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Basis Point Value
Basis Point Value
It is not new. It has been used for years. In many financial How do dealers adjust the BPV?
institutions it has been replaced or is used in conjunction with value Dealers adjust the BPV by altering the positions they have. Here is
at risk. an example. Let’s suppose a dealer expects interest rates to rise
and is long the $10m, 5 year bond from the previous example.
What does it show?
The dealer will want to reduce the BPV being run.
BPV tells you how much money your positions will gain or lose for a
0.01% parallel movement in the yield curve. It therefore quantifies
The BPV can be reduced by any of the following:
your interest rate risk for small changes in interest rates.
A. Using the current market price from a dealer quote, or 3. Paying fixed interest on an interest rate swap so the BPV
of the swap and bond give a lower net BPV.
B. Discounting the individual bond cash flows in order to
find the sum of the present values 4. Selling interest rate or bond futures, again to reduce the
overall BPV of the portfolio.
Let’s assume you use the second method. You will use current
market interest rates and a robust method for calculating accurate
discount factors. (Typically swap rates are used with zero coupon What are the advantages of BPV?
methodology). The main advantages of BPV are:
For the sake of simplicity we will use just one interest rate to • It is relatively simple to calculate.
discount the bond cash flows. That rate is 5.00%. Discounting the
cash flows using this rate will give you a value for the 5 year bond • It is intuitively easy to understand and has gained
of $10,000,000. (How to do this using a financial calculator is widespread acceptance with dealers.
explained on the second page of this document).
• You can apply the same approach to financial
We will now repeat the exercise using an interest rate of 5.01%, instruments that have known cash flows. This means you
(rates have increased by 0.01%). The bond now has a value of can calculate BPVs for money market products and
$9,995,671.72. swaps.
There is a difference of $4,328.28. • You can also amalgamate all the cash flows from a
portfolio of transactions and calculate the portfolio BPV.
It shows that the 0.01% increase in interest rates has caused a fall
in the value of the bond. If you held that bond you would have lost • It can be used by dealers to calculate simple hedge
$4,328.28 on a mark-to-market basis. ratios. (If you are long one bond and short another you
can calculate an approximate hedge ratio from the ratio
This is the BPV of the bond. of the two BPVs, more on this later).
• You may know the BPV but you do not know how much
Some firms do this by giving traders a maximum BPV that they are
the yield curve can move on a day-to-day basis.
permitted to run. For example, a limit where the portfolio BPV must
not exceed $20,000.
• BPV assumes that the yield curve moves up or down in a
parallel manner, this is not usually the case.
The more interest rate risk you are prepared to let dealers take the
higher the limit.
www.barbicanconsulting.co.uk
Financial Markets Training
Can anything be done to improve BPV? Hedge ratios
Yes. Firms that use BPV recognise these weaknesses and use Sometimes dealers construct trades that try to take advantage of
additional risk limits. Some of these limits capture the risks that anticipated changes in shape of the yield curve. For example they
dealers have from a non-parallel shift in interest rates. Risk may expect short term interest rates to increase and longer term
managers alter the shape of the yield curve. They make the yield rates to fall.
curve steeper or flatter around a particular maturity and look at the
impact that would generate on the P&L. Using the 3 year and 5 year bonds how could this trade be
constructed?
Many firms have moved towards statistical techniques like value at
risk. This provides a probability of loss. BPV cannot do this. You sell the 3 year bond and buy the 5 year bond. Because the two
bonds have different BPVs you would want to weight or ratio the
Here is a quick approximation for BPV trade according to their relative risks.
Press PV and the calculator will give you 10,000,000 The BPV falls from 4,328.28, (using 5.00% and 5.01%), to
Repeat the exercise using 5.01% as the interest rate, I. $3,305.71.
The calculator now gives you $9,995,771.72 As interest rates rise the BPV falls. Sometimes this is referred to as
A difference of $4,328.28, the BPV of this bond convexity.
And for a 3 year bond? It can be important to traders because it can mean that the interest
Use the following: rate risk they have changes as interest rates move and any hedges
they are using may need to be rebalanced.
N = 3.00
I = 5.00%
For risk managers this has important implications too. If you are
PMT = 500,000
using interest rates derived from swap rates to calculate the BPV of
FV = 10,000,000
financial instruments and those instruments trade with credit
Press PV and the calculator will give you 10,000,000 spreads over or under swap rates then your BPV calculations will be
approximations.
Repeat the exercise using 5.01% as the interest rate, I.
You can now see that longer dated bonds, (or swaps), give you
higher BPVs and therefore greater interest rate risk.
William Webster
Barbican Consulting Limited
Financial Markets Training
wwebster@barbicanconsulting.co.uk
00 44 (0)20 79209128