Vipul'sM Risk Manage

154
pondMathematics
155

AND TYPES OF IELD CURVE:

MEANING
M E A N I N

Chapter 10 10.1
al
ield curve is a line that plots the interest rates, at a
A yiel

AY
s e t
point.
in time, of bonds having equal credit quality but
ifering urity dates The most frequently reported yield

Bond Mathematics c u r v e
mpares the
c o m p
three-month, two-year, five-year
and
30-year t r e a s1Iry debt. This yield
is used as a curve
mark for other debt in the market, such as mortgage

Yield Curve
DE hank lending
rates or bar rates, and it is also used to predict
10. Meaning and Types of
in economicC output and growth.
0.2 Different Kinds of Yields changes

is shown in figure 10.1.

10.3 Yield-Price Relationships of Bonds A simple yield curve

0.4 Yields in Money Market

10.5 Theories of the Term Structure of Interest Rates
10.6 Solved Problems
10.7 Unsolved Problems
10.8 Questions

Maturity
Figure 10.1

shape of the yield curve gives an idea of future

The
interest rate changes and economic activity. There are three
main types of yield curve shapes: normal, inverted and flat

(or humped). A normal yield curve is one in which longer

to shorter
maturity bonds have a higher yield compared
term bonds due to the risks associated with time.

in which the shorter-term

An inverted yield curve is one

yields, which can be

yields are higher than the longer-term
a sign of upcoming recession.
 gondMathematics

156 Vipul'sTM Risk Management 157

Inverted
Yield Curve:
0.1.2
In a flat or humped yield curve, the shorter- and
iown-sloped yield
nich is \also
onger or curve
term yields are very close to each other, which is a An suggests yields
term bonds may continue
longer-term to fall, corresponding
predictor of an economic transition. economic recession.
t o eriods of
p e r i o d s

10.1.1 Normal Yield Curve: oP When

investors expect longer-maturity bond yields to
A normal or up-sloped yield curve
dicates yields. even lower in the future, many would purchase
rise, respondine n
e c o m e

longer-term bonds may continue to

olonger-maturity
ds to
bond: lock in yields before they decrease
periods of economic expansion. investors When
longer-maturity bond yields to become even higher in t
expec further

The increasing onset of demand for longer-maturity

the
future, many wouldtemporarily invest their funds
bonds and the lack of demand for shorter-term securities
shorter-term securities in hopes of purchasing
longer-tern higher prices but lower yields on longer-maturity
ad to higher
to
bonds later for higher yields.
bonds, and lower prices but higher yields on shorter-term
honds, and
In a rising interest rate environment, it is risky to haveecurities, further inverting a down-sloped yield curve.
investments in longer-term bonds when their value has vet is shown in
A simple example of normal yield curve
to decline as a result of higher yields over time. The igure 10.3.
increasing temporary demand for shorter-term securities
pushes their yields even lower, setting in motion a steeper
up-sloped normal yield curve.
A simple example of normal yield curve is shown in
figure 10.2.

Maturity
Figure 10.3

10.1.3 Flat Yield Curve:

inverted yield
A lat yield curve may arise from normal or

economic conditions.
VE, depending on changing to
from expansion
When the econo is transitioning
Maturity recession, yields on longer
Wer development and even
shorter-terim
on
Plgure 10.2 and yields
Lrity bonds tend to fall
 158 Vipul'sM Risk Managemen
BFM RondMathematicsatics
159
securities likely rise, inverting a normal yield curve ield curve into a
flat yield curve.
Since
it compares
pre-specified coupon with the
arket price,
it is called as current yield.
irom
When the economy is chang1ng
ecession to
recessi
recovery and potentially expansion, yields on longer. cor examp For
example,
if a 12.5% bond sells in the
market for
current yield will be computed as
maturity bonds are set to risea n d yields on sho 104.50,
maturity securities are sure to fall, tilting an inverted . orter. Rs.

12.5
104.5
x 100
curve toward a flat yield curve. yiel
11.96%
A simple example of normal yield curve is shows
figure 10.4. Current vield is
nt yie no longer
a standard
yield used as

measure, because it ails to capture the future cash flows,

-investment
r e - i n v e s t n e n t
income and capital gains/losses on

investment return. Current yield is considered a very

e r r o n e o u s measure of yield.
cim plistic and
With increase in market price current yield will decrease
and v i c e - a - v e r s a .

10.2.2 Yield to Maturity (YTM):

Maturity The YTM of a bond is that rate which equates the
discounted value of the future cash flows to the present
Pigure 10.4
return of the
pice of the bond. It is the internal rate of
raluation equation.
10.2 DIFFERENT KINDSs OF YIELDS:
maturity represents the yield on the bond,
Yield to
10.2.1 Current Yield:
provided the bond is held to maturity and the intermittent
Current yeld is one of the earlier measures on yield on a coupons are re-invested at the same YTM rate. ln otner
bond. Current yield is measured the rate that discounts all
as: Words, when compute YTM
we as

Current Yield = Annual coupon receipts the cash flows from the bond, at the same YTM rate, what
Market price of the bond effect is that each of these cash
flows
We are assuming in
n i s measure o fyield does not consider the time value of Can be re-invested at the YTM rate for the penoa una

money, or the complete

series of expected future cash flows.
It instead
maturity.
compares the coupon, as pre-specified, with the consider simple example.
market price at a To understand YTM let us a

point in time, to arrive at a measure a

Dond is currently trading at Rs. 105 and
have a face

rate is
value of Rs. 100. years and coupon
urity is of 5 bond?
10%(paid annually). What should be YTM of the
 BondMathematics
160 Vipul'sM Risk Management 161

Period Cash Flow Present value at

YTM needs trial and error approach. 1 art
start with let
es 8% discount rate
assume that YTM (discount rate) is 8%. u
10 9.20
Period Cash Flow Present value at 10
2 8.46
8% discount rate
3 10 7.
1 10 9.26 10
4 7.16
2 10 8.57 110
5 72.48
3 10 .94 Total 105.10
10 7.35 alue of the bond at 9.5% discount rate is Rs. 105.10
5 110 74.86 hich is very close to prevailing market prices. So YTM is
which

Total 107.99 around 8. 7%.

Value of the bond at 8% discount rate is Rs. 107.9 From above example it can be seen that calculating YTM
Value at 8% is more than prevail1ng market price. So istootedious process and requires multiple efforts.
need to increase the assumed YTM from 8% to 9%. So a 10.2.3 Yield to Maturity of a Zero Coupon Bond:
9% YTM value of the bond isS:
In the case of a zero coupon bond, since there are no

PeriodCash Flow Present value at intermittent cash flows in the form of coupon payments, the
8% discount rate YTM is the rate that equates the present value of the
1 10 9.17 maturity or redemption value of the bond to the current

market price, over the distance in time equal to the

2 10 8.42
settlement and maturity dates.
3 10 7.72
YTM of a ZCB is given as:
10 7.08
5 110 71.49 Face Value Years to Maturity _
Yield to Maturity Current Price of Bond
=

Total 103.89
consider Rs. 1,000 zero coupon bond that
Value of the bond at 9% discount rate is Rs. 103.89 has twoexample,
For a
vears until maturity. The bond is currently valued
Value at 9% is less than prevailing market price of Rs. 10at Rs. 950. When we substitute the values in the formula, it
So weneed to decrease the assumed YTM from 9% to
8.790 would look like:
So at 8.7% YTM value of the bond is
(1000) -1
950
= 0.025978
 RondMathematics
Vipul'sM Risk
162
Management (8F Given the tormula ove, bond equivalent yield is
163

Solving this equation,

would be rounded and listed
we get
as a
a vaiue of

yield of 2.59
0.025978, whih
0.025970
=
(1 + effective yield) /k 1
Yield: ing the numbers:from the same example,
10.2.4 Bond Equivalent
We usually determine the semi-annual coupon
coupon mthe BEY (1 +0.12095)/2- 1
annual coupon, by simply dividing the annual
ual con
coupon = 5.875%

If cash flows are compounded multiple times durin.

the effective rates are not the annual rate divided
during a I n the sield calculations for most fixed
income securities,
unless otherwise sta stated, it is the
number of compounding periods. This is
by the bond-equivalent-yield that
intermittent cash flows can be re-deployed, at because
prevaili,
is used.
is used.

effective annual rate. 10.2.5 Weighted Yield:

rates, to arrive at an
ulhen bonds are traded at diferent prices
For example, if annual yield is I1.75%o, the semi-an- during a day,
yield is simply taken as 11.75/2, which is 5.87
Seml-annua
annual vield
the
for the day is usually reported as the
weighted
75%.| yields, the weights being the market value of the trades
However, if the six monthly coupon is re-invested
5.875%, the effective annual yield will be higher th
at lorice time's quantities traded). The weighted yield is
ha computed using market values for each trade as the
11.75%, at 12.095%. In other words, semi-annual vieli
should be annualised, by incorporating the effect of the weightage.
Te
investment, as follows: Let us consider a simple example of a central
government bond in which there were 10 trades. Details of
Effective Annual yield =
(1+ Periodic interest rate)k -

1. which are given in table below:

Where k is the number of payments in ayear. This Quantity Price (Rs.) Market Value YTM
formula be used to effective yields for any
(%) YTM Proportion
can compute (Rs.) of market value
number of compounding periods in a year. 2000 101.0 202000 10.1
0.66584
In the above example, 3000 101.5 304500 10.0 0.993767
Effective annual yield =(1 +0.05875)2 -1 1000 101.7 101700 9.9 0.328589

5000 102.0 510000 9.8 1.631 148

12.095%
5000 102.1 510500 9.7 1.61608B6
Though it is well known that
semi-annual yields are
therefore 4000 102.2 408800 .65 1.287465
not half
the annual yields, in most bond markets
the convention is to 3000 102.4 307200 9.6 0.962475
simply divide the annual yield by 2,
get the semi-annual 2000 102.6 205200 9.55 0.639555
yield. The semi-annual yield
simplistically computed 1000 102.7 102700 9.5 0.318413
is called the Bond
(BEY). Equivalent Yie 1000 102.8 102800 9.4 0.315368

3000 308700 9.3 0.93695

102.9

3064|oD
 Vipul's Risk
Management (BFM
164 ondMathematics
165
yield 9% (total
is 9,.69%
(total of
ofs
above example weighted clienthad received
a total
For
YTM S o t h e c l i e n

coupon income of 5.25

t

Proportion of market value) the for 6 months at

10.2.6 YTM of a Portfolio: Rs.
5
r e i n v e s t e d

after a year
=
10.25 10%)+Coupon of 5

as the
eived
receiv

YTM of a portfolio is not computed

average realized yield =10.25
90
10
YTMs of the bonds in the portf Hence
weighted average of the
nly when
weighted yields only when the
folio
We are able to compute cash 22.5%.
flows of the bonds under question are
the same, as Wa
was the
case in weighted yields. In a portfolio
of bonds, each bond
each
would have a different cash 1low composition and therefo RELATIONSHIPS OF BONDS:
YIELD-PRICE1

erroneous
fore, 10.3

hasic bond valuation equation shows that the

using a weighted yield would provide results
We The yield
therefore find the YTM of the portfolio
as that rate whi
which
and price are are inversely related. This
relationship is

equates the expected

cash flows of the bornds in the owever, not uniform for all bonds, nor is it symmetrical for
the
portfolio,with the market value of the portfolio. reases
and decreases in yield, by the same
quantum.
10.2.7 Realised Yield: Consider figure 10.5 which plots the price-yield
The actual yield realised by the investor in a bond, overra for a set of bonds:
relationship
given holding period, is called realised yield. Realised viel 20

represents the horizon return to the investor, from all the 180

three components of bond return, namely, coupon, retum 160

irom re-nvestment of coupon and capital gain/loss from 140

selling the bond at the end of the holding period. The

*******s**s* Minsesas*sss*au*s***
20

realised yield to the investor is the, rate which equates cash I00

flows from all these three sources, to the initial cash 0

***********e n
outlow. Realised yield is also called total return from a 50

bond. 0

Suppose an investor had bought a bond at Rs. 90 which 20

was redeemed after a year at face value of Rs. 100. During 0.05 0.1 0.15 0.2 a.25
this year investor had received two semi-annual coupon
one YTM (%)
- CG2001 CG2002.CG2005--cG2009 - - CG2013
of Rs. 5 each. Coupon was reinvested at 10%. What should
be the realized yield for the investor? Figure 10.5
Client had made a capital gain of Rs. 10. Further the
Price-Yield Relationship- Some Principles:
first coupon of Rs. 5 was reinvested for 6 months at 1070.
4 Price-yield relationship between bonds is nota straight
for
ine, but is Convex. This means that price changes
 AondM athematics

166
vipul's Risk Managementi 167
Number of days until
T
not for incre.
symmetrical, for increase and maturity
yield changes are Mr. X purchases a T-Bill with a
Fore xa m p l e ,
For face value
100,000 and pays Rs. 97,000 for it. The
decrease in yield.
(b) The sensitivity of price to changes
in yield in not
t
Rs.
279
s in 2 7 days. What is the bank discount maturity
sa yield?
across bonds. Therefore for a same change in e
yield, 360
d a t e

Yield =

on the kind of
bond o n e holds,
Bank Discount
depending
in price will be different. changes t

3,000 360
(c) Higher the term to maturity
of the bond, greato. 1,00,000 *279
price sensitivity. Price sensitivities
are
for ln
higher for the
longe = 0.0387

tenor bonds, while in the short-term bond, pricen

are 3.9%
more stable for a wide range of changes in yield.
But,
there are a couple of problems with using this
(d) Lower the coupon, higher the price sensitivity. Oh.
same, bonds with
Other 1alized yield in determining investors return. For
things remaining the higher coUnoannuple, this yield uses a 360-day year to calculate the
than bonds with
upon
exhibit lower price sensitivity lower lowe
OWerurn an investor would receive. Also, it does not take into
etu
coupons. ount the potential for compounded returns, and only

assun
ssumes that investor have no other investment options.
10.4 YIELDS IN MONEY MARKET:
10.4.2 Holding Period Yield:
10.4.1 Bank Discount Basis: The holding period yield by definition is only calculated
T-Bills are quoted on a pure discount basis, which on a holding period basis. So there is no need to include the
means the agreement states the total money that will be number of days, which was included in the bank discount
paid at maturity, and the investor pays a lower amountyild.It seems pretty straight forward, that investor take
The difference between these two numbers (the discount) is
the increase in value from what investor paid, add on any
the return, but to get a yield it still needs to be converted tointerest or dividend payments and divide it by how much
a yearly percentage. nvestor purchased it for.
In this situation, the formula for calculating the yield is | This is the unannualized return, which is different than
simply the discount, divided by the face value, multiplied bymost return calculations that like to show returns on a
360 and then divided by the amount of days remaining to yearly basis. Also, the interest or cash disbursement paid,
maturity. at the time of
18 assumed to happen matunty
Annualized yield on
a bank discount basis =

350 HPY L-p+D

Po
Where, D Discount
received at maturity
wnere,Pi =
amount
F Face value
 AyndMathematics
168 Vipul'Risk Management (BFM
169
tion allows the
Po purchase pnice ofthe investment reld
d. T h i s c a l c u
quoted yield (which is in
be compared to an
D= interest received or distribution no:

at
o n
a
Bill)
T-B
to

1strument.
interest-bearing
These investments have
money
maturity market duration that
ration
a
r l l be

shorter term, and

shorter are often
classified as cash
10.4.3 Efective Annual Yield:
Money market instruments quote on a
The effective annual yield can give a more
arate yield
accurate
valents.

money market yield also

360-day
y basis so the
the
uses 360 in its
especially when alternative investments are available w
can compound the returns. This accounts
available which
for
calculation.

for interest 360x YBD

earned on interest. MMY 360- (tx YBD)
EAY (1 +HPY)365/t 1
Where,
Where, HPY holding period yield ield on a bank discount basis calculated earlier
YBD
t number of days held until maturity days held
until maturity.
For example, if the HPY was 3.87% over 279 days, then
the EAY would be 1.0387365/279 1 or 5.09%.
THEORIES OF THE TERM STRUCTURE OF
10.5
The
The compounding frequency that applies to the INTEREST RATES:
investment is extremely important, and can significanthy
known theories that attempt
alter investor's result. For periods longer than a year, the The most commonly an

of the shape of the yield curve are

calculation still works and will give a smaller, absoluteinterpretation
number than the HPY. The pure expectation hypothesis.
For example, if the HPY was 3.87% over 579 days, then The liquidity preference hypothesis.
the EAY would be 1.0387365/579 1 or 2.42%. The preferred habitat hypothesis.
Decrease in Value: 10.5.1 Pure Expectation Hypothesis:
For losses, the process is the same; the loss over the The traditional form of the pure expectations theory
average annual return on a long8
holding period would need to be made into the effective implies that the expected
of the expected short termn
annual yield. Investor needs to take one plus the HPY term bond is the geometric mean

which is a negative number, for example 1+-0.5) = 0.95. rates.

For if the HPY rate can be thought of as
example, was a loss of 5% 'over 180 days, or example, the one year spot rate
then the EAY would be 0.95365/180-1 or -9.88%. une product of the six-month spot and
the six month

10.4.4 Money Market Yield: SUX months from now (six month forward).
would therefore
be indifferent
The money market yield is also known as the CD ansk neutral investor
one year position
spot rate, and
a
equivalent yield, and is the fourth way we can calculate Ween the one year
 Vipul Risk
170 Management (BFM BondMathematics

171
formed by a combination of a six month spot and to shift away from
a (discounts) a
month forward. Therefore shape of the yield curve is d-
niums

etshape of the yield curve preferred

habitat. Th therefore is a function
rates.
by the expectations about the interest and supply, and does not have
any formal
d e m a n d

Based on the expectations hypothesis, we can calcula. of rate

to intere expectations.
ationship
series of short term rates, which over any given period
in aggregate, reproduce the market rates expressed in
will,
the 10.6 SOLVED PROBLEMS:
yield curve.
lustration 10.1:
10.5.2 Liquidity Preference Hypothesis:
onsider an Rs. 1, 000 zero coupon bond that has two
The liquidity preference theory suggests that an investor
until maturity. The bond is currently valued at
demands a higher interest rate, or premium, on securities years

maturities, which Rs.975. Calculate YTM of the bond.

with long-term carry greater risk,
investors prefer cash Solution:
because all other factors being equal,
or other highly liquid holdings. Yield to Face Value Years to Maturity_1
According to the liquidity preference theory, interest aturityCurrent Price of Bond
rates on short-term securities are lower because investors 1
are losing less liquidity than they do by investing in (10002 -1
975
medium-term or long-term securities.
1.2%
In simple terms investor to be wiling to loss more
Iustration 10.2:
liquidity, he must be offered a higher rate of return in
lf annual yield is 12%, calculate the BEY if coupon is
exchange for agreeing to have his cash tied up for a longer
period of time. paid semi-annually.
10.5.3 Preferred Habitat Hypothesis: Solution:
Preferred habitat hypothesis recognizes that the market Effective Annual yield =
(1+ Periodic interest rate)k -I
is segmented and that expectations of investors are not = (1 + 0.06)2- 1

uniform across various tenors. Further as per this theory 12.36%

distinct categories investors exist, and that each of these
of
u lustration 10.3:
categories prefers to invest at certain segments of the yIeu face value of $100,000
purchases a T-Bill with a
curve. A date is in 270 days.

pays $95,000 for it. The maturity

The preferred habitat theory therefore suggests uthat
What is the bank discount yield?
depending demand and supply
on
atvarying tenors o
the

yield curve, investors will have to be receiving pay)

 ondMathematics

172 vipul'sM Risk Management (ae 173

QUESTIONS:
10.8

note on yield curve.

Solution: Write a
S360
60 kind of yields.
CUSS different
Bank Discount Yield =
19 Brieflyexplain Price Relationships of Bonds.
5,000 360
1,00,000*270 Write a note on Yields in Money market.

= 6.66%6 Theories of the Term Structure of

plain Interest Rates.

10.7 UNSOLVED PROBLEMS:

(1) If 13.5% bond sells in the market for Rs. 105 s

a
50
calculate the current yield of the bond.

(2) A bond is currently trading at Rs. 110and have a f

ace
value of Rs. 100. Maturity is of 7 years and coupon
ate
rate
is 15 (paid semi-annually). What should be YTM of th
bond?
(3) Consider an Rs. 1, 000 zero coupon bond that has tun
years until maturity. The bond is currently valued at
Rs. 995. Calculate YTM of the bond.

(4) Calculate weighted yield with the help of followine

ing
information.
Quantity Price (Rs.) YTM (%)
2000 102.0 10.1
2000 103.0 10.05

3000 103.5 9.9

4000 103.55 9.85

5000 103.75 9.7

(5) Mr. B purchases a T-Bill with a face value of

Rs. 100,000 and pays Rs. 94,000 for it. The maturity
date is in 285 days. What is the bank discount yield?
174 vipul's Risk
anagement (BFM terestRate Risk

175
11.1 DEFINITION:

Chapter II trate
nterest
rate risk exposure
arises when a
has the potential to affect the
change in
terest rates
value of a
company or individual's assets and liabilities. As a
Interest Rate Risk onsequence,
interest rate risk could result in
higher costs
acOf
loss of earnings
and diminished profits. Changing interest
rates can impact companies in different ways and all
anies are interest rate movements in one
sensitive to
Definition
form or a n o t h e r .
.2 Identifying Interest Rate Risk
1.3 Analyzing Interest Rate Risk
I1.4 Measuring Interest Rate Risk 11.2 IDENTIFYING INTEREST RATE RISK:
1.5 Managing Interest Rate Risk Most companies will find that they are exposed to
I1.6 Solved Problems interest rate risk in several ways. This exposure will
I1.7 Practice roblem include all outstanding debt or cash deposits. Equally,
L.8 Questions the value of other assets and liabilities, or revenues and
expenses, may be affected by interest rate changes.
The company will need to identify exposures and gain
inderstanding of how interest rate changes might
affect the value of assets and liabilities and impact on
cash lows. In order to do so, the interest rate risk
needs to be measured.

11.3 ANALYZING INTEREST RATE RISK:

There are various factors to which bond prices are
Cnsituve like interest rate, credit rating, prepayment risk
etc.

(1) Interest Rate:

interest rate is most factor for bonds as t
important
crectly affects the prices of bond. For a plain vanilla bond
bon no option) there exist an inverse relationship
 176 Vipul'sTM Risk Management (BFM nterestRate Risk

177
M
between prices and interest rate. With increase in
edit rating a n d and default risk are closely related to
interes
rest ed
read

each
former have direct relationship with
rate prices of bond will decrease and vice a versa.
Reason is other prices of bonds.
that when a bond pays coupon higher than interest rate,
rate
aReinvestment Risk:
than price of bond will be more than its tace value and if exists only for bond with call
This risk option. A bond
pays coupon less than interest rate, than price of bond wi is one in which issuer
w sith call option have the
right to
be less than its face value.E.g. a bond pays a coupon af redeem ththe bond before maturity. With decline in
interest
10% and prevailing interest rate in market is 12%. Under rates prices of bond with call option also falls. In case of
such conditions will be less than face value
price of bond falling interest rate scenario issuers finds it profitable to
On the other hand if bond pays coupon of 10% and bond and issue
edeem
rede existing new bonds with lower
prevailing interest rate in economy is 8% than prices of coupon rate. E.g. a callable bond pays coupon of 12% when
bond will be more than its market price. interest rate in economy is 11/%. Now due to change in
Relation between bond prices and interest rate can be economicscenario interest rate falls to 9%, then
issuer can
explained by the figure given below: come with new issue which offers coupon of 10% and
redeem existing bonds which pays coupon of 12%.

Hence investors of callable bond will suffer as they will

be compelled to make investments in low coupon bearing
securities. This is called as reinvestment risk.

11.4 MEASURING INTEREST RATE RISK:

) Duration:
Duration is defined as first order derivative of price with
Tespect to interest rate. Duration is change in price of bond
Interest Rate nere 1s change in interest rates by 100 basis point

Fig.: 11.1 ie. 1%)

(2) Credit rating:
Duration Price if yield declines- price if yield rises_
Another important factor after interest rates which affect 2 x x(Initial Price) (Change in yield decimal
x

If auration of that for 100 basis

the price of bond is credit rating. With decline in credit a bond is 10 it means

bond will change by

point
rating, prices of bond wll fall as probability of companytchangesin
%.
interest rates,
price of
defaulting increases. On the other hand
improvement has
bond
credit rating will result into increase in prices of bond. As
Duration
*OnIs also a measure of time. If a
bond is
duration of it also means that price sensitivity of
bona.
s that of a 10 year zero coupon
 InterestR a t e Risk

Vipul's Risk
Management (BFMI 179
178
c a s h .
determined
flow is dete by dividing the present
value of the
the major drawbacks the price.
Effective Duration: One of of cash
low by
into consideration cha.
duration is that it does not take duration can be calculated:
Macaulay
in expected cash flow with change
in interest rate. Effecti ve
duration is a duration calculation for bonds With embeddea txC_ nx M
de
It takes into consideration change
in cash
flow with
,(1+y) (1 +yj
option. Macaulay Duration =
it more suitable ffor Current Bond Price
change in interest rate. This makes
measuring sensitivity of bond with embedded option. Where:

Modified Duration: t respective time period

Modified duration is a formula that expresses the
C periodic coupon payment
measurable change in the value of a security in response to
y periodic yield
a change in interest rates. Modified duration follows the
n =total number of periods
concept that interest rates and bond prices move in
directions. This formula is used to determine the
M maturity value
opposite
effect that a 100-basis-point (10) change in interest rates Current Bond Price = Present value of cash flows

will have on the price of a bond. The Macaulay duration can be viewed as the as the
Modified duration is given as: economic balance point of a group of cash flows. Another
Modified Durationacauley Duration way to interpret the statistic is that it is the weighted
1+M average number of years an investor must maintain a
n
position in the bond until the present value of the bond's
Where n = number of coupon periods per year cash flows equals the amount paid for the bond.
Now consider the above example where A bond's price, maturity, coupon and yield to maturity
we again
Macaulay Duration was 5.52. If we substitute this value inallfactor into the calculation of duration. All else equal, as
formula for Modified duration assuming YTM to be 10%. urity increases, duration increases. As a bond's coupon
Than Modified Duration 5.52/ (1.1) ncreases, its duration decreases.
and the
5.01 nS
interest rates increase, duration decreases
increases gocs
This shows that for every 1% movement in interest rates, Oas
sensitivity to further interest rate
scheduled prepayment
L ASO, sinking fund in place, lower a
a
the bond is this example would inversely move in pre bond's duration.
5.01%. before aturity and call provisions
straightforward.
Macaulay Duration: The calculation of Macaulay duration is a 0'o
Assume bond priced at Rs.
1,000 that pays
to
The Macaulay duration is the weighted average i e r e is a
at rates are o
ach
maturity of the cash flows from a bond. The weight oI ca Coupon a
nd matures in six years. Interest
180 Vipul's Risk
Management (BFM nterestR a t e Risk

181
The bond pays the coupon once a year, id
and pays the
pays Rs. 30
the
Period 3
=3 x
x0.8162 Rs. 73.46
principal on the final payment. Given this, the followin
cash flows are expected over the next three years:
ving Period 4
4 x Rs. 30 x 0.7628 Rs. 91.54
5 x Rs. 30 x 0.7129 Rs. 106.94
Period 5
=

Period 1: Rs. 30
Period 6 = 6 x Rs. 1,030x 0.6663 = Rs. 4118
Period 2: Rs. 30
these values
=
Rs. 4470.40 numerat
Period 3: Rs. 30 Sum
Curre Bond Price = sum of PV Cash Flows
Period 4: Rs. 30
30
Period 5: Rs. 30 7961"
30
(1 +7%)^2
***
" 1030
(1+ 7%)^6 Rs. 809.33
Period 6: Rs. 1,030 = denominator

With the periods and the cash flows known, a discount Macaulay duration = Rs. 4470.40 Rs. 809.33 5.52
factor must be calculated for each period. This is calculated
A coupon paying bond will always have its duration less
1 , where r is the interest rate and n is the period
than its time to maturity. In the example above, the
as(1+r)^n'
number in question. Thus the discount factors would be: duration of 5.52 around half years is less than the time to
maturity of 6 half years.
0.9345
Period 1 Discount Factor =1+7%101 (2) Convexity:
Period 2 Discount Factor =
0.8734 Convexity is another measure of bond risk. The measure
(1 + 7%)n2
of Duration assumes a linear relationship between changes
Period 3 Discount Factor 0.8162 in price and duration. However, the relationship between
(1+7%)^3
change in price and change in yield is not linear and hence
Period 4 Discount Factor (1 +7%)^4 = 0.7628
the estimated price change obtained by duration will give

only an approximate value.

Period 5 Discount Factor = (1 +7%)^5 0.7129
is insignificant when the change in yield
is
Ine error

1 in yield, as
Period 6 Discount Factor (1 +7%)^6 0.6663 SInall but does not hold true for larger changes
Convex1ty 1s
is convex.
eactual price-yield relationship relationship.
Next, multiply the period's cash flow by the period the measure
r of the of the price-yield
curvature
in
number and by its corresponding discount factor to find the It is also duration with a change
the rate of change of
present value of the cash flow:
yield
Period 1 = 1 Rs. 30
x0.9345 Rs. 28.03 h
characteristic as for a
often a desired
Convexity is a
bond's
Period 2 = 2 Rs. 30 or negative;
x0.8734 = Rs. 52.40 given ange in ield, positive
 InterestRate Risk

33
182 Vipul'sM Risk Management (BFM
M) that as market yields decrease,
duration
m e a n s

percentage rise in price is greater than the percentage prics decreases as well.

loss.
Effective Convexity: Similar to effective
Duration is first order derivative of price w.r.t takes into consideration
duration,
interestst ective
efect
convexity
change in cash
rate. Hence it is suitable only for small change in
interest flow with
h change in interest rate. Hence it is more
cha
suitable
rate. For larger change in interest rate convexity is a better
bonds with embedded option.
for
measure. Convexity is defined as second order derivative af (3) Gap analysis:
change in price to change in interest rates.
The simple way of measuring erest rate risk is by
Convexity is also useful for comparing bonds. If two
gap analysis. This method measures the gap between
bonds offer the same duration and yield but one exhibits usin
the volumes of interest-rate sensitive assets and liabilities
greater convexity, changes in interest rates will affect each
that are reprised atfter specific time periods. Interest rate
bond differently.
A bond with greater convexity is less
risk arises from net cash intlows or net cash outflows fora
affected by interest rates than a bond with less convexity.
given time period. In order to eliminate the risk for this
Also, bonds with greater convexity will have a higher price
than bonds with a lower convexity, regardless of whether period, all future cash outflows would need to be offset by
future cash inflows and vice versa.
interest rates rise or fall.
Price if yield declines+ price if yield rises 14) Scenario analysis:

Convexity
-(2 x Initial Price Scenario analysis is a more comprehensive method of
2 x (Initial Price) x (Change in yield decimal)
measuring interest rate risk. It employs different scenarios
Factors affecting Convexity:
modeling the most likely interest rate developments and
(1) The graph of the price-yield relationship for a plain their effects on the financial situation of the company
vanilla bond exhibits positive convexity. The price-yield portfolio.
curve will increase as yield decreases, and vice versa. 5) Value at Risk:
Therefore, as market yields decrease, the duration Value at analyses provides a singge
Risk (VaR)
increases (and vice versa). uNcasurement of risk faced by a company at a particular
o
(2) In general, the higher the coupon rate, the lower the ne, The VaR approach attempts to give an indication
when market
convexity of a bond. Zero-coupon bonds have the C
maximum loss that a company could face
The typical Vak
highest convexity. e interest rates) change adversely.
a
time perioa,
(3) Callable bonds (bonds which can be redeemed by issuer d ustic includes three ele ments- a

dence level and a loss amount (or loss percentage

before maturity) will exhibit negative convexity a
certain price-yield combinations. Negative convexity
 erest RateRisk

185
184
Vipul'sM Risk
Management (BFM has been there
recent past
significant
11.5 MANAGING INTEREST RATE
RISK: ume of IRF being traded mainly because of twoincrease
reasons: in
Various products available to manage Interest rate Rist
Risk u Increasing
interest rate fluctuations worldwide.
are explain below. (al in volumes of fixed income securities
ase
11.5.1 Interest Rate Futures (IRF}: traded.
being
IRF is a future contract for interest bearing instrument. Interest
rate swaps:
like T-bills, T-notes, T-bonds etc. Treasury bond futur L.5.2

est Rate Swaps 1s agreement where two or more

IRF contracts.
i n t e r e

contract are most common

agree to exchange interes obligation or income over

Fluctuation in interest rate is a major concern for both arties
oeriod of time which is specified in swap agreement. lf
borrowers. Lenders will lose i
p e r n

money lenders as well exchange of interest obligation it is called as

Is
interest rate goes down in future whereas borrowers will there
and if there is exchange of interest income it
lose if it goes up in future. To eliminate such risk IRF are ility swap
asset swap.
widely used worldwide. s called
Porking of IRS:
IRF is an agreement between two parties to buy or sell a

specific quantity of underlying asset, on a specific future

trequires initial exchange ot principal (optional), then
and re-exchange of principal amount
date and at a price agreed upon between two parties. schange of interest
is exchanged at beginning). A simple
Individuals or firms who are expecting an increase in ly1 principal
interest rate in futures can hedge themselves by taking terest rate swaps are popularly called plain vanilla swaps.
short This is because if interest rates rise in
positions. To understand this let us assume that there are two

future, the value of IRF will fall (as there exist an inverse irms A & B. Firm A has better credit rating as compared to

relation between bond prices and interest rates) and hence im B. Firm A requires loan in fixed rate and B requires
On the other hand individuals rate. Both approach bank to raise fund of
seller will make profit. oran in floating a

firms expecting a decline in interest rate can hedge their R1, 00, 00,000. Following are rates given to firm A&B by
isk by taking long position in IRF. bank
For example, borrowers face the risk of interest rates Firm Fixed rate (%) Floating rate (%)
rising. Futures use the inverse relationship between A 8 MIBOR+3

interest rates and bond prices to hedge against the risk ol MIBOR+6
B 10
rising interest rates. A borrower will enter to sell a future
absolute
ol Pron be that firm A have
today. Then if interest rates rise in the future, the value Om above it can seen
fixed
the future will fall (as it is linked to the advantage
underlying asset,antage in both fixed and floating rate.
However

tloating
firm B is only 2% than firm A whereas
bond prices), and hence a profit can be made when closingor
ate
more

firm B have a comparative

out of the future. 0 Therefore more.
 186
Vipul'sM Risk Management (BFM mterest R a t eR i s k

FM) 187
advantage in fixed rate. Hence according to
theory Swaption: A call
call Swaption:. swaption gives
its holder
comparative advantage of
af
right to
firm B should borrow in fixed rate
ate into enter i n t a fixed rate
swap as a
payer. On the other
and firm A should borrow in
floating rate. writer is floating rate payer. A firm will
hand
buy Call
However firm A requires loan in fixed rate and B swaptionsif i t is of the view that interest
requires rate will
loan in floating rate. If they borrow according to and hence is willing to pay fix rate and receive
their increase

requirement total cost of borrowing will be: oating rate. But hirm is aiso worried that interest
rates
8% + MIBOR + 6 = MIBOR + 14%. night starts falling after a certain period and hence
But if huyS a call swaption so that depending upon movement
they borrow according to theory of
comparative
interest rate it may enter into swap deal let
advantage i.e. firm B borrows in fixed rate and firm
A
of or
option
should borrows in floating rate then total cost of expire.
borrowing
will be: P u t Swaptions: A put swaption gives its holder right to
10 MIBOR +3 MIBOR + 13% enter into a swap as a floating rate payer. On the other
hand writer is fixed rate payer. Buyer of put swaption is
Hence it can be seen that if firm B borrows fix and firm A
of the view that interest in future will decrease and
floating they can benefit by 1% which can be shared
between them. hence is willing to pay floating rate and receive fixed
rate. But simultaneously is worried that interest rate
Thus both firms can enter into a swap agreement where
might starts rising after a certain period.
firm B borrows fix and firm A floating then exchange their
principal amount and interest obligation so that they can 11.5.3 Forward Rate Agreements:

fulfill each others requirement. It can be seen that such Forward Rate Agreements (FRA's) are over the counter
agreement is beneficial to both of them. denvative contracts that allow counter-parties to lock intooa

Valuation of IRS: specitied interest rate for a future date. The buyer of an

Value of IRS is gives as: RA lOcks in a borrowing rate while the seller locks into a

structured in
IEnding rate. Typically these contracts are
V Fb-Ff
rate and
Ca
way that the difference between the market
Where V =Value of the swapP
the "locked-in" rate is
Fb Value of fixed coupon bond.
settled.
.5.4 Interest rate Options:
Ff Value of floating rate note.
contracts tor which
options rate are option
Swaptions: CSt
ying security is a debt obligation. A grouping o
Swaptions are defined as options on swaps. Swaptions a
interest rate cap;
can be Call Swaption or Put Swaption.
interest rate calls is referred to a s an
to as an
referred
bination of interest rate puts is
188 H e r e sR
t a t eR i s k

Vipul's Risk Manage 189

(BFM duration of bond is 5.27 This means
interest rate floor. In
general, coupon bond sensitivity
H e n c e

a cap 1s like a call

and a fo. is same as that of zero of
is like a
put. loor with time to
of 5.27 years.
A cap, also called turity
ceiling,a is
call option on an a
intere.st dustration 1 1 . 2 :
rate. Buyer of cap pays a premium to buy a cap and
will h of a bond is 10. A portfolio manager is
receiving cash payments from the cap seller (the D u r a t i o n

holding
when the reference interest rate exceeds shor Rs. 9,00,00,000. Calculate
estimated change
the
cap's strike
p o n a s

if interest rates
rate. If the actual
interest rate exceeds the strike market
value
change by following basis
seller pays the difference between the rate, the
strike and the pounc:

interest rate 50 (c) 25 (d) 10 (e) 5

multiplied by the notional principal. a 100 (b)
The interest rate floor, like
the cap, is actually a
series of Sluto
Solution:

component options, except that they are put options. HereDuration is defined as percentage change in
prices of a
person taking long position is paid upon rate changes by 100 basis point ie. 1%.
maturity the ondifinterest
if
reference rate is below the floor's strike price.
Hence when change in basis point is 100; changes in

market price will be 10.

11.6 SOLVED PROBLEMS: Hence change will be Rs. 90,00,000 (10% of
1llustration 11.1: Rs.9,00,00,000).
A portfolio manager wants to know interest rate risk of a Similarly when change is of 50 basis point, change in
bond using duration. Current market price of bonds is rice of portfolio will be Rs. 45,00,000
Rs. 90. It was observed that if interest rates decline by 100
Change in interest rate Change in market price
basis point price
of bond will become Rs. 94.5. On the other
hand if interest rate increases by 100 basis 25 Rs. 22,50,000 90,00,000
point price of 4
bond will become Rs. 85. What is duration of bond?
10 (90,00,000
Solution:
Rs.9,00,00010
Duraion 2
Price if yield declines -Price if yield rises 90,00,000)
x (Initial Price) (Change in yield 05
Rs. 4,50,000
x
decimal 20
Price if yield declines =Rs. 94.5
Price if yield increases = Rs. 85 lustration 11.3: different
bonds having
Initial price = Rs. 90 Following table shows six different
more
and
Coupon rate.
rat Determine which will be priced a
94.5-x 85 provided yield
Hence Duration 2x90 0.01 = 5.27
hich D
will e priced less than
face value

Tequired by market is 12%.

190
Vipul'sM Risk Management s tR a t eR i s k

191
(BFM
Bond uration o f a bond is 8. Market
price is Rs. 90.
Coupon rate (%) f
interest
rate increases by5 basis point what should be
A 8 of the bond.
price
new
n e w

B 12 table shows six different bonds

Following
rate. Determine
having
C 11 ent coupon which will be
priced
more and which will be priced less than face value
D 6
market is 10%.
E 15
provided yield required by
pro
Bond Coupon rate (%)
F 13
A 12
Solution: B 15
Bond will be priced above par value if it have coupon C 20
more than yield required by market. Bond having coupon
D
less than yield required will be priced below par. Bond
E 11
having coupon equal to yield will be priced at par.
Hence bond E and F will be priced above F 08
par (as coupon
is more than yields
required). Bond A, C, D will be priced
below par as coupon is less than required
yield. Bond B will11.8 QUESTIONS:
be priced at par as coupon is same as yield required. Define Interest rate Risk.
1)
) Write a note on identification of Interest Rate Risk
11.7 PRACTICE PROBLEMS:
is done.
(1) A bond is having market price of Rs. 100. If interest ) Explain how analysis of Interest Rate Risk
Discuss about "Measurement of Interest Rate Risk"
rates increase by 50 basis
point there is 50%
Risk.
probability that prices will be that19 Write
90, 25% probability a note on management of Interest Rate
prices will be 92 and 25% probability that prices will be
89. On the other hand if interest rates declines by 50
basis point there is 45% probability that prices will be
105, 21 % probability that prices will be 103 and 34%
that prices will be 106. Find duration of bond.