PART 1: MEASURING THE SENSITIVITY OF BOND PRICES TO RATE CHANGES.

DURATION

A. Introduction

So far we have reviewed how risk free bonds are priced, and what rate of return
(ROR) we can expect them to pay in the future. In this note set we consider a related
question: how to assess the price sensitivity of a risk free bond (or a portfolio of such
bonds) to external changes in interest rates (the result, say, of a change in monetary
policy). An answer to this question will, in turn, lead us to the study of bond portfolio
risk management.

1. This issue of “risk management” is not only of concern to individual investors, but to
financial institutions as well.

Consider a hypothetical Pension Fund.

Assets Liabilities

20 yr. 10% coupon perpetual benefits of $1,000

bond per year
value: $10,000 value: $10,000

(the term structure is flat at 10%)

Now suppose interest rates decline to 5%

Assets Liabilities

20 yr, 10% coupon perpetual benefits of $1,000

bond per year
value: $16,231 value: $20,000

The Pension Fund is insolvent. Call in the PBGC!

What happened? These two bond prices reacted very differently to a rate decline. Both
assets and liabilities rose in value, but the value of the liabilities rose much faster.

1
B. The Setting for the Discussion: Default Free Bonds

1. Our analysis will be most precise only if we are also willing to assume either:

(i) the term structure is flat (so that internal rates of return (IRRs) on coupon
bonds = reinvestment rates of return (RRRs) on coupon bonds= r1=r2= … rT),

or

(ii) changes in interest rates represent uniform shifts of the term structure up or
down (i.e., the change in the rate, Δr, is identical for all maturities of discount
bonds). This amounts to assuming that rate changes do not cause the term
structure either to flatten out or to become more curved.

For the purposes of discussion we will typically assume the term structure is flat.

2. Our objective is to construct linear approximations to the true change in value resulting
from a change in rates. The accuracy of this approximation can be represented as follows
for a typical bond:

Price approximating tangent line

P
Slope  | r  rˆ
r

P0
Ptrue
Papprox

r r + r r, interest rate

If Δr > 0, our approximation will overstate the amount of the price change, while
If Δr < 0, our approximation will understate the amount of the price change.

In either case, to an approximation, ΔP  -(Slope) Δr

3. Intuitively, bonds with longer times to maturity will be more price-sensitive to

rate changes.

4. To make this notion precise, all we need is an expression for the slope as it is the
fundamental measure of price sensitivity to a rate change.

2
We will begin the discussion with a consideration of the sensitivity of default free
discount bond prices to rate changes since discount bonds are the “building blocks” of all
bonds.

C. Discount Bonds: Price Sensitivity to Rate Changes

1. For discount bonds, we know that

MVT
 1  r 
T
P0  MVT
1  r  T

Thus
P0
 T 1  r 
T 1
MVT ,
r

since the MVT is unaffected by changes in r.

Equivalently,

P0 T MVT
 ,
r 1  r (1  r ) T

2. To an approximation, this expression implies that:

P0 T
 P0 ,
r 1 r

This expression can be used to measure two things:

(i) percentage price change:

P 1
 Tr
P0 1 r
The time to maturity, T, in the above expression is said to be the bond’s Macaulay
1
duration or simply its duration; the expression T is defined as modified duration,
1 r
written Dm

(ii) Writing the above expression slightly differently gives a measure of absolute
price changes:

P   Dm P0 r

3. Let’s illustrate these notions with an example: consider a 6 year discount

bond, MVT=6=$1000, where the prevailing 6 year rate is 8%.

3
 1000
P0   $630.17
1.08 6
Effects of Rate Changes
True Value True Change (i) Approx. Change (ii)
r = 7% 666.34 +36.17 35.00
r = 7.5% 647.96 +17.79 +17.50
r = 8% 630.17 0 0
r = 8.5% 612.95 -17.22 -17.50
r = 9.0% 596.27 -33.90 -35.00

(i) change relative to r = 8% price

6
(ii) P    630.17  r
1.08
For example, Δr = 8.5% - 8% = 0 .5%

6
P    630.17 (0.005)  17.5
1.08

Not bad, as approximations go.

4. Duration calculations under semi-annual compounding.

2T
MVT  r
P0  2T
 MVT 1  
 r  2 
1  
 2

2T 1
P  r 1
 2T  MVT 1    
r  2 2
 
 
1  1 
 T MV T 
 r
2T
 r  
1    1   
 2  2
T
 P0
 r
1  
 2

This is the same formula, except that r is an annual rate with r/2 the 6-month, per
T
period rate. T still represents Macaulay duration (measured in years), while 1  r 
 
 2
is modified duration, given r as the annual rate. All the formulae are adjusted
T
DM 
accordingly; for example P   Dm P0 r with  r  , etc.
1  
 2

4
 Next, we consider the analogous notion for coupon bonds.

D. Coupon Bonds: Price Sensitivity to Rate Changes.

Since any coupon bond can be expressed as a portfolio of discount bonds, the
sensitivity to rate changes of a coupon bond must be expressible as the weighted
average of the price sensitivities of its constituent discount bonds.

1. Consider a typical debt security with the following pattern of payments:

t= 0 1 2 ……. T
-P0 c1 c2 cT + MVT

where ct denotes the coupon payment in period t, and MVT denotes the bond’s
maturity (or par) value at date T. If this bond is priced to pay the prevailing rate, then

T
ct MVT
P0   
t 1 1  r  t
(1  r ) T
Rewriting this equation gives us

T
P0   ct 1  r 
t
 MVT (1  r ) T
t 1

P
2. We are again interested in measuring . As before, first consider infinitesimal
r
changes in r and compute
P T
   tct 1  r     T  MVT (1  r ) T 1
 t 1

r t 1

Thus
P  1  T t  ct T  MVT 
   
r 1  r  t 1 1  r  t
1  r  T 
From which it follows that to an approximation,
P  1  T t  ct T  MVT 
    P0
r 1  r  t 1 P0 1  r  t
P0 1  r 
T

or

P  1  T  PV  ct    PV  MVT  
  t    T r
P0 1  r  t 1  P0   P0 

5
 DMacaulay of a coupon bond

DM of a coupon bond

The expression within the braces { } is the measure of Macaulay duration for a
coupon bond. It represents the average of the durations (t) of the component cash flows
of a bond, each weighted by the present value of the component relative to the bond’s
total value (PV(ct)/P0). If we include the 1/(1+r) term, the expression, as before, is the
measure of modified duration.

2. Let us interpret the formula

a. Since every risk free security can be expressed as a portfolio of discount bonds,
the duration of a coupon bond must somehow be related to the duration of its
constituent discount bonds. This relationship is exactly captured in the duration
formula for a coupon bond

T 1
 PV  ct    PV  cT   PV  MVT  
Dcoupon   t    T  
bond t 1  P0   P0 

b. Let us consider the t-th term:

PV  ct 
t
P0

Duration of the discount

bond coming due at the
same time as ct

value at t  0 of the discound bond with MV  ct


value of all the constituent discound bonds

 proportion of the coupon bond's value represented

by t period discount bonds

c. Thus,

T
Dcoupon 
bond
w
t 1
t t

6
where wt is the fraction of the bond’s value represented by t-period discount bonds in the
portfolio; i.e., it is a value weight.

This formula confirms our intuition: the duration of a coupon bond is the value-weighted
average of the durations of the equivalent portfolio of discount bonds.

3. Thus we again derive an expression:

ΔP0 = -DmP0Δr

This expression applies to all bonds. All that differs vis-à-vis coupon or discount
bonds is how D (or DM) is computed.

E. Example: The formula above suggests that, as with discount bonds, the higher a
bond’s duration measure, the more sensitive it will be to changes in the prevailing
rate. We illustrate this with an example:

1. You are asked to measure the relative interest rate sensitivity of two bonds. Bond #1 is
a 12% coupon bond with a 7 year maturity and a $1000 face value. Bond #2 is a zero
coupon bond also with a face value of $1,000 in 7 years. The prevailing IRR for bonds of
this type is also 12%. Determine the duration of each bond. If the IRR increases by 1%
what will be the capital loss suffered by each bond?

7
Year Cash Flow PV(12%) PV(13%)

Bond 1 Bond 2 Bond 1 Bond 2 Bond 1 Bond 2

1 120 0 107.14
2 120 0 95.66
3 120 0 85.41
4 120 0 76.26
5 120 0 68.09
6 120 0 60.80
7 1120 1000 506.63 452.35
___ ______ ______ _____ ______
P0 1000 452.35 955.77 425.06

Duration of Bond 1: (1/1000)

[107.14+2(95.66)+3(85.41)+4(76.26)+5(68.09)+6(60.80)+7(506.63)] = 5.1139

We interpret this result to mean that Bond 1 is as price sensitive to interest rate
changes as a discount bond maturing in 5.1139 years.

Duration of Bond 2: (1/452.35)[452.35)] = 7

Our theory tells as that Bond 2 is more sensitive to rate changes.

Let us confirm this: suppose rates increase,

If r = 13%
7
120 1000
P Bond1   t
  $955.77
t 1 1.13 1.13 7
1000
P Bond 2   $425.06
1.137

Capital Loss of Bond #1: 1000-955.77= $44.23

% Capital Loss of Bond #1: 44.23/1000= 4.423%

Capital Loss of Bond #2: 452.35 – 425.06 = $27.29

% Capital Loss of Bond #2: 27.29/452.35 = 6.033%

How does this compare to our approximation?

For Bond #1:

P 5.1139
  0.01  0.0456 or 4.56%
P0 1.12

For Bond #2:

8
 P 7
  0.01  0.0625 or 6.25%
P0 1.12
Not perfectly accurate, but then a change in rates from 12% to 13% is not a small change.

2. A rough comparison of bonds with different durations:

F. Portfolios of Bonds

1. Suppose we had a portfolio of bonds of various durations.

By the same logic (a coupon bond is itself simply a portfolio of discount bonds),
N
Duration portfolio   wi Di
i 1
where Di is the duration of the i-th bond type in the portfolio and wi is its value-weighted
proportion: i.e.,
value of bonds of duration Di
wi 
value of all bonds in the portfolio

The same relationship holds, as well, for the modified duration measure; i.e.,
N
M
D portfolio   wi DiM
i 1
2. Example: Consider the portfolio:

$4,000,000 bonds of duration 4

$6,000,000 bonds of duration 3

9
 4M 6M
The D p  ( 4)  (3)  3.4
10M 10 M

That is, the value of this portfolio will be as sensitive to a rate change as a discount
bond maturing in 3.4 years.

G. Conclusion

Our focus is still risk free Treasury bonds, for which there is no doubt that all
coupon and principal payments will be made. For these securities the only risk is price
risk, which arises form changes in the prevailing rate. The measures of this price
sensitivity to rate changes are the quantities “duration” and “modified duration.”

We have derived two equivalent expressions:

P
  DM r
P
and
P   DM Pr

We conclude by offering the following properties of the duration measure without

proof. We assume they refer to the case of a standard bond where ct=c, a constant
payment, for all t. When one component of the duration measure (i.e., r, c, MVT, or T) is
changed, all other components are assumed to remain fixed.

(a) As the bond coupon increases its duration decreases and the bond becomes
less sensitive to interest rate changes. Why?

(b) As the time to maturity T increases, duration increases and the bond’s price
becomes more sensitive to interest rate changes. Why?

Remark: Note that (b) above implies that with the passage of time a bond’s
duration measure will fall.

(c) As interest rates (r) increase, duration decreases and the bond becomes less
sensitive to further rate changes. Why?

Why do we care about these approximations when we can easily compute the price of a
bond (discount or coupon) for any market rate? The answer is that they become useful
when we wish to measure the sensitivity of a portfolio of many bonds to a rate change, or
when we need to construct a portfolio with a pre-chosen sensitivity. This is the subject of
our next class.

10
 PART II: THE MANAGEMENT OF BOND PORTFOLIO RISK: A FIRST APPROACH—
BONDS ONLY

A. Introduction

1. Since interest rates may change, there is risk inherent in holding a portfolio of bonds.
If rates rise, in particular, the value of the portfolio will decline.

How do we hedge (insure) against such a potential loss? There are many
ways to do this but they all amount to the same thing conceptually: add to the
portfolio other securities whose price movements are opposite to those of the
securities already present. For the case of bonds, we need to acquire other securities
whose prices will rise as interest rates rise (and vise versa), thereby offsetting the
anticipated loss in value of the bonds. What is lost on the existing bond portfolio is
gained back on the other instruments, provided the correct amount of them has been
purchased. Of necessity, the offsetting position must be a short one. This is where our
duration notion proves to be useful.

2. Recall from our previous lecture the following relationship:

N
Duration portfolio   wi Di
i 1
where Di is the duration of the i-th bond type in the portfolio and wi is its value-weighted
proportion: i.e.,
value of bonds of duration Di
wi 
value of all bonds in the portfolio

The same relationship holds, as well, for the modified duration measure; i.e.,
N
M
D portfolio   wi DiM
i 1

3. If we want to protect ourselves against small (!) interest rate changes, we would
like
D PM  0

This means that a change in rates will leave our portfolio’s value unaffected.

It is an example of “immunizing” our portfolio against rate changes.

B. An Example

1. You are currently managing a $10M portfolio of type 1 bonds (reference the example
in Part I of this lecture), with D=5.1139 and DM= 1/1.12 (5.1139)= 4.566.

11
You are concerned that interest rates may rise to 13% and you wish to hedge against the
possible loss by selling short type 2 bonds with a duration of 7. What is the value of the
bonds to be shorted?

First, if you do not hedge at all, and rates rise as feared, the loss will be:

ΔP = -DM Δr P
= -4.566 (.01)($10M)
=-$456,600

2. To solve for the number of bonds to be shorted we need to modify our formula:

D P  w1 D1  w2 D2  ...  w N D N

N
By definition, VP   ni Pi , where
i 1
ni = the number of bonds of type i,
Pi = the price of bonds of type i

n1 P1 n 2 P2 n N PN
4. Since w1  , w2  , and … w N 
VP VP VP
Substituting we get:
nP n P n P
DP  1 1 D1  2 2 D2  ....  N N D N
VP VP VP
Or
V P D P  n1 P1 D1  n 2 P2 D2  ...  n N PN D N (1)

Dividing everything by (1+r) gives:

V P DPM  n1 P1 D1M  n2 P2 D2M  ...  n N PN D NM (2)

(For all calculations to follow, either (1) or (2) may be used.)

4. In the above example, since we want Dp = 0, we must solve:

0 = 10,000 (4.56)(1000) + (6.25)(452.35) n2

or
 10,000( 4.56)(1000)
n2 
2827.18
or, n2 = -16,129.13; i.e., we need to short this many type 2 bonds

The value of these bonds, V2, is

12
 V2 = ( - 16,129.13)(452.35) = - $7,296,000.

Here we have solved for the number of bonds necessary to hedge. The simplicity of this
calculation makes clear the usefulness of the duration concept.

Question (1): How do we account for the cash proceeds of the short sale?

Question (2): What sort of a bond would we wish to short?

Question (3): Suppose the portfolio to be hedged contained bonds of many different
durations but with an overall duration of 4.56. Would the same hedge be effective?

Question (4): What happens when rates fall?

5. There are other ways to hedge that will accomplish the same thing: futures contracts
could be sold or put options purchased. These alternatives will be considered shortly,
but the principle behind their use is the same: append to the portfolio a security whose
value will increase when rates rise.

C. A Second Application of Duration: Funding a Future Cash Flow Stream

1. Consider a pension fund manager with fairly well defined liabilities who needs
assurance that the cash flow from her investments will match these liabilities. This is
a special case of the general problem of investing, so as to guarantee the creation of a
future cash flow.

A minimal condition must be:

I. The Value of Assets = The Value of Liabilities

But the manager is also affected by two key risks:

(i) Price Risk: as interest rates change, the bond’s price fluctuates and it may
have to be sold at a price different from expected.

(ii) (Coupon) reinvestment risk: coupons received from the bonds may end up
being reinvested at rates different from the returns expected at the time the
bond was purchased.

How should the pension manager take these risks into account? These are
offsetting risks, if the duration of the assets equals the duration of the liabilities.

Therefore he must also set

13
II. Dassets = D liabilities

2. Just as there are two requirements, there are two alternative procedures by which they
may be satisfied:

Method 1: Buy zero coupon bonds (or equivalent coupon bond portfolios or “strips”) in
amounts that exactly match liabilities. This matches duration directly, but it is
very expensive to execute, and sufficient numbers of STRIPS may not be
available.

Method 2: More generally, acquire coupon bonds in amounts so as to match the duration
of the assets to the overall duration of the liabilities.

Either way, if rates change, V Assets  V Liabilities ; effectively the

DM Portfolio of assets and liabilities = 0.

3. A simple but highly general example:

Liability - single payment of $1931 in 10 years; r = 10% (flat term structure).

PV (liability) = $745.

You must invest $745 now to accumulate enough cash to pay off liability in 10 years.

DURATION (liability) = 10.

 invest in a bond with D=10

Buying a bond with D=10 neutralizes price and reinvestment rate risk. The investment is
protected against a swing in rates in either direction.

At r = 10%, a 20-yr bond with $70 annual coupon has a price of $745 and a duration of

 70  1000
20  1.1t 
  1.120  10 1
D   t   20 
t 1  745  745

 


Rates Stay at 10% Rates fall to 4% Rates Rise to 16%

1
What would this expression look like under semi-annual compounding? Would the
duration number differ? How so?

14
Accumulated value $70x1.109 = $165 $70x1.049 =$100 $70x1.169=$266
of interest $70x1.108 = $150 $70x1.048 =$96 $70x1.168=$229
payments received $70x1.107 = $136 $70x1.047 =$92 $70x1.167=$198
and reinvented at $70x1.106 = $124 $70x1.046 =$89 $70x1.166=$171
indicated interest $70x1.105 = $113 $70x1.045 =$85 $70x1.165=$147
rates $70x1.104 = $102 $70x1.044 =$82 $70x1.164=$127
$70x1.103 = $93 $70x1.043 =$79 $70x1.163=$99
$70x1.102 = $85 $70x1.042 =$76 $70x1.162=$94
$70x1.10 = $77 $70x1.04 =$73 $70x1.16=$91
$70 x 1 = $70 70 x 1 = $70 70 x 1 =$ 70
_______ ______ ______
Total $1115 $842 $1492

Market value of bond $816 $1243 $565

In the 10th year at indicated
Interest rate
______ ______ _____
Grand Total $1931 $2085 $2057

Less required payment $1931 $1931 $1931

______ ______ ______
Surplus 0 $154 $126

70 70 1070
Market value of the bond in 10th year    ... 
1  r 1  r  2
1  r  10

4. Immunization, however, is not entirely a passive strategy. One must recomputed the
duration of your portfolio as rates change, and alter its composition accordingly:

r  => duration of bond becomes larger.

r  duration of bond becomes smaller.

In order to match the duration of assets to that of liabilities, the manager therefore needs
to change periodically the composition of his portfolio to reflect changes in the duration
of his assets as rates change.

5. An important question: Why is it the case in this example that the coupon bond
provides more value than liability if rates either rise or fall?

Does this suggest an arbitrage opportunity? Yes! Such opportunities are associated
with parallel shifts of the term structure. Thus, exact parallel shifts cannot occur.

15
D. Another Example of Funding a Future Cash Flow

You are the chief financial officer of a film production company. Due to prior
commitments associated with the production of a series of films, you are obliged to
underwrite for the following series of future payments:

t=0 1 2 3 4 5
5M 5M 5M 5M 5M

You decide to prepare for these outlays by assembling a portfolio of 3 year maturity 6.5%
risk free coupon bonds and 5 year 7.5% maturity risk free coupon bonds. The term
structure is flat at r = 8%. How many bonds of each type should you buy, not only to fund
the obligation, but also to ensure against having to invest more in the future to make up
for any shortfall if rates change (by a small amount)?

In order to satisfy the required conditions, it is necessary to equate

(i) PVAssets = PVLiabilities,

and

(ii) DAssets = DLiab.

Durations and PVs (at 8%)

Outflows Bond 1 (6.5%) Bond 2 (7.5%)

Ct PV(Ct) Ct PV(Ct) Ct PV(Ct)

t=1 5M 4.63M 65 60.185 75 69.44

t=2 5M 4.285M 65 55.73 75 64.30
t=3 5M 3.97M 1065 845.43 75 59.54
t=4 5M 3.675M 75 55.13
t=1 5M 3.405M 1075 731.63

19.965M 961.345 980.04

16
Doutflows =
4.63 4.285 3.97 3.675 3.405
 (1)  ( 2)  (3)  ( 4)  (5)
19.965 19.965 19.965 19.965 19.965
 0.231  0.429  0.597  0.736  0.853
 2.85

DBond 1 =
60.185 55.73 845.43
 (1)  ( 2)  (3)  0.063  0.1159  2.638
961.345 961.345 961.345
 2.82

DBond 2 =
69.44 64.3 59.54 55.13 731.63
 (1)  ( 2)  (3)  ( 4)  (5)
980.04 980.04 980.04 980.04 980.04
 0.0709  0.1312  0.1823  0.225  3.733
 4.34

Let n1 = the number of bonds of type 1 purchased,

n2 = the number of bonds of type 2 purchased

The following relationship must hold:

(i) V assets = V liabilities

19.95 M = n1(961.345) + n2(980.04)

(ii) D liabilities = D assets or DpVp = n1P1D1 + n2P2D2

(2.85)(19.965 M) = n1(2.82)(961.345) + n2(4.34)(980.04)

This is a system of two equations in unknowns n1, n2.

From (ii) we get

56.90M =n1 (2711) + n2 (4253)

n1 = (56.90M—n2 (4253))/2711

n1 =20,989 - n2(1 .57)

Substituting this expression for n1 into equation (i) yields

19.965M = [20,989— n2(1.57)](961.345) + n2(980.04)

17
 19,965,000 = 20,177,670— 1509.3 n2 + 980.04 n2

19,964,000 = 20,177,670 529.27 n2

- 212,670 = — 529.27 n2

n2 = 402

n1 = 20,989_L:57(402) = 20,989 -631

n1 =20,358

This is not a very satisfactory solution in the sense that it demands a lot of portfolio
changes along the way. Even if rates never change as t = 3 approaches, the chief financial
officer will have to gradually shift from type 1 to type 2 bonds. All this trading costs a lot
of money. There must be a better way!

E. Concluding Comments

By matching durations, price and reinvestment risks offset each other. This allows
us to fund a future cash flow and retain adequate funding in the face of small rate
changes. All large financial institutions will attempt to measure the overall duration
of their fixed income assets and liabilities on a regular basis. Some do this monthly,
others weekly, etc. The frequency of computation is often governed by the volatility
of interest rates. All this is an aspect of the “risk management” function.

18
 PART III: A SECOND APPROACH: DYNAMIC IMMUNIZATION WITH INTEREST RATE
FUTURES CONTRACTS

A. Introduction

1. A drawback to immunizing via the duration of bond portfolios is the need to rebalance
in response to rate shifts. This may create large transaction costs as the number of bonds
bought or sold may end up being very large. Another way is to use interest rate futures.

There are two advantages of immunizing with interest rate futures:

(i) the composition of the bond portfolio can be maintained and duration
adjusted using the future contracts

(ii) transactions costs of trading futures is much less than bond trading costs.

These considerations are especially important when the bonds trade in “thin”
markets.

B. Introduction to Futures Contracts

A futures contract is very similar to a forward; we briefly review forward contracts first.

1. Review of Forward Contracts

a. Definition: A forward contract is an obligation to buy a pre-specified security at a

pre-specified price (forward price) at a pre-specified future date.

The forward price is set so that it costs nothing to enter into such a contract (no
money exchanges hands at the contract’s signing except for a transactions fee).

b. Example: a contract to buy T-bills in 1 year which will have an aggregate

maturity value 1 year later of $1 M (T-bills are discount bonds).

Assume the term structure is flat at r =12%

T =0 1 2 3
-1P1 1,000,000

$1,000,000
1 P1  forward price   $892,857
1.12

(i) Suppose, when T=1 arrives, r=13%

19
 The actual price of the security at that time will be

$1,000,000
 $884,956
1.13

Thus, at T=1:

Security pay for the

is worth security
_______ ________
Purchaser of the contract receives: 884,956 - 892,857
(the “long” position) = -7901

Seller of the contract receives:

(the seller is also referred to 892,857 – 884,956
as the “writer;” and as having = +7901
the “short position”)

So, if rates rise, the agent with the short position benefits (he gets to sell a security
to the buyer for more than its market value). Therein arises a hedging opportunity!

(ii) Suppose, at T=1, rates have fallen to r =11%

$1,000,000
The security in question is now worth:  $900,901
1.11

Purchaser of the contact receives: Market value What he must

of the pay for the
security security
_______ _________
900,901 - 892,857
= 8044

writer of the contract receives: -8044

So, if you expect rates to decline – take a long position in a forward contract. If
you expect them to rise, take a short position.

c. Why does it cost nothing to enter into such a contract?

Answer: Aside from transactions costs, we can create the same payment structure
another way using only bonds:

(assume the term structure is remains flat at r =12%)

20
t= 0 1 2

Long 1,000 -$797,194 +$1,000,000

2 yr discount
bonds

Short 892.86 +797,194 -892,857

1 yr discount
bonds

1,000
(Price of a 1 yr discount bond is  $892.85 )
1.12

d. The problem with forward contracts for hedging is that offsetting payments are
not received until the contract expires. This leads to:

2. Futures Contracts

1. A futures contract is the same as a forward contract (the language “future price”
replaces the language “forward price” but the concept is the same), but with the
“making to market feature.”

2. Again, no money changes hands at signing

3. These contracts for Treasury securities are exchange traded (very low transactions
costs). There is cash settlement only (no exchange of underlying securities).

4. To illustrate the “marking to market feature”, suppose we had contracted to buy

the above security at a FP (futures price) of $892,857. Let us normalize our time
so that T=0 is the date of signing of the contract.

Suppose the FP changes in successive days as interest rates move around according to:

t= 0 1day 2days 3days 4days…

Future Price 892,857 893,100 893,100 892,800 892,300

Writer’s 0 -143 -243 +57 +557
Account
Balance

Buyer’s 0 +143 +243 -57 -557

Account
Balance

21
So money is lost or received immediately upon the change in rates (very important
for hedging).

5. The same argument (as in the forward contract case) applies here to explain why
it costs nothing to enter into such a contract: the replicating portfolio costs
nothing to construct (save for transactions costs).

Further, the portfolio’s value will change in conformity to the buyer’s account
balance.

C. Managing Duration using Futures Contracts: Immunization (Method 2)

1. The futures price represents the price of a security to be issued in the future (its future
price). This security will have a duration. Thus
D
FP   FPr *
1 r *
where FP = futures price
r* = prevailing interest rate
D =duration of the underlying security at maturity of the futures contract.

This duration can be written as   ct   MV N 

N    

D  t
1  r * t   N  1  r * N 
  P * 
 t 1  P0 *  
 
0
  
  

where Po* is the price of the underlying bond at contract maturity and t runs from
the first cash flow following maturity to its final payments.

The futures contract itself does not have a duration. The futures price, however, and its
sensitivity to rate changes depend on the duration and yield of the underlying security
that is expected to prevail at the contract maturity date.

2. Consider a T-Bill Futures contract calling for the delivery of $1M face value of T-bills
having 90 days remaining until maturity.

 Duration of T-Bills Futures = 90 days, or 0.25 year.

An example

Instruments Used in the Analysis

Coupon Maturity Yield Price Duration

Bond A 8% 4yrs. 12% $878.51 3.55
Bond C 4% 15yrs 12% 455.13 9.60
T-Bill Futures --- 1/4yr. 12% 972,065.00 .25

1,000,000
where futures price is found as:  972,065
1.12 0.25

22
For simplicity, we assume annual cash flows and compounding of funds.

Initially, manager holds $10M portfolio of Bond C.

Objective: Shorten Duration to 6 yrs.

“Bonds Only” hedging: alter the composition of the bond portfolio.

WADA + WcDc=6 yrs

=> Wa=59.5% (6773 bibds) Wc = 40.5% (8899 bonds)

3. “Bonds w/ Futures (T-Bills)”: write T-bill futures

Objective: hold $10M in Bond C and mimic price action of “Bonds Only” Portfolio using
T-bill futures.

Position must satisfy:

Vp = PcNc+FPTBillNTbill

Vp= portfolio value Nc= # of C bonds

Pc = bond C price NTbill = # of T-Bills futures
FPTbill =T-bill futures price

Substituting from the price-change formula (such as eq. (1)), we have

DPV P  DC PC N C  DTBill FPTBill N TBill

To mimic the “Bonds Only” portfolio, we must have:

Pp= $10M Nc= 21,971

Dp= 6 years DTbill =.25 years
Dc= 9.6 years FPTbill = $972,065
Pc= $455.13

 Write (sell short) 148 T-Bill Futures contracts

23
 Portfolio Characteristics for the Current Example

Portfolio 1 Portfolio 2
(Bonds Only) (Short T-Bill Futures)

Portfolio WA 59.5% --
Weights WC 40.5% 100%
WCASH ~0 ~0

Number of NA 6,773 0
Instruments NC 8,899 21,971
NTbill -- (148)

Value of NAPA 5,950,148 --

Each NCPC 4,049,747 9,999,661
Instrument NTBillFPTBill -- (143,865,620)*
Cash 105 339

Portfolio Value 10,000,000 10,000,000

(NAPA+NCPC+Cash)

* (148972,065)

5. Now, assume a shift in term structure from 12% => 13%.

The relevant prices are now:

PA= $851.28 FPTBill = $969,908

PC= $418.39

As the table below demonstrates, immunization is achieved with bond the “Bonds Only”
and “Bonds & T-Bill” strategies.

24
 Effect of a 1% increase in Yield on Realized Portfolio Returns

Portfolio 1 Portfolio 2

Original Portfolio Value 10,000,000 10,000,000

New Portfolio Value of Bonds 9,488,972 9,192,447
Gain/Loss on Futures -0- 319,236*
Total Wealth Level (511,028) (488,317)
Terminal Value of all Funds at T=6 9,488,972 19,802,865
(New Wealth Level x 1.136
Annualized Holding Period Yield Over 12.0164% 12.061%
6 Years

* $319,236 = 148(972,065 – 969,908)

Cost of Immunization

Bonds Only: Buy 6773 A Bonds

Sell 13,072 C Bonds
@$5/Bond, total costs = $99,025

Bonds-T-Bill: Sell 148 Contracts

@$25/Contract, total costs = $3700

D. Caveats

1. Our discussion has ignored a number of institutional details which are relevant for
bond traders. For instance:

(i) Both buyer and seller of a futures contract must establish margin accounts.

(ii) Some contracts allow the contract to be settled at expiration by the delivery of any
of a number of specified financial instruments. This applies to all CBOT Treasury
Note and Bond futures contracts. If you have shorted one of these contracts you
will want to deliver with the cheapest bond available that satisfies the contract’s
terms.

(iii) Most traders will close out the contract before expiration by taking the offsetting
position in the futures markets. The number of futures contracts outstanding that
have not been closed with an offsetting position is referred to as open interest.

25
E. Speculating with Futures and the Construction of a Market Neutral Position:
Long-Term-Capital Management

(Case Discussion)

F. Summary and Conclusion

We now have a second approach to the management of such risk using interest rate
futures contracts. This method is to be preferred as it minimizes transaction costs relative
to a bonds only approach. It has, however, recently fallen out of favor and has been
supplanted by Eurodollar futures contracts. We turn to this topic next.

26
 PART IV: SWAPS AND THE EURODOLLAR MARKET: A THIRD
PERSPECTIVE ON INTEREST RATE RISK MANAGEMENT

A. The Context of our Discussion: The Eurodollar Market and the LIBOR rate.

1. A Eurodollar is a U.S. $ (USD) denominated deposit held outside the U.S. The primary
market for these deposits is in London.

a. This market developed in the 1960s and 1970s to avoid US banking regulations.

(i) Europe typically has less financial regulations. (This is a recent topic of
discussion with regard to the equity IPO market.)

 No FDIC insurance premiums (12 cents for every $100 TD)

 No reserve requirements on time deposits (in the U.S. 5% of TD are held at
FED in non-interest bearing account)

(ii) Often there are beneficial tax advantages to doing USD-denominated transactions
overseas.

2. The instruments: fixed and floating rate deposits over various maturities: CDs, time
deposits, etc.

3. This market is benchmarked by the LIBOR rate:

London Inter-Bank Offered Rate: this is the rate at which major banks are willing to offer
USD deposits to one another (i.e. lend to one another).

(i) It is analogous to the “prime rate” in the U.S., domestic market.

(ii) The London Interbank Bid Rate (LIBID) is the rate at which major banks will accept
USD deposits from each other.

4. LIBOR is the lowest defaultable rate in the sense of being the rate at which highly rated
commercial banks can borrow and lend. As such it provides benchmark rates for
overnight, 1 week and 2-12 month deposits.

(i) Offshore rates exist for a number of other currencies: the Yen, SF, pound sterling,
Euro, etc.

5. Most interest rate derivatives and many bond issuances are linked to LIBOR, in
particular, floating rates on bonds, forward contracts and swaps.

a. Example: How would a floating rate loan based on, say, the 6 month LIBOR work?

27
Amount of Loan: $100 M
Terms: LIBOR + .5%

When would a borrower be disinclined to enter into floating rate loan?

6. LIBOR transactions are defaultable. Deposits are not FDIC guaranteed.

As a result, LIBOR should always be higher than the corresponding (same maturity)
Treasury Rate.

The TED spread is the difference, and is thought to be an indication of the financial
health of the banking sector.

7. Many organizations price securities using the term structure of LIBOR rates as a stand-in
for the U.S. Treasure term structure. They do this as the LIBOR rates are more relevant
for their borrowing activities.

For many purposes the Eurodollar market has become the stand-in replacement for the
Treasury market. All the concepts – a term structure, forward rates, forward contracts, and
futures contracts – have their counterpart in the Eurodollar market.

28
29
B. The Notion of a Swap

1. Forward Contracts allow borrowers to remove interest rate risk over a specific future time
period, say i periods ahead for n periods.

This requires continually signing such contracts if we wish to remove such risk on a
regular basis. A convenient way to do this is via a SWAP.

2. Definition: An interest rate SWAP is an enforceable agreement between two parties to

exchange cash flows period by period.

- One party pays a fixed rate payment and receives a variable floating rate payment.
- The counterparty pays the floating rate and receives the fixed rate payment.

These rates are applied to a fixed agreed upon “notional” amount.

3. The uses of such instruments are threefold:

(i) they give access to fixed or floating rate capital markets;
(ii) they allow participants to manage their asset/liability structure more effectively;
(iii) they provide a tool for hedging interest rate risk.

Example: Managing Assets and Liabilities

Consider a Bank with a very simple balance sheet:

Assets Liabilities
$100M $100M
10 year loan at 8% 6 mo. CDs at 5%

30
Every 6 months the Bank has to refinance the CDs, whose rates are typically tied to
LIBOR.

Suppose, for simplicity, the CD rate is the LIBOR rate. Consider a SWAP whereby the Bank
exchanges their variable liability for a fixed rate liability at 9%.

Now the bank only has to worry about the “credit risk” of the borrower and the SWAP dealer .

C. The Mechanism of a SWAP

1. What is actually swapped? It is the fixed and floating rate payments (“coupons”) on a
given principal that are exchanged.

Floating rates: corporate bond rates, mortgage rates or LIBOR rates

Fixed rate: typically a U.S. Treasury Rate plus some basis points premium

31
2. Time Horizon: specified by the SWAP contract: In principal it can be for any time
period: 1 year, 5 years, 10 years, etc.

3. Example of a SWAP contract:

X pays Y: 10% fixed rate per year on a notional $50 M

Y pays X: 6 month LIBOR rate adjusted every 6 months.

Payments are thus exchanged every 6 months.

 0.1 
X pays Y: $50 M   = $2.5 million.
 2 

Y pays X: 50 M x 6 month LIBOR rate (which varies)

X pays the fixed rate and receives the floating rate.

Y pays the floating rate and receives the fixed rate.

The fixed rate is known as the SWAP rate.

D. How Is the SWAP Rate Determined?

1. It is that rate which equates the PV of the two payment streams. It is computed as the
result of a three step procedure:

Step 1: Compute the floating rate payments using the forward LIBOR rates.

Step 2: Discount the floating rate payments using the LIBOR “term structure” to obtain
the present value of the expected floating rate payments.

Step 3: Adjust the Fixed Rate to bring about equality in the two present values.

This is an NPV = 0 procedure within the universe of LIBOR securities. It thus costs
“nothing,” aside from transactions fees, to enter into such contracts.

The Key Ingredient: the Forward LIBOR Term Structure

E. An Example:

1. Consider a 1.5 year SWAP with three payments exchanged. Notional Amount $100 M.

Although LIBOR rates are available only up to one year, forward LIBOR rates are
available from Bloomberg or Reuters since LIBOR forward contracts are traded.

We need r0.5LIBOR , f
0.5 0.5
LIBOR
, f
1 0.5
LIBOR
,

1.85% 2.2% 2.72%

(annualized)

32
 C0.5float C1float C1.5float
Thus,
 r0.5
LIBOR

C float
0.5  100 M 
 2   0.925 M
 
 f LIBOR

C1float  100 M 0.5 0.5   1.1 M
 2 
 1 f 0.5
LIBOR

C float
1.5

 100 M   1.36 M
 2 

These are the floating rate payments.

2. Next we discount these at the corresponding “spot” LIBOR rates. Problem: LIBOR spot
rates are available only up to one year.

However, knowledge of the forward rates allows us in a world of no (LIBOR) arbitrage

to construct a consistent set of corresponding spot rates.

This is another sense of “Bootstrapping” except that it uses forward rates to construct
spot rates (rather than the reverse as earlier).

 r LIBOR   0.0185 
1  0.5   1    1.00925
 2   2 
 
2
 
r LIBOR  r LIBOR  f LIBOR 
1  1   1  0.5 1  0.5 0.5 
 2   2  2 

 0.022 
 1.009251    1.02035  r1
LIBOR
 0.02049
 2 
3
 
r LIBOR  r LIBOR  f LIBOR  f LIBOR 
1  1.5   1  0.5 1  0.5 0.5 1  1 0.5 
 2   2  2  2 
    
 0.022  0.0272 
 1.009251  1    1.03423  r1.5
LIBOR
 0.02256
 2  2 

Thus, the value of the floating payments is:

0.925M + 1.1M + 1.36M

PVFLOAT = (1 .00925) (1 .02035) (1.03423)

= 3.309572M

3. Lastly, we compute the SWAP rate, where we discount the fixed payments at the same
term structure of LIBOR rates:

33
  
 
3
 S S S 
PV FIXED
    
t 1  r LIBOR
  1  0. 5   rLIBOR

2
 r LIBOR 
3

   1  1.5 
1 
1
 2     
   2   2  

3.309572 M = 2.9377 S
 S = 1.1265

This is a 6 month cash flow.

On an annual basis:

S= 2(1.1265) = 2.2531M

On an annualized rate basis, this is equivalent to 2.2531M/100M = 2.2531%

This is the SWAP rate. It is a no arbitrage rate within the scope of the LIBOR family of
rates.

F. Conclusion

We have illustrated the notion of a SWAP contract as another device for managing interest rate
risk. Next we will see how the writing of such contracts can allow us to hedge bond portfolio
price risk. A current issue in the SWAP market: the financial integrity of the banks participating
in the Eurodollar market.

1. Notice that entering into a SWAP contract is a zero NPV investment from the perspective
of either party. Thus, swap contracts cannot, at signing, enhance the value of the firms
undertaking them.

2. However, as LIBOR rates evolve (if they depart from the forward LIBOR rates at
signing), then one of the counterparties will suffer a loss while the other will experience a
gain.

34