Topic 5

Interest Rate Risk and

Yield Curve Strategies

FINA4120– Fixed Income 1

• In this topic, we will learn:
– How to measure interest rate risk (price sensitivity to
interest rate change)
• Duration, Convexity*

– How to manage interest rate risk

• Immunization*

• Yield curve strategies 

FINA4120– Fixed Income 2

 Price Sensitivity to Interest Rates
Although 1-yr and 30-yr interest rates are closely correlated…

18%
16% 1Year Rate
14% 30 Year Rate
12%
10%
8%
6%
4%
2%
0%

86

94
0

72

74

80

82

84

88

90

92
n -7

n -7

n -7
n-

n-

n-

n-

n-

n-

n-

n-

n-

n-
Ja
Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja
FINA4120– Fixed Income 3
 Price Sensitivity to Interest Rates
1-yr and 30-yr bond prices display drastically different interest rate sensitivity!

180 1 Year Price ($100 par)

160
30 Year Price ($1000 par)
140
120
100
80
60
40
20
0
70

2
74

76

80

2
84

86

90

2
94
n -7

n -7

n -8

n -8

n -9
n-

n-

n-

n-

n-

n-

n-

n-
Ja

Ja

Ja
Ja

Ja

Ja

Ja

Ja

Ja

Ja

Ja
Ja

Ja

FINA4120– Fixed Income 4

 Recall
• A bond’s yield answers the question: “What is the constant rate
of return that makes the bond price equal to the present value of
promised future payments?”
C C2 Cn
p 1   ...
(1 y) (1 y)2 (1 y)n
or
n Ci
p 
i
i  1(1  y)
p
• p = price
• Ci = cash flow at end of period i
• n = number of periods
• y = yield (per period)
y
• Given the other information, you can solve for the yield using a financial
calculator or spreadsheet program.

FINA4120– Fixed Income 5

 Two Quick and Dirty Calculations

1. Price Value of a Basis Point

Definition: The price value of a basis point is the

change in the price of a bond if the required yield to
maturity changes by one basis point (1/100th of 1%).

Example 2-1: 5 year 9% coupon bond (semiannual

payments), selling for $100.

The yield increases 1 basis point to 9.01%

New price =

4.5/(1.04505) + ... + 104.5/(1.04505)10

= 99.9604

The price value of a basis point =

$100 - $99.9604
= $0.0396
(per $100 face, or $.396 per $1000 face)
FINA4120– Fixed Income 6
 2. Yield Value of a Price Change

Definition: The yield value of a price change is the

change in the yield of a bond if the required price
changes by a specified dollar amount (often 1/32 of
$1).

Example 2-2: 5 year 9% coupon bond (semiannual

payments), priced at $100 to yield 9% (b.e.b.).

The price increases by 1/32 to 100 1/32.

New yield solves:

100 1/32 = 4.5/(1+y/2) + ... + 104.5/(1+y/2)10

The yield value of a price change =

.09 - .08992 = .00008,
or .008%

FINA4120– Fixed Income 7

 Duration Basics
• Duration is a commonly used measure of bond price sensitivity.

– Higher duration means higher price sensitivity to interest rate changes

(more volatility).

• It incorporates information about yield, coupon, and maturity.

• It is a property of a security or a portfolio at a point in time, which

changes over time

• We’ll look at its mathematical definition, its graphical and intuitive

interpretation, and its use as a hedging tool.

• We will discuss three traditional duration measures: Macaulay,

Modified, and Dollar, and more generalized concepts of duration:
effective, partial, and key rate

FINA4120– Fixed Income 8

(Macaulay) duration as a balancing point of a
CF PV seesaw

FINA4120– Fixed Income 9

 Macaulay Duration

• Macaulay Duration ( D ) is the weighted average of the times to

each coupon or principal payment made by the bond. The weights
are given by discounted values of coupon or principal payments.

1  PVC1 2  PVC2 T  PVCT

D   ... 
PB PB PB
– D – Macaulay duration
– PVCi – present value of cash flow at time i
– PB – current bond price

• Macaulay duration is the most intuitive duration measure, and gives

explanation as to why the name Duration came into being

FINA4120– Fixed Income 10

Example: Calculating Macaulay Duration

5 year, 6% bond, yielding 9% (b.e.b.)

Period Cash PV $1 @ PV of CF t x PVCF
Flow 4.5%
1 3.00 .9569 2.871 2.871
2 3.00 .9157 2.747 5.494
3 3.00 .8763 2.629 7.887
4 3.00 .8386 2.516 10.063
5 3.00 .8025 2.407 12.037
6 3.00 .7679 2.304 13.822
7 3.00 .7348 2.204 15.431
8 3.00 .7032 2.109 16.876
9 3.00 .6729 2.019 18.168
10 103.00 .6439 66.325 663.246
Total 88.131 765.895
Macaulay duration = 765.89/88.13
= 8.69 (half yrs) = 4.35 (years)

FINA4120– Fixed Income 11

 Formulas for Duration
T: Time to maturity in years; y: YTM quoted in APR; c: Annual coupon rate
k: # of compounding periods in a year (e.g. If y is BEY then k is 2)

1. Zero-Coupon Bond

DT
2. Perpetuity
1 y / k
D
y

FINA4120– Fixed Income 12

3. Annuity
1 y / k T
D 
y (1  y / k )Tk  1
4. Coupon Bond

1  y / k (1  y / k )  T (c  y )
D 
y c[(1  y / k )  1]  y
Tk

5. Par Bond (c = y)

1 y / k  1 
D 1  (1  y / k )Tk 
y  
FINA4120– Fixed Income 13
 Example

• 5 year, 6% bond, yielding 9% (bey)

– Use formula 4

1.045 1.045  5(0.06  0.09)

D   4.35
0.09 0.06[(1.045)  1]  0.09
10

• A perpetuity that pays you $1 every year forever, the

YTM is 10%
– Use formula 2
1.1
D  11
0.1
FINA4120– Fixed Income 14
 Properties of the (Macaulay) Duration
Measure

• Duration of an option-free coupon bond is less than its

time to maturity
• Duration of a zero coupon option-free bond is equal to its
time to maturity
• The longer the maturity the longer the duration
• The higher the coupon rate the shorter the duration
• As market yield increases, duration decreases

FINA4120– Fixed Income 15

Duration measures price sensitivity to interest rate change!

P
 P D
y
1 y / k

FINA4120– Fixed Income 16

Why Macaulay Duration measures the percentage change in bond prices
per percentage change in yield?
T Ct
Bond price PB   .
y
t 1 (1  ) t
k
(Ct is the cash flow in period t, T is the total number of periods, and y is the annual percentage
rate, and k is the number of compounding periods in a year.)

To find change in bond price for a small change in yield differentiate:

dPB T  t y
  ( )Ct (1  )  t 1
dy t 1 k k

This gives the dollar price change per small change in annual yield. To get the
percent price change, divide by PB.

To get the Macaulay duration (measured in years) multiply the percentage price
change by -(1+y/k):

T T
dPB / PB t y t t
   ( )Ct (1  ) / PB   ( ) PVCt / PB  D
dy /(1  y / k ) t 1 k k t 1 k

FINA4120– Fixed Income 17

 Modified Duration
• Modified Duration ( DM )

D
DM 
 y
 1  
 k
D – Macaulay duration
y – YTM
k – number of compounding periods per year

• Modified duration describes a percentage change in bond price

with respect to the yield change
PB
  DM  y
PB
FINA4120– Fixed Income 18
 Using Modified Duration Example
• 20 year, 6% coupon (semiannual payments) $100 face
value bond
– Currently yields 8%, and is priced at $80.21
– Macaulay Duration D = 10.92 years
– Modified Duration DM = 10.92/(1.04) = 10.5

• Suppose the yield increases from 8% to 8.1%

– Predicted price change = -10.5 × .001 = -1.05%
– Actual price change = -1.04%

FINA4120– Fixed Income 19

 Using Modified Duration - Continued

• Suppose the yield increases from 8% to 10%

– Predicted price change = -10.5 × .02 = -21%
– Actual price change = -18.11%

• Duration approach to estimating price changes is only

accurate for small yield changes!

FINA4120– Fixed Income 20

 Dollar Duration

• Dollar Duration Dd = DM × P

• Dollar duration describes a dollar change in bond price with

respect to the yield change

ΔP = -Dd × Δy

• Dollar duration can be interpreted as the absolute value of the

slope of a price curve as a function of yield.

FINA4120– Fixed Income 21

 Using Dollar Duration Example

• 20 year, 6% coupon (semiannual payments) $100

face value bond
– Currently yields 8%, and is priced at $80.21
– Modified Duration DM= 10.92/(1.04) = 10.5
– Dollar Duration Dd = 10.5 × 80.21 = 842

• Suppose the yield increases from 8% to 10%

– Predicted price change = -842 × .02 = -$16.84
– Actual price change = -$14.53
FINA4120– Fixed Income 22
 Portfolio (Modified) Duration

The modified duration of a portfolio is usually

measured as the value-weighted modified duration of
the bonds in the portfolio.

If the bonds have different yields, this means that the

modified duration of each bond in the portfolio will be
based on a different yield.

Example: Two-bond portfolio. P(1) = $8,000, DM(1) =

4.3 years. P(2) = $12,000, DM(2) = 3.6 years.

DM(portfolio) = (8/20)(4.3) + (12/20)(3.6) = 3.88

FINA4120– Fixed Income 23
 Duration – Graphic Interpretation

Price
Tangent Line

Yield-to-Price Curve

Current
Price

Duration Prediction Error

New
Price
Predicted
Price

Current New Yield

Yield Yield
FINA4120– Fixed Income 24
 Interpretation of duration
as a break-even point
• Recall from total return analysis
– IR goes up => reinvestment income goes up, capital loss
– IR goes down => reinvestment income goes down, capital gain
• At what investment horizon, does the two effects offset each
other exactly?
Reinvestment income Price income

– Answer is Macaulay Duration

FINA4120– Fixed Income 25
 Duration Takeaways

• Duration provides an answer the question “What

happens to the value of my bond portfolio
when interest rates change”…

• Duration Limitations
– Bonds are assumed option-free
– Accurate only for small yield changes
– Assumes a flat yield curve and parallel shifts

FINA4120– Fixed Income 26

 Generalized Measures of Duration (optional)

Traditional duration measures price sensitivity to small changes in the

general level of interest rates.

But other factors also influence bond prices.

Generalized measures of duration describe the total change in bond price

as the sum of the partial effects of multiple factors in a linear model:

dP 1  P P P 
  f1  f 2  ...  f n 
P P  f1 f 2 f n 

where fi is the ith factor that influences price.

P
f i is the sensitivity of price to the ith factor times a unit change in the
f i
ith factor. This is sometimes called a “partial duration.”

When the factors of interest are rates along the yield curve, the resulting
partial durations are called “key rate durations.”

FINA4120– Fixed Income 27

What is the value of this type of decomposition? (optional)

 Increases accuracy of sensitivity estimates, which in turn makes hedging

strategies more robust.

 Partial durations are inputs into statistical analyses, such as value-at-risk.

Perhaps the most important generalized measure is called “Effective Duration”

 For securities with uncertain cash flows (like MBS), duration is defined as
the price sensitivity of the security to general changes in the level of interest
rates.

 It is based on a more complicated model of price behavior, or estimated

empirically. It is not measured using a standard duration formula because
the cash flows are highly uncertain.

FINA4120– Fixed Income 28

 Convexity

 Convexity measures the degree of inward curvature

of the yield-to-price curve.

 Non-callable bonds always have positive convexity.

 Positive convexity is a desirable property (for a long

position). It means that duration underestimates
the price increase resulting from a drop in yields,
and overestimates the price decrease from an
increase in yields.

 Convexity decreases with yield (for bonds with

positive convexity).

FINA4120– Fixed Income 29

 Graphical Interpretation of Convexity

actual price curve

price

Positive Convexity

P*

P predicted with both

corrections
P new duration-based prediction error is
offset by convexity correction
P predicted
with duration
tangent line at Y*

Y* Y new
yield

FINA4120– Fixed Income 30

 Calculating Convexity

Convexity is found by taking the second derivative of the bond price

function (and then dividing by the price). An explicit expression for
convexity is:

T t ( t 1) X
C0   t  2 2 / PB
t
(1 y / k ) k
t 1

T = number of periods (maturity in years  k)

PB = bond price (present value of cashflows)
Xt = time t cashflow
y = quoted annual percentage rate (so y/k = effective yield per period)
k = number of compounding periods per year

Note that convexity is measured in terms of periods squared

Dollar Convexity = C0PB

FINA4120– Fixed Income 31

Example: Convexity Calculation

Five year, 9% bond, semi-annual payments, priced at 100.

Period Cashflow 1/(1.045)t+2 t(t+1)CF col(4)*

col(3)
1 4.50 .8763 9 7.9
2 4.50 .8386 27 22.6
3 4.50 .8025 54 43.3
4 4.50 .7679 90 69.1
5 4.50 .7348 135 99.1
6 4.50 .7032 189 132.9
7 4.50 .6729 252 169.6
8 4.50 .6439 324 208.6
9 4.50 .6162 405 249.6
10 104.50 .5897 11,495 6,778.0
Total 12,980 7,781.0

convexity = 7781/(100x4) = 19.45

dollar convexity = 19.45(100) = 1,945

FINA4120– Fixed Income 32

 Using Convexity to Improve Price Sensitivity Estimates
The prediction equation with duration and convexity is:

dPB
  DM ( dy )  12 C 0 ( dy )2
PB

Example: Approximating price change with duration and convexity

Estimate the percent price change of a 6% coupon bond with 25 years to maturity,
selling to yield 9% if there is a 200 basis point increase in required yield.

DM = 10.62
C0 = 182.92

dPB
 10.62(.02)  12 182.92(.02)2  2124%
.  366%
.  17.58%
PB
Contrast to the actual change = -18.03%.

Using convexity gets much closer than the estimate using duration alone!

FINA4120– Fixed Income 33

 Practice Problem: Duration and Convexity

• Calculate the modified duration and convexity for

a 7 year 9% coupon bond with semiannual coupon
payments, priced to yield 8% on a BEY

• Compare the approximate price change (using

duration and convexity) with the actual price
change if the yield increases to 8.5%

FINA4120– Fixed Income 34

Answer to Practice Problem
Ans. a. The modified duration = 5.18, and the convexity = 33.93.

Ans. b. Original price at 8% = 1052.82

Price at 8.5% = 1025.98
% price change = -2.55%

Estimated % change =
[-5.18(.005) + .5(33.93)(.005)2 ]100 =
-2.59 + .042 = -2.55%

FINA4120– Fixed Income 35

 Immunization

• Suppose you need some pattern of cash flows in the future

• To meet these cash needs requires holding a suitable portfolio

of bonds

• Ideally one would like to hold a portfolio of zero coupon

bonds, or Strips
– Such approach is known as “cash flow matching”
– Zero coupon bonds may not be the best because of possible
unattractive relative pricing

• It may be necessary to use a portfolio of coupon bonds

FINA4120– Fixed Income 36

 Immunization Objectives
• Immunization is a dynamic portfolio managing strategy
that allows to meet a set of liabilities out of proceeds
from a self-financing bond portfolio

• Immunization allows to meet future liabilities without

having to use a zero coupon bond portfolio

Major Users of Immunization Policies

• Pension Funds
• Life Insurance Companies
• Banks

FINA4120– Fixed Income 37

The Immunization Procedure:

(1) Find the modified duration of the liability.

(2) Choose a portfolio such that the modified duration of the portfolio
equals the modified duration of the liability.

(3) Select amounts to invest in each security so that the present

value of the portfolio equals the present value of the liability,
discounting at the rate implied by the immunization portfolio.

(4) Rebalance the investment portfolio as interest rates change and

liabilities are paid off.

By matching the modified duration of assets and liabilities, both have

the same price sensitivity to changes in interest rates.

Thus the value of assets and liabilities should move together over
time.

FINA4120– Fixed Income 38

 Immunization Example
• Assume a liability that consists of making a single payment
of $100 in 7 years
• Suppose that you can only use zero coupon bonds with
durations of 2 and 20 years and the face value of $100
• Assume the yield curve is flat, i.e. all bond maturities have
the same YTM
• The current YTM (BEY) is 10%
• This gives the present value of the liability of $50.51, and
modified duration of 6.667 years

FINA4120– Fixed Income 39

 Immunization Example Continued

• Matching the modified duration and the present

value of the liability, you constructed the
immunization portfolio that consists of:
– 0.443 shares of the 2 year zero coupon bond
– 0.988 shares of the 20 year zero coupon bond

• This immunization portfolio has

– PV = 50.51
– Modified duration = 6.667

FINA4120– Fixed Income 40

 Immunization Example Continued

• Consider following scenarios of the yield

behavior
– Yield changes the next day after you chose the
immunization portfolio
– Yield changes right before your liability is due

FINA4120– Fixed Income 41

 Immunization Example Continued
• Yield changes the next day after you chose the immunization
portfolio
Present Values (Year 0 – next day)
Yield Liability Immunization Portfolio
6% 66.11 69.67
8% 57.75 58.47
10% 50.51 50.51
12% 44.23 44.72
14% 38.78 40.42

• Immunization portfolio present value exceeds the value of the

liability because of the higher convexity of the immunization
portfolio
FINA4120– Fixed Income 42
 Immunization Example Continued
• Yield changes the next day after you chose the immunization
portfolio and stays there until liability is due (assume reinvesting
proceeds from the 2 year bond at the market rate)
Final Values (Year 7)
Yield Liability Immunization Portfolio
6% 100 105.39
8% 100 101.26
10% 100 100.00
12% 100 101.11
14% 100 104.23

• Immunization portfolio final value exceeds the value of the

liability because of the higher convexity of the immunization
portfolio
FINA4120– Fixed Income 43
 Immunization Example Continued
• Yield changes right before your liability is due (assume reinvesting
proceeds from the 2 year bond at the market rate)

Final Values (Year 7)

Yield Liability Immunization Portfolio
6% 100 118.02
8% 100 107.85
10% 100 100.00
12% 100 93.93
14% 100 89.23

• Immunization portfolio chosen at time 0 does not guarantee meeting the

liability obligation in year 7!!!
• Why???

FINA4120– Fixed Income 44

 Immunization Example Continued
• Notice that at the beginning of year 7
– Modified duration of the liability = 0.952
– PV of the liability = $90.70
– Modified duration of the immunization portfolio = 3.704
– PV of the immunization portfolio = $90.70
• There is a huge discrepancy in durations that resulted from the 2
year bond paid off and reinvested at the market rate of 10%
• You can not immunize liabilities over a long horizon by
passively holding the same immunization portfolio until
liabilities are due
• It is necessary to rebalance the immunization portfolio in
response to changes in interest rates and liability or portfolio
payments

FINA4120– Fixed Income 45

 Immunization Example Takeaway
• Immunization is an active dynamic strategy that involves
periodic portfolio rebalancing in response to changes in interest
rates and liability or portfolio payments

• Example
– In the previous example rebalancing the immunization portfolio in year 6 (1
year left until the liability is due) would require
– selling 20yr bond holdings of 0.988 shares at $25.51 per share
Proceeds = 0.988 × $25.51 = $25.20
– prior reinvestment of 2yr bond proceeds for 4 years at the market rate of 10%
yielded $65.50 in year 6
– reinvest the entire cash amount of $25.20 + $65.50 = $90.70 in year 6 for 1
year at the current market rate of 10%
– You have guaranteed $100 payoff in year 7 regardless of rate changes prior to
the liability expiration

FINA4120– Fixed Income 46

 Immunization Rebalancing
• How often do you need to rebalance the immunization
portfolio?

• You need to rebalance as soon as a significant discrepancy in

durations between liabilities and the immunization portfolio occurs
due to
– changes in interest rates
– payments made by immunization securities
– liabilities been paid off

• There is no one-fits-all answer to determine the size of a significant

discrepancy – it depends on your objectives and risk tolerance

FINA4120– Fixed Income 47

 Immunization Limitations

• Immunization matches duration, which assumes a flat yield curve

• Immunization only protects against parallel yield curve shifts
• Immunization is not a risk-free strategy
• Example
– Suppose in the previous example the 7yr liability yields 10%,
2yr zero coupon bond yields 4%, 20yr zero coupon bond yields 12%
– Immunization Portfolio:
• 0.395 shares of the 2 year zero coupon bond
• 1.446 shares of the 20 year zero coupon bond
• PV of Liability = PV of Immunization Portfolio = $50.51
– Suppose that only 2yr yield goes up to 8% overnight
• PV of Liability remains $50.51
• PV of Immunization Portfolio goes down to $47.78
• Capital loss now, and potential of cash flows mismatch in the future!

FINA4120– Fixed Income 48

 Possible Improvements

• Possible to consider more sophisticated measures of

duration

• Adjusting for convexity need not help in improved

performance
– However, understanding the effect of convexity helps appreciate the
residual risks involved while hedging interest rate risk using Duration

• Use of more sophisticated dynamic multifactor term

structure models helps

• Use of interest rate futures along with immunization helps

FINA4120– Fixed Income 49

 Practice question

My pension plan will pay me $10,000 once a year for a 10-

year period. The first payment will come in exactly 5 years.
The pension fund wants to immunize its position. The current
interest rate is 10% per year. Assume a flat yield curve.
a)What is the duration of its obligation to me? (Hint: you need to account
for the fact that the first cash flow does not occur in 1 year but in 5 years.)
(5 points)

b) If the plan uses 5-year and 20-year zero-coupon bonds to construct the
immunized position, how much money ought to be placed in each bond?
(Note: If you cannot solve part (a), assume a duration of 9 years for the
obligation in order to solve part (b).) (7 points)

FINA4120– Fixed Income 50

 Answer
a) Use the duration formula 3, the duration of the annuity if it were to
start in 1 year is: 1.10 10
- 10
 4.7255 years
.10 (1.10)  1

Because the payment stream starts in 5 years, instead of one year,

we must add 4 years to the duration, resulting in duration of 8.7255
years.
b) The present value of the deferred annuity is $41,968.
Call w the weight of the portfolio in the 5-year zero. Then
5w + 20(1 – w) = 8.7255
which implies that w = .7516 so that the investment in the 5-year
zero equals
.7516 * $41,968 = $31,543.
The investment in 20-year zeros is .2484 * $41,968 = $10,425.

FINA4120– Fixed Income 51

 Yield Curve Active Strategies

• Rolling Down the Yield Curve

• Bullet

• Barbell

• Ladder

FINA4120– Fixed Income 52

 Rolling Down the Yield Curve

• Works if the Yield Curve holds steep upward slope

• As bond approaches maturity or “rolls down the yield curve,”

the yield goes down and its price rises.

Maturity Price
 

• Bond is then sold prior to maturity to realize capital gain from

price appreciation

FINA4120– Fixed Income 53

 Rolling Down the Yield Curve - Examples

• Historic Data on U.S. Treasury Yields

U.S. Treasury Yields
Maturity 1/2/1999 1/3//2000 1/2/2001 1/2/2002 1/2/2003 1/2/2004 1/3/2005
3 Month 4.49% 5.48% 5.87% 1.74% 1.22% 0.93% 2.32%
6 Month 4.57% 5.81% 5.58% 1.85% 1.25% 1.02% 2.63%
1 Year 4.58% 6.09% 5.11% 2.28% 1.42% 1.31% 2.79%
2 Year 4.58% 6.38% 4.87% 3.22% 1.80% 1.94% 3.10%
3 Year 4.57% 6.42% 4.82% 3.75% 2.22% 2.47% 3.28%
5 Year 4.57% 6.50% 4.76% 4.52% 3.05% 3.36% 3.64%
7 Year 4.75% 6.65% 4.97% 4.97% 3.62% 3.90% 3.94%
10 Year 4.69% 6.58% 4.92% 5.20% 4.07% 4.38% 4.23%
20 Year 5.42% 6.94% 5.46% 5.86% 5.05% 5.21% 4.84%

Source: U.S. Treasury at www.ustreas.gov

FINA4120– Fixed Income 54

 Rolling Down the Yield Curve - Example

• Consider the yield curve on 1/2/2002

– Notice the steep upward slope on the short end

6%

4%

2%

0%
- 5 10 15 20
Maturity in Years

• If the 1/2/2002 Yield Curve holds its shape in 2004…

FINA4120– Fixed Income 55

 Rolling Down the Yield Curve - Example

• Assume for simplicity that above yields apply to U.S.

Treasury STRIPS
• Then the 1/2/2002 yields correspond to the following
STRIPS prices*:
Maturity 1 Year 2 Year 3 Year 5 Year 7 Year 10 Year 20 Year

Yield 2.28% 3.22% 3.75% 4.52% 4.97% 5.20% 5.86%

STRIPS Price $ 97.76 $ 93.81 $ 89.45 $ 79.97 $ 70.92 $ 59.85 $ 31.50

* Per $100 face value, semi-annual compounding

FINA4120– Fixed Income 56

 Rolling Down the Yield Curve - Example
• If the 1/2/2002 Yield Curve holds its shape in 2004…
Buy on 1/2/2002

Maturity 1 Year 2 Year 3 Year 5 Year 7 Year 10 Year 20 Year

Yield 2.28% 3.22% 3.75% 4.52% 4.97% 5.20% 5.86%
STRIPS Price $ 97.76 $ 93.81 $ 89.45 $ 79.97 $ 70.92 $ 59.85 $ 31.50

Sell on 1/2/2004

-$89.45 Hold for 2 years $97.76 $100.00

Buy 3yr Strip Sell it as a 1yr Strip The Strip Expires

t = 0 (2002) t = 2 (2004)
• Your return over 2 year period would be 4.49% (semi-annual compounding)
• You can increase your 2 year return from 3.22% to 4.49% !!! t = 3 (2005)

FINA4120– Fixed Income 57

 2002 Example – Historic Follow-Up

• What actually happened in 2004…

6%

4%
2002
2004
2%

0%
- 5 10 15 20
Maturity in Years

FINA4120– Fixed Income 58

 2002 Example – Historic Follow-Up
• What actually happened in 2004…
Buy on 1/2/2002

Maturity 1 Year 2 Year 3 Year 5 Year 7 Year 10 Year 20 Year

Yield (2002) 2.28% 3.22% 3.75% 4.52% 4.97% 5.20% 5.86%
STRIPS Price $ 97.76 $ 93.81 $ 89.45 $ 79.97 $ 70.92 $ 59.85 $ 31.50

Maturity 1 Year 2 Year 3 Year 5 Year 7 Year 10 Year 20 Year

Yield (2004) 1.31% 1.94% 2.47% 3.36% 3.90% 4.38% 5.21%

STRIPS Price $ 98.70 $ 96.21 $ 92.90 $ 84.65 $ 76.31 $ 64.84 $ 35.75

Sell on 1/2/2004

• Your realized return over 2 year period is 4.98% (semi-annual compounding)

• You increased your 2 year return from 3.22% to 4.98% !!!

FINA4120– Fixed Income 59

 Changes in Yield Curve (1999 to 2001)

6%

4%
1999
2001
2%

0%
- 5 10 15 20
Maturity in Years
FIN
FINA4120–
40660 - Debt
Fixed
Instruments
Income 60
 Rolling Down the Yield Curve - Counterexample

• Rolling down the Yield Curve from 1999 to 2001…

Buy on 1/2/1999

Maturity 1 Year 2 Year 3 Year 5 Year 7 Year 10 Year 20 Year

Yield (1999) 4.58% 4.58% 4.57% 4.57% 4.75% 4.69% 5.42%
STRIPS Price $ 95.57 $ 91.34 $ 87.32 $ 79.78 $ 71.99 $ 62.90 $ 34.32

Maturity 1 Year 2 Year 3 Year 5 Year 7 Year 10 Year 20 Year

Yield (2001) 5.11% 4.87% 4.82% 4.76% 4.97% 4.92% 5.46%

STRIPS Price $ 95.08 $ 90.83 $ 86.69 $ 79.04 $ 70.92 $ 61.51 $ 34.05

Sell on 1/2/2001

• Your realized return over 2 year period is 4.30% (semi-annual compounding)

• The potential return has decreased from 4.58% to 4.30%
FINA4120– Fixed Income 61
 Practice question

The current 1-year, 2-year and 3-year spot rates are

6%, 7% and 8%. You expect the yield curve to stay
the same in the future and you are considering two
investments: (1) buy a two-year zero-coupon bond
and hold it to maturity; (2) buy a three-year zero-
coupon bond and hold it for two years. What are the
realized yields (EAY) for the two investments?
Which investment should you choose? (5 points)

FINA4120– Fixed Income 62

 Answer

The realized yield for investment 1 is the 2-year spot

rate, 7%.
The current price of a three-year zero is
1000/(1+Y3)^3=793.83. Two year later, it becomes a
one-year zero with a price of 943.40. The realized
yield for investment 2 is therefore:
(943.40/793.83)^(1/2)-1=9.01%. Investment 2 is
better.

FINA4120– Fixed Income 63

 Bullet, Barbell, Ladder
• Bullet strategy uses portfolio with maturities highly concentrated at
one point on the yield curve
– Bullet Strategy performs Relatively best if the yield curve steepens

• Barbell strategy uses portfolio with maturities concentrated at two

extremes, such as 5 years and 20 years
– Barbell strategy performs best if the yield curve flattens

• Ladder strategy uses portfolio with equal amounts of securities

maturing periodically, usually every year
– Most common safe strategy that allows to match a steady liability stream, and to
avoid reinvestment risk

FINA4120– Fixed Income 64

 Example - Bullet, Barbell, Ladder

Bullet, Barbell and Ladder Portfolios:

US Strips Portfolio Composition of $100 Strips
Maturity Yield Price* Bullet Barbell Ladder
1 1.228% $ 98.78 - 2.4 1
2 1.845% $ 96.39 - - 1
3 2.398% $ 93.10 5 - 1
4 2.860% $ 89.26 - - 1
5 3.270% $ 85.03 - 2.6 1
Portfolio Values $ 465.49 $ 458.16 $ 462.57
Portfolio Duration 3 2.930 2.925

* Per $100 face value, semi-annual compounding

FINA4120– Fixed Income 65
 Yield Curve Scenarios
4.500%
Example - Bullet, Barbell, Ladder
Steepens
3.500%
Benchmark
2.500%

1.500%
Flattens

0.500%
1 2 3 4 5

Yield Portfolio Performance (dollars)

curve Bullet Barbell Ladder
Benchmark - - -
Steepens 0 (best) -4.18 (worst) -2.04
Flattens 0 (worst) 4.34 (best) 2.12

FINA4120– Fixed Income 66

 Yield Curve Active Strategies - Takeaways

• There are no risk-free strategies to increase

realized return!

• All strategies that provide increased return under

some market conditions, result in decreased return
if those market conditions fail to hold.

FINA4120– Fixed Income 67

 To summarize
• Which strategy to use?
– Current yield curve is upward sloping, and you don’t
expect it to change much;
– Current yield curve is upward sloping, but you expect it
to flatten soon;
– Current yield curve is inverted, likely to be upward
sloping again in two years;
– I have a liability in the form of annuity and I want a
sound sleep at night

FINA4120– Fixed Income 68

 Playing The ‘Yield Curve’

• Another way to bet on the slope of yield curve

• Direct instruments are available now
– US Treasury Steepener
– US Treasury Flattener
• Risks
– Yield curve risk
– Liquidity
• New developments: ETF on long/short duration
bonds
FINA4120– Fixed Income 69