BPV

What is basis point value, (BPV)?

BPV is a method that is used to measure interest rate risk. It is

sometimes referred to as a delta or DV01. It is often used to

measure the interest rate risk associated with swap trading books,

bond trading portfolios and money market books.

It is not new. It has been used for years. In many financial

institutions it has been replaced or is used in conjunction with value

at risk.

What does it show?

BPV tells you how much money your positions will gain or lose for a

0.01% parallel movement in the yield curve. It therefore quantifies

your interest rate risk for small changes in interest rates.

How does it work?

Let’s suppose you own a $10m bond that has a price of 100%, a

coupon of 5.00% and matures in 5 years time. Over the next 5

years you will receive 5 coupon payments and a principal

repayment at maturity. You can value this bond by:

A. Using the current market price from a dealer quote, or

B. Discounting the individual bond cash flows in order to

find the sum of the present values

Let’s assume you use the second method. You will use current

market interest rates and a robust method for calculating accurate

discount factors. (Typically swap rates are used with zero coupon

methodology).

For the sake of simplicity we will use just one interest rate to

discount the bond cash flows. That rate is 5.00%. Discounting the

cash flows using this rate will give you a value for the 5 year bond

of $10,000,000. (How to do this using a financial calculator is

explained on the second page of this document).

We will now repeat the exercise using an interest rate of 5.01%,

(rates have increased by 0.01%). The bond now has a value of

$9,995,671.72.

There is a difference of $4,328.28.

It shows that the 0.01% increase in interest rates has caused a fall

in the value of the bond. If you held that bond you would have lost

$4,328.28 on a mark-to-market basis.

This is the BPV of the bond.

How do risk managers use this?

BPV is an estimate of the interest rate risk you have. You can

therefore use it to manage interest rate exposure.

Some firms do this by giving traders a maximum BPV that they are

permitted to run. For example, a limit where the portfolio BPV must

not exceed $20,000.

The more interest rate risk you are prepared to let dealers take the

higher the limit.

How do traders use this?

Traders can use BPV in order to adjust their exposure to interest

rate risk. If a dealer expects interest rates to rise he will reduce the

BPV of the portfolio. If he expects rates to fall the BPV will be

increased.

How do dealers adjust the BPV?

Dealers adjust the BPV by altering the positions they have. Here is

an example. Let’s suppose a dealer expects interest rates to rise

and is long the $10m, 5 year bond from the previous example.

The dealer will want to reduce the BPV being run.

The BPV can be reduced by any of the following:

1. Selling the $10m 5 year bond and investing in a 3 month

deposit. The BPV of a $10m 3 month deposit is

approximately $250.

2. Selling another bond so the value of the long and short

positions give a lower net BPV.

3. Paying fixed interest on an interest rate swap so the BPV

of the swap and bond give a lower net BPV.

4. Selling interest rate or bond futures, again to reduce the

overall BPV of the portfolio.

What are the advantages of BPV?

The main advantages of BPV are:

• It is relatively simple to calculate.

• It is intuitively easy to understand and has gained

widespread acceptance with dealers.

• You can apply the same approach to financial

instruments that have known cash flows. This means you

can calculate BPVs for money market products and

swaps.

• You can also amalgamate all the cash flows from a

portfolio of transactions and calculate the portfolio BPV.

• It can be used by dealers to calculate simple hedge

ratios. (If you are long one bond and short another you

can calculate an approximate hedge ratio from the ratio

of the two BPVs, more on this later).

What are the disadvantages of BPV?

BPV has weaknesses, they are:

• You may know the BPV but you do not know how much

the yield curve can move on a day-to-day basis.

• BPV assumes that the yield curve moves up or down in a

parallel manner, this is not usually the case.

Reference : www.barbicanconsulting.co.uk