Basic Refinements in Interest Rate Risk

Management Problem Set

Q2. It is May 15, 2000 and an investor is planning to invest $100 million in one of the two
portfolios below. The investor’s main concern is the change in interest rates that might affect
the short-term value of the portfolio. Compute the percentage change in price of the security
stemming from duration and convexity. Which portfolio is less sensitive to changes in interest
rates (assume 1% increase in interest rates)? Assume today is May 15, 2000, which means you
may use the yield curve presented in the following table:
Maturity T Yield r2 (0, T )
0.50 6.49%
1.00 6.71%
1.5 6.84%
2 6.88%
• Portfolio A

– 40% invested in 1.5-year zero coupon bond

– 60% invested in 1.5-year coupon bond paying 9% annually

• Portfolio B

– 50% invested in 2-year zero coupon bond

– 50% invested in 1.5-year floating rate bond with zero spread and annual
payments.
Note: The term structure and the two portfolios are the same as in Q2 in Chapter 3
Portfolio A:
Convexity of zero-coupon bond: Cz = 1.52 = 2.25
Convexity of coupon bond:
PC (0,1.5) = = 9 × 0.9686 + 109 × 0.904 = $107. 257
9∗0.9886 109∗0.904
Cc = 107.257
∗ 0.52 + 107.257
∗ 1.52 = 2.087

CA = 0.4*2.25 + 0.6*2.087 = 2.152

Portfolio B
Convexity of zero-coupon bond: Cz = 22 = 4
Convexity of floating rate bond: Cfl = 0.52 = 0.25
CB = 0.5*4 + 0.5*0.25 = 2.125

Assume 1% increase in interest rates:

𝑑𝑉𝑎
𝑉𝑎
= -DA*dr + (1/2)*CA*(dr)2 = -0.451*0.01 + 0.5*2.152*(0.01)2 = -0.0144

𝑑𝑉𝑏
𝑉𝑏
= -DB*dr + (1/2)*CB*(dr)2 = -1.25*0.01 + 0.5*2.125*(0.01)2 = -0.0124

-0.0144 > -0.0124

So, portfolio A is more sensitive to the changes of interest rates
Q4. Suppose the investor has chosen portfolio A in Q2 above, but the investor is still worried
about the losses that the portfolio may suffer from an upward shift in the term structure of
interest rates.
(a) Consider duration hedging using 1-year zero coupon bonds. Find the dollar position.

VA* DA + V1-year zero*D1-yeat zero = 0

100∗1.452
V1-year zero = - 1
= -$145.1 million

(b) Consider duration+convexity hedging using both 1-year and 5-year zero coupon bonds.
Find the dollar position on each bond.
VA* DA + V1-year zero*D1-yeat zero + + V5-year zero*D5-yeat zero = 0
VA* CA + V1-year zero*C1-yeat zero + + V5-year zero*C5-yeat zero = 0
100 ∗ 1.451 + V(1 − year zero) ∗ 1 + V(5 − year zero) ∗ 5 = 0
{
100 ∗ 2.152 + V(1 − year zero ∗ 12 ) + V(5 − year zero) ∗ 52 = 0
V1-year zero = $-127.593 million
V5-year zero = $ -$3.506 million