FIXED INCOME SECURITIES

MULTI- FACTOR RISK METRICS & HEDGES Suppose,our forecast of r01 will go up 40BP, Key Rate Duration
Interest Rate r05 wl go up by 80 BP & r09 wl go up by Most liquid ,”On the run treasury securities”are
120BP. chosen as Hedging Instrument to reduce High
r10 Hedging Cost.
80 BP If we have 1 yr,5 yr & 9yr treasury securities for
80/4=20 hedging, always choose r01,r05 & r09 as the key
r05
spot rates.
Suppose, r02, r05 & r09 changes by 120 BP for a 30
Maturity r1 2 3 4 5 6 7 8 9 yr Bond.
Acc to Single Factor Risk Measure,if yield curve 0 20 40 60 80 60 40 20 0 Change in spot rates wl be as follows:
shifts in parallel manner,then only the overall
portfolio loss will be=0
BIGGEST DRAWBACK-Assumption that all spot
120BP r02
rates are perfectly positively correlated that 40BP 40/4=10 80
will bring a parallel shift.
120 40
THIS IS NOT TRUE IN REAL LIFE.
BP
r01 2 3 4 5
REAL LIFE SHIFTS TAKE PLACE AS FOLLOWS:- 40 30 20 10 r02 r03 r04 r05
New in case of steepening

Old
New in case of flattening 120/4=30

r05 6 7 8 9 r05 120/4=30

Steep new
old [DOUBLE WHAMMY]
Butterfly shift
So, Use Multi factor Risk Measures like
1. Key Rate Duration
2. Partial 0,1
3. Forward Bucket 0,1
1.KEY RATE DURATION
STEP 1: Choose specific Key Rates
Key Rate Duration is % change in price due to
1% change in spot rate of a particular
maturity,keeping other spot rates constant.
Since its hard to find out treasury securities of
all maturities traded in market,we choose
SPECIFIC KEY RATES from the most liquid
ON-THE-RUN SECURITIES.
STEP 2: Forecasting change in Spot Rates
Eg: If economy is going on through
recession,so,in short run,RBI should decrease
interest rates to make borrowing cheaper for
companies,in order to increase their
production.
STEP 3: Assume a certain pattern of change in
neighbouring rates [LINEAR DECAY]
0 30 60 90 120 80 90
40 60
NOTE:Only neighbouring rates are affected 30
i.e. change in r01 will only affect r02, r03 & r04 &
not r06,r07 & r08. r02 r03 r04 r06 r07 r08 r09
STEP 4: Find out Key Rate Duration
Kr01 = ∆ in portfolio value for a 1 Basis Point
shock in spot rate of particular maturity.
Whereas, Key Rate Duration =A % change in r09 120BP
price due to 1% change in spot rate of a 90
particular maturity,keeping other spot rates 60
constant. 30
NOTE: For an increase in yield,if there is
positive Key Rate Duration(KRD) & positive r05 r06 r07 r08
KR01 which indicates there is decrease in Sum of Key Rate Durations=Effective Duration
value. If trades neutralize all Kr01s,then yield based
Taking the above supposition,we will DV01 is neutralized.But,if trades neutralize DV01,
calculate individual Kr01 will not be neutralized.So,a good
KRD & KR01 for only R01 change, for only R05 hedge neutralizes individual sensitivities too.
change & for only R09 change.
Had it been a case of Duration & DV01 ,we 2.PARTIAL 01
would have simply shifted all the spot rates Gives sensitivity of swap portfolio for one basis point shock in the
by say 40BP & found out the change in swap rates rather than the Key Spot Rates.
portfolio. In key rates, no. of interest rates are smaller as compared to
STEP 5: Hedging swap rates.
i.e. Partial01/Entire time period*more periods
Suppose, when only R01 changes ,KR01 as per
Partial01 curve is constructed based on swap curve & swap curve
calculations =0.0125 & we hve the foll inf:- is based on prices of money market & swap instruments.
BOND Kr01 of Kr01 Kr01 of r09 No of securities used in Partial01 > no. used in Key Rate
r01 r05 framework.-Calc of Partial01 is not independent of underling
swap curve.
A 0.0025 -
Swap market participants fit money market curves using-“DAILY
B 0.0030 0.0120 FIT INTO CURVE”.
3.FORWARD BUCKET01-Involves framing buckets from diff.
periods like (0 to 5)& (5 to 9).Then,forecast a parallel shift in 1yr
C 0.0010 0.0050 0.0130 fwd rate for each bucket.Reverse engineering these fwd
rates,new spot rates can be manufactured.
For hedging,  5*10 yr Swaption with E=5%,is an option to enter into
a swap after 5yrs for 10 yrs.Swap wl be entered if
Short these bonds;
actual swap rate in mkt after 5 yrs>5%.
0.0025/100*(FV of A)+0.0030/100*(FV of PORTFOLIO VOLATILITY
B)+0.0010/100*(FV of C)=0.0125 ∆ in portfolio value=KR01*∆r01+KR01*∆r05+ KR01*∆r09
Use similar equations for r05 & r09. Portfolio volatility=Sq root of (KR012σ2r012+
Solving ,we get FV of A,FV of B,FV of C. KR012σ2r052+2rKR01KR05*σr01*σr05)
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