CFA Level I

Study Session 16 Reading 56

Reading 57
Reading 58
Reading 59
Introduction to the Valuation of Debt Securities
Yield Measures, Spot Rates, and Forward Rates
Introduction to the Measurement of Interest Rate Risk
Fundamentals of Credit Analysis
 CFA Level I: Fixed Income
LOS 58:
Introduction to measurement of interest rate risk

• Distinguish between the full valuation approach and the duration/convexity

approach for measuring interest rate risk, and explain the advantage of using the full
valuation approach
• Demonstrate the price volatility characteristics for option-free, callable, prepayable,
and putable bonds when interest rates change
• Describe positive and negative convexity and relation to bond price and yield
• Calculate and interpret the effective duration of a bond, given
information about how the bond's price will increase and decrease for given
changes in interest rates
• Calculate the approximate percentage price change for a bond, given the bond's
effective duration and a specified change in yield
• Distinguish among the alternative definitions of duration and explain why effective
duration is the most appropriate measure of interest rate risk for bonds with
embedded options
 CFA Level I: Fixed Income
LOS 58:
Introduction to measurement of interest rate risk

• Calculate the duration of a portfolio, given the duration of the bonds comprising the
portfolio, and explain the limitations of portfolio duration
• Describe the convexity measure of a bond and estimate a bond‘s percentage price
change, given the bond's duration and convexity and a specified change in interest
rates.
• Differentiate between modified convexity and effective convexity
• Calculate the price value of a basis point (PVBP), and explain its relationship to
duration
• Discuss the impact of yield volatility on the interest rate risk of a bond
Measuring interest rate risk
Full valuation approach: Re - value a bond based on changes in interest rates. It is also called scenario analysis.
Good valuation model takes care of the parallel and non – parallel shifts.

Duration/convexity approach: it looks at one time parallel move in interest rates using the properties of price
volatility.

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Price volatility
Option - free bond price yield curve

Price % of par

An option free bon has Price yield

curve convex towards the origin

P1
Price fall as yields increase
P2

5% 7% YTM

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Price volatility

Price yield relation of a callable bond

Price % of par

Call option
Negative
value convexity

Callable Bond

Negative Positive Yield

convexity Convexity

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Price volatility

Price yield relation of a putable bond : Less interest rate sensitive

Price % of par

Putable bond

Put option value

Option free bond

Negative Positive Yield

convexity Convexity

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Effective duration

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Duration measures

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Portfolio duration

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Convexity
Convexity is a measure of the curvature of the price-yield curve. The more curved the price-yield relation is, the
greater the convexity.

A straight line has a convexity of zero.

Effective duration underestimates or overestimates the value of the bond.

Convexity adjustment to percentage price change = C * change in yield squared * 100

Total price change = (-duration * change in yield * 100) + (C * change in yield squared * 100)

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Present value of basis point

PVBP is the absolute value of the change in price of a bond for a one basis point change in yield. It is another way to
measure interest-rate risk.

PVBP = initial price – price if yield changes by 1 basis point

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Impact of yield volatility

• Keeping all other factors constant, higher the coupon rate, lower the price volatility of a bond.

• Higher the coupon, lower the duration.

• Higher the yield level, lower the duration.

• Greater the expected yield volatility, greater the interest rate risk for a given duration.

• A framework that ties together the price sensitivity of a bond position to

interest rate changes and yield volatility is the value-at-risk (VaR) framework.

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