FM 300 Section A

Fixed-income portfolio management

Lecture Note 7
Dr. Georgy Chabakauri
London School of Economics

FM 300 Lecture Note 7 1

Outline

Effects of interest rate changes on bond prices

Duration and Convexity
Immunization

FM 300 Lecture Note 7 2

 Interest rate risk

Assume that you are a bond portfolio manager: how can you
shield the value of your portfolio from risk?
What risk does a bond portfolio manager face?
– The key source of risk to the entire portfolio is interest rate
risk: the effect that interest rate movements can have on
the prices of bonds and bond portfolios.

FM 300 Lecture Note 7 3

Bond price and yield

Recall that the price of a bond with T years to maturity, face

value F and coupon rate c is:

cF cF cF (c + 1)F
P= + + + ... +
1 + r1 (1 + r2 ) 2 (1 + r3 )3 (1 + rT ) T

The yield to maturity is the “hypothetical constant” discount

rate that makes the PV of the bond’s cash flows equal to the
bond’s price. It is the bond’s IRR:
T -1
cF (1 + c)F
P=å +
i =1 (1 + y) (1 + y)T
i

FM 300 Lecture Note 7 4

 Relationship between price and yield

Price

Yield

FM 300 Lecture Note 7 5

Inference from the term structure

Yields of zero coupon bonds are equal to spot rates !! .

A plot of zero-coupon yields !! against time to maturity t is
called a yield curve (or term structure).
Yield curve varies over time.
If we look at a plot of the yield curve and notice that it is
upward/downward sloping, what can we conclude?
We need some assumptions on investor behavior.

FM 300 Lecture Note 7 6

 Inference from the term structure

Various shapes of term structure:

FM 300 Lecture Note 7 7

Explaining Term Structure:

Forward Rates
Forward rates can be found from equation:

(1+ r s ) s (1+ fs,t ) t−s = (1+ r t ) t

Otherwise, arbitrage is possible:
– E.g., suppose (1+ r s ) s (1+ fs,t ) t−s > (1+ r t ) t
– To make arbitrage borrow £1 at rate rt for t years, lend £1 at
rate rs for s years, and then £(1+rs)s at rate fs,t for t − s years.

FM 300 Lecture Note 7 8

 Explaining Term Structure
WI
Expectations Hypothesis: Forward rates are unbiased
predictors of future spot rates: fs,t=E[rs,t].
This hypothesis helps explain various shapes of term structure.
Term structure reflects expectations about future interest rates:
(1+r2)2=(1+r1)(1+f1,2), f1,2=E[r1,2].

E.g., upward sloping term structure means that r2>r1. Therefore,

f1,2 > r1 => investors expect future interest rates to increase.

FM 300 Lecture Note 7 9

Explaining Term Structure

W
Liquidity Premium Hypothesis:
– Lenders prefer liquidity (short-term), borrowers prefer long-
term => market provides a term premium: long-term bonds
offer premium over short-term bonds => higher long-term
rates.
Segmentation Hypothesis
– Every maturity has its own clientele (lender & borrower),
and the yield curve is determined by demand for bonds
with different maturities.

FM 300 Lecture Note 7 10

 Inference from the term structure

If the yield curve is downward sloping, we could infer:

– The forward rate for the coming period is smaller than the
yield at the same maturity
– Investors anticipate short rates to fall in the future.
– A downward sloping yield curve is not likely to be due to
term premia because they are positive under the liquidity
preference story.
Conclusion: the theories of term structure determination
provide a framework within which we can use the information
contained in yield curves.

FM 300 Lecture Note 7 11

Inference from the term structure

FM 300 Lecture Note 7 12

 Interest rate changes and bond prices

To see the influence of interest rate changes on bond prices,

assume that term structure is flat, that is, !! =r.
Assume a menu of £1 zeros with different periods to maturity.
The price of a T period zero is Pk = 1/(1+r)T.
Similar for coupon bearing bonds
Notice that r = y in this case
Price Pk more sensitive to r when T is large

FM 300 Lecture Note 7 13

Duration

Definition: The duration of a bond is the elasticity of its price

with respect to changes in yields.
– Duration shows the sensitivity of bond prices to small
changes in interest rates.
– Duration is approximately the % change in price
associated with a 1% change in yield.

FM 300 Lecture Note 7 14

 Duration
M Bond
Value

y-Δy y y+Δy
Interest rate (%)

The sensitivity to interest rate changes is determined by the

steepness (slope) of the bond price curve.

FM 300 Lecture Note 7 15

Calculating durations
M
From the definition, we can write the duration of a bond with
price P and yield y as
dP
P 1 + y dP
D=− =−
d(1 + y) P dy
1+y

Change in the price of a bond, given a change in yield:

D
dP = − ×P×dy,
1+y
D
ΔP ≈ − ×P×Δy,
1+y

FM 300 Lecture Note 7 16

 Calculating Duration
µModified duration: D∗ = D/(1 + y)

Calculate duration of a zero-coupon bond with price P = (1+y)-T:

Duration equals maturity T:

1+y T
D=T=
P (1 + y)#$%

FM 300 Lecture Note 7 17

…Calculating durations
um
Consider an arbitrary portfolio of coupon and zero-coupon
bonds which has cash flows Cj for j=1,…,N. Given a yield of y,
this implies a portfolio value of
N
Cj
P=å
j=1 (1 + y) j

Using the definition of duration we obtain

(1 + y)dP (1 + y) N Cj N C j /(1 + y) j
D=-
Pd(1 + y)
= åj =åj
P j=1 (1 + y) j+1 j=1 P

N C j /(1 + y) j
D=åj
å
N
j=1
j=1
C j /(1 + y) j

FM 300 Lecture Note 7 18

 …Calculating durations

The duration (called Macaulay duration) for bonds when term

structure is flat is given by:

PV(C% ) PV(C& ) PV(C# )

D = 1× + 2× + ⋯ + T×
P P P

Duration is a weighted average of payment dates.

– Weights PV(Ct)/P sum up to 1.
– Cash flows with larger present values are given larger
weights PV(Ct)/P in this average.

FM 300 Lecture Note 7 19

Facts about duration

The duration of a coupon bond is lower than maturity because

a lot of the cash flows accrue before maturity.
Duration generally increases with maturity
Duration falls as coupon rate rises: the weight on the early
payments is higher.
Duration falls as yield rises: a higher yield reduces the value
of later cash flows by a greater proportional amount.
– Weights of earlier cash flows in the total become greater.

FM 300 Lecture Note 7 20

 Immunization

Immunization is a strategy used by financial institutions to shield

their financial status from exposure to interest rate fluctuations.
By choosing the structure of assets firm can reduce the interest
rate sensitivity of the net worth (= asset value – liability value).
This is achieved by matching durations of assets and liabilities.
– Hence, net worth is not sensitive to interest rate fluctuations
and firms do not lose money because of these fluctuations.

FM 300 Lecture Note 7 21

… Immunization

Suppose, you are a manager of an insurance company. Your

assets consist of £30mln in cash and the liabilities consist of
four £10mln payments in years 5, 6, 7, and 8 from now.
Current interest rate (which is also your discount rate) is r =
5%. However, you are concerned that the interest rates may
go down. What is the immunization strategy in year t = 0?

Balance Sheet
Assets Liabilities
£30 mln year: 5 6 7 8

£10 £10 £10 £10

PV=L=29.173 mln

FM 300 Lecture Note 7 22

 … Immunization

Net worth W is defined as the difference between the values

of assets and liabilities:
10 10 10 10
W = 30 - - - -
(1+ 0.05)5 (1+ 0.05)6 (1+ 0.05)7 (1+ 0.05)8
= £0.82 mln

If r falls to 4% W becomes:
10 10 10 10
W = 30 - - - -
(1+ 0.04)5 (1+ 0.04)6 (1+ 0.04)7 (1+ 0.04)8
= -£1.02 mln

The company loses money if the interest rate drops!

FM 300 Lecture Note 7 23

… Immunization

Suppose, to immunize the net worth the manager invests £30

mln and buys x3 units of 3-year zeros at price P3 and x10 units of
10-year zeros at price P10.
3-year and 10-year bonds with face value £100. Hence, their
prices are:
– P3 =100/(1+0.05)3=86.384; P10 =100/(1+0.05)10=61.391

Need to find x3 and x10 such that the net worth is not sensitive
to interest rates.

FM 300 Lecture Note 7 24

 … Immunization

Modified duration of the stream of liabilities is: DL* = 6.13.

Hence, changes in liabilities are given by:
DL » -DL*LDr
The value of assets is given by:
! = #! $! + #"# $"#
Approximate change in asset value is given by:
∆! ≈ −)!∗ #! $! ∆* − )"#
∗
#"# $"# ∆*
change in value change in value
of 3-year zeros of 10-year zeros

FM 300 Lecture Note 7 25

… Immunization

Objective: choose x3 and x10 such that:

DW = DA - DL » 0
Hence:
)!∗ #! $! + )"#
∗
#"# $"# = )%∗ 1

Moreover, we should have enough money to buy zeros:

#! $! + #"# $"# = £30 mln

total money
investment available

FM 300 Lecture Note 7 26

 … Immunization
Putting numbers to these equations we get:
246.811x3 + 584.676 x10 = 178.899mln,
86.384 x3 + 61.391x10 = 30mln.
Hence, x3=185476 , x10=227684.
Net worth (=assets – liabilities) the same as before: W =
£0.82mln. How does it change when r = 4%?

18.547 22.768
W= +
( 1+ 0.04 ) ( 1+ 0.04 )10
3

10 10 10 10
- - - -
( 1+ 0.04 )5 ( 1+ 0.04 )6 ( 1+ 0.04 )7 ( 1+ 0.04 )8

= £0.842 mln we no longer lose money when r ↓!

FM 300 Lecture Note 7 27

… Immunization

Note that immunization is a dynamic strategy and has to be

revised at future dates.
This is because as time passes 3-year and 10-year bonds
become 2-year and 9-year bonds and hence their durations
change. Moreover, term structure may change.
Duration of the liabilities also changes when 1 year passes. In
particular, the stream of liabilities becomes:

year: 4 5 6 7

£10 £10 £10 £10

PV=L=32.269

FM 300 Lecture Note 7 28

 Duration and convexity

How does immunization perform for large yield changes?

Approximate change in bond price associated with a change
in yields Δy using a second order Taylor approximation:

∆P 1 dP 1 d& P
≈ ∆y + 0.5 &
(∆y)&
P P dy P dy

Define convexity as:

1 d& P
C= × &
P dy

FM 300 Lecture Note 7 29

…Duration and convexity

Using the formula for modified duration and convexity, we have

∆P
≈ −D∗ ∆y + 0.5C(∆y)&
P

Using durations only, we get a linear approximation to bond

price changes as yields change. This is why duration-based
immunization strategies only work for small changes in yield.
If we introduce convexity, we can approximate bond (portfolio)
price changes far more accurately by a quadratic function.
We can construct immunization strategy with respect to both
duration and convexity.

FM 300 Lecture Note 7 30

 …Duration and convexity

The expression for the convexity is as follows:

#
1 t(t + 1)C'
C= :
P (1 + y)'$&
'(%

FM 300 Lecture Note 7 31

…Duration and convexity

Price

convexity

Duration

Yield

FM 300 Lecture Note 7 32

 Swaps
Swap is an important tool for managing interest rate risks.
Swap is a contract that allows two parties to exchange their
cash flows in the future.
– A company that pays fixed interest rate on its debt may
prefer to pay a floating rate;
– A company that receives cash flows in pounds may prefer
to receive cash flows in dollars;
– The market for swaps is large. The notional amount of
swaps outstanding is several hundred trillion dollars.

FM 300 Lecture Note 7 33

Interest Rate Swaps

In interest rate swaps two parties agree to exchange a stream of
interest payments of one type (fixed or floating) for a stream of
payments of the other type.
Consider the following example.
– Firm A agrees to pay firm B a floating rate note (FRN):

t=0 t=1 t=2 t=3 t=4 t=T-1 t=T

£N×r0,1 £N×r1,2 £N×r2,3 £N×r3,4 .... £N×rT-2,T-1 £N×rT-1,T+£N

– In exchange, firm B pays firm A a constant coupon bond:

t=0 t=1 t=2 t=3 t=4 t=T-1 t=T

£N×k £N×k £N×k £N×k .... £N×k £N×k+£N

FM 300 Lecture Note 7 34

 … Interest Rate Swaps
Swaps have the following characteristics:
– Payments are based on a notional amount £N;
– On payment dates net difference (rt -1,t - k ) ´ N is
exchanged;
– At the inception, fixed interest rate k is set such that the
swap has zero value;
– There is a secondary market for swaps;

FM 300 Lecture Note 7 35

… Interest Rate Swaps

The floating rate in many swap contracts is based on London

Interbank Offer Rate (LIBOR) plus/minus several basis points.
LIBOR is the rate at which banks are willing to lend to each
other.
In practice, swaps are arranged via financial intermediaries
such as investment banks, that charge certain commission.

LIBOR LIBOR
A Bank B
k k

FM 300 Lecture Note 7 36

 … Interest Rate Swaps
Fixed interest rate k is found from the condition that the value
of floating rate note equals the value of coupon bond with
coupon yield k:
VFRN =Vbond(k).
Fixed rate k is set at t=0, similar to forward interest rate.
Value of fixed coupon bond is found using the term structure
at time 0 (i.e. interest rate r0,t between date 0 and date t):

£N ´ k £N ´ k £N ´ k £N ´ k + £N
Vbond = + + + ... + .
1 + r0 ,1 (1 + r0 ,2 ) (1 + r0 ,3 )
2 3
(1 + r0,T )T

FM 300 Lecture Note 7 37

… Interest Rate Swaps

The price of FRN is £N because £N is enough to replicate the
stream of cash flows:
– Invest £N at t = 0, get £N+£N×r0,1 at t =1, pay coupon
£Nr0,1;
– Invest £N at t =1, get £N+£N×r1,2 at t =2, pay coupon £Nr1,2
etc.
t=0 t=1 t=2 t=3 t=4 t=T
£N×r0,1 £N×r1,2 £N×r2,3 £N×r3,4 .... £N×rT-1,T+ £N

£N £N×r0,1+ £N £N×r1,2+ £N £N×r2,3+ £N £N×r3,4+ £N £N×rT-1,T+ £N

....
invest £N invest £N invest £N invest £N
at r0,1 at r1,2 at r2,3 at r3,4

FM 300 Lecture Note 7 38

un … Interest Rate Swaps
Fixed interest rate k is then determined form the condition that
the value of floating rate note equals the value of coupon
bond with coupon yield k:
£N ´ k £N ´ k £N ´ k £N ´ k + £N
£N = + + + ... + .
1 + r0 ,1 (1 + r0 ,2 )2 (1 + r0 ,3 )3 (1 + r0,T )T
The equation for k can be rewritten as follows:

k k k k +1
1= + + + ... + .
1 + r0 ,1 (1 + r0 ,2 ) (1 + r0 ,3 )
2 3
(1 + r0,T )T

FM 300 Lecture Note 7 39

mi Quick Question
Consider a 2-year swap with annual payments, notional
amount $1. Floating coupon rate is the 1-year rate
observed one year earlier. Current data: r0 ,1 = 7%, r0 ,2 = 10%.
– What is the fixed rate k for this swap agreement?
t =0 t =1 t =2

r0 ,1 = 7%

r0 ,2 = 10%

Cash Flows:
receive fixed k k
pay floating - 0.07 - r1,2

40
FM 300 Lecture Note 7
W
Answer
Fixed rate of return solves the following equation:
k k +1
+ = 1.
1 + r0 ,1 (1 + r0 ,2 )2

– Substituting the interest rates we obtain:

k k +1
+ = 1 Þ k = 9.855%.
1 + 0.07 (1 + 0.1)2

41
FM 300 Lecture Note 7