Finance 361

Workshop 8

1
Bond Portfolio Hedging and Securitisation
Objective: Prevent value of hedged portfolio from changing as interest
rates change

• When we perform hedging activities with bonds and bond portfolios, we

are hedging against interest rate risk
Bond Portfolio Hedging and Securitisation
• There are two sources from which interest rate risk stems:

1 2
Duration
• The first partial derivative of
bond price w.r.t. yield
• In plain English: The rate of
change of the bond’s price as
yield changes (AT A CERTAIN
POINT)
Convexity
• The second partial derivative of
bond price w.r.t. yield
• In plain English: The rate of
change of the bond’s duration
as yield changes

We must hedge against both

Duration
1
Macaulay Duration
Duration
1 2
Macaulay Duration Modified Duration

Scaled by First derivative

bond price w.r.t yield

Slope
Convexity
• Convexity gives you the rate of change of the rate of change to
account for the non-linear relationship between bond price and yield

Don’t need to calculate for 361, just understand what it means and where it
comes from
Putting the two together

Component on bond prices Component on bond prices

change driven by duration change driven by convexity

REMEMBER THIS EQUATION

Workshop 8 Question 1
Your bond portfolio currently values at $100mn. You wish to hedge the interest
rate risk exposure of your portfolio to prevent any portfolio value changes due to
possible interest rate fluctuations. The bond portfolio has a duration of 2.8 and a
convexity of 40.
There are two derivative securities which may be used as hedging instruments:
an interest rate swap contract and an interest rate call option. Details of the
instruments are as follows:

Interest rate swap contract: Interest rate call option:

Value: $1mn Value: $1mn
Duration: 4.5 Duration: 2.0
Convexity: 15 Convexity: 110
Workshop 8 Question 1
Workshop 8 Question 1

Change in hedge
Change in bond
Hedging Objective:
value due to duration = instrument value due
to duration
Workshop 8 Question 1
Use the swap contract

• To hedge changes in the value of bond portfolio due to interest rate risk exposure,
you can offset changes in value by taking short positions in 62 swaps
Workshop 8 Question 1
Use the call contract

Change in hedge
Change in bond
Hedging Objective:
value due to duration = instrument value due
to duration
Workshop 8 Question 1

𝑎
Workshop 8 Question 1

Hedging Objective(s):

Change in bond Change in hedge instrument

1
value due to duration = value due to duration

Change in bond value Change in hedge instrument

2
due to convexity = value due to convexity
Workshop 8 Question 1

EQ. 1

EQ. 2
Workshop 8 Question 1
Eq. 1 Eq. 2

3
Workshop 8 Question 1
Eq. 1 Eq. 2

3
Workshop 8 Question 1
Eq. 1 Eq. 2

3
Workshop 8 Question 1
Eq. 1 Eq. 2

3
Workshop 8 Question 1
Workshop 8 Question 1
Workshop 8 Question 2 2015 S1 Final Q4
Workshop 8 Question 2 2015 S1 Final Q4
Workshop 8 Question 2 2015 S1 Final Q4
Workshop 8 Question 3 2017 S1 Final Q5

a) Calculate the market value of the bond. [5 marks]

Bond Price = $104.31

Workshop 8 Question 3 2017 S1 Final Q5

Macaulay Duration: Modified Duration:

Workshop 8 Question 3 2017 S1 Final Q5

Macaulay Duration: Modified Duration:

𝐶𝐹𝑡
𝑃𝑉 𝐶𝐹𝑡 =
(1 + 𝑦𝑡 )𝑡
Workshop 8 Question 3 2017 S1 Final Q5
𝐶𝐹𝑡
𝑃𝑉 𝐶𝐹𝑡 =
(1 + 𝑦𝑡 )𝑡

Time Coupon FV CF
31-Dec-17 2% 0.60% 2.6%
31-Dec-17 $3 $3
30-Jun-18 2.5% 0.60% 3.1%
30-Jun-18 $3 $3
31-Dec-18 3.0% 0.60% 3.6%
31-Dec-18 $3 $3
30-Jun-19 3.2% 0.60% 3.8%
30-Jun-19 $3 $100 $103
$112

Discount Factor PV(CF)

98.72% $2.96
96.99% $2.91
94.83% $2.84
92.81% $95.60
$104.31
Workshop 8 Question 3 2017 S1 Final Q5
𝐶𝐹𝑡
𝑃𝑉 𝐶𝐹𝑡 =
(1 + 𝑦𝑡 )𝑡

Time Coupon FV CF
31-Dec-17 2% 0.60% 2.6%
31-Dec-17 $3 $3
30-Jun-18 2.5% 0.60% 3.1%
30-Jun-18 $3 $3
31-Dec-18 3.0% 0.60% 3.6%
31-Dec-18 $3 $3
30-Jun-19 3.2% 0.60% 3.8%
30-Jun-19 $3 $100 $103
$112

Discount Factor PV(CF)

98.72% $2.96
96.99% $2.91
94.83% $2.84
92.81% $95.60
$104.31
Workshop 8 Question 3 2017 S1 Final Q5
𝐶𝐹𝑡
𝑃𝑉 𝐶𝐹𝑡 =
(1 + 𝑦𝑡 )𝑡

Time Coupon FV CF
31-Dec-17 2% 0.60% 2.6%
31-Dec-17 $3 $3
30-Jun-18 2.5% 0.60% 3.1%
30-Jun-18 $3 $3
31-Dec-18 3.0% 0.60% 3.6%
31-Dec-18 $3 $3
30-Jun-19 3.2% 0.60% 3.8%
30-Jun-19 $3 $100 $103
$112

Discount Factor PV(CF)

98.72% $2.96
96.99% $2.91
94.83% $2.84
92.81% $95.60
$104.31
Workshop 8 Question 3 2017 S1 Final Q5

Macaulay Duration: Modified Duration:

Time PV(CF) Weighted CF Multiplied by t

0.5 $2.96 0.03 0.01
1 $2.91 0.03 0.03
1.5 $2.84 0.03 0.04
2 $95.60 0.92 1.83

Macaualay Duaration 1.92

Workshop 8 Question 3 2017 S1 Final Q5

Macaulay Duration: Modified Duration:

= 1.92
Workshop 8 Question 3 2017 S1 Final Q5

Macaulay Duration: Modified Duration:

= 1.915879 = 1.915879 / (1.03776625)

= 1.846157
Workshop 8 Question 3 2017 S1 Final Q5
 Workshop 8 Question 3 2017 S1 Final Q5

Old:
31-Dec-17 2% 0.60% 2.6%
30-Jun-18 2.5% 0.60% 3.1%
31-Dec-18 3.0% 0.60% 3.6%
30-Jun-19 3.2% 0.60% 3.8%

New: Change in discount rate = 0.3% - 0.1% = 0.2%

31-Dec-17 2.3% 0.50% 2.8%

30-Jun-18 2.8% 0.50% 3.3%
31-Dec-18 3.3% 0.50% 3.8%
30-Jun-19 3.5% 0.50% 4.0%
Workshop 8 Question 3 2017 S1 Final Q5

= -1.846157 x 0.2% x 104.31

= -$0.385
Percentage Change = -0.385/104.31 = -0.369%