Submitted to:

Prof. David Veredas

Submitted by GROUP 2
Puneet Patwari 220601033
Siddhant Sharda 220601045
Ayushi Srivastava 220601009
Shivendra Singh 220601043
Rishabh Chhikara 220601037
Q1 How does this increase affect the value of a fixed-income portfolio? Justify your answer
Ans. An increase in interest rates adversely impacts the portfolio. As the increase in interest
means an increase in the discount rate by which the cash flow (coupons and principal) of the
bonds will be discounted and hence directly decrease the present value of the fixed-income
portfolio.
Example: A bond of 1000 face value with a coupon of 10% (paid annually) and maturity of 2yrs
discounted by the interest rate of 4%.
The price of this bond will be:
= 100/(1.04) + 1100/(1.04)^2
=1113.17
Currently, the value of this bond is INR 1113.17.
After the rise in interest rate from 4% to 6.5%,
=100/(1.065) + 1100/(1.065)^2
=1063.72
As we can see, the value of our bond reduced from 1113.17 to 1063.72. showing the reduction
in the value of our bond.
Q2 What is more affected by the increase, a portfolio with short or with long duration?
Justify your answer.
Ans.
Let’s say the above durations refer to the maturity of the portfolio then, the portfolio having
longer maturity will have more negative impact
on the value as compared to the portfolio with
shorter maturity. It happens because the bond
with the higher maturity has an amplified effect
of discounting as they are the cashflow realized
in the later future. For example, let’s say that
there are two bonds A and bond B having the
same coupons and principal but different maturity.
We can see from the example that the bond with long maturity is more sensitive to the increase
in the interest rate.
Q3 What is more affected by the increase, a portfolio with higher or with lower convexity?
Justify your answer.
A portfolio with high convexity has less impact from the increase in the interest rate then a
portfolio with lower convexity. As we know the convexity shows the increase in the Dmod if
there is an increase in the interest rate. So a portfolio with higher convexity will have a higher
margin of error given by the Dmod calculation, which means there will be a lower loss in the
portfolio hence there will be less impact on a higher convexity portfolio. We can see the same
in the example.