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Topic 61: One Factor Risk Metrics And Hedges

Interest Rate Factors


Price sensitivity
Price changes are based on interest rate factors
Dollar Value Of a Basis Point (DV01) = the change in a fixed income
securitys value for every one basis point

Application to hedge = produce a combined position that will not change in value
for a small change in yield.

Yield beta = relationship between the yield of the initial position and the implied
yield of the hedging instrument.
If the yield beta is anything other than 1, multiple the hedge ratio by yield beta.
Duration
Duration captures the impact of all three bond variables (coupon, maturity, initial
yield) in a single measure.
Three duration measures: Macaulay, modified and effective
Macaulay duration: bonds interest rate sensitivity based on time, in years, until
promised cash flow will arrive.

Macaulay & modified duration are not an appropriate measure of interest rate
sensitivity for bonds with embedded options.
Effective duration = use for callable and putable bonds.

DV01 vs. Duration


Duration is more convenient than DVO1 in an investing context.
DV01 would be more useful when analyzing trading or hedging situations.
(because dollar amounts of the 2 sides of the transaction are different)
Convexity = measure of the curvature in the relationship btw bond yield and
price
Convexity corrects the price sensitivity measure by duration as rate changes
grow larger and durations linear estimation will contain errors.

Combining duration and convexity

Portfolio duration & convexity


Using portfolio duration as a measure of interest rate exposure has a significant
problem by implicate that all the yields for every bond are perfectly correlated.
Convexity Negative
Barbell Portfolio = use bonds with short and long maturities, thus forgoing any
intermediate-term bonds (be preferred when rates are believed to be especially
volatile).
Bullet strategy = buy bonds concentrated in the intermediate maturity range.

VAR METHODS
Value at risk measures the potential loss in portfolio value over a given time
period and for a given distribution of historical return.
Assuming that asset returns conform to a standard normal distribution. Mean = 0
& sigma = 1

If an expected return other than 0 is given:

VaR Conversions

VaR methods
Linear Valuation: The Delta Normal Valuation Method (this method is fast
and efficient)
For example, consider a fixed income portfolio:

Full Valuation: Monte Carlo & Historic Simulation Methods (more time
consuming and costly but these methods may be the only appropriate methods
for large portfolios with substantial option-like exposures, a wider range of risk
factors, or a longer-term horizon.)
Monte Carlo revalues a portfolio for a large of number of risk factor values,
randomly selected from a normal distribution.
Historical simulation revalues a portfolio using actual values for risk factors taken
from historic data.

Topic 52: Quantifying Volatility in VAR Model


3 common problematic from normality in modeling risk: fat-tailed, skewed, or
unstable
Fat-tailed: distribution with a higher probability of observations occurring in the
tails relative to the normal distribution

Skewed: the distribution is not symmetrical


Unstable: some of the model parameters are unstable, they are not constant but
vary over time