FI: Quantifying Interest Rate Risk

Lecture Set IV

Professor John P. Miller

Professor John P. Miller FI: Quantifying Interest Rate Risk 1 / 26

Price-Yield Relationship of an Option-Free Bond
What is this shape?
Does it hit the axes?
Price/Yield for a 10−YR 6% Bond

160
140
120
100
90
80
70
60
50
40
30

0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14 0.16 0.18 0.20 0.22 0.24 0.26

Yield

Professor John P. Miller FI: Quantifying Interest Rate Risk 2 / 26

Price-Yield Characteristics of Option-Free Bonds

Price-Yield Relationship: 10-YR 6% Bond

Prices moves in y(%) ∆y(%) Price ∆Price ∆Price/∆y(%)
opposite direction of 2.00 -0.50 136.09 5.29 -10.58
2.50 -0.50 130.80 5.05 -10.09
yield 3.00 -0.50 125.75 4.81 -9.62
Small ± changes in 3.50 -0.50 120.94 4.59 -9.18
4.00 -0.50 116.35 4.38 -8.76
required yield leads to 4.50 -0.50 111.97 4.18 -8.36
similar price changes 5.00 -0.50 107.79 3.99 -7.98
5.50 -0.49 103.81 3.73 -7.62
As yields increase 5.99 -0.01 100.07 0.07 -7.44
above the par yield, 6.00 0.00 100.00 0.00
the price decreases 6.01 0.01 99.93 -0.07 -7.44
6.50 0.49 96.37 -3.56 -7.27
at a decreasing rate
7.00 0.50 92.89 -3.47 -6.94
As yields decrease 7.50 0.50 89.58 -3.32 -6.63
8.00 0.50 86.41 -3.17 -6.34
below the par yield,
8.50 0.50 83.38 -3.03 -6.06
the price increases 9.00 0.50 80.49 -2.89 -5.79
at an increasing rate 9.50 0.50 77.72 -2.77 -5.53
10.00 0.50 75.08 -2.65 -5.29

Professor John P. Miller FI: Quantifying Interest Rate Risk 3 / 26

Impact of Maturity on the Price-Yield Relationship
How does increasing maturity impact the price-yield relationship?
Price/Yields for 6% Bonds with Various Maturities

160
20−Yr

140
120
Price ($)

100

5−Yr
80

10−Yr
60
40

0.02 0.04 0.06 0.08 0.10 0.12 0.14 0.16

Yield
More generally, how do we characterize the price-yield relationship for
other bond characteristics such as the coupon size?
Professor John P. Miller FI: Quantifying Interest Rate Risk 4 / 26
Price-Yield Characteristics of Option-Free Bonds
Instantaneous Percentage Price Change: 6% Initial Yield
9%/5 Yr 9%/20 Yr 6%/5 Yr 6%/20 Yr
Yield (%) ∆y (bps) 112-25+ 134-21+ 100-00 100-00
3.00 -300 13.18% 40.90% 13.83% 44.87%
4.00 -200 8.57% 25.04% 8.98% 27.36%
5.00 -100 4.17% 11.53% 4.38% 12.55%
5.50 -50 2.06% 5.54% 2.16% 6.02%
5.90 -10 0.41% 1.07% 0.43% 1.17%
5.99 -1 0.04% 0.11% 0.04% 0.12%
6.01 1 -0.04% -0.11% -0.04% -0.12%
6.10 10 -0.41% -1.06% -0.43% -1.15%
6.50 50 -2.01% -5.13% -2.11% -5.55%
7.00 100 -3.97% -9.89% -4.16% -10.68%
8.00 200 -7.75% -18.40% -8.11% -19.79%
9.00 300 -11.34% -25.75% -11.87% -27.60%
For a given term to maturity and initial yield, the lower the coupon
rate, the greater the price/yield sensitivity
For a given coupon rate and initial yield, the longer the maturity, the
greater the price/yield sensitivity
Professor John P. Miller FI: Quantifying Interest Rate Risk 5 / 26
Measures of Bond Price-Yield Sensitivities
Price of a Basis Point
Initial Price Price at Price of Price of a bp
Bond 6% Yield 6.01% of a bp (32nds)
5-Yr 9% Cpn 112.7953 112.7494 0.0459 0-01+
20-Yr 9% Cpn 134.6722 134.5287 0.1435 0-04+
5-Yr 6% Cpn 100.0000 99.9574 0.0426 0-01+
20-Yr 6% Cpn 100.0000 99.8845 0.1155 0-03+
5-Yr Zero Cpn 74.4094 74.3733 0.0361 0-01
20Yr Zero Cpn 30.6557 30.5962 0.0595 0-02

Yield Value of a Point

Initial Price New Price ∆Yield
Bond 6% Yield Price Change (bps)
5-Yr 9% Cpn 112.7953 111.7953 -1.0 21.9
20-Yr 9% Cpn 134.6722 133.6722 -1.0 7.0
5-Yr 6% Cpn 100.0000 99.0000 -1.0 23.6
20-Yr 6% Cpn 100.0000 99.0000 -1.0 8.7
5-Yr Zero Cpn 74.4094 73.4094 -1.0 27.9
20Yr Zero Cpn 30.6557 29.6557 -1.0 17.1
Professor John P. Miller FI: Quantifying Interest Rate Risk 6 / 26
Bond Price-Yield Sensitivity: Duration

Begin by differentiating the pricing function

C C C C 100
P = + + + ··· + +
1+y (1 + y)2 (1 + y)3 (1 + y)T (1 + y)T

 
dP C 2C 3C TC T × 100
=− + + + · · · + +
dy (1 + y)2 (1 + y)3 (1 + y)4 (1 + y)T +1 (1 + y)T +1
" T #
1 X tC T × 100
=− +
1 + y t=1 (1 + y)t (1 + y)T

We have the weighted average term to maturity of the cash flows. Dividing through
by P gives the approximate percentage price change:
" T #
dP 1 1 X tC T × 100 1
=− +
dy P 1 + y t=1 (1 + y)t (1 + y)T P
Macaulay duration
=− = −modified duration
1+y

Professor John P. Miller FI: Quantifying Interest Rate Risk 7 / 26

Bond Price Sensitivity: Modified Duration
Make the following adjustment to represent the periodic duration in years:
duration in m periods per year
duration in years =
m
5-Yr 6% Bond Priced at 5% YTM
Period t Cash Flow PV of $1 at 2.5% PV of CF t× PVCF
1 3 0.97561 2.92683 2.9268
2 3 0.95181 2.85544 5.7109
3 3 0.92860 2.78580 8.3574
4 3 0.90595 2.71785 10.8714
5 3 0.88385 2.65156 13.2578
6 3 0.86230 2.58689 15.5213
7 3 0.84127 2.52380 17.6666
8 3 0.82075 2.46224 19.6979
9 3 0.80073 2.40219 21.6197
10 103 0.78120 80.46344 804.6344
104.37603 920.2642
Macaulay duration (1/2 year) = 920.2642/104.37603 = 8.8168
Macaulay duration in years = 8.8168/2 = 4.41
modified duration = Macaulay duration/(1+y)=4.41/1.025=4.30
Professor John P. Miller FI: Quantifying Interest Rate Risk 8 / 26
Compact Modified Duration Formula

Begin by writing the pricing formula in closed-form

T
1 − (1 + y)−T
 
X C M 100
P = + =C +
(1 + y)t (1 + y)T y (1 + y)T
t=1

Now differentiate
1 − (1 + y)−T T (1 + y)−T −1
   
dP 1 1 T × 100
=− −C − −
dy P P y2 y (1 + y)T +1
 
1 C −T

T (100 − C/y)
=− 1 − (1 + y) +
P y2 (1 + y)T +1
| {z }
modified duration

Divide by m, the number of coupon periods in a year, to get

annualized modified duration

Professor John P. Miller FI: Quantifying Interest Rate Risk 9 / 26

Duration Examples

Assume a 5% YTM
Bond Price Modified Duration
5-year 9% coupon 117.5041 4.11
20-year 9% coupon 150.2056 11.17
5-year 6% coupon 104.3760 4.30
20-year 6% coupon 112.5514 12.09
5-year zero coupon 78.1198 4.88
20-year zero coupon 37.2431 19.51

Impact of increasing
Maturity
Payment frequency
Coupon
Yield

Professor John P. Miller FI: Quantifying Interest Rate Risk 10 / 26

Approximating Percent and Dollar Price Changes
What is the approximate percentage change in price for a 20-year
6% bond when the YTM increases from 5% to 5.1% (or 10 bps)?
dP 1 dP
= −modified duration ⇒ = −modified duration × dy
dy P P

−12.09 × 0.001 = −1.209%

Modified duration is quoted as a positive value with the negative
price-yield relationship assumed
Dollar duration
dP = − modified
| duration
{z × P} ×dy
dollar duration
What is the approximate change in price for a 20-year 6% bond when
the YTM decreases from 5% to 4.99%?
dP = −12.09 × 112.5514 × (−0.0001) = 0.1361
Professor John P. Miller FI: Quantifying Interest Rate Risk 11 / 26
DV01
DV01 is important metric for measuring risk as measured by the
change in the value of a position for a 1 bp change in yield
DV01 is generally measured per $1 million of a position
P
DV 01 = modified duration × × 0.0001 ×1,000,000
| {z 100 }
dollar duration of a 1 bp change
= modified duration × P
Examples:
Bond Price Modified Duration DV 01
5-year 9% coupon 117.5041 4.11 483
20-year 9% coupon 150.2056 11.17 1,678
5-year 6% coupon 104.3760 4.30 449
20-year 6% coupon 112.5514 12.09 1,361
5-year zero coupon 78.1198 4.88 381
20-year zero coupon 37.2431 19.51 727
Use: Multiply the position size by the number of bp change in yield
and the DV01 to get an estimated change in position
Example: Suppose you have a $10 million position of the 5-year 6%
bond and yield falls 8 bps. What is the change in the value of the
position: 10 × 8 × 449 = 35,920
Professor John P. Miller FI: Quantifying Interest Rate Risk 12 / 26
DV01 is a Hedging Metric
Fixed income market makers (generally investment banks) buy and sell
securities, earning revenue off the bid-offer spread
To facilitate market making, dealers need to hold positions of securities,
but do not want profit/loss (P/L) exposure to interest rate movements
Using DV01, market makers can neutrallize most of the impact of
adverse interest rate changes
Consider a portflio of bonds with a face amount PortF with a DV01 of
DVport
The impact of changing interest rates are approximated by DVport , and
this can be offset by taking a short position in another security, say
U.S. Treasuries, with a DV01 of DVhedge
Want to size the hedge with X face amount to solve the following:
DVport
PortF × DVport + X × DVhedge = 0 =⇒ −X = PortF ×
DVhedge
This strategy is also used by portfolio managers looking to protect
against rising interest rates
Professor John P. Miller FI: Quantifying Interest Rate Risk 13 / 26
Limitation of Duration
Modified duration gives the approximate percentage change in price
for a given change in the level of yield
Example: Based on the 4.30 year duration for the 5-YR 6% bond at a
5% required yield, we calculate that a 100 bp interest rate decline
(from 5% to 4%) increases the bond price by 4.30%
What is actual price if computed directly?
What is the error?

P ∗ = 1.043 × 104.376 = 108.8651

1 − 1.02−10
 
100
P ∗∗ =3 + = 108.9826
0.02 1.0210
Error = P ∗∗ − P ∗ = 108.9826 − 108.8651 = 0.1175
The error results from the fact that modified duration is a linear
approximation of a nonlinear function - namely, the relationship
between YTM and the price of the bond
Professor John P. Miller FI: Quantifying Interest Rate Risk 14 / 26
Duration with Large Yield Changes

Duration provides a good approximation to prices change for small

changes in yield, but for larger changes: Duration underestimates the
price increases when yields fall, it overestimates the price declines
when yields rise
Price/Yield Curve: 20-YR 6% Bond
Actual
Actual Estimated
YTM Price Price Error

150
1% 190.43 157.79 32.64
2% 165.67 146.23 19.44
3% 144.87 134.67 10.20
4% 127.36 123.11 4.24

Price
5% 112.55 111.56 0.99

100
Estimated

6% 100.00 100.00 0.00

7% 89.32 88.44 0.88
8% 80.21 76.89 3.32
9% 72.40 65.33 7.07 50

10% 65.68 53.77 11.91

11% 59.88 42.21 17.67
12% 54.86 30.66 24.21 0.02 0.04 0.06 0.08 0.10 0.12

Yield

Professor John P. Miller FI: Quantifying Interest Rate Risk 15 / 26

Convexity
To approximate the price change, we begin by taking a Taylor
expansion of the pricing formula:
dP 1 d2 P 2 1 d3 P 3
dP = dy + dy + dy + · · ·
dy 2 dy 2 6 dy 3

Dividing through by P and ignoring derivative orders higher than two

dP dP 1 1 d2 P 1
= dy + dy 2 + error
P dy P 2 dy 2 P
| {z } | {z }
-modified duration convexity measure
1
= −modified duration × dy + convexity measure × dy 2 + error
2
Now multiply through by P to get the change in price
P
dP = − modified duration × P ×dy + × convexity measure ×dy 2 + error
|2
| {z }
dollar duration
{z }
dollar convexity
convexity in m periods each year
Note: convexity measure in years = m2
Professor John P. Miller FI: Quantifying Interest Rate Risk 16 / 26
Convexity: Compact Formula

Begin with the closed-form equation for duration:

 
dP C
T (100 − C/y)
= − 2 1 − (1 + y)−T +
dy y (1 + y)T +1

Now take the second derivative and collect terms:

d2 P 2C  2T C T (T + 1)(100 − C/y)
= 3 1 − (1 + y)−T − 2

2 T +1
+
dy y y (1 + y) (1 + y)T +2

Convexity measure for a bond with m coupon payments per year:

d2 P 1
DCvx =
dy P × m2
2

Professor John P. Miller FI: Quantifying Interest Rate Risk 17 / 26

Using Duration and Convexity
Using the formula from the previous page, we find the convexity
measure for the 20-Yr 6% bond at YTM = 5%
d2 P 1
= 199.5407
dy 2 P m2
The approximate price change
112.5514
= −12.09 × 112.5514 × dy + × 199.5407 × dy 2
2
160

Actual
140
120
Price

100

Estimated using
duration and convexity
80
60
40

0.02 0.04 0.06 0.08 0.10 0.12

Yield

Professor John P. Miller FI: Quantifying Interest Rate Risk 18 / 26

Duration and Convexity Details
20-Yr 6% Bond at YTM = 6%
Actual Estimated Versus 6%
YTM Price ∆ Duration ∆ Convexity Price Error
1% 190.43 57.79 23.35 181.14 9.29
2% 165.67 46.23 14.95 161.18 4.49
3% 144.87 34.67 8.41 143.08 1.79
4% 127.36 23.11 3.74 126.85 0.50
5% 112.55 11.56 0.93 112.49 0.06
6% 100.00 0.00 0.00 100.00 0.00
7% 89.32 -11.56 0.93 89.38 -0.05
8% 80.21 -23.11 3.74 80.62 -0.41
9% 72.40 -34.67 8.41 73.74 -1.34
10% 65.68 -46.23 14.95 68.72 -3.03
11% 59.88 -57.79 23.35 65.57 -5.68
12% 54.86 -69.34 33.63 64.28 -9.42
Professor John P. Miller FI: Quantifying Interest Rate Risk 19 / 26
Properties of Convexity

The convexity measure along with the squared yield changes add
curvature to the linear duration measure
If the convexity of bond A is greater than bond B, then all else equal,
the price-yield curve of bond A will greater than or equal to that of
bond B
As the required yield increase (decreases), the convexity of the bond
decreases (increases) - positive convexity
For a given yield and maturity, the lower the coupon the greater the
convexity
For a given maturity and modified duration, the lower the coupon the
lower the dollar convexity
Zero-coupon bonds have the lowest dollar convexity for a given duration

Professor John P. Miller FI: Quantifying Interest Rate Risk 20 / 26

Other Durations
Spread duration
For bonds other than Treasuries, the required yield includes a spread to a
benchmark as compensation for credit risk
Spread duration is a measure of how the bonds price changes when the
spread changes
Spread duration is also used to measure floater price changes when the
discount margin changes
Portfolio duration
The portfolio duration is simply the weighted-average duration of the
individual bonds
The contribution of a bond to the portfolio duration is its weight times
duration
Value Contribution to
Bond ($million) Weight Duration Duration
A $10 0.10 5 0.5
B $15 0.15 6 0.9
C $25 0.25 10 2.5
D $50 0.50 7 3.5
Portfolio $100 1.00 7.4 7.4
Professor John P. Miller FI: Quantifying Interest Rate Risk 21 / 26
Approximating Duration and Convexity

Items to compute
Increase yield by a small number of bps and determine a new price P+
Decrease yield by a small number of bps and determine a new price P
Compute the yield change, ∆y, in decimal form
Duration estimate
dP 1 P− − P+
=
dy P 2 × P0 × ∆y
Convexity estimate
d2 P 1 P− + P+ − 2P0
=
dy 2 P P0 ∆y 2
Example: 20-year 6% bond priced at 6%, at 5.98% and at 6.02%
P+ = 99.7692 P− = 100.2315 P0 = 100 ∆y = 0.0002
dP 1 100.2315 − 99.7692
= = 11.557
dy P 2 × 100 × 0.0002
d2 P 1 99.77692 + 100.2315 − 2 × 100
= = 186.828
dy 2 P 100 × 0.00022

Professor John P. Miller FI: Quantifying Interest Rate Risk 22 / 26

Measuring Bond Portfolio Change to Non-parallel Changes
in Interest Rates: Curve Reshaping Duration

Choose three maturity points on the Treasury curve: 2-year, 10-year

and 30-year yields
Short-end duration:
1 Steepen the yield curve at the short end by x bps (S)
2 Flatten the yield curve at the short end of x bps (F)

VSE,S − VSE,F
SEDUR =
2 × V0 × ∆y

Long-end duration:
1 Steepen the yield curve at the long end by x bps (S)
2 Flatten the yield curve at the long end of x bps (F)

VLE,F − VLE,S
LEDUR =
2 × V0 × ∆y

Professor John P. Miller FI: Quantifying Interest Rate Risk 23 / 26

Other Limitations of Duration

Duration assumes all cash flows are discounted at the same rate
Assumes the yield curve is flat - generally it is not
Assumes that yield curve shifts are parallel
Duration alone does not account for embedded options - need to use
an effective duration measure
Duration is NOT a measure of time
Financially engineered bonds can have durations greater than the
maturity of the underlying assets (e.g., collateralized mortgage
obligations (CMOs))
Duration can be negative: Mortgage interest-only strips
Duration relates the price change to changes in yield

Professor John P. Miller FI: Quantifying Interest Rate Risk 24 / 26

Computing Modified Duration and DV01 between Coupon
Dates
Pricing a bond with d1 days since beginning accrue period and d2 days
in coupon period have ν = dd21 , where 0 ≤ ν < 1
T
1 − (1 + y)−T
 
X C 100 100
P +νC = + = (1 + y)ν C +
t=1
(1 + y)t−ν (1 + y)T −ν y (1 + y)T −ν

Changing y does not impact ν C, so modified duration is relative to

position value which is the invoice price = P + ν C = Pi , therefore,
modified duration for m coupon payments per year becomes:
"
dPi 1 1 C 
Dm = =− −ν (1 + y)ν−1 1 − (1 + y)−T
dy Pi m Pi y

  #
C  −T
 TC (T − ν) 100
+(1 + y)ν 1 − (1 + y) − +
y2 y (1 + y)T +1 (1 + y)T +1

DV01 per million face is given as

DV 01 = Dm (P + ν C)
Professor John P. Miller FI: Quantifying Interest Rate Risk 25 / 26
Computing the Convexity Measure between Coupon Dates

Define y1 = 1 + y, y2 = 1 − y1−T and Pi = P + ν C then modified

duration for 0 ≤ ν < 1 becomes
" ! #
dPi 1 1 C C TC (T − ν) 100
= ν y1ν−1 y2 − y1ν y2 − − y1ν
dy Pi m Pi y y2 y × y1T +1 y1T +1−ν

Now take the second derivative wrt y and divide result by m2 , the
number of payment per year, and Pi , the invoice price:
d2 Pi
" !
1 1 ν−2 C ν−1 C TC
DCvx = = −ν (ν − 1)y1 y2 − 2 ν y 1 y2 − T +1
dy 2 m2 Pi m2 Pi y y2 y× y1
! #
ν C 2T C T (T + 1) C (T − ν) (T + 1) 100
−y1 − y2 + T +1
+ T +2
+ T +2−ν
y3 y 2 × y1 y × y1 y1

Professor John P. Miller FI: Quantifying Interest Rate Risk 26 / 26