow (2) Discount factor (3) Present value (4) =
maturity (1) (2) x (3)
0.5 26500 ? ?
1.0 26500 ? ?
1.5 26500 ? ?
2.0 1026500 ? ?
Sum $987,334
Advanced issues in bond pricing

ƒ In summary
o Pricing bond using spot rate and yield to maturity gives the same
result.
Bond price volatility

ƒ Bond price volatility = percentage change in bond price

ƒ Some useful relationships:
p
a. Bond prices are inversely related to yields
b. Bond price volatility is positively related to term to maturity
c. Bond price volatility increases at a diminishing rate as term to
maturity increases
d. A decrease in yield raises bond prices by more than an
increase in yield of the same amount lowers prices (eg if a 1%
d
decrease iin yield
i ld raises
i b
bond
d price
i b by $10
$10, th
then a 1%
increase in yield will lower bond price by only $9)
e. Bond price volatility is inversely related to coupon
Bond price volatility

ƒ Trading strategies
o Assume you were an asset manager
o You predict a major decline in yields Æ you predict an
increase in bond prices (#a)
™ You want a portfolio of bonds with maximum bond price
volatility
l tilit to
t enjoy
j maximum
i price
i changes
h ((capital
it l gains)
i )
from changes in yields
™ You should buy long-term maturity bonds with low
coupons (#b & #e)
Duration, DV01 & hedging

ƒ Savings and loan debacle in 1980s

o U.S. savings and loan companies earned a spread between
long-term mortgage rates and short-term deposit rates
o Positive spread (ie profit) if long-term mortgage rates > short-
term deposit rates
o B t in
But i early
l 1980
1980s

18
16
14
Percent (%)

12
10
8
6
4
2
0
Jan/70

Jan/72

Jan/74

Jan/76

Jan/78

Jan/80

Jan/82

Jan/84

Jan/86

Jan/88

Jan/90

Jan/92

Jan/94

Jan/96

Jan/98
3 month U.S.
3-month US T T-bill
bill Source: H
H.15
15 database released by U
U.S.
S Federal Reserve
Reserve.

o Implication: Interest rate risk management is important!

Duration, DV01 & hedging

ƒ How to measure and manage interest rate?

• Duration
• DV01 • Futures/forward
•Value‐at‐Risk (VaR) • Swap
S
Duration, DV01 & hedging

ƒ Duration:
o Bond price volatility is positively related to term to maturity
(#b) but inversely related to coupon (#e)
o Need a composite measure to combine #b and #e to
maximize/minimize bond price volatility
o Th composite
The it measure off bond
b d pricei volatility
l tilit iis duration
d ti
Duration, DV01 & hedging

ƒ Characteristics of duration:
o Duration of zero-coupon bond = term to maturity
o Duration of coupon bond < term to maturity
o Duration is inversely related to coupon rate
o Duration is positively related to term to maturity
o D ti iis inversely
Duration i l related
l t d tto yield
i ld tto maturity
t it

ƒ Two duration measures:

o Macaulay duration
o Modified duration
Duration, DV01 & hedging

ƒ Macaulay duration (example)

o A 5.3% p.a. semi-annual coupon Treasury bond maturing in 2
years is priced at 6% p.a. compounded semi-annually. The
bond has a face value of $1mil. Calculate the Macaulay
duration of the bond

Time to Cash flow (2) Discount PV of cash Weight (5) Time x Weight
maturity (1) factor (3) flow (4) (1) x (5)

05
0.5 26500 0 9709
0.9709 25,728 0.02607 0.0130

1.0 26500 0.9426 24,979 0.02531 0.0253

1.5 26500 0.9151 24,251

, 5 0.02457
0.0 57 0.0369

2.0 1026500 0.8885 912,032 0.92405 1.8481

Sum 986,990 1 1.9233

1.92 yrs
Duration, DV01 & hedging

ƒ Macaulay duration = 1.92 years

MacD
ƒ Modified duration (in years): ModD = ( 4)
⎛ y⎞
⎜1 + ⎟
⎝ m⎠

1.9233
ModD = = 1.867
⎛ 0.06 ⎞
⎜1 + ⎟
⎝ 2 ⎠
Duration, DV01 & hedging

ƒ Interpretation:
o Not helpful to think of duration in terms of time
o Better interpretation: The bond price is sensitive to rate
changes of a 1.867-year (modified duration) zero-coupon
bond, or
o Th bond
The b d pricei willill approximately
i t l change
h b
by 0
0.01867%
01867% ffor a 1
basis point change in the yield

100 bp = 1%
Duration, DV01 & hedging

ƒ Macaulay & modified durations (you try!)

o A 7% p.a. semi-annual coupon bond maturing in 5 years has a
yield to maturity of 8% p.a. compounded semi-annually. The
bond has a face value of $1mil. Calculate its Macaulay and
modified durations
Duration, DV01 & hedging

ƒ Why use Macaulay/modified duration?

o Provide a price approximation to interest rate sensitivity of the
bond (with no embedded options eg not a convertible bond) ie
how bond price will react to a very small change in yield
o How?

Property #a

ΔP = − ModD × P × Δy (5)

DV01 (dollar value of 1 basis point) or PV01 (price 
value of 1 basis point) ie
l f1b i i t) i how bond price will change 
h b d i ill h
if the yield changes by 1 bp?
Duration, DV01 & hedging

ƒ Examples:
o Calculate the DV01:
ΔP
ΔP 184.3
= = 0.018673%
ΔP = −1.8673× 986990 × 0.0001 P 986990
= $184.30 (in absolute value)

o Full valuation: A 5.3% p.a. semi-annual coupon Treasury bond

maturing in 2 years has a face value of $1mil
$1mil.

Yield (compounded semi‐ Bond price Difference

annually)
5.99% $987,174 +$184
6.00% $986,990 NA
6.01% $886,806 ‐$184
Duration, DV01 & hedging

ƒ Remember:
o Modified duration only provides a price approximation to a
very small change in yield (eg 1 bp change in yield)
o Example: Use modified duration to calculate price
approximation when the yield changes by 50 bp

ΔP = −1.8673× 986990 × 0.0050

= $9215 (in absolute value)

o Full valuation:
Yield (compounded
Yield (compounded semi‐
semi Bond price
Bond price Difference
annually)
5.50% $996,261 +$9270
6 00%
6.00% $986 990
$986,990 NA
6.50% $977,830 ‐$9160
Duration, DV01 & hedging

ƒ Reason: Convexity effect

o The relation between bond prices and yield is not linear but
convex
true bond price follows
duration is the
the blue curve line
p of the curve
slope
bad
approximation

Price

goodd error
approximation

Yield approximated bond

price using duration
follows the purple line
Duration, DV01 & hedging

ƒ Portfolio modified duration:

o Weighted average of modified duration of the bonds in the
portfolio:

ModDP = w1ModD1 + w2 ModD2 + .... + wN ModDN (6)

where wi = weight for bond i

ModDi = modified duration for bond i
N = number of bonds in the portfolio
Duration, DV01 & hedging

ƒ Examples:
Bond (semi‐ Yield 
Yield Bond price 
Bond price Modified Weight
annual coupon,  (semi‐ (Market  duration 
$1mil face  annual value) (years)
value) compoun
ding)
5.3% pa 2‐yr 6% pa $986,990 1.867 0.507
7.0% pa 5‐yr 8% pa $959,446 4.122 0.493
Total $1,946,436 1.000

ModDP = 0.507 ×1.867 + 0.493 × 4.122

= 2.979 yrs

IInterpretation: The portfolio market value will 
t t ti Th tf li k t l ill
approximately change by 0.02979% for a 1 bp change in the 
yield 
Duration, DV01 & hedging

ƒ Proof:
o Price (market value) approximation for the bond portfolio for 1
bp change in yield:
ΔPP = − ModDP × PP × Δy (7 )

ΔPP = −2.979 ×1,946,436 × 0.0001

= $579 (in absolute term)

ΔPP 579
or = = 0.02979%
PP 1,934,889
Duration, DV01 & hedging

ƒ Proof using full valuation:

Bond (semi‐ Yield 
Yield Bond price 
Bond price New yield 
yield New bond 
bond
annual coupon,  (semi‐ (Market  (increase by  price (market 
$1mil face  annual value) 1 bp) value)
value) compoun
ding)
5.3% pa 2‐yr 6% pa $986,990 6.01% pa $986,806
7.0% pa 5‐yr 8% pa $959,446 8.01% pa $959,050
Total $1,946,436 $1,945,856

Difference = $580 or 0.02979%
Duration, DV01 & hedging

ƒ Important assumptions for bond portfolio modified

duration:
o Only provide a portfolio price approximation to a very small
change in the yields
o Assume a parallel shift in the term structure eg 6% Æ 6.01%
AND 8% Æ 8.01%
Duration, DV01 & hedging

ƒ Trading strategies using portfolio modified duration:

o Longest portfolio modified duration provides maximum price
volatility (ie percentage price change)
o Hence, as an investor/asset manager:
™ If you expect a decline in the yield, you should increase
portfolio
tf li modified
difi d duration
d ti to t maximize
i i bond
b d price
i
increase.
¾ How to increase portfolio modified duration? Æ
sell/short short
short-term
term bonds (eg commercial papers)
and use the proceeds to long/buy long-term bonds or
long term futures
™ If you expect an increase in the yield, you should reduce
portfolio modified duration to minimize bond price decline.
¾ How to reduce portfolio modified duration? Æ
g
sell/short long-term bonds or long-term
g futures and
use the proceeds to long/buy short-term bonds (eg
commercial papers)
 In the trading game, you were the issuer of a 
Duration, DV01 & hedging portfolio of debt rather than a buyer (owner) of a 
portfolio of debt ie you were a liability manager
portfolio of debt ie you were a liability manager

ƒ Trading strategies using portfolio modified duration:

o As an liability manager:
™ If you expect a decline in the yield, you should reduce
portfolio modified duration to have minimal bond price
increase.
¾ HowH tto decrease
d portfolio
tf li modified
difi d d ti ? Æ buy-
duration? b
back long-term bonds or long term futures and
short/sell/issue short-term bonds (eg commercial
papers)
™ If you expect an increase in the yield, you should increase
portfolio modified duration to have maximum bond price
decline.
¾ How to increase portfolio modified duration? Æ
sell/short/issue long-term bonds or long-term futures
and use the p proceeds to buy-back
y short-term bonds
(eg commercial papers)
Duration, DV01 & hedging

ƒ Hedging with modified duration:

o A long position in bond B can be hedged by a short position in
bond H
o Intuitive reason: If interest rate rises (ie bond price falls), we
lose in bond B (assuming we hold/long bond B), but we gain in
b d H ((since
bond i we short/issue
h t/i b
bond d H)
H).
o A perfect hedge suggests the total DV01 of our portfolio is
zero or equivalently, DV01B = DV01H.

ΔPB = ΔPH
− ModDB × PB × 0.0001 = − ModDH × PH × 0.0001
ModDH PB
= (8)
ModDB PH
Duration, DV01 & hedging

ƒ Examples:
Bond (semi‐ Position Type Yield (semi‐
Yield (semi‐ Bond price 
Bond price Modified
annual coupon,  annual (Market  duration 
$1mil face  compoundi value for 1  (years)
value) ng) bond)
5.3% pa
3% 2‐yr
2 Long Unhedged
h d d 6%
6% pa $986 990
$986,990 1.867
86
bond B
7.0% pa 5‐yr Short Hedge bond  8% pa $959,446 4.122
H

ModD H PB
=
ModD B PH To perfectly hedge one bond B with a 
p y g
market value of $986,990, we need 
4 .122 986 ,990
= bond H with a market value of $447,043 
1 . 867 PH ie 0.4659 bond H
PH = 447 ,043
Duration, DV01 & hedging

ƒ Proof using full valuation:

o A 1 bp yield rise (6% Æ 6.01%) decreases bond price B
(which we hold) from $986,990 to $986,806 ie –$184

o A 1 bp yield rise (8% Æ 8.01%) decreases bond price H

(which we short) from $959,446 to $959,050 ie –$395.

o Since we short 0.4659 bond H, we gain $184.03

o Total net portfolio value is about $0!