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Risk Management Interest Rate Risk
Risk Management Interest Rate Risk
Price Sensitivity
Slope = ∆P / ∆y
∆P
∆y
Yield
Copyright © 1996-2006 Investment Analytics Interest Rate Risk Slide: 5
Worked Exercise:
Bond Values & Interest Rates
¾ Start Bond Tutor
¾ Subject: Bond Values & Interest Rates
¾ Follow worked exercise
Slope = ∆P / ∆y ∼ D
P*
y* Yield
Copyright © 1996-2006 Investment Analytics Interest Rate Risk Slide: 11
Two Ways to Think About Duration
P*
y1 y* y2
Yield
Copyright © 1996-2006 Investment Analytics Interest Rate Risk Slide: 20
Convexity
¾ Duration assumes linear price-yield relationship
Duration proportional to the slope of the tangent line
Accurate for small changes in yield
= αt x Change + βt x Change in
in spread long rate
¾ Spread: (Long rate - Short rate)
¾ Two factor Model:
αT : sensitivity of T-period spot rate to changes in spread
βT: sensitivity of T-period spot rate to changes in long rate
¾ Factors
Long rate
Spread = long rate - short rate
¾ Regression Analysis
∆RT = AT + αT∆S + βT∆L + εT
1.000
0.800
0.600
0.400
0.200
0.000
0 2 4 6 8 10 12 14
Spread Sensitivity Long Rate Sensitivity
DRD = 2.8
IRD = -2.8
NET DURATION = 0
Deterministic analysis
Option analysis
0.0
K
= - (1/P) x Vega
¾ Vega greatest for ATM options
30
25
20
Vega
15
10
0
K
12.00%
10.00%
8.00%
Frequency
6.00%
4.00%
2.00%
0.00%
More
3.45%
3.68%
3.91%
4.14%
4.37%
4.60%
4.83%
5.06%
5.29%
5.52%
5.75%
YTM
2.50
2.00
1.50
LSE DUR
Duration
SIM DUR
OAD
1.00
0.50
0.00
3.5% 4.5% 5.5% 6.5% 7.5% 8.5% 9.5% 10.5% 11.5% 12.5%
LIBOR at Maturity
7
Yield (%)
5
CMT FRN
4
SURF
3
3 5 7 9 11
10Yr CMT at Maturity (%)
4.0
Dura tion
3.5
3.0
2.5
2.0
3 4 5 6 7 8 9 10 11
10Yr CMT at Maturity
0
3 5 7 9 11
Volatility Duration
-2
(bps/vol)
-4
-6
-8
-10
10Yr CMT at Maturity (%)
LIBOR
6
Key Rate Duration (years)
Discounting
5
CMT
4
3
2
1
0
-1 3 4 5 6 7 8 9 10 11 12
-2
Maturity