Introduction to the

Measurement of Interest
Rate Risk

Interest Rate Risk

Bond values
are inversely
proportional
to interest
rate.
Relation between
interest
rate
and bond
value

Approaches to measuring interest rate risk

1. Full Valuation Approach
2. Duration/Convexity Approach

Full Valuation Approach

It is a process in which the position of bond is
evaluated for various scenarios of change in
interest rates.
Step in Full Valuation Approach
1. Identification of the current price and yield of a
bond or bond portfolio.
2. Determination of possible yield change
scenarios.
3. Calculate the bond price for each new scenario.
Note:
4. Calculate the percentage
change in the price of
Each security in the portfolio is valued
the bond or bond
portfolio
forthe
each
scenario.
separately
under
full valuation
approach, and portfolio value is
determined as the sum of constituent
parts.
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Full Valuation Approach

Example
Current Position of bond: 8% coupon 15 year bond
(option free)
Current Market Price: Rs.125.09
Yield to Maturity: 5.5%
Par value of bond: Rs.1,00,000
Market Value of the position: Rs.1,25,250
Solution

Price Volatility Characteristics of Option-Free Bonds

Facts
Price of option free bond moves
in opposite direction to a change
in the bonds yield.
The relationship is not linear i.e.
not a straight line relationship.
The price-yield relationship for
any option free bond is referred as
convex.
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Price Volatility Characteristics of Option-Free Bonds

Properties
Percentage change in price is not the same for all
the bonds for a change in yield.
Percentage change in price for a given bond is
approximately the same (whether increase or
decrease in yield) for a small change in yield.
For a large change in yield, the percentage price
change increase in greater that the percentage
price decrease.

Price Volatility of Bonds with Embedded Options

Components of price of bond with embedded
option
The price of the same bond considering it to be an
option free bond.
Value of the embedded option.
Value of bond with embedded option = Value
of option free bond + Value of the embedded
option

Types of Options
Call Option (Prepay): It is the right to the issuer to call
back the issue or repay the debt prior to the principal
payment date.
Put Option: It is the right with the investor to demand
for the prepayment of the debt.
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Bonds with Call or Prepay Options

Facts
A callable bond exhibits positive convexity at high
yield levels and negative convexity at low yield levels.
Negative convexity means that for a large change in
interest rates, the amount of the price appreciation is
less than the amount of the price depreciation.
When the required yield for the callable bond is higher
than its coupon rate, the bond is unlikely to be called.
Therefore, the callable bond will have similar
price/yield relationship (positive convexity) as a
comparable option-free bond.
When the required yield becomes lower than the
coupon rate, the value of the call option increases
because it is getting more and more likely that the
bond may be retired at the call price.
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Bonds with Embedded Put Option

Facts
Bonds with putable options can be redeemed by the
bondholder on the dates and at the put price
mentioned in the indenture.
If bond value < put price in case the yield rises, put
option may get exercised by the bondholder.
If put price is par value and yield > coupon rate, put
option my get exercised.
Value of putable bond = value of option free bond +
value of put option.
If the yield is low, price of putable bond = price of
option free bond.
If yield rises, decline in the price of putable bond is
less as compare the decline in price of option free
bond.
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Duration
Facts
It is the approximate price sensitivity to the
change in interest rate.
It can also be interpreted as percentage change
in price for a 100 bps change in interest rate.
Calculation of Duration

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Duration
Example
Consider a 7% coupon 15 year option free bond selling at
Rs.109.7122 to yield 6%. Calculate the duration for a 25
bps change in interest rate?
Solution:
Price if yield declines by 25 bps = Rs.112.3411
Price if yield rises by 25 bps = Rs.107.1667
Initial price = Rs.109.7122
Change in yield in decimal = 0.0025
Therefore,
Duration = (112.3411 107.1667)/(2 x 109.7122 x 0.0025)
= 9.43%
Interpretation: For a 100 bps change in yield, the price of
the bond changes by 9.43%
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Approximating the percentage price change

using duration
Given the duration of a bond, the percentage
change in the price of a bond can be approximated
as:
Approximate % price change = - Duration x change
in yield x 100
Example
Consider the 7%, 15-year bond trading at
Rs.109.7122 whose duration we calculated in
previous slide is 9.43%. For a 10 basis point
Note: percentage price
increase in yield, the approximate
The negative sign before
change is
duration is due to the inverse
-9.43 x 0.001 x 100 = -0.9430%.
relationship between price
and yield change
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Modified Duration
It is the approximate percentage change in a bond's
price for a 100 basis point change in yield assuming that
the bond's expected cash flows don't change when the
yield changes.
Modified duration shows how bond prices move
proportionally with small changes in yields.
P/P x 100 = -Dmod x i
where:
Note:
Modified duration cannot
P = change in price for the bond
be used to measure the
-Dmod = the modified duration for theinterest rate risk for
bonds with embedded
bond
options
because
a
i = yield change in basis points divided
change in yield may
by 100
significantly affect the
expected cash flows of
P = beginning price for the bond
bonds

with
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embedded

Macaulay Duration
It is calculated as:
Macaulay Duration = Mod. Duration (1 + yield/k)
Where,
k = number of periods
Yield = yield to maturity of the

Note:
As Modified duration
cannot be used to
measure the interest
bondrate risk for bonds with
embedded
options,
same holds true for
Macaulay Duration too.

Example
A bond with a Macaulay duration of 5 years, a yield to
maturity of 7% and semiannual payments will have a
modified duration of:
Dmod = 5/(1 + .07/2)
= 5/1.035 = 4.83 years
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Interpretations of duration
1

15

Portfolio Duration
It is obtained by calculating the weighted average
of the duration of the bonds in the portfolio.
Portfolio Duration = w1D1 + w2D2 + w3D3 +
wnDn
Where,
w1,w2,wn = weight of individual bonds in portfolio
D1, D2, Dn = duration of Note:
individual bonds in
For the duration measure to be
portfolio

useful, the change in yield for each

of the bond in the portfolio should
be equal, i.e. there should be a
parallel shift in the yield curve.
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Portfolio Duration
Example

Market Value = 4385500 + 9216800 + 3000000 =

Rs.16602300
w1 = 4385500/16602300 = 0.2642
w2 = 9216800/16602300 = 0.5552
w3 = 3000000/16602300 = 0.1807
Portfolio Duration = w1D1 + w2D2 + w3D3
= (0.2642 x 6.3392) + (0.5552 x 8.3543) + (0.1807 x
3.6453)
= 6.9711%
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18

Convexity measure
It is used to approximate the changes in price that
is not explained by duration.
Convexity Measure = C x (y*)2 x 100
Where,

y* = the change in yield for which the percentage

price change is sought.

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Modified convexity and effective convexity

Modified convexity
It is the convexity measure investors obtain if they
assume that yield changes have no effect on the
bond's expected cash flows.
It does not consider the effect of embedded options
on expected cash flows.
Effective convexity
It includes the effects of yield changes on the cash
flows.
It requires an adjustment in the estimated bond to
reflect any change in estimated cash flows due to
the presence of embedded options.
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Price value of a basis point (PVBP)

It is the absolute change in the price of a bond for a 1
basis point change in yield.

PVBP = | Initial price - price if yield is changed by 1 basis

point |
PVBP differs from traditional duration as :
It is identical for both increases and decreases in yield,
because it explains how price changes due to very small
interest rate shifts (one basis point). When interest
rates are adjusted by this small amount, the price-yield
schedule would be approximately linear.
It shows the dollar change in price, rather than
percentage change.
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Thank You

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