Fixed Income

Introduction to the Measurement

of Interest Rate Risk
Reading -58

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Interest Rate Risk
Relation between interest rate and bond value
Interest Rate
• Bond values are Risk
inversely
proportional to • It is the risk of
interest rate. change in bond
value due changes
in the interest rate
as bond values
Bond Value

Approaches to measuring interest rate risk

1. Full Valuation Approach
2. Duration/Convexity Approach

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Full Valuation Approach
It is a process in which the position of bond is evaluated for
various scenarios of change in interest rates.
Step in Full Valuation Approach
1. Identification of the current price and yield of a bond or
bond portfolio.
2. Determination of possible yield change scenarios.
3. Calculate the bond price for each new scenario.
4. Calculate the percentage change in the price of the bond or
bond portfolio for each scenario.
Note:
Each security in the portfolio is valued separately
under the full valuation approach, and portfolio
value is determined as the sum of constituent parts.
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Full Valuation Approach
Example
Current Position of bond: 8% coupon 15 year bond (option free)
Current Market Price: Rs.125.09
Yield to Maturity: 5.5%
Par value of bond: Rs.1,00,000
Market Value of the position: Rs.1,25,250
Solution

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Price Volatility Characteristics of Option-Free Bonds
Facts
• Price of option free bond moves
in opposite direction to a change
in the bond’s yield.

• The relationship is not linear i.e.

not a straight line relationship.

• The price-yield relationship for

any option free bond is referred as
convex.

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Price Volatility Characteristics of Option-Free Bonds

Properties
• Percentage change in price is not the same for all the bonds
for a change in yield.

• Percentage change in price for a given bond is approximately

the same (whether increase or decrease in yield) for a small
change in yield.

• For a large change in yield, the percentage price change

increase in greater that the percentage price decrease.

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Price Volatility of Bonds with Embedded Options
Components of price of bond with embedded option
• The price of the same bond considering it to be an option free
bond.
• Value of the embedded option.

Value of bond with embedded option = Value of option free

bond + Value of the embedded option

Types of Options
• Call Option (Prepay): It is the right to the issuer to call back
the issue or repay the debt prior to the principal payment
date.
• Put Option: It is the right with the investor to demand for the
prepayment of the debt.
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Bonds with Call or Prepay Options
Facts
• A callable bond exhibits positive convexity at high yield levels
and negative convexity at low yield levels.
• Negative convexity means that for a large change in interest
rates, the amount of the price appreciation is less than the
amount of the price depreciation.
• When the required yield for the callable bond is higher than
its coupon rate, the bond is unlikely to be called. Therefore,
the callable bond will have similar price/yield relationship
(positive convexity) as a comparable option-free bond.
• When the required yield becomes lower than the coupon
rate, the value of the call option increases because it is getting
more and more likely that the bond may be retired at the call
price.
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Bonds with Embedded Put Option
Facts
• Bonds with putable options can be redeemed by the
bondholder on the dates and at the put price mentioned in
the indenture.
• If bond value < put price in case the yield rises, put option
may get exercised by the bondholder.
• If put price is par value and yield > coupon rate, put option my
get exercised.
• Value of putable bond = value of option free bond + value of
put option.
• If the yield is low, price of putable bond = price of option free
bond.
• If yield rises, decline in the price of putable bond is less as
compare the decline in price of option free bond.
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Duration
Facts
• It is the approximate price sensitivity to the change in interest
rate.
• It can also be interpreted as percentage change in price for a
100 bps change in interest rate.

Calculation of Duration

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Duration
Example
Consider a 7% coupon 15 year option free bond selling at Rs.109.7122 to
yield 6%. Calculate the duration for a 25 bps change in interest rate?
Solution:
Price if yield declines by 25 bps = Rs.112.3411
Price if yield rises by 25 bps = Rs.107.1667
Initial price = Rs.109.7122
Change in yield in decimal = 0.0025
Therefore,
Duration = (112.3411 – 107.1667)/(2 x 109.7122 x 0.0025)
= 9.43%
Interpretation: For a 100 bps change in yield, the price of the bond
changes by 9.43%
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Approximating the percentage price change using duration

Given the duration of a bond, the percentage change in the price

of a bond can be approximated as:
Approximate % price change = - Duration x change in yield x 100
Example
Consider the 7%, 15-year bond trading at Rs.109.7122 whose
duration we calculated in previous slide is 9.43%. For a 10 basis
point increase in yield, the approximate percentage price change
is
-9.43 x 0.001 x 100 = -0.9430%.
Note:
The negative sign before duration is
due to the inverse relationship
between price and yield change

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Modified Duration
• It is the approximate percentage change in a bond's price for a
100 basis point change in yield assuming that the bond's
expected cash flows don't change when the yield changes.
• Modified duration shows how bond prices move
proportionally with small changes in yields.
∆P/P x 100 = -Dmod x ∆i
where:
Note:
∆P = change in price for the bond Modified duration cannot be
-Dmod = the modified duration for the used to measure the interest
rate risk for bonds with
bond embedded options because a
∆i = yield change in basis points divided change in yield may
significantly affect the
by 100 expected cash flows of bonds
P = beginning price for the bond with embedded options.
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Macaulay Duration
It is calculated as:
Macaulay Duration = Mod. Duration (1 + yield/k)

Note:
Where, As Modified duration cannot
k = number of periods be used to measure the
interest rate risk for bonds
Yield = yield to maturity of the bond with embedded options, same
holds true for Macaulay
Duration too.
Example
A bond with a Macaulay duration of 5 years, a yield to maturity
of 7% and semiannual payments will have a modified duration
of:
Dmod = 5/(1 + .07/2)
= 5/1.035 = 4.83 years
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Interpretations of duration
• Duration is known as the approximate percentage price change in price
for a 100 basis point change in rates. This measure is often known as
1 the "first derivative" of the price/yield function.

• Duration is the first derivative of the price/yield relationship of a bond.

For example, a bond with a duration of 4 means that the first
2 derivative of the bond's price function is 4.

• Duration is the weighted average time to receive the present value of

each of the bond's coupon and principal payments. For example, a
bond with a duration of 4 means that on average, it takes 4 years to
3 receive the present value of the bond's cash flows.

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Portfolio Duration
It is obtained by calculating the weighted average of the duration
of the bonds in the portfolio.

Portfolio Duration = w1D1 + w2D2 + w3D3 + ………wnDn

Where,
w1,w2,…wn = weight of individual bonds in portfolio
D1, D2, …Dn = duration of individual bonds in portfolio
Note:
For the duration measure to be useful, the
change in yield for each of the bond in the
portfolio should be equal, i.e. there should
be a parallel shift in the yield curve.
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Portfolio Duration
Example

Market Value = 4385500 + 9216800 + 3000000 = Rs.16602300

w1 = 4385500/16602300 = 0.2642
w2 = 9216800/16602300 = 0.5552
w3 = 3000000/16602300 = 0.1807
Portfolio Duration = w1D1 + w2D2 + w3D3
= (0.2642 x 6.3392) + (0.5552 x 8.3543) + (0.1807 x 3.6453)
= 6.9711%
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Convexity measure
It is used to approximate the changes in price that is not
explained by duration.

Convexity Measure = C x (∆y*)2 x 100

Where,

∆y* = the change in yield for which the percentage price change
is sought.

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Modified convexity and effective convexity
Modified convexity
• It is the convexity measure investors obtain if they assume
that yield changes have no effect on the bond's expected cash
flows.
• It does not consider the effect of embedded options on
expected cash flows.

Effective convexity
• It includes the effects of yield changes on the cash flows.
• It requires an adjustment in the estimated bond to reflect any
change in estimated cash flows due to the presence of
embedded options.
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Price value of a basis point (PVBP)
• It is the absolute change in the price of a bond for a 1 basis
point change in yield.

PVBP = | Initial price - price if yield is changed by 1 basis point |

PVBP differs from traditional duration as :

• It is identical for both increases and decreases in yield,
because it explains how price changes due to very small
interest rate shifts (one basis point). When interest rates are
adjusted by this small amount, the price-yield schedule would
be approximately linear.
• It shows the dollar change in price, rather than percentage
change.

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