FINM7405

Interest Rate Risk Management

Kam Fong Chan g University of Queensland Business School

Lecture outline:
1

Types of short-term and long-term debt Shapes of interest rates term structure
This is an example text. Go ahead Theories of interestand replaceterm structure rates it

Fundamentals of bond pricing Advanced issues in bond pricing Bond price volatility Duration, DV01 & hedging

Summary: There are various short- and long-term debts in Australia. There are 4 main yield curves/term structure
o o o o Normal (upward sloping) curve Flat curve Inverse (downward sloping) curve Humped curve

The different yield curve shapes can be explained by 3 different theories

o Pure expectation theory o Liquidity theory o Market segmentation theory

Summary: When we calculate bond price, we obtain clean price. What investors really pay is the dirty price. Yield to maturity (aka internal rate of return) is a constant rate that makes the present value of the bond equals to p q its market price Duration is a composite measure used to maximize/minimize bond price volatility. There are 2 duration measures
oM Macaulay d ti l duration o Modified duration

Summary: Duration can be used as an approximation to interest rate sensitivity of a bond (ie how the bond price will react to t a very small change i th yield) ll h in the i ld)
o How to approximate bond price change? Compute DV01 aka PV01 o Wh merely approximation? B Why l i ti ? Because of convexity effect f it ff t

If we hold (long position) bond B, we can perfectly hedge it by taking a short position in bond H.
o How? By making the portfolio DV01 = 0

Short-term and long-term debt in Australia

Short-term (maturity up to 12 months) Bank Accepted Bills (BAB) Long-term (maturity up to 30 years) Treasury bonds

Treasury notes y Certificates of Deposit (CD) Commercial Papers Interbank deposit

State bonds Corporate bonds Eurobonds

Bank Accepted Bills (BAB) Similar to a cheque, but with fixed maturity of 90, 120 or 180 days y Involve 3 parties: drawer, discounter & acceptor Drawer Acceptor p Discounter

SellBABi.e.borrowcash

PromisetopayfacevalueofBAB(e.g. $100,000)onmaturity $100 000) on maturity

Bank Accepted Bills (BAB) Similar to a cheque, but with fixed maturity of 90, 120 or 180 days y Involve 3 parties: drawer, discounter & acceptor Drawer Acceptor p Discounter

BuyBABi.e.lendcashtodrawer

Cansell(trade)BABtoanotherdiscounter Finalholder(discounter)receivesfacevalue ( ) atmaturityofbill

Bank Accepted Bills (BAB) Similar to a cheque, but with fixed maturity of 90, 120 or 180 days y Involve 3 parties: drawer, discounter & acceptor Drawer Acceptor p Discounter

Thefacilitator(i.e.bank) Guarantee(accept)theBABi.e.guaranteethedrawerwillpaythe facevalueonmaturitybytakingthecashfromthedrawerandpassit y y g p tothediscounter

Treasury notes Issued by the Australia gov. to assist in within-year funding needs. g Within-year funding needs arise because timing of gov. revenues does not match expenditure profile. Issued by tender and typically mature in 5-26 weeks

Certificates of deposit (CD) Usually matures between 1 and 3 months Issued by banks to raise funds to finance their lending y g activities Contain credit risk of the issuing bank

Commercial Papers Commercial papers (CP) are unsecured short-term debt Usually matures between 2 and 270 days y y Instead of taking bank loans, companies with high credit rating issue CP to raise funds to finance projects Usually has zero coupon and trades at discount to at discount reflect interest

Interbank deposit Most popular is LIBOR (London Interbank Offer Rate)

o LIBOR is the interest rate at which banks offer to lend unsecured funds to another bank in the London interbank market o Usually matures between 1 and 90 days o Singapore Interbank Offer Rate (SIBOR) is the LIBORequivalent bank offer rate in Singapore interbank market o E ib i th equivalent b k offer rate i E Euribor is the i l t bank ff t in Euro i t b k interbank market. o Daily LIBOR rate is determined by the British Bankers Association (BBA) at 11am every business day by taking the average of the rates supplied by member banks (see http://www.bbalibor.com/bbalibor-explained/the-basics) o LIBOR can be denominated in USD, GBP, Euro, CAD, AUD, Yen and Swiss francs.

Interbank deposit Most popular is LIBOR (London Interbank Offer Rate)

o Why is LIBOR so popular? Widely used as a reference rate for interest rate swaps etc Commonly used as a proxy for risk-free rate in practice (but seldom in academic)

Treasury bonds Issued by Australia gov. Typically matures in 2 10 yrs yp y y Has face value and pays coupons, payable every 6 months Commonly used as proxy for risk-free rate in academic (but not in practice)

State bonds Semi-gov bonds issued by State Treasury (e.g. QTC) to meet funding needs of state, local gov and gov g , g g instrumentalities (to build new port etc).

Corporate bonds Issued by companies Typically maturity is up to 10 y yp y y p yrs Has face value and pays coupons, usually payable every 6 months

Eurobonds Eurobond is a bond issued in a currency (eg. USD) other than the currency of the country (eg. Australia) or y y( g ) market (eg. Japan) in which it is issued. Eurobonds are classified based on currency in which the issue is denominated e g Eurodollar bonds Euroyen e.g. bonds, bonds Example: A Eurodollar bond issued in Japan by an Australian A t li company i a E b d is Eurobond Attractive because issuer (eg. Australian company) can y (eg. p ) choose the country ( g Japan) in which to offer its bond in its preferred currency (eg. USD)

Shapes of interest rates term structure The interest rates term structure/yield curve at time t defines the relationship between the level of interest p rates and their time to maturity There are 4 main yield curves:
o Normal (upward sloping) curve o Flat curve o Inverse (downward sloping) curve o Humped curve

The shape of term structure serves as an indicator of market expectation towards direction of future interest rates (see Figure 1)

Shapes of interest rates term structure

Normal (upward sloping) curve
Yieldfor15yr=3.99%p.a.

Yieldfor1yr=0.49%p.a.

Figure 1: U.S. treasury curve on June 10, 2010. Source: Bloomberg

Shapes of interest rates term structure

Flat curve, which usually leads to .

Figure 2: Japanese government yield curve on Nov 4 2002 Source: Bloomberg Nov. 4, 2002.

Shapes of interest rates term structure

Inverted (downward sloping) curve
Yieldfor3mth=6.11%p.a.

Yieldfor10 yr 5.31% p.a. Yield for 10yr =5.31%p.a.

Figure 3 U S t Fi 3: U.S. treasury curve on D Dec. 15 2000 S 15, 2000. Source: Bl Bloomberg b

Shapes of interest rates term structure

Humped curve

Figure 4 U S t Fi 4: U.S. treasury curve on M 26, 2000 S May 26 2000. Source: Bl Bloomberg b

Shapes of interest rates term structure Two points to notice:

Different dates have different shapes of term structure Flat term structure leads to inverted term structure
FlatinAug2000 InvertedinFeb2001

Figure 5: U.S. dollar swaps curve between Aug 29, 2000 and Aug 29, 2001. Source: Bloomberg

Shapes of interest rates term structure Inverted term structure signals economic recession. Proof:
18 16 14 Pe ercentage 12 10 8 6 4 2 0 Apr/53 Apr/56 Apr/59 Apr/62 Apr/65 Apr/68 Apr/71 Apr/74 Apr/77 Apr/80 Apr/83 Apr/86 Apr/89 Apr/92 Apr/95 Apr/98 Apr/01 Apr/04 Apr/07

3-month T-bill 10-year bond

Figure 6: 3-month U.S. T-bill vs. 10-year U.S. treasury bond. Source: H.15 database released by U.S. Federal Reserve.

Shapes of interest rates term structure Inverted term structure signals economic recession. Proof:
5 4 3 Percentage 2 1 0 Apr/53 Apr/56 Apr/59 Apr/62 Apr/65 Apr/68 Apr/71 Apr/74 Apr/77 Apr/80 Apr/83 Apr/86 Apr/89 Apr/92 Apr/95 Apr/98 Apr/01 Apr/04 -1 -2 -3 Apr/07

Figure 7: U.S. spread (10-year treasury bond minus 3-month T-bill). The shaded areas indicate recession periods designated by the U S NBER Source: H 15 database U.S. NBER. H.15 released by U.S. Federal Reserve and NBER.

Theories of interest rates term structure The different shapes of interest rates term structure can be explained by 3 different theories: p y o Pure expectation theory o Liquidity preference theory o Market segmentation theory
(See attached reading by Fabozzi F., (2007 2nd ed.), Fixed Income Analysis, John Wiley & Sons, Inc., pp. 79-81)

Fundamentals of bond pricing Standard formula to price BAB:

PBAB = FV t 1+ y 365 (1)

where

FV = face value of bill y = yield t = days to maturity

Fundamentals of bond pricing Example: o On 2 Feb 2010, HighGear issued a $100,000 90-day , g , y BAB with 9.5% p.a. yield to LowGear. What is the price of the bill?

PBAB

$100,000 = = $97,711 90 1 + 0.095 365

Fundamentals of bond pricing Example (Cont): o 30 days have passed. On 4 Mar. 2010, LowGear sold the BAB to TopGear at a new yield of 8.5% p.a. What is the price of the bill?
You try over here!

Time 0

30 days later

90 days later

LowGear lent $97,711 to HighGear

LowGear sold the BAB to TopGear at $98,622

TopGear redeemed the BAB from HighGear i.e. HighGear paid $100k to TopGear p

LowGear gained $911

TopGears interest (received) = $1378

Fundamentals of bond pricing Standard formula to price a coupon-paying bond assuming discrete compounding: g p g
y n 1 1 + m FV C PC = + n y m 1 + y m m
where FV = face value of the bond C = coupon amount (pa) y = yield (pa) n = number of periods m = compounding frequency
m isusually2because: y couponsarepaidsemiannually accordingly,yieldsare compoundedsemiannually

( 2)

Fundamentals of bond pricing Example: o A 5.3% p.a. semi-annual coupon Treasury bond p p y maturing in 2 years is priced at 6% p.a. compounded semi-annually. The bond has a face value of $1mil. Calculate the bond fair price price.
1 1 + 0.06 2 $1,000,000 $53,000 PC = + 4 0.06 2 1 + 0.06 2 2

= $986,990

Fundamentals of bond pricing Example (cont): o A 5.3% p.a. semi-annual coupon Treasury bond p p y maturing in 2 years is priced at 6% p.a. compounded semi-annually. The bond has a face value of $1mil. Calculate the bond fair price price. mt
Assumecouponsandfacevalueare stripped into4zerocouponbondswith differenttimetomaturities different time to maturities Time to maturity (1) 0.5 1.0 1.5 2.0 Sum Cash flow (2) 26500 26500 26500 1026500 Discount factor (3) 0.9709 0.9426 0.9151 0.8885

y 1+ m

Present value (4) = (2) x (3) 25728 24979 24251 912032 986990

Fundamentals of bond pricing Example (Cont): o 6 months have passed i.e. the Treasury bond now has p y 1.5 years to maturity. The current yield is 5% p.a. compounded semi-annually. Calculate the bond fair price (assume the regular coupon has just been paid) paid).

You try!

Fundamentals of bond pricing Example (Cont): o Another 4 months have passed i.e. the Treasury bond p y now has 1 year & 2 months to maturity. The current yield is 4.8% p.a. compounded semi-annually. Calculate the bond fair price price.

You try!

Fundamentals of bond pricing Example (Cont): o Another 4 months have passed i.e. the Treasury bond now h 1 year & 2 months t maturity. Th current has th to t it The t yield is 4.8% p.a. compounded semi-annually. Calculate the bond fair price. p
t=4mths t=$26500 t $26500 t=$26500 t=$26500+$1mil t=2mths t=8mths t=1yr2mths

Fundamentals of bond pricing Example (Cont): o Another 4 months have passed i.e. the Treasury bond now h 1 year & 2 months t maturity. Th current has th to t it The t yield is 4.8% p.a. compounded semi-annually. Calculate the bond fair price. p
t=4mths t=$26500 t $26500 t=$26500 t=$26500+$1mil t=2mths t=8mths t=1yr2mths

Fundamentals of bond pricing Discrete compounding vs continuous compounding y=4.8%p.a. compoundedsemi annually

r = m ln1 + y m

(3)

Fundamentals of bond pricing Example (again): o Another 4 months have passed i.e. the Treasury bond p y now has 1 year & 2 months to maturity. The current yield is 4.8% p.a. compounded semi-annually. Calculate the bond fair price price.
df = e rt

Time to maturity (1) 0.166667 0 166667 0.666667 1.166667 Sum

Cash flow (2) 26500 26500 1026500

Discount factor (3) 0.992126 0 992126 0.968873 0.946165

Present value (4) = (2) x (3) $ $ $ 26 291 26,291 25,675 971,238 $1,023,205

Fundamentals of bond pricing Summary: o The bond price is the same regardless if y use p g you discrete compounding (eg 4.8% pa compounded semiannually) or continuous compounding (eg 4.7433% pa compounded continuously)

Advanced issues in bond pricing Clean price vs. dirty price

o Clean price (quoted in Bloomberg system etc) is like an accounting price accounting price o What investors actually pay is dirty price:

Dirtyprice=Accruedinterest+cleanprice

Advanced issues in bond pricing Example:

o Another 4 months have passed i.e. the Treasury bond now has 1 year & 2 months to maturity The current yield is 4 8% p a maturity. 4.8% p.a. compounded semi-annually. Calculate the bond fair price.
t= 4mths t= 4mths t=$26500 t=$26500 t=$26500+$1mil t=2mths t=8mths t=1yr2mths t=1yr 2mths

now

Accrued interest = C

day diff since last coupon day diff between two coupons 4 = $26500 = $17,667 6

o Dirty price = $1,023,305 + $17,667=$1,040,872

Advanced issues in bond pricing Term structure is not flat

o A coupon-paying bond can be stripped into n zero-coupon bond o Each nth zero-coupon bond has its own discount rate and time to maturity o Thus, discount each zero-coupon bond using its own discount rate & time to maturity and sum up to get the clean bond price t ti t t it d t t th l b d i o Example: A 5.3% p.a. semi-annual coupon Treasury bond maturing in 2 years has a face value of $1mil The term structure $1mil. term-structure is upward sloping (see next slide). Calculate the bond fair clean price.

Advanced issues in bond pricing

y 1+ m
Time to maturity (1) 0.5 1.0 1.5 2.0 Yield (p.a.) (2) 4.6% 5.6% 5.8% 6.0% Cash flow (3) 26500 26500 26500 1026500 Discount factor (4) 0.9775 0.9463 0.9178 0.8885

mt

Present value (5) = (3) x (4) $ $ $ $ 25,904 25,076 24,322 912,032

Sum = $987,334

Advanced issues in bond pricing Yield to maturity

o Internal rate of return o A constant rate that makes the present value of future cash flows equals to the current market price o Think of it as another way to re-express the bond price
Whatisy that solvesforbond price=$987,334?

y 1+ m
Present value (4) = (2) x (3) ? ? ? ? $987,334

mt

Time to maturity (1) 0.5 1.0 1.5 2.0 Sum

Cash flow (2) 26500 26500 26500 1026500

Discount factor (3) ? ? ? ?

Advanced issues in bond pricing In summary

o Pricing bond using spot rate and yield to maturity gives the same result.

Bond price volatility Bond price volatility = percentage change in bond price Some useful relationships: p
a. Bond prices are inversely related to yields b. Bond price volatility is positively related to term to maturity c. Bond price volatility increases at a diminishing rate as term to maturity increases d. A decrease in yield raises bond prices by more than an increase in yield of the same amount lowers prices (eg if a 1% decrease i yield raises b d price b $10 th a 1% d in i ld i bond i by $10, then increase in yield will lower bond price by only $9) e. Bond price volatility is inversely related to coupon

Bond price volatility Trading strategies

o o Assume you were an asset manager You predict a major decline in yields you predict an increase in bond prices (#a) You want a portfolio of bonds with maximum bond price volatility t enjoy maximum price changes ( l tilit to j i i h (capital gains) it l i ) from changes in yields You should buy long-term maturity bonds with low coupons (#b & #e)

Duration, DV01 & hedging Savings and loan debacle in 1980s

o o o U.S. savings and loan companies earned a spread between long-term mortgage rates and short-term deposit rates Positive spread (ie profit) if long-term mortgage rates > shortterm deposit rates But i B t in early 1980 l 1980s
18 16 14 Percent (%) 12 10 8 6 4 2 0 Jan/70 Jan/72 Jan/74 Jan/76 Jan/78 Jan/80 Jan/82 Jan/84 Jan/86 Jan/88 Jan/90 Jan/92 Jan/94 Jan/96 Jan/98

3-month U.S. T-bill 3 month U S T bill Source: H 15 database released by U S Federal Reserve H.15 U.S. Reserve.

Implication: Interest rate risk management is important!

Duration, DV01 & hedging How to measure and manage interest rate?

Duration DV01 ValueatRisk(VaR)

Futures/forward S Swap

Duration, DV01 & hedging Duration:

o o o Bond price volatility is positively related to term to maturity (#b) but inversely related to coupon (#e) Need a composite measure to combine #b and #e to maximize/minimize bond price volatility The Th composite measure of bond price volatility i d ti it fb d i l tilit is duration

Duration, DV01 & hedging Characteristics of duration:

o o o o o Duration of zero-coupon bond = term to maturity Duration of coupon bond < term to maturity Duration is inversely related to coupon rate Duration is positively related to term to maturity Duration is inversely related t yield t maturity D ti i i l l t d to i ld to t it

Two duration measures:

o o Macaulay duration Modified duration

Duration, DV01 & hedging Macaulay duration (example)

o A 5.3% p.a. semi-annual coupon Treasury bond maturing in 2 years is priced at 6% p.a. compounded semi-annually. The bond has a face value of $1mil. Calculate the Macaulay duration of the bond
Time to maturity (1) 0.5 05 1.0 1.5 2.0 Sum Cash flow (2) Discount factor (3) 0.9709 0 9709 0.9426 0.9151 0.8885 PV of cash flow (4) 25,728 24,979 24,251 , 5 912,032 986,990 Weight (5) Time x Weight (1) x (5) 0.0130 0.0253 0.0369 1.8481 1.9233

26500 26500 26500 1026500

0.02607 0.02531 0.0 57 0.02457 0.92405 1

1.92yrs

Duration, DV01 & hedging Macaulay duration = 1.92 years Modified duration (in years): ModD =
MacD y 1 + m ( 4)

ModD =

1.9233 = 1.867 0.06 1 + 2

Duration, DV01 & hedging Interpretation:

o o Not helpful to think of duration in terms of time Better interpretation: The bond price is sensitive to rate changes of a 1.867-year (modified duration) zero-coupon bond, or The b d i Th bond price will approximately change b 0 01867% f a 1 ill i t l h by 0.01867% for basis point change in the yield

100bp =1%

Duration, DV01 & hedging Macaulay & modified durations (you try!)
o A 7% p.a. semi-annual coupon bond maturing in 5 years has a yield to maturity of 8% p.a. compounded semi-annually. The bond has a face value of $1mil. Calculate its Macaulay and modified durations

Duration, DV01 & hedging Why use Macaulay/modified duration?

o Provide a price approximation to interest rate sensitivity of the bond (with no embedded options eg not a convertible bond) ie how bond price will react to a very small change in yield How?
Property#a

P = ModD P y

(5)

DV01(dollarvalueof1basispoint)orPV01(price valueof1basispoint)ie h b d i l f1b i i t) i howbondpricewillchange ill h iftheyieldchangesby1bp?

Duration, DV01 & hedging Examples:

o Calculate the DV01:

P = 1.8673 986990 0.0001 = $184.30 (in absolute value)

o

P P 184.3 = = 0.018673% P 986990

Full valuation: A 5.3% p.a. semi-annual coupon Treasury bond maturing in 2 years has a face value of $1mil $1mil.
Yield(compounded semi annually) 5.99% 6.00% 6.01% Bondprice $987,174 $986,990 $886,806 Difference +$184 NA $184

Duration, DV01 & hedging Remember:

o o Modified duration only provides a price approximation to a very small change in yield (eg 1 bp change in yield) Example: Use modified duration to calculate price approximation when the yield changes by 50 bp

P = 1.8673 986990 0.0050 = $9215 (in absolute value)

o Full valuation:
Yield(compounded semi Yield (compounded semi annually) 5.50% 6.00% 6 00% 6.50% Bondprice Bond price $996,261 $986,990 $986 990 $977,830 Difference +$9270 NA $9160

Duration, DV01 & hedging Reason: Convexity effect

o The relation between bond prices and yield is not linear but convex
duration is the p slope of the curve true bond price follows the blue curve line

bad approximation

Price
good d approximation error

Yield

approximated bond price using duration follows the purple line

Duration, DV01 & hedging Portfolio modified duration:

o Weighted average of modified duration of the bonds in the portfolio:

ModDP = w1ModD1 + w2 ModD2 + .... + wN ModDN

where wi N = weight for bond i

(6)

ModDi = modified duration for bond i = number of bonds in the portfolio

Duration, DV01 & hedging Examples:

Bond (semi annualcoupon, $1milface value) 5.3%pa 2yr 7.0%pa5yr Total Yield Yield (semi annual compoun ding) 6%pa 8%pa Bondprice Bond price (Market value) Modified duration (years) Weight

$986,990 $959,446 $1,946,436

1.867 4.122

0.507 0.493 1.000

ModDP = 0.507 1.867 + 0.493 4.122 = 2.979 yrs

Interpretation:Theportfoliomarketvaluewill I t t ti Th tf li k t l ill approximatelychangeby0.02979%fora1bp changeinthe yield

Duration, DV01 & hedging Proof:

o Price (market value) approximation for the bond portfolio for 1 bp change in yield:

PP = ModDP PP y
PP = 2.979 1,946,436 0.0001 = $579 (in absolute term)

(7 )

or

PP 579 = = 0.02979% PP 1,934,889

Duration, DV01 & hedging Proof using full valuation:

Bond (semi annualcoupon, $1milface value) 5.3%pa 2yr 7.0%pa5yr Total Yield Yield (semi annual compoun ding) 6%pa 8%pa Bondprice Bond price (Market value) New yield yield (increaseby 1bp) New bond bond price(market value)

$986,990 $959,446 $1,946,436

6.01%pa 8.01%pa

$986,806 $959,050 $1,945,856

Difference=$580or0.02979%

Duration, DV01 & hedging Important assumptions for bond portfolio modified duration:
o o Only provide a portfolio price approximation to a very small change in the yields Assume a parallel shift in the term structure eg 6% 6.01% AND 8% 8.01%

Duration, DV01 & hedging Trading strategies using portfolio modified duration:
o o Longest portfolio modified duration provides maximum price volatility (ie percentage price change) Hence, as an investor/asset manager: If you expect a decline in the yield, you should increase portfolio modified duration to maximize b d price tf li difi d d ti t i i bond i increase. How to increase portfolio modified duration? sell/short short term bonds (eg commercial papers) short-term and use the proceeds to long/buy long-term bonds or long term futures If you expect an increase in the yield, you should reduce portfolio modified duration to minimize bond price decline. How to reduce portfolio modified duration? g g sell/short long-term bonds or long-term futures and use the proceeds to long/buy short-term bonds (eg commercial papers)

Duration, DV01 & hedging

Inthetradinggame,youweretheissuerofa portfolioofdebtratherthanabuyer(owner)ofa portfolioofdebtie youwerealiabilitymanager portfolio of debt ie you were a liability manager

Trading strategies using portfolio modified duration:

o As an liability manager: If you expect a decline in the yield, you should reduce portfolio modified duration to have minimal bond price increase. How t decrease portfolio modified d ti ? H to d tf li difi d duration? buyb back long-term bonds or long term futures and short/sell/issue short-term bonds (eg commercial papers) If you expect an increase in the yield, you should increase portfolio modified duration to have maximum bond price decline. How to increase portfolio modified duration? sell/short/issue long-term bonds or long-term futures p y and use the proceeds to buy-back short-term bonds (eg commercial papers)

Duration, DV01 & hedging Hedging with modified duration:

o o A long position in bond B can be hedged by a short position in bond H Intuitive reason: If interest rate rises (ie bond price falls), we lose in bond B (assuming we hold/long bond B), but we gain in bond (since we short/issue b d H) b dH( i h t/i bond H). A perfect hedge suggests the total DV01 of our portfolio is zero or equivalently, DV01B = DV01H.

PB = PH ModDB PB 0.0001 = ModDH PH 0.0001 ModDH PB = ModDB PH (8)

Duration, DV01 & hedging Examples:

Bond (semi annualcoupon, $1milface value) 5.3%pa 2 3% 2yr 7.0%pa5yr Position Type Yield(semi Yield (semi annual compoundi ng) 6%pa 6% 8%pa Bondprice Bond price (Market valuefor1 bond) $986,990 $986 990 $959,446 Modified duration (years) 1.867 86 4.122

Long Short

Unhedged h d d bondB Hedgebond H

PB ModD H = ModD B PH 4 .122 986 ,990 = 1 . 867 PH PH = 447 ,043

ToperfectlyhedgeonebondBwitha p y g marketvalueof$986,990,weneed bondHwithamarketvalueof$447,043 ie 0.4659bondH

Duration, DV01 & hedging Proof using full valuation:

o A 1 bp yield rise (6% 6.01%) decreases bond price B (which we hold) from $986,990 to $986,806 ie $184 A 1 bp yield rise (8% 8.01%) decreases bond price H (which we short) from $959,446 to $959,050 ie $395. Since we short 0.4659 bond H, we gain $184.03 Total net portfolio value is about $0!

o o