5 - Fixed Income Risk and Return - Fipm

Summary
FIXED INCOME PRODUCTS

AND MARKETS • Bond Mathematics
DV01/PVBP or Price Risk
Duration and Modified Duration
5. Fixed Income Risk and Interpretations
Properties
Return PVBP and duration of portfolios
Trading and Hedging
Convexity
Bullet vs barbell securities (butterfly trade)
Effective Duration and Effective Convexity
José A. de Azevedo Pereira Fixed Income Products and Markets 2
Terminology Introduction
• Dollar value of a basis point (DV01) or price value of a basis point (PVBP) • Treasury bonds are really riskless?
• Price elasticity of debt in relation to interest rates
• Macaulay duration • Distinction between credit risk and price risk;
• Modified duration
• Convexity • A word about corporate debt risk.
• Trading applications and Hedging applications
• Yield curve trades
• Butterfly trades
• Effective duration
José A. de Azevedo Pereira Fixed Income Products and Markets 3 José A. de Azevedo Pereira Fixed Income Products and Markets 4
Price Risk Price Risk
• Price risk of a bond is given by the change in price due to changes in interest
rates:
∂P
− • PVBP or DV01 measures the price change in debt for a basis point change in yield:
∂y
∂P
If, −
∂y
C
100 −
C y If,
P= + N &
y  y
1 +  & 100 + '
 2 $% (
' ' -
1(2
  N (100 −
C
) .$
∂P C  1  y +
− = 1 − + N +1
.'
∂y y 2  (1 + y ) N   y &
Where,  2  21 +  & 1 20100 + ' 1
 2 % 1+
P0 is the price of the bond in moment 0; '/ ' - ( ' -34
01 ( 21 2 1(2
C is the (value of the) coupon;
y is the yield to maturity of the bond;
N is the maturity of the bond.
Price Value of a Basis Point (PVBP/DV01) –

Price Risk another measure of price risk
Change in the price of a bond per basis point of change in the yield.
• Normally the price risk is scaled by a value of 100 to reflect the change in price for a percentage • Also called DV01;
change in yield:
• Another measure of price risk used in the industry;
• Typically, it is expressed in dollars (euros) per million par;
• Different ways to calculate:
∂p    C 
−  N (100 − ) PVBP = ∆ P × 100
∂y 1 C  1  y 
∆P = =  1 − y N
+ N +1 
100 100  y 2  y
 (1 + ) 
 2  21 +  
  2   ∆P
PVBP = − × 10000
∆y
Price Value of a Basis Point (PVBP/DV01) ) –
PVBP and approximate modified duration
another measure of price risk
The approximate modified duration Example:
is a linear approximation of the
slope of the price/yield curve. The Consider a bond with one year to maturity, with a coupon of 5% paid semiannually
Price and a YTM of 6,5%.
difference is due to the convexity of
the price/yield curve. a) What is the price of the bond?
b)What change in price can we expect, if the YTM increases by 1 b.p.?
56
c) Based on the previous calculation, what is the price risk ( ), expressed as DV01,
57
of a $1 million par amount of this security?
d)Perform the same calculation asked in the previous item, identifying the changes
in prices induced by an increase or a decrease of 0,5 b.p. in the YTM.
Tangent line = PVBP
Yield
Price Value of a Basis Point (PVBP/DV01) ) – Price Value of a Basis Point (PVBP/DV01) ) –
another measure of price risk another measure of price risk
Face value $ 100,00
Face value $ 100,00 Maturity 1
Coupon 5,00%
Maturity 1
YTM 6,50%
Coupon 5,00%
YTM 6,50% Time 1 2
CFs $ 2,500 $ 102,500
PV $ 2,421 $ 96,149
Time 1 2
Price $ 98,570
CFs $ 2,500 $ 102,500
PV $ 2,421 $ 96,149 P' (price with YTM of 6,505%)
Price $ 98,570 Time 1 2
CFs $ 2,500 $ 102,500
PV $ 2,421 $ 96,144
P' (price with YTM of 6,51%)
Price $ 98,565
Time 1 2
CFs $ 2,500 $ 102,500 P' (price with YTM of 6,495%)
PV $ 2,421 $ 96,139 Time 1 2
CFs $ 2,500 $ 102,500
Price $ 98,561
PV $ 2,421 $ 96,153
Price $ 98,575
P-P'= $ 0,0094
(P-P')x10000 $ 94,2880 P-P'= $ 0,0094
(P-P')x10000 $ 94,2948
Price Value of a Basis Point
(PVBP/DV01) ) – another measure of Price Value of a Basis Point (PVBP/DV01) ) –
price risk another measure of price risk
Example 5.2:
BENCHMARK YIELDS FOR SETTLEMENT ON FEBRUARY 9, 2022

For all the benchmark securities mentioned in the following table, calculate de DV01 (PVBP) for $1
million par value Yield to Clean price
Maturity Date Coupon Clean Price Yield PVBP Comments
Maturity '@'+1bp
BENCHMARK YIELDS FOR SETTLEMENT ON
31-01-2024 0,875% 1,303% 99,16796876 1,3030% 99,1486357 193,33107 Two-year
FEBRUARY 9, 2022
15-01-2025 1,125% 1,533% 98,83593751 1,5326% 98,8075835 283,53977 Three-year
Yield to
Maturity Date Coupon Comments 31-12-2026 1,250% 1,788% 97,49218751 1,7878% 97,4462382 459,49294 Five-year
Maturity
15-11-2031 1,375% 1,929% 95,09375 1,9287% 95,0076111 861,38908 Ten-year
31-01-2024 0,875% 1,303% Two-year
15-01-2025 1,125% 1,533% Three-year 15-11-2051 1,875% 2,254% 91,8125 2,2540% 91,6077199 2047,8012 Thirty-year
31-12-2026 1,250% 1,788% Five-year
15-11-2031 1,375% 1,929% Ten-year
15-11-2051 1,875% 2,254% Thirty-year
Price Value of a Basis Point (PVBP/DV01) ) – Duration

another measure of price risk
• Widely used measure of risk;
• Two alternative measures:
BENCHMARK YIELDS FOR SETTLEMENT ON FEBRUARY 9, 2022
• Macaulay Duration;
Yield to Clean price Clean price
Maturity Date Coupon Clean Price Yield PVBP Comments • Modified Duration.
Maturity '@'+0,5bp '@'-0,5bp
31-01-2024 0,875% 1,303% $ 99,16797 1,3030% $ 99,15830 $99,17764 $ 193,35486 Two-year
15-01-2025 1,125% 1,533% $ 98,83594 1,5326% $ 98,82176 $98,85012 $ 283,58791 Three-year
31-12-2026 1,250% 1,788% $ 97,49219 1,7878% $ 97,46921 $97,51517 $ 459,61466 Five-year
15-11-2031 1,375% 1,929% $ 95,09375 1,9287% $ 95,05067 $95,13685 $ 861,81744 Ten-year
15-11-2051 1,875% 2,254% $ 91,81250 2,2540% $ 91,71004 $91,91510 $2 050,57566 Thirty-year
Macaulay Duration Macaulay Duration
N
CFt
Po = 
1. Discounted cash-flow-weighted time to receipt of all the promised cash of a
bond, divided by its price (interpretation 1):
t =1 (1 + y ) t
• Measures the average time taken by the security, on a discounted basis, to
pay back the original investment; ∑-
)*4 & ' &()
• The shorter the duration, the smaller risk; 01 ( '1)
Macaulay Duration %
• In this sense, it can be measured in units of time. Where, $+
P0 is the price of the bond in moment 0;
CFt is the cash flow in moment t;
y is the yield to maturity of the bond;
N is the maturity of the bond.
Macaulay Duration Macaulay Duration

The price elasticity of the bond (interpretation 2):
Percentage change in price for a percentage change in the yield
The greater the duration, the greater the risk. The price elasticity of the bond (interpretation 2):
-./0.1&23. 0ℎ213. 51 -/50. 67 2 8619

,%+ Since + 56;57 is just the DV01 of the bond, it is possible to
-./0.1&23. 0ℎ213. 51 &ℎ. '5.:9 67 &ℎ. 8619
conclude:
.$ .$
$ .$ 1
,%+ %+ $ 1(' %+ 1('
.' .' .' $
1(' ,<01
,% 1('
$
With semiannual compounding, it is usual to use the following convention:
.$ 1 '
,%+ 1(
.' $ 2
Modified Duration Macaulay Duration
Percentage change in price for a change in the yield:
Example:
5.3. Consider a three-year bond paying an annual coupon of 4% per annum and
.$;
$ yielding a 4% YTM.
=, % +
.' a) What should be the price of the bond?
b) What is the discounted cash-flow weighted time to receipt off all the
,<01
=, % corresponding cash flows (Macaulay duration of the bond)?
$
Where P, is the dirty price of the bond
Macaulay Duration Macaulay Duration (example)

Face value $ 100,00
c 4% 5.5. Consider the three year coupon bond mentioned in example 5.3.
y 4% 1. Calculate the corresponding price elasticity, based on a proxy of changes
P $ 100,00 in prices induced by an increase or a decrease of 0,5 b.p. in the YTM;
2. Calculate the corresponding DV01;
Cash Flow Discounted Cash
Discount 3. What is the Macaulay Duration?
Year CFs weighted Flow Weighted
factors 4. What is the Modified Duration?
time Time
1 $ 4,00 4 3,846
2 $ 4,00 8 7,396
3 $ 104,00 312 277,367
Total 288,609
Price $ 100,00
Sum of discounted cash-flow-
weighted times divided by price
2,8861
Macaulay Duration Modified Duration
Face value $ 100,00
c 4%
• Economic intuition behind Modified Duration:
y 4%
P $ 100,00
1/2 b.p. 0,005%
Cash Flow Cash Flow Cash Flow
(D10-E10)*(10000/P)*(1+B3)
.$; % +=, ' .'
Year CFs Discounted at Discounted Discounted
$
4,000% at 3,995% at 4,005%
1 $ 4,000 $ 3,846 $ 3,846 $ 3,846 Percentage change in bond price is the modified duration multiplied by the corresponding
2 $ 4,000 $ 3,698 $ 3,699 $ 3,698 change in yield
3 $ 104,000 $ 92,456 $ 92,469 $ 92,442
Total $ 100,000 $ 100,014 $ 99,986
Price elasticity => (dP/dy) x (1/P) x ( 1+y) 2,8861 .$ % +=, ' $ ' .'
DV01 $ 277,51
Macaulay Duration 2,8861
Modified Duration 2,7751 ?@AB (The higher the modified duration the higher is its percentage change to a change in its yield)
>? %
C
P is the dirty price.

• Duration increases with maturity, in a non direct proportion.
However, as in this case the accrued
interest is 0, dirty price = clean price
Excel functions for duration and modified

duration Modified Duration (example)
6. Calculate the durations and modified durations for the bonds mentioned in Table 7. Compare the modified duration of the 30-year T-bond mentioned in
mentioned in 5.2: 5.2 with that of a strip maturing on November 15, 2051, that was
BENCHMARK YIELDS FOR SETTLEMENT ON 09/02/2022 trading at a yield of 2,5% for settlement on February 9, 2022. Assume
Yield to Mod Dur Mac Dur that you have $ 1 million par value of each security.
Comments Coupon Maturity Date
Maturity (from Excel) (from Excel)
Two-year 0,875% 31-01-2024 1,3030% 1,95 1,96 a) What are de durations and PVBPs of both sovereigns? Which security
Three-year 1,125% 15-01-2025 1,5326% 2,87 2,89 is riskier?
Five-year 1,250% 31-12-2026 1,7878% 4,71 4,75
Ten-year 1,375% 15-11-2031 1,9287% 9,03 9,12
b) For a similar par value of investment in each security what is the less
Thirty-year 1,875% 15-11-2051 2,2540% 22,23 22,48 risky?
Modified Duration (example) Properties of Duration and PVBP
Settlement date 09/02/2022
/D,EFG
T-Bond Strip H,I% % 29,397
43
Face value $ 100,00 H • Summary of previous findings:
Maturity (Strip) 15/11/2051 15/11/2022
YTM (Strip) 2,500% Comparison between durations (based on dirty prices - • Duration of ZCB its equal to its maturity => ZCB is the most
Duration of Strip = Time to Maturity (in years) $ 29,764 market values) provides a notion of risk that might differ interest rate elastic security for a given bond class;
from that provided by PVBP (based on par values) .
Modified Duration 22,23 $ 29,397
Price $ 91,8125 $ 47,7354 100 • Duration is increasing in maturity;

/D,EFG'/ % 47,735
2,5%
1(
Market value corresponding to 2
1 million par value $ 918 125,00 $ 477 353,82 • Duration is decreasing in coupons and YTM;
Price with YTM increased by 1
b.p. $ 47,595 Comparison between PVBPs (based on par
values) provides a different impression.
PVBP $ 2 050,58 $ 1 401,18
• Duration of coupon bonds is less than its maturity;
Comparison based on a similar
market value $ 2 050,58 $ 2 694,98
• Duration changes in time.
PVBP and duration of portfolios PVBP and duration of portfolios

(example)
The PVBP of a portfolio is the par value-weighted PVBP of individual securities
in the portfolio 8. Consider a portfolio that was constructed with $10 million par value of the 2
year note mentioned in example 2 and $20 million par value of the 5-year
$<P$Q % 14 $<P$4 ( 1/ $<P$/ note.
a) What is the PVBP of the portfolio?

Where n1 is the par value of security 1 and n2 is the par value of security 2
b) What is the duration of the portfolio?

Generalization:
S*-
$<P$Q % R 1S $<P$S
S*4
PVBP and duration of portfolios (example) Trading and Hedging (example)
Portfolio Par
PVBP values ($
million) 1. A trader has been assessing the shape of the yield curve for settlement on February
Par value of 2-
year T-note n2 $ 193,35486 10,00 9, 2022 and is considering the possibility of implementing a steepening trade.
trade. Based
Par value of 5- on the data provided in 5.2, help her in the definition of the details of her trade:
trade:
year T-note n5 $ 459,61466 20,00
a) What is the yield spread between the 10 year T-note and the 2-year T-note?
PVBP p (Portfolio $<P$Q % 1 / $<P$/ ( 1 4+$<P$4+
euro exposure) $ 11 125,84179 b) Knowing that the trader wants to set up a portfolio of including (only) 2-year and 10
Settlement Date 09/02/2022 year T-notes, and that she is prepared to bet in an increase in spreads, in what
Comments Coupon Maturity Date Clean Price Yield
Mod Dur Mac Dur Last Coupon
Next
Coupon Issue Date
Accrued Dirty Price
Market Values
Market
Value
security should she assume a long position and in what security should he assume a
(Excel) (Excel) Date
Date
Interest per $100 par
Weights short position? Why?
Two-year 0,875% 31-01-2024 $ 99,16797 1,3030% 1,95 1,96 31-01-2022 31-07-2022 31-01-2022 $ 0,02175 $ 99,18972 $ 9 918 972,29076 33,69%
Three-year 1,125% 15-01-2025 $ 98,83594 1,5326% 2,87 2,89 15-01-2022 15-07-2022 15-01-2022 c) Knowing that the trader is prepared to assume a position (short or long) of $100
Five-year 1,250% 31-12-2026 $ 97,49219 1,7878% 4,71 4,75 31-12-2021 30-06-2022 31-12-2021 $ 0,13812 $ 97,63031 $ 19 526 061,81435 66,31%
Ten-year 1,375% 15-11-2031 $ 95,09375 1,9287% 9,03 9,12 15-11-2021 15-05-2022 15-11-2021 $ 0,32666 $ 95,42041
million (par value) in the 10 year T-note, what will be the par value of the 2 year T-
Thirty-year 1,875% 15-11-2051 $ 91,81250 2,2540% 22,23 22,48 15-11-2021 15-05-2022 15-11-2021 note?
Portfolio Total Market Value $ 29 445 034,10511
Weights are market
Portfolio Modified Duration 3,779
value proportions
Trading and Hedging (example) Convexity (example)

a)
Yield spread between 10-year T-Bonds and 2-year T-notes 62,6 b.p. • Slope of the price-yield relationship varies in accordance with yield
levels;
b)
Bulish Market (situation in which "all" rates are expected to fall) :
For spreads to increase => 2-year yields must drop by much more than 10-year yields => long position in 2 year notes
Bearish Market (situation in which "all" rates are expected to rise) : As the PVBPp = 0, • Low yields correspond to steeper slope tangents to the curve;
For spreads to increase => 10-year yields must increase by much more than 2-year yields => short position in 10-year bonds ,<014+
1/ % + +100 '
c)
,<01/
n2 445,72
• This phenomena is usually called convexity
n 10 -100 Short position (value defined in the text)
$<P$Q % 1/ $<P$/ ( 1 4+ $<P$4+
Par amount of 2-year note $ 445 718 011,11 (Approximately $ 446 M )
Convexity Convexity
• Convexity contributes favorably to the price change
• Using a Taylor series approximation (considering only linear and quadratic terms), we can
express the percentage price change in the following terms: • Holding maturity and YTM fixed, the convexity decreases as the coupon increases.
.$ .$ ./$ / • Convexity increases with duration.

T .' ( 0,5 / .'
$ .' .'
• Or • Example 5.10:
./$ /
.$ T $ ' +=, ' .' ( 0,5 ' $ ' .' Consider a 2-year zero coupon bond with an YTM of 10%. What is its convexity, assuming
.' / annual compounding?
• The price change of a debt security consists of two terms:

• The first (duration effect ) is negative: as yields increase, prices decline;
• The second (convexity effect) is positive: gain from convexity.
Convexity (example) Convexity (example)

11. Calculate the gain from convexity for the securities mentioned in example 5.2.
Bullet vs Barbell securities (example) Bullet vs Barbell securities (example)
a)
12. Consider data from the previous example.
1 / $/ ( 1 4+ $4+ % 100
A trader holds a long position (bullet position) with a par value of $100 million in a 5-
year T-note. He is considering the possibility of replacing this position with a barbell 1 / $<P$/ ( 1 4+ $<P$4+ % 100$<P$U
position based on 2-year and 10-year T-notes such that i) the market value of its
investment remains the same (no cash outlay); and ii) the PVBP remains the same. b)
Settlement Date09-02-2022
Gain from
a) Specify the constraints mentioned above; Estimated
Clean Price Clean Price + PVBP at y + 1 Convexity Portfolio
Securities Coupon Maturity Date Clean Price Yield PVBP at y Second Dirty Price Value PVBP of portfolio
+ 1bp 2bp bp For 1% positions (n )
b)Identify the weights of both T-notes in the barbell portfolio; Derivative
Change
c) Analyze the potential effects induced by a generalized drop (increase) in the yields. Two-year 0,875% 31/01/2024 $ 99,16797 1,303% $ 99,14864 $ 193,33107 $ 99,12931 $ 193,28371 473,61 0,02 $ 57 114 629,71 $ 99,19 $ 56 651 842,95 $ 11 042,03
What are the main differences between the barbell and the bullet portfolio? Three-year 1,125% 15/01/2025 $ 98,83594 1,533% $ 98,80758 $ 283,53977 $ 98,77924 $ 283,44378 959,86 0,05
Five-year 1,250% 31/12/2026 $ 97,49219 1,788% $ 97,44624 $ 459,49294 $ 97,40031 $ 459,24997 2429,70 0,12 $ 100 000 000,00 $ 97,63 $ 97 630 309,07 $ 45 949,29
Ten-year 1,375% 15/11/2031 $ 95,09375 1,929% $ 95,00761 $ 861,38908 $ 94,92156 $ 860,53305 8560,30 0,43 $ 41 745 137,33 $ 95,42 $ 39 833 380,13 $ 35 958,81
Thirty-year 1,875% 15/11/2051 $ 91,81250 2,254% $ 91,60772 $ 2 047,80125 $ 91,40349 $ 2 042,26446 55367,83 2,77
$ 96 485 223,08 $ 47 000,84
Thank You
José A. de Azevedo Pereira Fixed Income Products and Markets 43

5 - Fixed Income Risk and Return - Fipm

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

5 - Fixed Income Risk and Return - Fipm

Uploaded by

Copyright:

Available Formats

Summary

FIXED INCOME PRODUCTS

José A. de Azevedo Pereira Fixed Income Products and Markets 2

Price Value of a Basis Point (PVBP/DV01) –

Tangent line = PVBP

BENCHMARK YIELDS FOR SETTLEMENT ON FEBRUARY 9, 2022

Price Value of a Basis Point (PVBP/DV01) ) – Duration

Macaulay Duration Macaulay Duration

-./0.1&23. 0ℎ213. 51 -/50. 67 2 8619

Where P, is the dirty price of the bond

Macaulay Duration Macaulay Duration (example)

P is the dirty price.

Excel functions for duration and modified

Price $ 91,8125 $ 47,7354 100 • Duration is increasing in maturity;

PVBP and duration of portfolios PVBP and duration of portfolios

a) What is the PVBP of the portfolio?

b) What is the duration of the portfolio?

Trading and Hedging (example) Convexity (example)

.$ .$ ./$ / • Convexity increases with duration.

• The price change of a debt security consists of two terms:

Convexity (example) Convexity (example)

$ 96 485 223,08 $ 47 000,84

José A. de Azevedo Pereira Fixed Income Products and Markets 43

You might also like