Lecture 3 Int Rate Risk MGT

Fixed Income
Felix Matthys
Lecture 3: Interest Rate Risk Management

Outline
1 Bond Price Sensitivity
Effects of changing interest rates, coupon rate and Maturity
2 Duration
Duration of a Zero Coupon Bond
Duration of a Portfolio of Securities
Duration of a Floating Rate Note
Properties, Sensitivity and Traditional Definitions of Duration
Duration and Risk Measures
3 Cash Flow Matching and Immunization
4 Asset-Liabilities Management
5 Convexity
6 Hedging portfolios based on Duration and Convexity factors
7 Slope and Curvature of the Term Structure
8 Principal Component Analysis
Felix Matthys Fixed Income ITAM 2 / 223

Term Structure of Interest rates over Time
Term Structure of Interest Rates over Time
10
3M
1Y
8 5Y
10Y
6
0
1990 2000 2010
Figure 1: Panel A: Yield Curve evolution over time. Source: Federal Reserve Board. Panel B:
Mexican inter-bank rate from March 1996 until February 2016 (Banco de Mexico).

Two key observations
• Interest rates vary substantially over time (see Panel A)
• High co-movement between yields across maturities
1Y 2Y 3Y 5Y 7Y 10Y
1Y 1 0.993 0.982 0.952 0.927 0.896
2Y 1 0.997 0.979 0.961 0.936
3Y 1 0.991 0.979 0.958
5Y 1 0.997 0.987
7Y 1 0.996
10Y 1.000
Table 1: Yield Correlation Matrix

Level of Interest Rates
Term Structure of Interest Rates
9 Average TB yields
8
1990 1995 2000 2005 2010
Figure 2: Average Yield Curve evolution over time. Source: Federal Reserve Board.
Definition: Level of Interest Rates

The level of interest rates is the average yield across maturity Ti , i = 1, 2, . . . , n, in other
words
n
1X
r¯(t) = r (t, Ti ) (1)
n i=1

Bond Price Sensitivity
Recall the pricing formula for a coupon bond using continuous compounding is
m
!
cX
Pc (t, T ) = N Z (t, Ti ) + Z (t, T )
n i=1
m
!
c X −r (t,Ti )(Ti −t) −r (t,T )(T −t)
=N e +e
n i=1
where m = ⌊(T − t) × n⌋ is the total number of coupon payments over the lifetime of
the bond.
There are three factors that affect the bond price above, of which two are fixed, namely
the coupon rate c and the maturity T .
rtT
• The level of interest rates ( , )
Bond prices and yields move in opposite directions.
▶ As the term structure increases, its price decreases, r (t, T ) ↑ → Pc (t, T ) ↓
and vice versa.
▶ In other words, there is an inverse relationship between movements in rates
and bond prices
∆Pc (t, T )
<0
∆r (t, T )
A parallel shift in the Term Structure
Figure 3: Left Panel: Parallel shift in the yield curve from r (t, T ) to r (t, T ) + ∆r . Right
Panel: Discounted coupons when yield curve shifts from r (t, T ) to r (t, T ) + ∆r (without
principal repayment at maturity.)
• An increase of 2.5% in yields leads the bond price decline from $ 73.6349 to $
59.6919, which is a decrease of -18.935%.

Bond Price and Yield to Maturity
An easier way to study the relationship between bond prices and interest rates is to use
the yield to maturity. Recall that the continuously compounded yield to maturity solves
m
!
c X −y (Ti −t) −y (T −t)
Pc (t, T ) = N e +e
n i=1
Consider the following bond: Coupon rate is 5%, paid quarterly with maturity 10 years.
Key observation: Bond price is decreasing in yield to maturity!

Changing the Coupon Rate and Maturity
How does the bond price change in the level of interest rates if,
1 we change the coupon rate ? c
▶ From the bond pricing equation above it is clear that ∂Pc∂c
(t,T )
> 0, i.e. no
matter what the interest rate level is, a bond with higher coupons will always
trade at a higher price.
▶ However, suppose we are given two bond one with a relatively low coupon
rate cl and one with a relatively high coupon rate ch . Now, which bond is
exposed to higher interest rate risk, meaning given a change in the term
structure, which bond will change more in percentage terms? The low- or
the high coupon bond?
▶ For this comparison we use the continuously compounded yield to maturity
denoted by yc .
2 we change the maturity T of the bond?
▶ We are interested how two bonds with the same characteristics except for
time to maturity react to changes in the level of interest rates.
Further details on how coupon rate and maturity affect bond prices

Further Factors affecting the Bond Price
The primary risk factor studied above is the change in level of interest rates. However,
there are a number of other factors (from which we have abstracted so far) that affect a
bonds price
1 Reinvestment Risk: At which interest rate can the obtained cash flows be
reinvested? Depends on the future, prevailing interest rate level.
• Reinvestment risk is larger, the longer the investment period
• It is also greater for securities that pay large, early cash flows (High coupon
bonds)
• Note: Interest rate risk and reinvestment risk move in opposite directions
2 Credit Risk: The risk of default or downgrading the creditworthiness of the bond
issuer
• Default risk refers to the risk that the issuer will not pay back (either in part
or full) his/her debt
• Downgrade risk is associated with a deterioration in the credit quality
which then lead to the market requiring a higher spread due to a perceived
increase in the risk (higher credit spread).

Further Factors affecting the Bond Price cont.
3 Inflation or Purchasing Power Risk: Since most bonds are nominal, an increase
in price level may deteriorate the purchasing power of cash flows received from the
bond investment.
4 Liquidity Risk: A market is liquid if a security can be sold/bought with low

transaction cost and execution time.
▶ In a liquid market, there are many sellers and buyers competing to offer the
best quotes
▶ Key indicator for liquidity: Bid-Ask Spread. Low/High Bid-Ask spreads
indicates that the market is liquid/iliquid.
5 Legal or Political Risk: Refers to unexpected changes in regulations and taxation
of trading securities.
• A typical example is: Change in tax law of that imposes withholding or other
additional taxes on a bond investment. a bond.

Duration: A measure of bond price sensitivity
Since in general, the coupon rate and the maturity of a bond is fixed, the main risk
factor for bond pricing is changes in the level of interest rates.
• Furthermore, since price sensitivity tends to increase with time to maturity,
making long-term bonds more susceptible to changes in interest rate levels.
• A key measure for bond price sensitivity that is widely used by traders is Duration.
Definition: Duration
The duration of a security is defined as the sensitivity of the security’s price to small,
uniform changes in the yield curve (typically 1 Basis point = 0.01%).
• Thus, the duration tells us by how many percentage points the bonds price is
going to change in response to a X % change in interest rates.
• In other words, bonds with higher durations carry more risk and have higher price
volatility than bonds with lower durations.

Duration cont.
• Let’s define duration of an asset as its sensitivity to small, uniform changes in the
continuously compounded yield r (t, T ).
• That is, the change in the security’s price when we change the function r (t, T )
from r0 (t, T ) to r1 (t, T ) = r0 (t, T ) + dr where dr is small number (say, one basis
1%
point = 100 ).
General Definition Duration

The duration of a security with price P by
1 ∂P(t, T )
DP = − (2)
P(t, T ) ∂r (t, T )
Using this Equation, we can duration measures the impact of a uniform change in
interest rates on a security with price P

∂P dP −1 ∂P
dP = dr ↔ =− dr = −DP × dr (3)
∂r P P ∂r
Thus, the percentage change in portfolio value is given by the negative of the portfolio
duration times the change of interest rates.

Duration of a Zero Coupon Bond
• Example: consider a zero coupon bond with time to maturity T and price
Z (t, T ). By applying the definition we have:
1 ∂Z (t, T )
Dz (t, T ) = −
Z (t, T ) ∂r
1 h i
=− × −(T − t) × e −r (t,T )×(T −t)
Z (t, T )
1
=− × [−(T − t) × Z (t, T )]
Z (t, T )
=T −t
where Dz (t, T ) denotes the duration of a zero coupon bond with time to maturity
T − t.
Remark: Duration of a Zero Coupon Bond

The duration of a zero coupon bond is simply equal to its time to maturity T − t.

Duration of a Zero Coupon Bond cont.
100
90
80
70
Zero Coupon Bond Pz(r,t;T)
60 Accurate Approximation
50
40
30
20
10
Non Accurate Approximation
0
0 5 10 15
Interest Rate r (%)
Figure 4: Price of a 20-year Zero Coupon Bond against r , and its first derivative
Duration of a Zero Coupon Bond cont.
Figure 5: Price of a 20-year Zero Coupon Bond against r . First order Taylor approximation at
r1,0 = 2.5% and r2,0 = 10%

• We will now show that the duration of a portfolio with N securities each with price
Pi (t, T ) = Pi , i = 1, . . . , N, is simply the weighted sum (where the weights are
the relative holdings) of durations of all the securities.
• Let’s start with the simple two security case.
• Suppose we have ϕ1 units of security 1 and ϕ2 of security 2. Let P1 and P2 be
the prices of the two securities and D1 and D2 their durations, respectively.
• Let W be the value of the portfolio
W = ϕ1 × P1 + ϕ2 × P2

• We can then compute:

1 dW 1 ∂P1 ∂P2
DW = − = −ϕ1 × − ϕ2 ×
W dr W ∂r ∂r

1 (−1) ∂P1 (−1) ∂P2
= ϕ1 × P 1 × + ϕ2 × P 2 ×
W P1 ∂r P2 ∂r
= w1 × D1 + w2 × D2
where
ϕi × Pi
wi = , i = 1, 2 (4)
W
is the fraction of wealth invested in bond i.
Duration of a portfolio of N securities

Suppose we have a portfolio with N securities each with price Pi (t, T ) = Pi ,
i = 1, . . . , N, then the duration of the portfolio DW is equal to the weighted sum of
duration of the individual securities, i.e.
N
X
DW = wi × Di
i=1
where wi is given in Equation (4) and asset i’s duration is denoted by Di .

Duration of a Coupon Bond
Formal Definition: Duration
The duration of a coupon bond Dc (t, T ) is then defined as
m
X
Dc (t, T ) = wi × Dz (t, Ti ) (5)
i=1
where Dz (t, Ti ) = Ti − t is the duration of a zero coupon bond with maturity Ti − t and
wTi , i = 1, . . . , n be the present value contribution of the cash flow at time Ti . Then,
c/n · Pz (t, Ti )
wTi = , i = 1, . . . , m − 1
Pc (t, T )
(1 + c/n) · Pz (t, Ti )
wTn = , i =m
Pc (t, T )
• More specifically, duration is a weighted average of individual maturities of all the

bond’s separate cash flows.
• Thus, the weight is the present value of the payment divided by the current time t
bond price.

Figure 6: Duration: Present Value of Cash Flows of 6% Coupon bond with Maturity T = 10.
Remark: Duration of a bond as the center of gravity of the present value of its cash
flows.

Duration: Some more Intuition
Duration: An intuitive explanation

• Duration tells us how long it takes for the price of a bond to be repaid by its own
cash flows.
• Therefore, investors prefer bonds with relatively low duration because this implies
that they get their money back earlier.
Some remarks:
• Looking at Figure 6 above, this does NOT imply that the sum of discounted cash
flows to the left of the duration arrow (smaller than 7.058 years) is equal to the
sum of cash flows received (including the repayment of the face at maturity) after
the duration date.
• To get the balance right (center of gravity in Figure 6) we need to weight each
discounted cash flow by its (time) ’distance’ to duration.
Further details on the interpretation of duration

Duration Comparison
From the above analysis we can deduce the following fact,
Comparing Duration: Zero vs. Coupon Bond

Dc (t, T ) < Dz (t, T ) = T − t,
• Intuitively, it’s clear why the duration of a coupon bond is always shorter than the
duration of a zero coupon bond. In the former case the investor gets intermediate
cash flows and therefore has to wait a shorter period of time to get back his/her
invested money, whereas in the latter case the investor has to wait until maturity
to get any payment.

Proof of Duration formula for Coupon Bond
Exercise (Duration Formula for a coupon bond)

• Proof the duration formula in Equation (5).
Hint: Use the following equation
Pz (t, Ti ) = N × Z (t, Ti ) = N × e −r (Ti −t) , i = 1, . . . , n (6)
where Pz (t, Ti ) denotes the current time t price of a zero coupon bond with
maturity Ti and continuously compounded interest rate r .
• Deduce that
dPc (t, T )
= −Dc (t, T )dr (7)
Pc (t, T )
and interpret this formula.
• Suppose we hold a portfolio of 10-year at-par coupon bonds worth $ 100 Mio. (1
Mio. ×N) with duration equal to 5. By how much will the value of this portfolio
decline if the yield increases by one basis point (dr = 0.01%)?

Solution: Proof of Duration formula for Coupon Bond
Solution
• Recall the pricing formula for a coupon bond
m
! m
cX cX
Pc (t, T ) = N Z (t, Ti ) + Z (t, Tn ) = Pz (t, Ti ) + Pz (t, Tn ) (8)
n i=1 n i=1
Then taking the first derivative with respect to r (t, Ti ), i = 1, . . . , n of the coupon
bond price in Equation (8) above gives
m
!
dPc (t, T ) ∂ cX
= Pz (t, Ti ) + Pz (t, Tn )
dr ∂r n i=1
m
cX
=− Pz (t, Ti )(Ti − t) − Pz (t, Tn )(T − t) (9)
n i=1
from which we obtain Pm

−1 ∂Pc (t, T ) i=1 c/n × Pz (t, Ti ) + Pz (t, T ) × (Ti − t)
Dc (t, T ) = =
Pc (t, T ) ∂r (t, Ti ) Pc (t, T )
m
X Xm
= wi × (Ti − t) = wi × Dz (t, Ti )
i=1 i=1
Solution
• From the definition of duration for any asset with price P, we have that
DP = − P1 ∂P
∂r
. Therefore,

∂P dP −1 ∂P
dP = dr ↔ =− dr (10)
∂r P P ∂r
| {z }
:=DP
Then, from Equation (9) we immediately obtain

Pm
dPc (t, T ) i=1 c(Ti )/n × Pz (t, Ti ) + Pz (t, T ) × (Ti − t)
=− dr
Pc (t, T ) Pc (t, T )
X n X m
=− wi × (Ti − t)dr = − wi × Dz (t, Ti )dr = −Dc (t, T )dr
i=1 i=1
Thus, the duration gives the percentage change in bond price for a given increase
in interest rates r , provided the change in interest rates is very small.

Solution
• We know that a one-basis point increase in the yield (dr = 0.01%) is going to
change the value of the bond approximately by
dPc = −D × dr /100 × N × 1′ 000′ 000

= −5 × 0.01/100 × 100 × 1′ 000′ 000 = −50, 000.
Thus the bond portfolio will loose about $ 50’000.

Duration and Bond Price: An Important Formula
Using the duration result derived in Equation (5) we can deduce a very simple formula
which relates the change in bond price dP to the change in interest rate dr
Bond Price Sensitivity and Duration

The change in bond price dPc (t, T ) is given by
dPc (t, T ) = PcN (t, T ) − PcO (t, T ) = −Dc (t, T ) × PcO (t, T ) × dr (11)
where PzO (t, T ) and PzN (t, T ) denotes the old (before the interest rate change) and new
bond price, respectively.
• Note that the same formula holds for zero coupon bonds, i.e.
dPz (t, T ) = PzN (t, T ) − PzO (t, T ) = −Dz (t, T ) × PzO (t, T ) × dr
where Dz (T − t) = (T − t)

Dollar Duration
Closely related to the bond price change formula in Equation (11) is the concept of
Dollar duration which, for any asset with price P, is defined as
Dollar Duration D $
dP = −D $ × dr , DP$ = DP × P (12)
Some remarks:
• Instead of giving us the percentage change of our portfolio, i.e. dPP
when interest
rates change, the Dollar duration gives us the absolute change i.e. dP in wealth
given a change in interest rates.
• The definition of duration in Equation (2) implicitly assumes that the portfolio of
securities P is nonzero. However, for many trading strategies the securities may
have value equal to zero.
• Furthermore, the dollar duration of a portfolio of N securities is the weighted
average of the dollar duration of the individual securities, i.e.
N
X
$
DW = wi$ × Di$
i=1
where wi$ is the number of units in security i and Di$ is it’s corresponding dollar
duration.
Duration of a Floating Rate Note
How price sensitive is a floating rate bond?

• Consider the floating rate bond with reset dates Ti , i = 1, . . . , n and suppose that
we are in between two reset dates, i.e. Ti < t < Ti+1
• Maturity of the floating rate bond is T and coupons are payed semi-annually
• The price of the floating rate bond at time t is

r2 (Ti , Ti+1 )
FRB(t, T ) = Z (t, Ti+1 ) × N × 1 + (13)
2
where r2 (Ti , Ti+1 ) is the reference rate that is determined at the last reset date.

Duration of a Floating Rate Note cont.
Assuming that Ti < t < Ti+1 :

• The duration of the floating rate bond DFRB (t, T ) is given by
1 ∂(FRB(t, T ))
DFRB (t, T ) = −
FRB(t, T ) ∂r

1 dZ (t, Ti+1 ) r2 (Ti , Ti+1 )
=− ×N × 1+
FRB(t, T ) dr 2

1 r2 (Ti , Ti+1 )
=− [−(Ti+1 − t)Z (t, Ti+1 )] × N × 1 +
FRB(t, T ) 2
= Ti+1 − t
• Duration of the floating rate bond is simply the time until the next coupon
payment Ti+1 − t.
• Important observation: Even if the maturity date of the floating rate bond is
relatively long, for instance T = 10 years, its duration could be very small since it
is maximally Ti+1 − t which depends on the frequency of coupon payments.

Properties of Duration
The duration of a coupon bond crucially depends on the level of coupon payments. In
fact,
• As the coupon rate c increases, the duration decreases!
• Not obvious to see that because both the weights wi , i = 1, . . . , n − 1, wn as well
as the price of the bond Pc (t, T ) depend on c.
• Intuitively, when the coupon rate increases, the weights will be tilted towards the
earlier payment dates, and the center of gravity will move closer to the current
date t (see Figure 6).
• Two intuitive explanations:
• Lower average time of cash flow payments. A higher coupon rate implies
that a larger fraction of payments will be received earlier with respect to
maturity (where the last and largest payment of the face value is due).
Therefore, the average time of coupon payments gets closer to today.
• Lower sensitivity to interest rates. The higher the coupon rate, the larger the
fraction of coupons received in the near future making them less sensitive to
interest rate changes as the discount factor is lower compared to the
discount factor of coupon payments in the far future.

Sensitivity of Duration: Numerical Illustration
Coupon c Price Pc Duration Interest Rate r2 Price Pc Duration
0 61.03 10 1% 147.47 8.13
2% 76.62 8.85 3% 125.75 7.95
4% 92.21 8.26 5% 107.79 7.76
6% 107.79 7.76 7% 92.89 7.56
8% 123.38 7.39 9% 80.49 7.35
10% 138.97 7.11 11% 70.12 7.12
12% 154.56 6.88 13% 61.44 6.9
Table 2: 6% coupon bond (semi-annual) with maturity T = 10 years.

Traditional Definitions of Duration
Recall the pricing formula for a bond that pays a coupon rate c semi-annually with yield
to maturity y
m
X c/n N
Pc (t, T ) = N× +
y n×(Ti −t) y n×(Tm −t)

i=1 1+ n
1+ n
• Macaulay Duration:
• The Macaulay duration is defined as
(1 + y /n) ∂P
DMc (t, T ) = −
P ∂y
• Some algebra shows
m
X
DMc (t, T ) = wj × (Tj − t)
j=1
where ! !
1 N × c/n 1 N × (1 + c/n)
wTj = , wm = m (14)
1 + yn
j
Pc 1 + yn Pc

Traditional Definitions of Duration cont.
• Modified Duration:
• The modified duration DMD (t, T ) is instead defined as
1 ∂Pc (t, T )
DMD (t, T ) = −
Pc (t, T ) ∂y
• It is easy to see that
DMc (t, T )
DMD (t, T ) =
1 + yn

Remarks:
• Since fluctuating interest rates will affect duration, modified duration shows how
much the duration changes for each percentage change in yield.

Comparing Macaulay and Modified Duration
Although the Macaulay and the modified duration both measure the price sensitivity of
a bond with respect to changes in YTM, there are some important differences that need
to be discussed.
• Whereas the Macaulay duration is expressed in years, the modified duration is

expressed as a percentage (because of the scaling by 1+1 y )
n
• If y > 0, then we always have DMD (t, T ) < DMc (t, T )

• When interest rates increase (decrease), the modified duration yields a more (less)
accurate approximation of the change in the bond price due to a change in interest
rates as the slope of the modified duration lower (higher)
→ This implies that the modified duration better accounts for the inherent convex
relationship between bond prices and interest rates, when interest rates increase.
→ Note that since we are more concerned with rising interest rates (bond price
loosing in value) than falling (bond price increases), modified duration is preferred
over Macaulay duration as, this measure gives a more accurate approximation.

Comparing Macaulay and Modified Duration cont.
Figure 7: Price of 20 year zero coupon bond with Macaulay and Modified Duration at
r0 = 7.5%.
How Good is the Approximation?
Suppose we are given a zero coupon bond with time to maturity T − t = 5 years and we
want to compare the estimated change in the bond price dP for a given percentage
change in yields dr
• Let’s assume that the current interest rate is r = 1.5% and they are assumed to
rise by dr = 0.5%, i.e. 50 basis points.
• The zero bond prices before and after the increase in interest rates are
PzC (t, T ) = 93.01 and PzN (t, T ) = 90.71.
• Now, the new bond price can be approximated by
dPz (t, T ) = PzN (t, T ) − PzO (t, T ) = −Di (t, T ) × PzO (t, T ) × dr
PzN (t, T ) = PzO (t, T ) − Di (t, T ) × PzO (t, T ) × dr , i ∈ {Mc, Mod}
• The estimated price using the Macaulay and Modified duration is
PzN,Mc (t, T ) = 90.6814, PzN,Mod (t, T ) = 90.7158
• The exact new price is PzN (t, T ) = 90.71, which shows that the error using the
Modified duration is only -0.01 as opposed to 0.03 (Macaulay duration).

Macaulay Duration and YTM
• Using YTM, can we say more about the direction of how changes in y will affect
the duration Dc (t, T ) of a coupon bearing bond?
• In fact, we can proof that duration falls in YTM:
Relationship between duration and yield to maturity

The change in the modified duration DMD (t, T ) of a bond with coupon rate c and
maturity T due to a change in the n times compounded yield to maturity y is
dDMD (t, T ) S
=− (15)
1 + yn

dy
where S is given by
m
X
S := wi ((Ti − t) − DMc )2
i=1
Details of Derivation

Macaulay Duration and Maturity
• Next we want to analyze how (modified) duration changes as we increase maturity

of the bond considered.
• Suppose we have a fixed rate coupon bond with rate c and YTM y at
compounding frequency n.
• From the coupon bond pricing equation
n×T
N X c/n
Pc (t, T ) = n×T
+ (16)
[1 + y /n] i=1
[1 + y /n]i
we now look at the case when T → ∞.

• Obviously, if the maturity of the bond tends to infinity, the first term in Equation
(16) disappears.
• Now the questions is, does duration also tend to infinity when maturity goes to
infinity or does it converge?

Duration and Maturity
100
0% bond
1% bond
5% bond
50 10% bond
0
0 50 100
Maturity T
Figure 8: Duration: Data based on semi-annually paid cash flows.
Remark: Duration of coupon paying bonds is always lower than the corresponding zero
coupon bond duration.
Duration and Maturity: Passing to the limit T → ∞
Large Maturity T asymptotic for Macaulay Duration

1 1
lim DMc (t, T ) = +
T →∞ n y
Some remarks
• Duration does not diverge when maturity T tends to infinity.
• Duration is still decreasing in YTM y .
• Duration is independent of the coupon rate c
• Coupon payment/compounding frequency n also reduces duration
Details of Derivation

Some Remarks on YTM and Duration
• We may use, instead of the semi-annually compounded YTM, the continuously

compounded spot curve.
• The reason is because of the issues associated with yield to maturity such as
• It is bond specific, i.e. it depends on the coupon rate.
• For some fixed income securities, the notion of YTM is not well defined (for
instance floating rate bonds, or bonds with embedded options such as
convertible bonds)
• Some formulas are analytically more tractable when using the continuously
compounded spot curve as opposed to YTM.

Exercise (Duration)
Based on the semi-annually compounded yield curve (next slide), compute the duration
of following securities
(a) 3-year zero coupon bond

(b) 3 1/4-year coupon bond paying 6 % semiannually
(c) 1-year coupon bond paying 4% quarterly
(d) 6-year floating rate bond with zero spread, paying semiannually
(e) 3-year floating rate bond with a 35 basis point spread and semi-annual payments
Hint: Use the following formula

m
X
Dc (t, T ) = wi Dz (t, Ti )
i=1
where the weights are given by

c(Ti )/n · Pz (t, Ti )
wTi = , i = 1, . . . , m − 1
Pc (t, T )
(1 + c(Ti )/n) · Pz (t, Ti )
wTn = , i =m
Pc (t, T )
Exercise (Modified & Macaulay Duration and Dollar Duration)
Questions:
(1) For the 5 securities in exercise Duration from above, compute the Macaulay and
modified duration
(2) Compute the dollar duration for the following securities
(a) Long a 5-year coupon bond paying 4% semiannually
(b) Short a 7-year zero coupon bond
(c) Long a 3,5 year coupon bond paying 7% quarterly
(d) Long a 2 year zero spread floating rate bond paid semiannually

Maturity Yield Maturity Yield Maturity Yield
0.25 6.33% 2.75 6.86% 5.25 6.39%
0.5 6.49% 3 6.83% 5.5 6.31%
0.75 6.62% 3.25 6.80% 5.75 6.24%
1 6.71% 3.5 6.76% 6 6.15%
1.25 6.79% 3.75 6.72% 6.25 6.05%
1.5 6.84% 4 6.67% 6.5 5.94%
1.75 6.87% 4.25 6.62% 6.75 5.81%
2 6.88% 4.5 6.57% 7 5.67%
2.25 6.89% 4.75 6.51% 7.25 5.50%
2.5 6.88% 5 6.45% 7.5 5.31%
Table 3: Yield Curve on March 15, 2000 calculated from CRSP data (Daily Treasuries).

Solution (Duration Exercise)
(a) 3, equal to the maturity of the zero bond
(b) 2.9542
(c) 0.9850
(d) 0.5 (half a year). Just the time until the next coupon payment is due
(e) 0.5111, Note: first we have to obtain the price of a floating rate bond, then in
analogy to a coupon bond we have
s
P3
N Z (0, t) × t
DFRB = 0.5 × + 2 t=0.5 (17)
FRB FRB

Modified and Macaulay Duration
Solution (Modified and Macaulay Duration)
Yield Duration Macaulay Modified
a. 6.95% 3 3 2.8993
b. 6.28% 2.9542 2.9974 2.9061
c. 6.66% 0.9850 0.9850 0.9689
d. 0.00% 0.5 0.5 0.5
e. 6.82% 0.5111 0.5111 0.4943

Solution (Dollar Duration)
Price Duration $ Duration
a. $89.56 4.55 $407.88
b. $67.63 -7.00 ($473.39)
c. $79.46 3.50 $277.74
d. $100.00 0.5 $50.00

Value at Risk (VaR)
• The Value at Risk (abbr. VaR) is a quantitative risk measure, which tries to
assesses the risk in a given portfolio.
• It is widely used by both financial corporations (banks, insurances, hedge funds,
etc.) and regulators to quantify possible losses over a given time period and
probability α.
• More specifically, the VaR at a given probability α, where α is typically large, i.e.
α = 0.95, 0.99, tries to answer the following question:
▶ With α = 95% probability, what is the maximum loss over a given time
period n (a day, week, month, etc)?

• Example: If we have a 100 Mio. stock portfolio and the 95% VaR over half a year
is 5 Mio., then we would expect, under normal market conditions, that with
probability α = 95%, the losses will not exceed $ 5 Mio over the next six months.
• Or reformulated: In 5% of the cases we would expect, that the losses to exceed
the VaR threshold

Definition (Formal): Value-at-Risk (VaR)
• Given a random (loss) variable −LT = (PT − P0 ),a with T ≥ 0 and a scalar
α ∈ (0, 1).
• Consider some portfolio of risky assets and a fixed time horizon T , and denote by
FL (l; T ) = P(LT ≤ l) the cumulative distribution function of the losses LT .
• Then, the VaR at a confidence level α with horizon T is defined as
VaRα (LT ) ≡ inf {l ∈ R : P(LT ≤ l) ≤ α}

= inf{l ∈ R : FL (l; T ) ≥ 1 − α},
where α is usually 95% or 99%.

• Thus, VaRα (LT ) defines a quantity such that
P (LT ≥ VaRα (LT )) = 1 − α (18)

Interpretation:
• Equation (18) states, that the probability of a portfolio loss being larger (losses
are positive in this case) than VaRα (LT ), is equal to 1 − α, which is very large as
α = 95%, or 99%.
• If α = 95% for a given time period, we expect that 95 out of 100 times, that the
losses are smaller than the VaR.
a
The negative sign is due to the convention of reporting VaR as a positive number.
Interpretation continued
Note that the previous definition of VaR is concerned with the ’normal’ losses, i.e. the
losses not far out in the tails of the distribution. We can rewrite Equation (18) as follows
P (LT ≥ VaRα (LT )) = 1 − α (19)

FL (VaRα (LT )) = α (20)
where we take α to be high, i.e. α = 0.95, 0.99. Interpretation:

• Conversely, Equation (19) states, that the probability of a portfolio loss being
smaller than VaRα (LT ), is very low.
• If α = 95% for a given time period, we expect that 5 out of 100 times, the losses
are bigger (more negative) than the VaR.
• In other words, this formulation of VaR is concerned with the ’extreme’ negative
events.
• Lastly, in probabilistic terms, the VaR is just a quantile of a loss distribution (see
Equation (20) above).

VaR: Quantile of a Distribution Function
Figure 9: VaR: A quantile for a given confidence level α.

Value at Risk and Expected Shortfall
Expected Value−at−risk
Shortfall
frequency
−6 −4 −2 0 2 4
return

Duration and Value at Risk
VaR when changes in interest rates are normally distributed

The change in a bond portfolio P can be expressed as
dP = −DP × P × dr
where DP denotes the duration of the bond portfolio and dr is the change in interest
rates. Since LT = −dP, if dr is normally distributed, i.e.
dr ∼ N (µr , σr2 ) → L ∼ N (µL , σL2 )
we obtain that µL = DP × P × µr and σL = DP × P × σr . Then the Value at Risk at

confidence level α is
VaRα (LT ) = σL × zα + µL
where zα denotes the α percentile of the standard normal distribution, i.e.
zα = Φ−1 (α).
Remark:
: For α ∈ (0.5, 1) it follows that zα > 0

Proof of VaR formula under Normality
Exercise (VaR for normally distributed returns)

Show that
VaRα (LT ) = σL × zα + µL (21)
−1
where zα = Φ (α).
• Hint 1 : Start with Equation (18).

• Hint 2 : Standardize the random variable LT .
• We define as ϕ(·) and Φ(x), the standard normal density and cumulative
distribution function, respectively. More formally, they are given by
Z x
1 x2
ϕ(x) = √ e − 2 , Φ(x) = ϕ(u)du
2π −∞

Solution
Since the changes in interest rates dr are normally distributed the corresponding
(standard) normal cumulative distribution function Φ is a strictly monotone continuously
increasing function in x (inverse exists) and therefore the inf is attained. Hence, we can
start with Equation 18 to get
P (LT ≥ VaRα (LT )) = 1 − α

P (LT ≤ VaRα (LT )) = α

LT − µ L VaRα (LT ) − µL
P ≤ =α
σL σL

VaRα (LT ) − µL
Φ =α
σL
VaRα (LT ) = σL Φ−1 (α) + µL
with µL = DP × P × µr and σL = DP × P × σr and zα = Φ−1 (α) > 0 because

∀ α ∈ (0.5, 1).

Interest Rate Risk and VaR
Figure 10: Daily changes in USD LIBOR from Jan 1986 to Sep 2019 (Left Panel).
Daily changes in MXN LIBOR from Apr 1996 to May 2018 (Right Panel).

Figure 11: Histrogram of daily changes in USD LIBOR from Jan 1986 to Jan 2016
(Left Panel). Histrogram of daily changes in MXN LIBOR from Apr 1996 to Jan 2010
(Right Panel).
VaR of a Bond Portfolio: An Example
• Consider a portfolio manager who has invested into a $ 100 Mio. bond portfolio
whose estimated duration is DP = 5.
• Then the bond portfolio sensitivity can be approximated as
dP = −DP × P × dr (22)
where dr are the daily changes in the LIBOR rate (USD or MXN).
• We define the losses by LT = −dP = − (PT − Pt ).
We want to compute the 1-day value at risk with confidence level α = 95%. Let’s
consider two very popular approaches.
• Historical (Empirical) Distribution Approach. This method is non-parametric,
i.e. does not postulate any model or distributional assumptions. Relies on past
data only.
• Normal Distribution Approach. This method is parametric and it relies on
distributional assumptions. Furthermore, parameters of the distribution of interest
rate changes need to be estimated.

How to compute empirical VaR?
1 Historical distribution Approach

• Main idea: Use past changes in interest rate levels dr to evaluate potential
changes in the bond portfolio dP using Equation (22).
• Multiply each daily change in interest rate dr with −DP × P to get an
empirical distribution of changes in the bond portfolio value dP (profit and
loss). In other words,
dPi = −DP × P × dri , i = 1, . . . , n (23)
and P = 100 Mio. in either USD or MXN.

• first sorting the portfolio profits from highest losses to highest gains, and
then count from the left of the distribution until we count 95% of the total
number of observations. This will give us the daily VaR at 95% confidence
level.

How to compute empirical VaR?
• More formally, using Equation (23) we have
▶ Let the loss be denoted by Li = −dPi . Then, the order values of the losses
are such that L1 ≤ L2 ≤ . . . ≤ Ln
▶ Our estimator for the VaR based on the empirical quantiles of the
distribution is simply1
VaR
d α (LT ) = L[n(1−α)] (24)
where [n(1 − α)] denotes the largest integer not exceeding n(1 − α).
▶ Example: if n = 1′ 000 and α = 0.99, we would estimate the VaR by taking
the 10th largest loss observation.
• How do these numbers look like for our two portfolios?
▶ For the USD bond portfolio case, we get VaRUSD
α (LT ) = $6, 29 Mio.
▶ MXN Bond portfolio: VaRMXN

α (LT ) = $9, 84 Mio.
▶ Interpretation: With 5% probability (confidence), we expect the portfolio loss
to be equal or larger than $6, 29 Mio. USD.
1
Recall that the VaR is usually reported as a positive number, see Equation (18)
Figure 12: Histrogram of daily changes in Bond Portfolio (USD, reft Panel).
Histrogram of daily changes in in Bond Portfolio (MXN, right Panel).

How to compute the parameteric VaR?
2 Normal distribution Approach
▶ Main idea: Use the normal distribution to model changes in interest rates dr .
▶ Since the change in the bond portfolio dP in Equation (22) is a linear

function of dr , implies that also dP and therefore the losses LT are normally
distributed, i.e.
LT ∼ N (c cL 2 )
µL , σ
Pn 2 Pn
where µ 1
cL = n i=1 LT ,i and σ 1
cL = n−1 i=1 (LT ,i − µ cL )2 are the empirical
sample mean and variance of the changes in the interest rate r .
▶ Thus we denote by Lc T the estimated loss of the bond portfolio.
▶ In this case, using the USD (MXN) LIBOR date we obtain
µ[USD
L = −0.14 × 106 = −142′ 999, µ[MXN
L = −0.19 × 106 = −189′ 739,
√ √
σ[
USD
L = 24.81 × 106 = 4′ 980′ 556, σ[
MXN
L = 54.33 × 106 = 7′ 370′ 845
▶ The estimated VaR at confidence level α = 95% can be computed as
d iα (LT ) = σ
VaR ci × lα + µ
ci , i = {USD, MXN}
L L
d USD
VaR α (LT ) = 8.05 Mio. USD,
d MXN
VaR α (LT ) = 11.93 Mio. MXN
Historical vs. Normal Distribution VaR
The computed bond portfolio VaR differ quite a lot depending which method we are
using to compute it.
• Based on USD LIBOR
d USD
1 Hist. Dist. VaR d USD
α,HD (LT ) = 6.29$ vs. Normal Dist. VaRα,ND (LT ) = 8.05$
2 Corresponds to almost 28% difference!

• Likewise for the VaR computed from the Mexican LIBOR we have,
1 d MXN
Hist. Dist. VaR d MXN
α,HD (LT ) = 9.84$ vs. Normal Dist. VaRα,ND (LT ) = 11.93$
2 Corresponds to 21% difference!

• Question: Why is this the difference so large?
1 The VaR computed using the normal distribution approach is a parametric
method which assumes that changes in interest rates are normally
distributed.
2 The empirical distribution of dr (which is the basis upon the hist. dist. VaR
is computed) is clearly NOT normally distributed.

Historical vs. Normal Distribution VaR: Under Normality
Consider the following setting

iid
• Assume dr ∼ N (0, 1), i.e. changes in interest rates are normally distributed.
• For a finite sample size n, then the bond portfolio changes are approximately
dP ∼ N (µP , σP2 ), with dP = −DP × P × dr
Then the losses LT = −dPT are normally distributed as well with

µL = DP × P × µr = 0 and σL = DP × P × σr = DP × P.
• Under these assumptions, the normality approximation of the data LT should yield
fairly accurate results.
• Lets consider the empirical distribution of LT and plot it against the standard
normal density.

VaR and Duration under Normality
iid
Figure 13: Histrogram of changes in Bond Portfolio dP when dr ∼ N (0, 1).
Key Observation:
• Standard Gaussian approximation mimics empirical shape of data very well.
Historical vs. Normal Distribution VaR: Under Normality
Now computing both the historical and normal distribution VaR at confidence level
α = 95% we obtain
• Hist. Dist. VaR
d α,Sim (LT ) = 8.31$ vs.
• Normal Dist. VaR

d α,Sim (LT ) = 8.26$
• Corresponds to a difference of only 0.6%.
What we learn from this
• When using a parametric (normal distribution assumption) approach for
computing VaR, we have to first carefully evaluate whether the data can be
accurately described by the chosen distribution.

VaR and Duration: Some Warnings
There are some problems with using (jointly) the Value at Risk and duration as a risk
measure.
• VaR is a statistical risk measure and thus depends on distributional assumptions
and the sample (time span) used for calculations.
• Another problem is estimation error when estimating the parameters of the
distribution which are used for modeling the changes in interest rate.
• The VaR is a percentile, and thus only gives a threshold value for the losses. For
example, if the VaR is 8 Mio., implies that with probability α we do not lose more
than 8 Mio. However, the VaR does not say anything about the distribution of
losses once we have passed this threshold (the VaR level). It might be the case
that there are extremely rare loses which are potentially very large.

VaR and Duration: Some Warnings cont.
• Using the normal approach produces very poor fits when the empirical
distribution is very heavy tailed, i.e. a lot of data points in either the extreme
left or right of the distribution. This is because the normal distribution assigns
very low probability to extreme events. (See difference in VaR based on historical
distribution and normal approach)
• The VaR formula uses as input the expected change in the bond portfolio, i.e.
µP = DP × P × E[dr ], which is very hard to estimate with high precision from the
data. Therefore, these errors can generate a larger error in the computation of the
VaR. For this reason, it is generally better to consider only the unexpected VaR
(setting µP = 0)
• Lastly, using duration as a measure of interest rate sensitivity is only a good
approximation when there are small and parallel changes in the yield curve.
However, by the very definition of VaR, which is concerned with large changes, this
approximation becomes very inaccurate.

VaR Calculation: Leaving Normality
We saw that, when the data do not follow a normal distribution, the VaR based on the
normal approach may produce very poor VaR estimates. Let’s consider the following
setup
• We assume that interest rate changes are standardized t distributed, i.e. t(ν, 0, 1)
where ν > 0 denotes the degrees of freedom dr . Then
dr ∼ t(ν, 0, 1) → LT ∼ t(ν, µL , σL2 )
where the mean and standard deviation of the losses are given by
r
ν−2
µL = DP × P × µr σL = DP × P × σr , ν>2
ν
• Then the Value at Risk at confidence level α is
VaRα (LT ) = µL + σL × qν,α
where qν,α denotes the α percentile of the standard t distribution.

• For the simulation experiment, where the number of simulations is n = 10′ 000 and
we use ν = 3
• We standardize the losses LT to have mean zero and unit variance.

.4
.3
.2
.1
0
-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6
data t(3)
t(10) normal
iid
Figure 14: Histrogram of standardized LT when dr ∼ t(ν, 0, 1) with ν = 3, 10.
Remarks:
• Data seem to have more extreme observations.
• t(3, 0, 1) density matches data in the tails better than t(10, 0, 1) or N (0, 1).
• Note: limν→∞ t(ν, 0, 1) → N (0, 1)
Leaving Normality: Changes in Bond Portfolio
Now based on the t(ν, 0, 1) simulated interest rate changes, let us compare the VaR at
confidence level α ∈ {95%, 96%, 97%, 98%, 99%} using the
• Historical distribution approach
• Normal distribution approach with mean zero and variance equal to unity
• t - Distribution approach with mean zero and variance equal to unity and degree
of freedom ν equal to three (the true underlying distribution)
The question is: How big is the differences in VaR comparing the three methods?

Remarks:
• VaR based on tν,0,1 significantly larger than the other VaRs for any α.
• Historical distribution VaR, is very close to VaR based on based on tν,0,1 ,
especially for α relatively large
• Note: This result can change considerably, when we change the sample size n is
small.
Convergence of t-VaRα (LT ) to normal VaRα (LT )
Now suppose we repeat this analysis but now assuming that the changes in interest
rates are again normally distributed
Figure 15: Comparison of bond portfolio VaR for α ∈ {95%, 96%, 97%, 98%, 99%}.
i.i.d
Sample size is n = 10′ 000 and dr ∼ N (0, 1).
Convergence of t-VaRα (LT ) to normal VaRα (LT )
Remarks:
• VaR based on tν,0,1 significantly overestimates risk for any significance level.
• Historical distribution VaR, is very close to VaR based on based on N (0, 1),
especially for α relatively large
• Note: When ν ↑ the t-VaRα (LT ) approaches the normal VaRα (LT )
• Convergence is very fast, as for ν = 30 the t-VaRα (LT ) is only slightly above the
normal VaRα (LT ).

Duration and Expected Shortfall (ES)
• One of the most severe problems of the VaR is, that this risk measure does not
indicate how big the losses can become, once we exceed the VaR threshold.
• The expected shortfall (or conditional VaR) precisely overcomes this conceptual
deficiency of the VaR by taking all the losses into account that are further in the
tail of the loss distribution.
• Informally speaking, tries to answer the following question:
▶ Over a given time horizon T , how large are the expected losses of a portfolio
once we exceed the VaR level?
• For highly fat-tailed distributions or when the portfolio contains highly non-linear
derivative securities, the expected shortfall is a more accurate risk metric than the
VaR.

Formal Definition: Expected Shortfall
• Consider some portfolio of risky assets and a fixed time horizon T − t, and denote
by FL (l; T ) = P(LT ≤ l) the cumulative distribution function of the losses.
• Given a random (loss) variable LT = −(PT − Pt ), with T ≥ t ≥ 0 and a scalar
α ∈ (0, 1).
The ES at a confidence level α with horizon τ is defined as
ESα (LT ; τ ) = E [LT |LT ≥ VaRα (LT )] , (25)

Z 1
1
= VaRu (LT )du (26)
1−α α
Interpretation:
• Conversely to the VaR, for a given confidence level α, the expected shortfall
averages over all levels of α ≤ u ≤ 1 and therefore considers all the losses that
exceed the VaR level.
• We can interpret the ES as a conditional expectation, where we only consider
losses that are larger than VaRα (LT )
• It follows immediately that ESα (LT ) ≥ VaRα (LT ), i.e. the ES measure is more
conservative than the VaR measure

Exercise (Proof of Expected Shortfall Formula)
Show the equivalence between the conditional expectation representation of the ES and
VaR in Equation (25)
• Hint 1: Start with E [LT |LT ≥ VaRα (LT )] and using Bayes’ rule we can write this
conditional expectation as
E [LT ∩ {LT ≥ VaRα (LT )}]
E [LT |LT ≥ VaRα (LT )] = (27)
P[LT ≥ VaRα (LT )]
• Hint 2: Use Equation (20).

• Hint 3: Use the substitution FL (l) = u

Solution
Solution (Expected Shortfall Formula)
To simplify the notation, we set VaRα := VaRα (LT ; τ ). Starting with
E [LT ∩ {LT ≥ VaRα }]

E [LT |LT ≥ VaRα ] =
P[LT ≥ VaRα ]
Then, the denumerator is

P[LT ≥ VaRα ] = 1 − P[LT ≤ VaRα ] = 1 − FL FL−1 (α) = 1 − α (28)
and the numerator can be expressed as

h i Z ∞
E [LT ∩ {LT ≥ VaRα }] = E LT × I{L ≥VaRα } = l × fL (l)dl
T
VaR α
where fL (l) is the density of the losses. Now setting u = FL (l) such that du = fL (l)dl
and the integration limits are
l → VaRα , u → FL (VaRα ) = FL (FL−1 (α)) = α

l → ∞, u → 1

Solution cont.
Solution
By Leibniz rule for differentiating integrals, we have for a continuous function f that
Z b(u) ! Z
b(u)
d ∂f
dx + f b(u), u · b ′ (u) − f a(u), u · a′ (u)

f (x, u) dx =
du a(u) a(u) ∂u
Using this formula we have

Z l
∂FL (l) ∂
= fL (u)du = fL (l)
∂l ∂l −∞
Then we can express the integral as follows

Z ∞ Z 1 Z 1
1
l × fL (l)dl = FL−1 (u) ×fL (l) du = VaRu du (29)
VaRα α | {z } fL (l) α
VaRu
which after using Equation (28) immediately gives the result in Equation (26).

Expected Shortfall under Normality
ES when changes in interest rates are normally distributed

As above, we assume that changes in a bond portfolio P can be expressed as
dP = −DP × P × dr
where DP denotes the duration of the bond portfolio and dr is the change in interest
rates. Let LT = −dP denote again the losses, if dr is normally distributed, i.e.
dr ∼ N (µr , σr2 ) → dP ∼ N (µL , σL2 )
where µL = DP × P × µr and σL = DP × P × σr . Then the expected shortfall at

confidence level α is
σL
ESα (LT ) = µL + × ϕ(zα )
1−α
where zα (x) = Φ−1 (α) and ϕ(x) denote the α percentile and density function of the
standard normal distribution, respectively.

Exercise (ES under Normality)
Show the previous formula for the ES, i.e. show that
σL
ESα (LT ) = µL + × ϕ(zα )
1−α
• Hint: Set LT = µL + σL X where X is a standard normal random variable, i.e.

X ∼ N (0, 1)

Solution
By the linearity property of conditional expectation we have
h i h i
E [LT ∩ {LT ≥ VaRα }] = µL × E I{L ≥VaRα } + σL × E X × I{L ≥VaRα } (30)
T T
Now the first term in Equation (30) is equal to
µL × P[LT ≥ VaRα ] = µL × (1 − α)
and the second term can be expressed as

Z ∞
−1
xϕ(x)dx = −ϕ(x)|x→∞VaRα −µL = −ϕ Φ (α)
VaRα −µL x→
σL σL
Therefore, since the conditional expectation can be expressed as

E [LT ∩ {LT ≥ VaRα }]
P[LT ≥ VaRα ]
where the denumerator is
P[LT ≥ VaRα ] = 1 − FL (VaRα ) = 1 − α
the result follows immediately.

How To Estimate Expected Shortfall
Using our bond portfolio from above, we can again estimate the empirical expected
shortfall using the same two approaches
1 Historical distribution Approach
▶ Let the loss be denoted by Li = −dPi . Then, the order values of the losses
are such that L1 ≤ L2 ≤ . . . ≤ Ln
▶ Our estimator for the Expected Shortfall based on the empirical quantiles of
the distribution is simply2
Pn
i=[nα] Li
ESα (LT ) =
c (31)
[n(1 − α)]
where [n(1 − α)] denotes the largest integer not exceeding n(1 − α).
▶ Thus we simply average over the [n(1 − α)] largest losses.
▶ Example: Suppose n = 1′ 000 and α = 0.99, then our estimate for the
expected shortfall would simple be the average over the 10 largest losses.
2
The minus sign in front of the sum is due to the convention that the expected shortfall is reported as a positive number.
See slides on VaR, see Equation (18)
Let’s consider again our bond portfolio in USD and MXN
• In order to compute our estimate for the expected shortfall, we first localize the
[n(1 − α)]th observation.
• With α = 95 and n = 7609 we obtain that [n(1 − α)] = 380
• Therefore, we simply average over all losses that are larger and equal to the 380th
observation.
• We obtain that
c USD
ES α (LT ) = 11.051,
c MXN
ES α (LT ) = 19.83, (32)
which is 75.5% and 101.5% larger than the estimated VaR, which was
d USD
VaR d MXN (LT ) = 9.84, at the same confidence level
α (LT ) = 6.29 and VaRα
α = 5%! Why is this difference so large?
• Recall that the expected shortfall is the average over all losses exceeding the VaR
threshold.
• For the USD (MXN) LIBOR, the largest three losses are 72.99 (91.97) Mio.,
51.73 (74.44) Mio. and 50 (72.02) which are all substantially larger than the
estimated VaR.

2 Normal distribution Approach

▶ Same idea as with the VaR from above. We need to estimate the parameters
of the loss distribution LT .
i.i.d
▶ Since dr ∼ N (µr , σr2 ) we have that the losses are also normally distributed
LT ∼ N (c cL 2 )
µL , σ
cL = n1 ni=1 LT ,i and σ
cL 2 = n−1
Pn
1
cL )2 are the empirical
P
where µ i=1 (LT ,i − µ
sample mean and variance of the losses LT .
▶ As above, we denote by Lc
T the estimated loss of the bond portfolio.
▶ In this case, using the USD (MXN) LIBOR date we obtain
[
µ USD
L = −0.14 × 106 = −142′ 999, µ[
MXN
L = −0.19 × 106 = −189′ 739,
p p
σ[
USD
L = 24.81 × 106 = 4′ 980, σ[
L
MXN
= 54.33 × 106 = 7′ 371

• The estimated ES at confidence level α = 95% can be computed as
ci
σ
c iα (LT ) = µ
ES ci +L
× ϕ (zα ) , i = {USD, MXN}
L
1−α
USD
ES
c α (LT ) = 10.42 Mio. USD, ES c MXN
α (LT ) = 15.39 Mio. MXN
• For the USD, these values are fairly close to the estimated ES using the historical
distribution approach.
• Based on USD LIBOR
c USD
1 Hist. Dist. ES c USD
α,HD (LT ) = 11.05$ vs. Normal Dist. ESα,ND (LT ) = 10.42$
2 Corresponds to a 5.7% difference.

• Likewise for the VaR computed from the Mexican LIBOR we have,
1 c MXN
Hist. Dist. ES c MXN
α,HD (LT ) = 19.83$ vs. Normal Dist. ESα,ND (LT ) = 15.39$
2 Corresponds to 22.4% difference!

• The reason why the difference for the MXN bond portfolio is that large, is because
the normal approximation for dr is clearly wrong. Even more ’wrong’ than for
the USD bond portfolio.
Some Key Take Aways
• Accounting for tail-risk is important:
▶ Since ESα (LT ) can be thought of as an average over all losses that are
greater than or equal to VaRα (LT ), it is sensitive to the size of losses
exceeding VaRα (LT ) threshold.
• Distributional assumptions matter:
▶ It has to be checked whether the selected theoretical distribution matches
the observed empirical one.
▶ Compare estimated ES for the Mexican bond portfolio
• Clearly, the ES does a better job in taking large extreme events into account than
the VaR. However, we could also increase the confidence level α to for instance
99% to get a more conservative estimate for the losses.
• A final remark on bias
▶ It can be shown that
Pn
i=[nα] Li
lim ES
c α (LT ) = lim = ESα (LT )
n→∞ n→∞ [n(1 − α)]
which implies that with larger sample size n, we can the empirical estimator
converges to the theoretical expected shortfall.
Losses over several Periods and Scaling
• So far we have considered one-period loss distributions and associated risk

measures.
• It is often the case that we would like to infer risk measures for the loss
distribution over several periods from a model for single-period losses.
• For example, suppose that we work with a model for daily risk-factor changes
which is set up to allow calculations of a daily VaR and expected shortfall. We
might want to also obtain estimates of VaR and expected shortfall for the
one-week or one-month loss distribution assuming that the portfolio is held
constant throughout that time.
• An obvious approach is to aggregate daily risk-factor change data in order to
obtain risk-factor change data at a lower frequency and to make a one-period
estimation using these data.
• However, this results in a significant reduction in the number of data points
• This is problematic as we are dealing with extreme events which are by their very
nature rare. Therefore, reducing the number of data points may lead to poor
estimates of our risk measures.

Let’s assume we want to compute the loss of our bond portfolio over h periods.
• Suppose the interest rate changes are iid with distribution N (µL , σL ).
• Let SLh = hj=1 Lt+i denote the sum of losses over h-periods.
P
• It can be shown that SLh ∼ N (hµL , hσL2 ).

• Then sum of√losses over h periods is distributionally equivalent to
SLh = hµL + h × σL × X where X ∼ N (0, 1)
Then we have the following scaling results for the Value at Risk and Expected Shortfall
Time Scaling of VaR and ES under Normality

√
VaRα (Lh ) = σL × h × zα + µL × h
√
σL × h
ESα (Lh ) = × ϕ (zα ) + µL × h
1−α
• For example, if we have computed the daily VaR and ES, we can simply compute
the weekly, monthly or yearly VaR and ES by setting h = 5, 20 or h = 252.

• For estimating the VaR and ES using the historical distribution approach, no
such scaling formula exists.
• The obvious way to estimate a monthly instead of a daily VaR or ES is of course
to just use monthly data. In this case, we will just take the first, middle or last
observation in each month.
• Since this procedure reduces the number of observations considerably, the resulting
VaR and ES estimates are more noisy (imprecise).
• However, we can improve our data in the sense that we can aggregate daily losses
to monthly by averaging over all the observations within a month.

• More formally, suppose there are n observations within each month m = 1, . . . , M.

• Then instead of taking one element out of Lt+i,m , i = 1, . . . , n to get one monthly
observation Lt,m (i th observation, if i = 1 we take the first, if i = n we take the
last observation), we take the average over all the losses within this month, i.e.
n
1X
Lt,m = Lt+i,m , m = 1, . . . , M (33)
n i=1
• Since the average is less noisy (has lower variance) than a single observation, with
this method, we more precisely estimate the empirical quantiles of our
distribution.
• Therefore, since both the VaR and the ES crucially depend on the estimated
empirical quantiles, we get a better estimate for our risk measures.

Cash Flow Matching and Immunization
• The previous analysis was concerned with bond price sensitivity when interest rates
change.
• Now we want to discuss methods that help us to completely eliminate interest
rate risk.
The management of interest rates risks is important to a number of different investors
and financial institutions.
• Home owners: Mortgage rates/payments
• Banks: Their assets and Liabilities usually have different maturities
• Pension funds: Most of their assets are bonds which are used to finance periodical
payments to retirees.
Recall that a change in interest rates has two effects:
• A price risk (dP < 0 if dr > 0)
• A reinvestment risk
The two effects work in opposite directions: If interest rates increase, so do the cash
flows but they will be discounted at a higher rate Z .
• We are now going to exploit this fact in order to immunize our bond portfolio
against interest rate risks.
Example: Pension Fund
Suppose we are analyzing a pension fund with the following asset and liability structure
• Currently, the pension fund has cash balance of 1 Mio. USD at disposal.
• The goal of the pension fund is to guarantee a fixed amount (annuity) over the
next 30 years to the retirees which will be paid out semi-annually.
• Suppose that the term structure today at time t is flat and given by r2 = 5%.
Now the question is: Which amount can the pension fund promise to pay out its
retirees every six months over the next 30 years?
• At the current interest rate, such a promise to deliver a semi-annual payment of X

has to satisfy
n
X X
I = r2 i

i=1 1 + 2
where I denotes the invested money by the retirees at the pension fund.
• We can rewrite this as
I × (1 − q) 1
X = , q= r2

q(1 − q n ) 1+ 2

Example: Pension Fund
• At the current interest rate r2 = 5% this allows the pension fund to pay out
X = 32′ 352 every half year.
• In other words, the pension fund is now obliged to pay out 32’352 USD regardless
of what happens to the interest rate level in the future.
• The main question now is: How can the pension fund hedge its financial
commitment over the next 30 years?
• Note that n × X > I due to discounting. Thus the pension fund has to invest the
money in a smart way in order to meet its obligations.
There are two main strategies the pension fund can pursue:
1 Cash Flow Matching
2 Dynamic Immunization

One Solution: Cash Flow Matching
• The pension fund can try to buy securities that exactly match the payoff
characteristics.
• For instance, the pension fund could buy exactly the amount of zero coupon bonds
needed in order to pay the promised amount to retirees.
• This will in turn render the portfolio entirely risk free.
However, there are some problems associated with this hedging approach
• It is difficult to find a set of securities with precisely the required payoff
characteristics.
• Even if such securities are available, low liquidity or transaction costs may render
this approach too costly as for such long term commitments, a relatively high
number of securities needs to be traded.
However, there exists a better way of eliminating interest rate risk which is commonly
referred to dynamic immunization strategy

Dynamic Immunization Strategy
How does this strategy work?

• In essence, the dynamic immunization strategy selects a hedging portfolio with the
same present value and duration as of the cash flow liabilities.
Suppose the pension fund has the following two securities available for its investments
• a short term zero coupon treasury bill with current time t price
Pz (t, TS ) = 1+rN2 /2 where TS = 0.5 (half a year) and r2 is the current interest rate
level using semi-annual compounding.
• or a long term 5% coupon bond whose current price we denote by Pc (t, TL ) with
maturity TL = 30 years.
• The duration of the short term bond is Dz (t, TS ) = 0.5 and Dc (t, TL ) = 15.84 for
the long term bond.

Dynamic Immunization Strategy
How do we implement this strategy?

• Key concept: Duration matching.
▶ Duration of the hedging portfolio = duration of the liability portfolio
▶ With our short - and long term bonds we have that the current time t
portfolio weight wt (in the long term bond) solves
wt × Dc (t, TL ) + (1 − wt ) × Dz (t, TS ) = DL (t, TL )
where DL is the duration of liabilities.

▶ With our numbers we obtain that the optimal portfolio weight satisfies
DL (t, TL ) − Dz (t, TS )
wt∗ = = 0.67
Dc (t, TL ) − Dz (t, TS )
▶ Now we assume that the pension fund is re-balancing the hedging portfolio
every six months.

Dynamic Immunization Strategy cont.
At every re-balanced date t = 0.5, 1, 1.5, . . . , 30 the pension fund does the following
• Obtain the 5/2 = 2.5% coupon from the 30 year bond.
• Collect the interest obtained from the investment on the short term treasury bill,
Rz (t, 0.5) = Z (t, 0.5)−1 − 1 = 0.97561−1 − 1 = 0.025%,
• Pay the X = 32′ 352 pension plan to the retirees.
• Reinvest the remaining cash into the short - and long term bond according to
DL (t, TL ) − D(t, TS )
wt∗ = , t = 0.5, 1, . . . , 30 (34)
D(t, TL ) − D(t, TS )
• In theory, with re-balancing the portfolio according to Equation (34) the pension
fund is completely immune to interest rate changes.
• In other words, the fund will always be able to pay out the guaranteed amount to
the retirees.

How does the strategy perform?
• First, let’s assume the interest rates evolve as follows
Simulated Interest Rate
13
12
11
10
6
rt1
5 rt2
rt2
4
0 5 10 15 20 25 30
Payment Dates
Figure 16: Initial level of interest rate r0 = 4%. Simulation based on Feller process with
κ = 0.25, θ = 0.075 and σ = 0.05.

Given the simulated interest rate path from above, how does our wealth Wt evolve over
time.
• The pension funds initial wealth is W0 = 1 Mio. USD
• The initial portfolio holding in the long term bond is equal to w0∗ = 0.67
• Now the next periods wealth Wt+1 evolves according to
Wt+1 = Wt × (1 − wt∗ ) × (1 + Rz (t, 0.5))

Pc (t + 1, 30) + N×c

+ Wt × wt∗ × 2
−X
Pc (t, 30)
where Pc (t, 30) is the current price of the 30 year coupon bond and X denotes the
liabilities (payments to retirees)
• Note: If the interest rate were to stay at 5% over all periods, then the final wealth
would be precisely equal to zero.

How well does the Immunization Strategy Perform?
Let’s consider the three simulated interest rate paths rt1 , rt2 and rt3 in Figure 16 above
and look at how
• the short Pz (t, t + 0.5) and long term bond prices Pc (t, t + 30)
• the duration of the long term bond Dc (t, t + 30)
• the optimal weight in the long term bond wt∗
• the duration of the pension funds liabilities DL (t, t + 30)
evolve over time.

Wealth Evolution Wt Portfolio weight wt
1000000 0.7
Wt1 wt1
900000 Wt2 wt2
Wt3 wt3
800000 0.65
700000
600000 0.6
500000
400000 0.55
300000
200000 0.5
100000
0 0.45
0 5 10 15 20 25 30 0 5 10 15 20 25 30
Payment Dates Payment Dates
Figure 17: Wealth Wt and portfolio wt evolution based on the three simulated interest
rate paths rt1 , rt2 and rt3 .
Observation
• Terminal Wealth is always greater than zero.

Long term bond Pc (t, TL ) Short term bond Pz (t, TS )
100 98.5
Pz1 (t, TL )
98 Pz2 (t, TL )
90 Pz3 (t, TL )
97.5
80
97
70 96.5
96
60
95.5
50 Pc1 (t, TL )
Pc2 (t, TL ) 95
Pc3 (t, TL )
40 94.5
0 5 10 15 20 25 30 0 5 10 15 20 25 30
Figure 18: Short - and long term bond price evolution based on the three simulated
interest rate paths rt1 , rt2 and rt3 .
Observation

Long term bond Pc (t, TL ) Short term bond Pz (t, TS )
100 98.5
Pz1 (t, TL )
98 Pz2 (t, TL )
90 Pz3 (t, TL )
97.5
80
97
70 96.5
96
60
95.5
50 Pc1 (t, TL )
Pc2 (t, TL ) 95
Pc3 (t, TL )
40 94.5
0 5 10 15 20 25 30 0 5 10 15 20 25 30
Figure 18: Short - and long term bond price evolution based on the three simulated
Observation
• Higher interest rates lead zero coupon bond to trade at a lower price

Duration D(t, TL ) of Long Term Bond Duration DL (t, TL ) of Liabilities
18 14
1
D (t, TL ) DL1 (t, TL )
16 D2 (t, TL ) DL2 (t, TL )
12
D3 (t, TL )) DL3 (t, TL ))
14
10
12
10 8
8 6
6
4
4
2
2
0 0
0 5 10 15 20 25 30 0 5 10 15 20 25 30
Figure 19: Short - and long term bond duration evolution based on the three simulated
Observation
• Variability of both the long term bond and the liability duration decreases as we
get closer to maturity.

• Based on the three simulated interest rate paths, we see from Figure 17 that
wealth of the pension fund is always positive over all periods.
• Now the question is: Whether this is true for any interest rate scenario
• In order to answer this question, we are going to simulate M = 25′ 000 different
interest rate paths and compute terminal wealth WT at maturity T = 30.
• If the immunization strategy works, we should expect to see only positive values of
wealth after 30 years.

Terminal Wealth WT
2000
1800
1600
1400
1200
1000
800
600
400
200
0
50000 100000 150000 200000 250000
Dollars
Figure 20: Histrogram of terminal wealth distribution WT based on M = 25′ 000
simulation runs.
Key observation:
• Regardless of the interest rate scenario, with this immunization strategy the
pension fund will always have a strictly positive terminal wealth after 30 years.
Average Wealth Evolution
Suppose we would just fix the portfolio weight in the long term bond to be equal to
w f = (0, 0.5, 1, w )
Terminal Wealth WT
2500
w 1 =0
w 2 =0.5
w 3 =1
2000 w 4 =0.59911
1500
1000
500
0
−1 0 1 2 3 4 5 6
Dollars x 10
6
Figure 21: Histogram of terminal wealth distribution WT based on M = 25′ 000

simulation runs and four different asset allocation strategies.

How Do the Simple Strategies Perform?
Analyzing the terminal wealth distribution under the four different scenarios we observe
the following
• Terminal wealth can become negative under all scenarios considered.
• Variance of terminal wealth varies considerably depending on the selected asset
allocation.
• For this particular simulation, investing 50% of the deposits into the zero coupon
bond and 50% of the deposits in the long term bond yields on average the highest
terminal wealth.
• Contrarily, investing all the deposits in the long term coupon bond yields on
average negative terminal wealth
• Terminal wealth remains fairly similar in the case when the pension fund invests
50% in each bond or according to w = 60%.

How Do the Simple Strategies Perform?
In order to compare the four different asset allocations, we compute the so called Sharpe
ratio defined as
Et [WTi ]
SR i = p ,
Vt [WTi ]
for each portfolio weight w̄f = (0, 0.5, 1, w ).
p
PF weight w Et [WTi ] Vt [WTi ] Sharpe Ratio
0 418’241 764’537 0.5471
0.5000 821’872 387’564 2.1206
1.0000 -194’055 299’394 -0.6481
0.5954 713’727 292’414 2.4408
Table 4: Estimated Sharpe Ratios based on M = 25′ 000 Monte Carlo Simulation
Runs.

Exercise (Interest Rate Immunization)
Suppose that a pension fund is confronted with the following investment problem
• The pension fund must pay its depositors X = 500 Mio USD in 20 years
• The current term structure is flat and equal to r = 3.5%
500
• The fund’s current assets equal W0 = 1.03520
= 251.2829 Mio USD
• There are two zero coupon bonds available to the pension fund with maturity 1
year and 30 years respectively.
Questions:
1 What are the current prices of these two bonds assuming a face value of N = 100?
2 How much should the pension fund invest into the two zero coupon bonds?
3 Verify that this strategy indeed gives 500 USD in 20 years.
Hint: Recall that the annualized return on a zero coupon bond is
1
1 τ
Rz (t, T ) = − 1, τ ≥0 (35)
Z (t, T )

Exercise (Interest Rate Immunization)
4 Now suppose right after the fund buys the bonds interest rates rise to 5%
• What is the new present value of the fund’s bond position?
• What is the new present value of the fund’s liabilities?
5 Now suppose interest rates fall to 1.5%
▶ What is the new present value of the fund’s bond position?
▶ What is the new present value of the fund’s liabilities?
6 What do you conclude from these results regarding the price sensitivity of your
bond portfolio?
7 What is the value of the fund’s portfolio after 20 years when the liabilities are due?
Is the fund able to fully guarantee all its payments regardless of the interest rate
scenario?

Solution: Bond Immunization
Solution (Bond Immunization)

• The bond prices are
100 100
Pz (0, 1) = = 96.6184, Pz (0, 30) = = 35.6278
1+r (1 + r )30
• We have to match the duration of assets with the duration of liabilities, i.e.
w × Dz (t, TL ) + (1 − w ) × Dz (t, TS ) = DL (t, TM )
where DL (t, TM ) = 20. Since both bonds do not pay any coupon, we get
Dz (t, TL ) = 30 and Dz (t, TS ) = 1. Therefore solving Equation (113), we obtain
that w ∗ is
DL (t, TM ) − Dz (t, TS ) 20 − 1
w∗ = = = 0.655172
Dz (t, TL ) − Dz (t, TS ) 30 − 1
Therefore, the portfolio holdings in the 30 year and 1 year bond are
ϕ1 = w × W0 /Pz (0, 30) = 4.6209, ϕ2 = (1 − w ) × W0 /Pz (0, 1) = 0.8968

Solution
1 The wealth dynamics are
Wt+1 = Wt × w × (1 + Rz (0, 1)) + Wt × (1 − w ) × (1 + Rz (0, 30))

1
1 20
Now since Rz (0, 20) = Z (0,20)
− 1 = 0.035 = Rz (0, 1) := Rz , we can write the
wealth equation as
X
WT = (1 + Rz )T × W0 = (1 + Rz )T =X
(1 + Rz )T
as Rz = r .
2 If interest rates rise, our bond portfolios present value is
P N = ϕ1 × PzN (0, 30) + ϕ2 × PzN (0, 1) = 192.329
where the new interest rate is r N = 5%. Likewise, the present value of the pension
fund’s liabilities are now
X
XN = = 188.44
1.0520
which leaves us with a net effect of
∆ = P N − X N = 3.885 Mio.

Solution
3 Likewise, if interest rates drop to 1.5% then we obtain
∆ = P N − X N = 12.751 Mio. (36)
4 In either interest rate scenario the pension fund will not loose any money if it
invests its deposits following the immunization strategy. In other words, the
pension fund is entirely hedged or immune to interest rate changes.
5 After 20 years the fund’s net assets are
N 20
ϕ1 × 10
+ ϕ2 × N × 1 + r N −X (37)
(1 + r N )
For the two interest rate scenarios we have considered Equation (37) yields
∆ = 21.6379, r N = 5%; ∆ = 18.9588 r N = 1.5% (38)
Therefore, regardless of the interest rate scenario, the fund will be able to fully
guarantee the promised payments. It even makes profit from using the
immunization strategy.

Asset-Liabilities Management
The most classical example of managing interest rate risk is asset liability management.
• For most corporations, their assets duration do not match the duration of their
liabilities.
• Example: Commercial banks collect deposits whose duration is relatively short, i.e.
close to zero up to one year as interest rates change almost continuously
depending on market conditions.
• On the other hand, the banks give out loans which are usually medium (3-5 years)
to long term (5-20 years). These are for instance, corporate loans or mortgages to
households.
• Therefore, if those payments are fixed, the duration of their assets is relatively
long, for instance 3 - 10 years depending on the loan contract.
• There exists a duration mismatch or gap, as the duration of assets does not
equal to the duration of liabilities.
• This setting implies that the bank will suffer a loss when interest rates increase, as
it will still receive the fixed payments on its loans but now has to pay a higher
interest rate on its customers deposits.
• Other examples: Pension funds/Insurance companies have long term commitments
of usually 30 years or more (long liability duration) but invest in securities whose
maturity is shorter (low duration).
Asset Liability Structure
• Let’s consider the P
following a firm with n assets Ai (r ), i = 1, . . . , n such that total
assets are A(r ) = ni=1 Ai (r ) with assetPduration denoted by DA,i and m liabilities
Lj such that total liabilities are L(r ) = mj=1 Lj (r ), j = 1, . . . , m with liabilities
duration denoted by DL,j .
• r denotes the current interest rate level.
• The firms equity E is just given by the difference between assets and liabilities, i.e.
E (r ) = A(r ) − L(r ).
• We know that the duration of a portfolio of securities is just the weighted average
of the individual securities.
• The asset DA and liability duration DL are therefore given by
n
X m
X
DA = wA,i × DA,i DL = wL,j × DL,j
i=1 j=1
where the asset weights wA,i and liability weights wL,j are given by
Ai (r ) Lj (r )
wA,i = Pn wL,j = Pm
i=1 Ai (r ) j=1 Lj (r )

Duration Gap
With the setup we can describe the change of equity as
Duration of Equity and Duration Gap

dE (r ) ∂E (r ) 1 A L
= dr = −DE × dr = − DA × − DL × dr (39)
E ∂r E E E
where DE is the duration of equity. From Equation (39) we can deduce the duration
gap denoted by DGap as

L
dE = − DA − × DL × A × dr
A
= −DGap × A × dr (40)
• Note that whenever DA × A ̸= DL × L we have that DE ̸= 0 and therefore, the
equity value of the firm is sensitive to changes in interest rates.
• If DGap = DA − DL × AL > 0 an increase in interest rates leads to a fall in the
market value of equity.
Exercise (Proof Equity Duration)

Verify Equation (39) above.
∂L (r )
Hint: Recall that Di,A := − Ai1(r ) ∂A∂ri (r ) and likewise Dj,L := − Lj 1(r ) ∂rj
Solution Equity Duration
Solution
Given the left hand side of Equation (39), we have
n m
!
∂A ∂L X ∂Ai (r ) A Ai X ∂Lj (r ) L Lj
dE (r ) = − dr = − dr
∂r ∂r i=1
∂r Ai A j=1
∂r Lj L
n m
!
X Ai X Lj
=− ×DA,i × ×A− DL,j × × L dr
i=1
A j=1
L
n m
!
X X
=− wA,i × DA,i × A − wL,j × DL,j × L dr = − (DA × A − DL × L) dr
i=1 j=1
now multiplying through by 1/E gives the result.

Duration Gap with Macaulay and Modified Duration
We can express the previous equity duration Equation (39) in terms of both the
Macaulay and Modified duration.
• Note, if we use the asset/liabilities Macaulay duration
/n) dLj (r )
Mc
DA,i (t, TAi ) = − (1+y
Ai
/n) dAi (r )
dr
Mc
and DL,i (t, TLj ) = − (1+y
Lj dr
• Then Equation (39) becomes

dE A L dy
= DAMac × − DLMac × (41)
E E E 1 + y /n
Mc
Mod DA,i (t,TA )
• And since the modified asset/liability duration is defined as DA,i = i
and
(1+ yn )
Mc
DL,j (t,TL )
Mod j
DL,j = 1+ yn
we can write Equation (41) as follows,
( )

dE A L
= DAMod × − DLMod × dy
E E E

Position Amount Dur. Dollar Dur. Position Amount Dur. Dollar Dur.
Cash 200 0 0 Deposits 500 0 0
ST Loans 450 1 450 ST Debt 250 0.5 125
MT Loans 500 5 2500 MT Debt 400 2 800
LT Loans 1500 10 15’000 LT Debt 750 8 6’000
Total 2’650 17’950 Total 1’900 10.5 6’925
Equity 750 11’025
Table 5: Example: Asset and Liability Structure of a Financial Institution. Numbers are
in Mio. $
Example:
• If interest rates increase by 10 Basis points, the market value is expected to decline
by approximately 11′ 025 × 0.001 = 11.025 Mio. $.
Convexity
• We know that, bond prices depend non linearly on interest rates.

• So far, we have used duration, which is a linear approximation, to estimate the
change in a bond price when interest rates move.
• We have seen that this approximation works well as long as changes in interest
rates are relatively small.
• However, when there are large movements in interest rates, the duration
approximation yields poor estimates of the expected change in bond prices.
• Especially for risk management purposes, we would like to have a more accurate
approximation of how large interest rate changes affect our bond portfolio.
• This can be done by using second order approximations to better accounts for the
convexity of bond prices in interest rates.
Let’s compare the accuracy of adding the convexity adjustment to the duration
approximation for a zero coupon bond for three different maturities T = 1, T = 5 and
T = 20 years.

Zero Bond Price with Mat. 1Y Approx. Error: 0-Bond with Mat. 1Y
1 0.012
0.98
0.01
Dz (t, T )
0.96 Dz (t, T ) + Cz (t, T ))
0.94 0.008
0.92
0.006
0.9
0.004
0.88
0.86 0.002
0.84
Pz (t, T ) 0
0.82 Dz (t, T )
Dz (t, T ) + Cz (t, T ))
0.8 −0.002
0 0.05 0.1 0.15 0.2 0 0.05 0.1 0.15 0.2
Interest rate r Interest rate r
Figure 22: Price of Zero Coupon bond with maturity 1 year. Approximation point is
r = 5%.

1 0.2
0.9 Dz (t, T )
0.15 Dz (t, T ) + Cz (t, T ))
0.8
0.7
0.1
0.6
0.5
0.05
0.4
0.3
0
Pz (t, T )
0.2 Dz (t, T )
Dz (t, T ) + Cz (t, T ))
0.1 −0.05
0 0.05 0.1 0.15 0.2 0 0.05 0.1 0.15 0.2
Figure 23: Price of Zero Coupon bond with maturity 5 years. Approximation point is
r = 5%.

1 0.8
0.8
0.6
Dz (t, T )
Dz (t, T ) + Cz (t, T ))
0.6
0.4
0.4
0.2
0.2
0
0
−0.2
−0.2
Pz (t, T ) −0.4
−0.4 Dz (t, T )
Dz (t, T ) + Cz (t, T ))
−0.6 −0.6
0 0.05 0.1 0.15 0.2 0 0.05 0.1 0.15 0.2
Figure 24: Price of Zero Coupon bond with maturity 15 years. Approximation point is
r = 5%.

Convexity
Convexity and Bond Price Change

1 Let P(r ) denote the price of a security. Then convexity is defined as the second
derivative of the security’s price with respect to the interest rate r ,
1 ∂2P
C =
P ∂r 2
Therefore, convexity C accounts for the convex (non-linear) relationship between
the bond price P and the interest rate level r .
2 Furthermore, we can augment the approximation formula (see Equation (11)) for
the change of bond price due to a change in interest rates as follows
dP 1
= −D × dr + × C × dr 2 (42)
P 2
The more curvature the bond price has with respect to the interest rate level, the
better the approximation of the percentage change in the bond price is due to
adding the convexity adjustment.

Convexity of a Zero Coupon Bond
For a given interest rate level r , the time t price of a zero coupon bond with maturity T
is given by
Pz (r ; t, T ) = Pz (t, T ) = N × Z (t, T ) = N × e −r ×(T −t)
Then the convexity of the zero coupon bond Cz is given by
1 ∂ 2 Pz (t, T ) 1 ∂Pz (t, T )

Cz (t, T ) = =− × (T − t) ×
Pz (t, T ) ∂r 2 Pz (t, T ) ∂r
1 2 2
= × (T − t) × Pz (t, T ) = (T − t)
Pz (t, T )
Remark:
• Convexity of a zero coupon bond is just time to maturity squared.
• Similar to the duration of a zero coupon bond, convexity is independent of the
interest rate level.

Convexity of a Portfolio of Securities
• Recall that duration of a portfolio of securities is just the weighted average of

durations of the individual securities.
• We will now show that convexity of a portfolio with N securities each with price
Pi (t, T ) = Pi , i = 1, . . . , N, is simply the weighted sum (where the weights are
the relative holdings) of convexities of all the securities.
▶ As above, let’s start with the simple two security case.
▶ Suppose we have ϕ1 units of security 1 and ϕ2 of security 2. Let P1 and P2 be
the prices of the two securities and C1 and C2 their convexities, respectively.
▶ Let W be the value of the portfolio
W = ϕ1 × P1 + ϕ2 × P2

Convexity of a Portfolio of Securities
• We can then compute:
1 ∂W 2 ∂ 2 P1 ∂ 2 P2

1
CW = = ϕ 1 × + ϕ 2 ×
W ∂r 2 W ∂r 2 ∂r 2
1 ∂ 2 P1 1 ∂ 2 P2

1
= ϕ1 × P1 × + ϕ 2 × P 2 ×
W P1 ∂r 2 P2 ∂r 2
= w1 × C1 + w2 × C2
where
ϕi × Pi
wi = , i = 1, 2 (43)
W
is the fraction of wealth invested in bond i.
Convexity of a portfolio of N securities

i = 1, . . . , N, then the convexity of the portfolio CW is equal to the weighted sum of
convexities of the individual securities, i.e.
N
X
CW = wi × Ci
i=1
where wi is given in Equation (4) and asset i’s convexity is denoted by Ci .

Convexity of a Coupon Bond
Formal Definition: Convexity
Convexity of a coupon bond Cc (t, T ) is then defined as
m
X
Cc (t, T ) = wi × Cz (t, Ti ) (44)
i=1
where Cz (t, Ti ) = (Ti − t)2 is the convexity of a zero coupon bond with maturity Ti − t
and wTi , i = 1, . . . , n be the present value contribution of the cash flow at time Ti .
Then,
c/n · Pz (t, Ti )
wTi = , i = 1, . . . , m − 1
Pc (t, T )
(1 + c/n) · Pz (t, Ti )
wTn = , i =m
Pc (t, T )
• Similar to duration of a coupon bond, convexity is a weighted average of squared

individual maturities of all the bond’s separate cash flows.
• Moreover, the weight is the present value of the payment divided by the current
time t bond price (precisely the same as for the duration formula of a coupon
bond).
Example Heding interest rate risk: Duration vs Convexity
• Suppose we an investor has bought 100 Mio. USD (at par) worth of a 25 years
bond with 4% coupon paid out semi-annually
• Flat term structure with continuously compounded interest rate 3.5%.
• The current bond price is P(t, T ) = 107.7491, duration Dc (t, T ) = 16.3861 and
convexity Cc (t, T ) = 346.0587.
By how much does the investor expect the bond price to decline due to a uniform 1%
increase in interest rates using
1 the duration approximation
2 adding to the duration approximation a convexity correction
The exact value of the bond after the increase in interest rates is PcN (t, T ) = 91.8233
and thus the investor would suffer a loss of
• ϕ × (PcN (t, T ) − PcO (t, T )) = 106 × (91.8233 − 107.7491) = −15.926 Mio.
• or in percentage terms (91.8233 − 107.7491)/107.7491 = −14.7804%

Example: Adding Convexity Correction
1 Using only duration, the approximate absolute and relative losses are
dPc = −Dc × Pc × dr = −17.656 Mio.

dPc
= −Dc × Pc × dr = −0.1639
Pc
where Pc = ϕ × PcO (t, T ) is the total value of the bond portfolio before the change
in interest rates.
2 whereas adding the convexity adjustment yields
1
dPc = −Dc × Pc × dr + Cc × Pc × dr 2 = −15.791 Mio.
2
dPc 1
= −Dc × dr + Cc × dr 2 = −0.1466
Pc 2
which gives a very accurate approximation of the actual absolute loss of −15.926
Mio. or percentage loss of −14.7804%.

Dollar Convexity
Similar to the Dollar duration we have introduced in Equation (12), we can define dollar
convexity as follows
Dollar Convexity
Let P denote the price of a security and let r denote the interest rate level. Then the
dollar convexity is defined as
∂2P ∂D $
C$ = = −
∂r 2 ∂r
$
where D is the dollar duration from Equation (12).
• As for duration and dollar duration above, dollar convexity measures the absolute
change in the bond price due to a change in interest rates, as opposed to the
percentage/relative of the bond price due to a change in interest rate.
• Note that the dollar convexity of a zero coupon bond is not constant in the
interest rate level as Cz$ = (T − t)2 × Pz (r ; t, T ) clearly depends on r through the
bond price Pz .

Exercise (Convexity Adjustment)
• Suppose we an investor has bought 100 Mio. USD (at par) worth of a 2 years
bond with 6% coupon paid out semi-annually
By how much does the investor expect the bond price to decline due to a uniform 2%
increase in interest rates using
1 the duration approximation
2 adding to the duration approximation a convexity correction
3 How do the two approximations compare to the exact change in the bond price?

Solution (Solution: Convexity Adjustment)
The price of the 2 year coupon bond is P(t, t + 2) = 102.7403 and its duration and
convexity are Dc (t, t + 2) = 1.9156 and Cc (t, t + 2) = 3.7614, respectively
1 Using only duration, the approximate absolute and relative losses are
dPc = −Dc × Pc × dr = −3.936 Mio.

dPc
= −Dc × dr = −0.0383
Pc
2 whereas adding the convexity adjustment yields
1
dPc = −Dc × Pc × dr + Cc × Pc × dr 2 = −3.859 Mio.
2
dPc 1
= −Dc × dr + Cc × dr 2 = −0.0376
Pc 2
which gives a very accurate approximation of the actual absolute loss of −3.86
Mio. or percentage loss of −3.7569%.

Convexity: Another Approximation Formula
We can also approximate the convexity adjustment factor using the following formula
Convexity Approximation Formula

Let Pc (t, T ) denote the current price of a coupon bond with maturity T , and Pc+∆r (t, T )
and Pc−∆r (t, T ) denote the price of the coupon bond when we increase (decrease) the
current interest rate level by ∆r . Then the approximate convexity CcApprox (t, T ) is
Pc+∆r (t, T ) + Pc−∆r (t, T ) − 2 × Pc (t, T )

CcApprox (t, T ) =
2 × Pc (t, T ) × ∆r 2
and therefore we obtain that the approximative bond price change formula is
dPc C Approx
= −Dc × dr + c × dr 2
Pc 2

Constructing duration hedged portfolios
Basic idea: We want to make a bond portfolio ”duration risk neutral”:

• Let’s consider again our example of an investor which has bought 100 Mio. USD
(at par) worth of a 25 years bond with 5% coupon paid out semi-annually.
• The current bond price is Pc (t, T ) = 107.7491, duration Dc (t, T ) = 16.3861 and
convexity Cc (t, T ) = 346.0587.
• In addition to the coupon bond, there is also a 10 year zero coupon bond Pz (t, T )
available to the investor whose current price is Pz (t, T ) = 41.6862
Now the investor wants to hedge the interest rate risk by trading θ units of the zero
coupon such that his/her portfolio V = Pc + θ × Pz is insensitive to changes in interest
rates?

Constructing duration hedged portfolios cont.
• Formally speaking, the bond portfolio is independent of interest rate changes if
dV = 0.
• Using only duration to hedge the portfolio holdings in the zero coupon bond ϕ
must satisfy
dV = dPc + θ × dPz = −Pc × Dc × dr − θ × Dz × Pz × dr = 0 (45)

Pc × Dc
→ θ∗ = − (46)
Pz × Dz
and recall that Pc = PcO × ϕ where ϕ = 106 denotes the number of coupon bonds
the investor holds.
• With the numbers from above we obtain
16.3861 × 107.7491 × ϕ
θ∗ = − = −1.6942 × 106 (47)
10 × 41.6862
• Therefore, the investor has to short 1,6942 Million units of the zero coupon bond
in order to hedge against parallel shifts in the term structure of interest rates.
Now since the duration hedge in Equation (45) holds only true approximately, we can
compute, using the exact changes of the two 10 year bond prices, how accurate the
investor’s hedge is.
Constructing duration hedged portfolios cont.
• From the first equality in (45) now using the exact changes in bond prices, and
assuming that interest rates increase from 3.5% to 4.5%, we obtain that
dV = ϕ × (PcN − PcO ) + θ∗ × (PzN − PzO ) = −30′ 3920 (48)
Thus even though we used the (duration) optimal hedging strategy, the investor
will loose approximately −30′ 3920 USD.
• Conversely, if interest rate drop by 1% the change in portfolio value is
dV = −38′ 7430 USD.
• In other words, in both interest rate scenarios, the investor is going to loose money!
• Now the question is: Is this always the case? Meaning for every interest rate
scenario?

Change in Portfolio Value dV
200000
−200000
−400000
−600000
−800000
−1000000
−1200000
−1400000
−1600000
−1800000
0.01 0.02 0.03 0.04 0.05 0.06
Interest rate r + ∆r
Figure 25: Change in Portfolio Value using only duration hedging when interest rates
change by dr = ±2%. Initial interest rate level is r = 3.5% and the investor holds
Pc = ϕ × PcO = 106 × 107.7491 units of the 5% Coupon bonds with maturity 25 years.

Is the Change in Portfolio Value dV always Negative?
Change in Portfolio Value dV Change in Portfolio Value dV
6000000 200000
0
5000000
−200000
4000000 −400000
−600000
3000000 −800000
−1000000
2000000
−1200000
1000000 −1400000
−1600000
0
0.01 0.02 0.03 0.04 0.05 0.06 −1800000
0.01 0.02 0.03 0.04 0.05 0.06
Interest rate r + ∆r Interest rate r + ∆r
Figure 26: Change in Portfolio Value using only duration hedging when interest rates change
by dr = ±2%. Initial interest rate level is r = 3.5%. Maturity of the hedging bonds are T = 10
(Left Panel) and T = 25 (Right Panel).
Remark:
• If the maturity of the zero coupon bond is T = 10 we get θ∗ = −2.7621 × 106 ,
which is substantially larger than maturity T = 25, compare with Equation (47).
• For a shorter maturity bond, its duration is much smaller (see (46).)
How good is the Duration Hedged Portfolio
Remarks:
• No matter the change in interest rate level, the portfolio will loose money.
• The larger the change in interest rates, the larger the portfolio loss regardless of
the sign of ∆r .
• Portfolio losses are asymmetric, i.e. when interest rates drop, they are bigger than
when interest rates rise.
• However, since the portfolio is not convexity hedged, it is not surprising that for
large interest rate movements, the investors suffers a substantial loss on his/her
bond portfolio.
Let’s now add the convexity adjustment term to Equation (45) and investigate by how
much we can improve the hedge of the investors bond portfolio.

Adding a Convexity Adjustment Term
Analogous to above, we want that the bond portfolio is insensitive to changes in interest
rates, i.e. dV = 0
dV = dPc + θ × dPz
Cc
= −Pc × Dc × dr + × Pc × dr 2
2
Cz 2
+ θ × −Dz × Pz × dr + × Pz × dr
2

Cc Cz
= − (Pc × Dc + θ × Dz × Pz ) × dr + × Pc + θ × × Pz × dr 2 = 0 (49)
2 2
where Dz = T − t = 25 and Cz = (T − t)2 = 252 .
• Previously, we have just considered neutralizing the impact of the first bracket in
Equation (49) above.
• The optimal duration hedge θ∗ from Equation (46) above eliminates the first
bracket.
• However, due to the convex relationship between bond prices and interest rates,
this hedging approach is incomplete.
• Adding a convexity adjustment will improve on the hedge, especially for relatively
large movements in r .
Convexity Hedge
We are going to consider two approaches:

1 Choose θ∗ and the maturity of the zero coupon bond such that Equation (49)
holds.
▶ This gives the investor two ’tuning’ parameters for hedging the portfolio.
▶ For simplicity, let’s we fix the maturity of the zero coupon bond to equal the
maturity of the coupon bond, then the optimal duration and convexity
hedging strategy is
C
∗ Pc Dc − 2c dr
θDC = (50)
Pz C2z dr − Dz
▶ For the given setup, this approach will generate gains (losses) from hedging
when the investor trades a zero coupon bond with shorter (longer) maturity.
2 An other hedging strategy involves trading two additional securities to hedge both
duration and convexity separately.

Hedging both Duration and Convexity
Suppose now that the investor can trade, apart from the long term 25 year zero coupon
bond Pc (t, TL ) and the 10 year zero coupon bond Pz (t, TL ), also a short term 5 year
zero coupon bond Pz (t, TS ).
• Let θTS and θTL denote the position in the short and long term bond, respectively.
Then, the value of the hedging portfolio is given by,
V = Pc (t, TL ) + θTS × Pz (t, TS ) + θTL × Pz (t, TL ) (51)
Therefore, the change in the portfolio is
dV = dPc (t, TL ) + θTS × dPz (t, TS ) + θTL × dPz (t, TL )

Cc (t, TL )
= −Pc (t, TL ) × Dc (t, TL ) × dr + × Pc (t, TL ) × dr 2
2
− (θTS × Dz (t, TS ) × Pz (t, TS ) + θTL × Dz (t, TL ) × Pz (t, TL )) × dr

Cz (t, TS ) Cz (t, TL )
+ θ TS × × Pz (t, TS ) + θTL × × Pz (t, TL )× dr 2
2 2
• If the investor wants to be hedged, then dV = 0.

• We can achieve this by setting the terms multiplying dr (small changes) and dr 2
(large changes) equal to zero.

Hedging both Duration and Convexity cont.
This gives us two equations in two unknowns
0 = Pc (t, TL ) × Dc (t, TL ) + θTS × Dz (t, TS ) × Pz (t, TS ) + θTL × Dz (t, TL ) × Pz (t, TL )

Cc (t, TL ) Cz (t, TS ) Cz (t, TL )
0= × Pc (t, TL ) + θTS × × Pz (t, TS ) + θTL × × Pz (t, TL )
2 2 2
whose solutions are given by

Pc (t, TL ) Dc (t, TL ) × Cz (t, TL ) − Cc (t, TL ) × Dz (t, TL )
θT∗S = ×
Pz (t, TS ) Cz (t, TS ) × Dz (t, TL ) − Dz (t, TS ) × Cz (t, TL )

Pc (t, TL ) Dc (t, TL ) × Cz (t, TS ) − Cc (t, TL ) × Dz (t, TS )
θT∗L = ×
Pz (t, TL ) Cz (t, TL ) × Dz (t, TS ) − Cz (t, TS ) × Dz (t, TL )
With the numbers we obtain that Pz (t, TS ) = 83.9457, Pc (t, TL ) = 107.7491 and the
portfolio holdings in the short and the long term bond are given by
θT∗S = −0.8163 × 106 , θT∗L = −1.3654 × 106 (52)
In other words, the investor has to short both the short and the long term bond.

Change in Portfolio Value dV Comparison dVSL − dV
200000 1800000
0 1600000
−200000 1400000
−400000
1200000
−600000
1000000
−800000
800000
−1000000
600000
−1200000
−1400000 400000
−1600000 θ∗∗ 200000

θSL
−1800000 0
0.01 0.02 0.03 0.04 0.05 0.06 0.01 0.02 0.03 0.04 0.05 0.06
Interest rate r + ∆r Interest rate r + ∆r
Figure 27: Comparison of hedging strategies when interest rates change by dr = ±2%.
Initial interest rate level is r = 3.5% and the investor holds
Pc = ϕ × PcO = 106 × 107.7491 units of the 5% Coupon bonds with maturity 25 years as
well as θT∗S and θT∗L units of the short and long term bond respectively. θSL
∗
refers to the
strategy of holding trading both a long term and a short term bond Equation (52).

Convexity Trading and the Passage of Time
The convexity hedging strategy shown above misses on an important element which is
the passage of time.
• We wrote that the change in the hedging portfolio is given by
∂V 1 ∂2V 2
dV = dr + dr (53)
∂r 2 ∂r 2
which implies that the portfolio is only dependent on the interest rate level r .
• However, bond prices change in value even though interest rate do not move as
time passes (time-to-Maturity becomes shorter).
• Therefore, in Equation (53), the portfolio V (r ) should be augmented by another
variable which is time, i.e.
V dt + ∂V dr + 1 ∂ V dr
∂ 2
t
2
dV (t, r ) = 2
(54)
∂ ∂r 2 ∂r
Therefore, the first term in Equation (54) implies that hedging portfolio depends on
time, which the previous hedging strategy has omitted.

Slope and Curvature
When we introduced the concept of bond duration above, we assumed that the changes
in interest rate were uniform, i.e. that the shifts in the term structure of interest rates
are parallel.
• This assumption has important implications for risk management because we
essentially assume that the term structure moves the same at the short and as it
does at the long end.
• In other words, we assume that the slope and the curvature of the term structure
do not change.
• Thus, if we use duration hedging, we only guard ourselves against parallel shifts in
the term structure, but not against changes in its slope or curvature.
• Therefore, a duration hedging strategy eliminates the risk, while leaves us still
exposed to slope and curvature risk.
• We are now going to extend the previous analysis to hedge also slope and
curvature risk.

Slope and Curvature: US Data
Panel A: US Term Structure of Interest Rates
10 8.8
9 1Y
8.6
8
2Y
7
3Y 8.4
6
5
5Y 8.2
4 7Y
8
3 10Y
2 7.8
1
0 7.6
1990 1995 2000 2005 2010 2015 1 2 3 4 5 6 7 8 9 10
Dates
Figure 28: Panel A: Yield Curve evolution over time. Panel B: Term Structure of Interest
Rates for two different dates. Source: Federal Reserve Board.
Remarks:
• If the assumption of parallel changes in interest rates were true, then the
differences between yields should be constant (Panel A).
• There can be considerable movements in slope and curvature for any given two
dates (Panel B)
Slope and Curvature: US Data cont.
Panel A: Term Spread 10Y-1Y Panel B: Curvature
3.5 2
3
1.5
2.5
1
2
1.5 0.5
1
0
0.5
-0.5
0
-0.5 -1
1990 1995 2000 2005 2010 2015 1990 1995 2000 2005 2010 2015
Figure 29: Panel A: Term Spread evolution over time and Curvature in Panel B: Source:
Federal Reserve Board.
Remarks:
• As above, if the assumption of parallel changes in interest rates were true, then the
term spread and curvature should be constant over time.

Empirical Estimates for Level, Slope and Curvature
• We know that yields tend to co-move considerably along any pair of maturities
(see Table 1).
• Therefore, a single factor consisting of any maturity Ti should have large predictive
power in explaining the variation in interest rates for any other maturity Tj .
• For instance, the level of interest rates r¯(t) = n1 ni=1 r (t, Ti ) (see Equation (1)
P
from above), will have large predictive power in explaining movements in interest
rates for any maturity.
• However, as seen above, the slope (or Term Spread) defined as
TS(t, Ti , Tk ) = r (t, Tk ) − r (t, Ti ), Ti < Tk or the curvature changes stochastically
over time.
• How do we construct an empirical estimate of curvature?
• Intuitively, if we have Ti < Tj < Tk where Ti = Tj − ∆t and Tk = Tj + ∆t, then
the following equation holds
r (t, Tj ) − r (t, Ti ) = r (t, Tk ) − r (t, Tj ) (55)
if and only if the term structure is linear, i.e. r (t, T ) = r (T − t), r > 0.
• However, if Equation (55) does not hold then we can estimate the curvature of the
term structure by
C (t, Ti , Tj , Tk ) := −r (t, Ti ) + 2 × r (t, Tj ) − r (t, Tk ) (56)

Factor Models
• Previously, we have only considered duration for interest rate risk management.
• Now we are going to extend the analysis to incorporate also the factors slope and
curvature which drive the term structure of interest rates.
Definition: Factor Model

Let Ti , i ∈ {1, . . . , n} be maturities of the term structure and let ri := r (t, Ti ) be the
corresponding zero coupon rate. Then a m− dimensional factor model, with common
factors ζjt , j ∈ {1, . . . , m}, assumes that the changes in interest rates
dr n
t = (dr1t , dr2t , . . . , drnt ) ∈ R are given by
 drt = β × d ζt  (57)
where  β11 β12 ... β1m 

 
 
 β21 β22 ... β2m 
 ∈ Rn×m
 
β= 
 .. .. .. 

 . . .


 
 
βn1 βn2 ... βnm
and βij represents the sensitivity of changes in interest rates at maturity Ti with respect
to factor j.
Estimation of Factor Models
How can we estimate the factor sensitivities β?
• We need historical data on the zero yields t and the factors ζt . r
• In our case, we need the time series of zero rates for all maturities plus the time
series of the level, slope and curvature from above.
• Suppose we have yields with n maturities available, i.e. T1 , T2 , . . . , Tn , and denote
by τi = Ti − t time to maturity.
• For example T1 = 1 year and Tn = 10 years.
• Let h be the time interval of our historical data.
• If we have daily data then h = 1/252 or for monthly data h = 1/12.
• Lets consider the change in zero rates between time t and t + h,3
∆rit = r (t + h, t + h + τi ) − r (t, t + τi ) = r (t + h, h + Ti ) − r (t, Ti ) (58)
• Therefore, if τi = 1 year, then ∆rit is the change in one year zero rate over the
time period h.
3
For our estimation we assume that r (t + h, t + h + τi ) = r (t + h, t + τi ), since it is difficult to obtain data for maturities
not equal to 1,2,3,5,7 or 10 years. For monthly data, as we are using here, this difference is not very large, especially for longer
maturities.
Estimation of Factor Models cont.
r
Let ∆ t = (dr1t , dr2t , . . . , drnt ) ∈ Rn be the vector of changes in zero rates for all
maturities i = 1, . . . , n and let ∆ζt the denote the vector of changes in m factors. Then
we can estimate the factor sensitivity β be running the following OLS regression
r
∆ t = α + β × ∆ζt + ϵt (59)
n n
where α ∈ R denotes the intercept vector and ϵ ∈ R is the vector of random error
terms.
Remark:
• α can be interpreted as the average change in interest rates which is not due to
the factors ζt .
• It is important to note that if α is not small, then the factor model will produce
poor estimates of the changes in zero rates ∆ t . r
• However, in most applications, α is relatively small and thus the factor model
should yield accurate predictions about the changes in zero rates.

Factor Sensitivity of Interest Rates: Factor Duration
• Equation (57) describes how a given factor ζjt affects interest rates at maturity Ti .
• Suppose we use the factors ’level’, ’Slope’ and ’Curvature’ from above and
interpret them as factor ζ1t , ζ2t and ζ3t and estimate the factor loadings βij in
Equation (57) above.
• Lets consider first the one factor model (m = 1), meaning that we only consider
the impact of the level factor.
Mat 1Y 2Y 3Y 5Y 7Y 10Y
βc
i1 0.799 1.012 1.093 1.103 1.043 0.950
SE 0.050 0.033 0.023 0.019 0.033 0.046
2
Radj. 0.717 0.913 0.966 0.970 0.915 0.814
dr d d
Table 6: Estimation Results for one factor model = β ζ1t where ζ1t is estimated
from changes in the level of interest rates. Bootstrapped yield data are collected over
the time period January 1990 until September 2015.

Factor Duration cont.
Some comments on the one factor model

• The OLS estimates for the level factor are all close to one and statistically
significant at all maturities.
• In the case of duration based risk management, we considered only parallel shifts
in the term structure which would imply βi,1 = 1, ∀i.
• Therefore, assuming that all the factor loadings are equal to one (duration
approximation), is not very far away from the empirical estimated factor loadings
βc
i1 .
• Explanatory power of the level factor is large, as the average adjusted R 2 is

0.8825, which indicates that almost 90% of the variation in the term structure can
be explained by the first factor.
• The explanatory power of the level factor is especially large for maturities ranging
from 2 years up to 7 years.
• Next, we want to add the term spread and curvature to the equation in order to
quantify their impact on the term structure.

Now suppose we add as second factor the term spread to the model and estimate the
following equation via OLS
dr
t = β ζt d (60)
d d d
where the first (second) element in ζt = ( ζ1t , ζ2t ) refers to the level (slope) factor.
βc
i1 0.879 1.058 1.114 1.078 0.993 0.879
SE 0.015 0.014 0.017 0.009 0.007 0.015
βc
i2 -0.528 -0.306 -0.135 0.167 0.330 0.472
SE 0.019 0.017 0.022 0.011 0.009 0.019
2
Radj. 0.973 0.981 0.978 0.988 0.989 0.978
Table 7: Estimation Results for two factor model dr d d

t = β ζt where ζt = ( ζ1t , ζ2t ) d d
are estimated from changes in the level of interest rates and the term spread.
Bootstrapped yield data are collected over the time period January 1990 until
September 2015.
Adding a Slope Factor
• βc
i2 denotes the estimate for the term spread.
• Coefficient is statistically significant for any maturity.

• The factor is negative for shorter maturities and positive for longer term yields.
• The reason why we see this pattern in the slope estimates is because the term
structure is upward sloping for the most part of the sample period.
• Lastly, adding the term spread factor increases the average adjusted R 2 is 0.9812,
in other words almost all the variation in yields is explained by only those two
factors!
• The increase in adjusted R 2 is especially large at the short end (1 year maturity),
where the adjusted R 2 increased by about 35%.

βc
i1 0.992 1.015 1.025 0.992 0.985 0.992
SE 0.008 0.017 0.015 0.008 0.010 0.008
βc
i2 -0.417 -0.348 -0.222 0.083 0.321 0.583
SE 0.009 0.018 0.018 0.009 0.010 0.009
βc
i3 -0.284 0.107 0.223 0.216 0.021 -0.284
SE 0.012 0.027 0.024 0.012 0.018 0.012
2
Radj. 0.973 0.981 0.978 0.988 0.989 0.978
Table 8: Estimation Results for three factor model drt = βd ζt where

d ζt = (d ζ t , d ζ t , d ζ t ) are estimated from changes in the level of interest rates, the
1 2 3
term spread and the curvature as given in Equation (56). Bootstrapped yield data are
collected over the time period January 1990 until September 2015.
Adding both a Slope and Curvature Factor
• βc
i3 denotes the estimate for the curvature.
• Coefficient is also statistically significant for any maturity.

• The factor is negative for shorter and longer maturities and positive for medium
term yields.
• Thus, an increase in the curvature factor on the term structure decreases yields at
both the short and the long end but raises the yields in between. In other words,
this factor bends the term structure.
• Lastly, adding the term spread factor increases the average adjusted R 2 marginally
from 0.9812 to 0.992.

Definition: Factor Duration
Let the bond price be denoted by P. The factor duration is defined as the partial
derivative of the bond price P with respect to the factor ζj , j = 1, . . . , m
1 ∂P
Dj = − (61)
P ∂ζj
∂P
where ∂ζj
represents the sensitivity of the bond price with respect ot the factor ζj .
Remarks:
• Note that Equation (61) is given for any factor. Can be level, slope, curvature or
any other factor.
• If ζj is the interest rate level, then Equation (61) is essentially equivalent to the
classical duration.

Factor Duration for Fixed Income Securities
1 for a Zero Coupon Bond
Let Pz (t, Ti ) denote the current time t price of a zero coupon bond with maturity
Ti . Then the factor duration Dz,j (t, Ti ) for the Ti maturity zero coupon bond with
respect to factor ζjt is
Dz,j (Ti − t) = (Ti − t) × βij (62)
2 for a portfolio of N securities
i = 1, . . . , N, then the duration of the factor duration of a portfolio DW ,j is equal
to the weighted sum of the factor durations of the individual securities, i.e.
N
X ϕi × P i
DW ,j = wi × (Ti − t) × βij , wi =
i=1
W
3 for a coupon bond

m
X
Dc,j (t, T ) = wi × Dz,j (t, Ti ) (63)
i=1
c(Ti )/n·Pz (t,Ti )
where wTi , i = 1, . . . , n and wTi = Pc (t,T )
, i = 1, . . . , m − 1 and
(1+c(Ti )/n)·Pz (t,Ti )
wTn = Pc (t,T )
, i =m

Factor Duration for Fixed Income Securities
Exercise
Verify the duration formulas on the previous slide
• Hint 1 : Use the change rule to compute
∂P ∂P ∂r (t, Ti )
= (64)
∂ζj ∂r (t, Ti ) ∂ζj
• Hint 2 : In order to verify the second bullet point, use two securities with prices
P1 (t, Ti ), P2 (t, Ti ) with portfolio holdings ϕ1 and ϕ2 . Furthermore, let W be the
value of the portfolio, i.e.
W = ϕ1 × P1 + ϕ2 × P2

Solution
1 Using hint 1, we have
∂P ∂P ∂r (t, Ti )
= = −(Ti − t) × Pz (t, Ti ) × βij (65)
∂ζj ∂r (t, Ti ) ∂ζj
from which the j th − factor duration using Equation (61) immediately follows.
2 By hint 2 we have

1 ∂W 1 ∂P1 (t, Ti ) ∂P2 (t, Ti )
DW ,j = − = −ϕ1 × − ϕ2 ×
W ∂ζj W ∂ζj ∂ζj
1
= (ϕ1 × P1 × (Ti − t) × βij + ϕ2 × P2 × (Ti − t) × βij )
W
= w1 × D1,j (t, Ti ) × βij + w2 × D2,j (t, Ti ) × βij
ϕi ×Pi
where wi = W
, i = 1, 2
3 This result follows immediately from
m m
1 c X ∂Pz (t, Ti ) 1 c X ∂Pz (t, Ti ) ∂r (t, Ti )
Dc,j (t, T ) = − =−
Pc (t, T ) n i=1 ∂ζj Pc (t, T ) n i=1 ∂r (t, Ti ) ∂ζj
m m
c 1 X X
= (Ti − t) × Pz (t, Ti ) × βij = wTi × (Ti − t) × βij
n Pc (t, T ) i=1 i=1
Bond Price Sensitivity and Factor Duration
Recall the bond price approximation formula in Equation (11)
We can now derive a similar formula using factor duration
Bond Price Sensitivity and Factor Duration

m m
dPc X 1 ∂Pc X
= dζj = − Dc,j dζj (68)
Pc j=1
Pc ∂ζj j=1
where Dc,j is the factor duration of a coupon bond.

Estimating Bond Price Change Using Factor Duration
Suppose we want to analyze the accuracy of Equation (68) in predicting the change of
bond price with respect to three factors, i.e. m = 3.
• Lets assume today is October 30, 2007.
• Consider a 4% Coupon bond (paid annually) with time to maturity 10 years.
• We want to estimate the change in bond price using the factors level, slope and
curvature from above.
• The factor durations are given by
DL = 9.8231, DS = 4.7200, DC = −2.6564, (69)
Interpretation:
• An increase in the level of interest rates by 1 basis point will lead to a -0.098231%
decline in bond price.
• Likewise, an increase in the term spread by 1 basis point will lead to a -0.0472%
decline in bond price.
• Contrarily, an increase in curvature by 1 basis point will increase in the bond price
by 0.026564%

Large Movement in Zero Rate Term Structure
8.8
8.6
8.4
8.2
7.8
7.6
1 2 3 4 5 6 7 8 9 10
Figure 30: Zero Rate Term Structure. Source: Federal Reserve Board.
Remarks:
• Large level shift (short end)
• Slope considerably steepened
Comparing Duration vs. Factor Duration
Let’s compare first the estimates for the duration as well as the estimates for the level,
slope and curvature factors.
Estimated Durations
Dc Dc,L Dc,S Dc,C
9.9879 9.8231 4.72 -2.6564
Table 9: (Factor) Duration of 4% coupon bond (paying annually) with Maturity 10

years. Estimates are based on term structure data of October 2007.
Remarks:
• Level duration factor and standard duration are almost identical.
• Therefore, both methods will produce very similar predictions of changes in the
level of the term structure.
• Relatively large impact of curvature factor Dc,S indicates larges changes in slope.

How Accurate is the Approximation
We are trying to approximate the percentage bond price change with
dPc
= −Dc,L dζLt − Dc,S dζSt − Dc,C dζCt (70)
Pc
and also using the standard duration formula
For the given change in the term structure in Figure (30), the bond price increases from
64.0859 to 70.0442 which is equivalent to a 9.30 % increase.
Important question?
• In order to make a fair comparison, how do we select the changes in
dζjt , j = {L, S, C }?
• Clearly, if we just assume dζjt = 0.01%, j = {L, S, C } this will lead to a very poor
approximation as not only the magnitude of the changes is off, but possibly also
the directions.
• For simplicity, we assume that we know the level, slope and curvature changes for
the two dates. dζLt = −0.0184, dζSt = 0.0161 and dζCt = 0.0010.
• Furthermore, the investor holds one unit of the bond, i.e. ϕ = 1.

How Accurate is the Approximation cont.
Exact and Estimated Bond Price Changes
Factor Dc Dc Exact
dP 6.8603 11.7594 5.9583
dP/P (%) 10.7048 18.3494 9.2974
Table 10: Comparison of bond price change approximation. In order to compute the
bond price change using only duration we set ∆r = dζLt = −0.0184%. Factor duration
is given in Equation (70) and Dc stands for duration only as in Equation (71).
Remarks
• Even though we are using the exact change in interest rates level
∆r = dζLt = −0.0184%, using only duration yields a very poor estimate of the
expected change in bond price.
• This can be mainly attributed to the fact, that the slope has changed considerably

How Accurate is the Approximation cont.
Comparing the approximations we see that

• The level factor duration DcL is almost identical to the standard duration Dc .
• This implies that the underlying assumption of βi1 = 1, ∀i = 1, . . . , n when
computing standard duration is not too far off.
• Approximation using only duration yields poor bond price change estimates, as
slope of term structure changed considerably.
• It overestimates the change by almost a 100 % (= 100 × 11.7594/5.9583 − 1)
even using the exact change in levels of interest rates.
• The factor duration estimate yields fairly accurate results. Error is about 15%
(= 100 × (6.8603/5.9583 − 1))

Factor Duration Hedging
• Lets consider an investor who holds a long term 10 year coupon bond Pc (t, TL )
who wants to guard him/herself against movements in the level and slope of the
term structure.
• To implement factor neutrality, the investor needs to trade an other security for
each factor the investor wants to neutralize
Suppose there are two types of zero coupon bonds available to the investor:
1 T
short term S = 2 year with level and slope factor duration Dz,L (t, TS ) and
Dz,S (t, TS ) as well as
2 T
long term L = 10 zero coupon bond with level and slope factor duration
Dz,L (t, TL ) and Dz,S (t, TL )
In order to be fully hedged against these two factors, the investors bond portfolio has to
be insensitive with respect to changes in either factor.
• Bond Portfolio: V = Pc (t, TL ) + θTS × Pz (t, TS ) + θTL × Pz (t, TL )
• where θTS and θTL denote the position in the short and long term bond,
respectively.
• Therefore, the change in the portfolio is
dV = dPc (t, TL ) + θTS × dPz (t, TS ) + θTL × dPz (t, TL ) = 0

Factor Duration Hedging cont.
Inserting the factor duration approximation we obtain
dV = −Pc (t, TL ) × (DcL (t, TL ) × dζL + DcS (t, TL ) × dζS )
− θTS Pz (t, TS ) (Dz,L (t, TS ) × dζL + Dz,S (t, TS ) × dζS )
− θTL Pz (t, TL ) (Dz,L (t, TL ) × dζL + Dz,S (t, TL ) × dζS ) (72)
Now pooling terms in the level dζL and slope factor dζS we obtain
0 = − (Pc (t, TL ) × DcL (t, TL ) + θTS Pz (t, TS )Dz,L (t, TS ) + θTL Pz (t, TL )Dz,L (t, TL )) dζL
− (Pc (t, TL ) × DcL (t, TL ) + θTS Pz (t, TS )Dz,S (t, TS ) + θTL Pz (t, TL )Dz,S (t, TL )) dζS
(73)
In order to be fully hedged, we need both parenthesis above to be equal to zero, i.e.
Pc (t, TL ) × DcL (t, TL ) = − (θTS Pz (t, TS )Dz,L (t, TS ) + θTL Pz (t, TL )Dz,L (t, TL ))
Pc (t, TL ) × DcL (t, TL ) = − (θTS Pz (t, TS )Dz,S (t, TS ) + θTL Pz (t, TL )Dz,S (t, TL )) (74)
Solving the system gives
Pc (t, TL ) Dc,L (t, TL ) × Dz,S (t, TL ) − Dc,S (t, TL ) × Dz,L (t, TL )
θ TS =
Pz (t, TS ) Dz,L (t, TS ) × Dz,S (t, TL ) − Dz,S (t, TS ) × Dz,L (t, TL )
Pc (t, TL ) Dc,L (t, TL ) × Dz,S (t, TS ) − Dc,S (t, TL ) × Dz,L (t, TS )
θ TL =
Pz (t, TL ) Dz,L (t, TL ) × Dz,S (t, TS ) − Dz,S (t, TL ) × Dz,L (t, TS )
Optimal Portfolio Holdings
• If we only use a duration hedging approach (see Equation (45)) we obtain that
θ∗ = −1.1281
• In other words, the investor shorts -1.1281 units of the long term zero coupon
bond.
• Using the two factor duration hedging approach, we obtain the following optimal
portfolio holdings
θT∗S = 0.2721, θT∗L = −1.2246,
which implies that the investor goes long 0.2721 units of the short term zero
coupon bond and short −1.2246 units of the long term zero coupon bond.
Now lets compare the two hedging approaches under a number of different term
structure movements.

1
0.5
-0.5
1000 2000 3000 4000 5000
Figure 31: Change in bond portfolio value when using a duration hedging approach for various
term structure scenarios. The bond portfolio is V = Pc (t, TL ) + θ × Pz (t, TL ) where both bonds
have maturity TL = 10. Duration optimal portfolio holding is θ∗ = −1.1281.

1
0.5
-0.5
1000 2000 3000 4000 5000
Figure 32: Change in bond portfolio value when using a factor duration hedging approach for
various term structure scenarios. The bond portfolio is
V = Pc (t, TL ) + θTS × Pz (t, TS ) + θTL × Pz (t, TL ) where both long term bonds have maturity
TL = 10 years and the short term bond has maturity TS = 2 years. Optimal factor duration
∗ = 0.2721, θ ∗ = −1.2246.
portfolio holdings are θT
S LT

0.5
-0.5
-1
-1.5
1000 2000 3000 4000 5000
Figure 33: Comparison of factor duration vs duration only hedging. The (factor
duration) bond portfolio is V = Pc (t, TL ) + θTS × Pz (t, TS ) + θTL × Pz (t, TL ) where both
long term bonds have maturity TL = 10 years and the short term bond has maturity
TS = 2 years and the (duration only) bond portfolio is V = Pc (t, TL ) + θ × Pz (t, TL ).

Comparison of Hedging Approaches
• On average, the factor duration hedging approach does a better job at guarding
the investor against movements in the term structure.
• Average change in bond portfolio for the duration hedging approach is 0.1097,
whereas for the factor duration approach, the average change in bond portfolio is
0.4336.
• This result is to be expected as we have an additional degree of freedom to
improve the hedge.
• Furthermore, we use the entire time series of the level and slope factor in order to
estimate βi1 and βi2 .
• Therefore, the comparison is in-sample and should provide a better hedging result.
• If we were using only historical data, let’s say up until October 2007, then the
factor duration hedging approach still outperforms the simple duration hedging
method, but the difference in bond portfolio change is smaller.
• However, the two factor duration hedging approach does not always produce
better results than the more simple duration hedging method.
• As we consider a number of different term structure scenarios, for which there the
duration approach yields better results.

Drawbacks of the Factor Duration Approach
• The labeling of the first three factors as level, slope and curvature is arbitrary.
• We have chosen the level to be equal to the mean term structure across all
maturities, the slope as the difference between the long end minus the short end
rate and the curvature factor as a linear combination between short, medium and
long term rates.
• Note that the three factors are not independent of each other
Level Slope Curvature
1.0000 -0.4382 0.3507
-0.4382 1.0000 0.5403
0.3507 0.5403 1.0000
Table 11: Unconditional correlation matrix between level, slope and curvature
factor over the time period January 1990 until September 2015.

Drawbacks of the Factor Duration Approach cont.
• Thus, we see that the level and slope move in opposite directions.
• However, the factor duration approach does not take this joint movement into
account.
We are now going to discuss an other statistical method that yields independent factors
in order to improve on the management of interest rate risk.

Principal Component Analysis (PCA)
PCA: The main idea
• PCA is a statistical method used to explain a set of observations with fewer
variables.
• More precisely, it converts a set of possibly correlated variables into a set of
linearly uncorrelated variables, which are called the principal components.
• Therefore, PCA reduces the dimensionality of the variables, in the sense that it
takes the components who accounts for most of the variation in the data.
• The number of PCA’s is lower than the number of variables in the data set
(dimensionality reduction).
• The first principal component has the largest possible variance explains the largest
fraction of the variability in the data and each succeeding component accounts for
the largest fraction of variability under the constraint that it is orthogonal to the
preceding components.
• The higher the correlation between the variables, the fewer PCAs will be needed
to explain the data set.
• This last comment makes PCA an ideal tool to analyze the term structure.

Factor Model with PCA
• Note that the factor model in Equation (57) allows us to specify the factors
ζjtPC , j ∈ {1, . . . , m} freely.
• Now we are going to extend the analysis to incorporate the principal components
version of the factor model from above.
• We are going to label the first principal component as the level factor, the second
principal component as the slope factor and finally the third principal component
as the curvature factor.
• An open question at this point here is, how do we estimate the PCs from the yield
data?
• Note that the PC factors are not observable, i.e. latent.

Factor Model with PCA cont.
Definition: PC Factor Model

Let Ti , i ∈ {1, . . . , n} be maturities of the term structure and let ri := r (t, Ti ) be the
corresponding zero coupon rate. Then a m− dimensional factor model, with common
factors ζjt , j ∈ {1, . . . , m}, assumes that the changes in interest rates
dr n
t = (dr1t , dr2t , . . . , drnt ) ∈ R are given by
 drt = β × d ζtPC  (75)
where  β11 β12 ... β1m 

 
 
 β21 β22 ... β2m 
 ∈ Rn×m
 
β= 
 .. .. .. 

 . . .


 
 
βn1 βn2 ... βnm
and βij represents the sensitivity of changes in interest rates at maturity Ti with respect
to PC-factor j.

Implementation of PCA
Let M denote the variance covariance matrix of the yield changes ∆rt , i.e.
M = C(∆rt ) ∈ R where C(·) denotes the covariance operator. Let v be the
n×n
eigenvector, i.e. v = (ϑ , ϑ , . . . , ϑ ) ∈ R .
i
n
i i1 i2 in
Implementing the PCA:

1 Compute the eigenvalues λ ∈ Rn and order them from highest to lowest, i.e.
λ1 > λ2 > . . . > λ1 . Furthermore, extract their corresponding (normalized)
eigenvectors ϑi1 , ϑi2 , . . . , ϑi3 .
2 The first eigenvector ϑi1 will be used to the construct the first PC factor, namely
r
n
∆ζ1PC
X
t = ϑ1i ∆ it
i=1
which gives us the change in the first PC factor ζ1PC

t and i = 1, . . . , n denotes the
maturities.
3 We then run the following regression
r
∆ t = α + β1 × ∆ζ1PC
t + ϵt (76)
where α ∈ Rn denotes the intercept vector, β1 ∈ Rn is the factor loading

coefficient of the first PC and ϵt ∈ Rn is the vector of random error terms.
4 From the regression equation (76) above, extract the estimated residuals. ϵ̂t
5 In order to obtain the second factor, we now use the extracted residuals from
above as well as the second eigenvector ϑ2 and set
n
∆ζ2PC
X
t = ϑ2i ϵ̂it
i=1
Note that since we are using the residuals from the first regression, we are now
going to use only that part of unexplained variation which is not already
captured by the first factor.
6 To obtain the estimated sensitivities β̂i2 for the second factor ζ2PC
t we run again
the following regression,
r
∆ t = α + β2 × ∆ζ2PC t + ϵt (77)
n
where β2 ∈ R is the factor loading coefficient of the second PC. Extract again
the estimated residuals from the regression equation (77) above.
7 In order to obtain the factor loadings β̂i2 for the third PC factor, we again set,
n
∆ζ3PC
X
t = ϑ3i ϵ̂it
i=1
where ϵ̂t are given in (77).

8 This procedure can be continued to obtain higher order factors.
Estimated PCs for Yield Curve Data
Estimated PC Coefficients β̂ P C
1
0.5
Level
-0.5
Slope
Curvature
-1
2 4 6 8 10
Maturity
Figure 34: Estimated PC factors level, slope and curvature using US zero rates from
January 1990 - September 2015.

Estimated PCs for Yield Curve Data cont.
Remarks:
PC
• First factor seems to be almost flat, implying when ζ1t increases, then the entire
term structure moves up.
• This is why this factor is interpreted as the level factor.
• Contrarily to the factor duration we considered previously, the estimated sensitivity
βb1iPC is considerably smaller than the first factor duration estimate βb1i .
• Note that the second factor, labeled ’slope’, is negative at the short and positive at
the long end of the term structure indicating that its slope is positive. (similar to
the factor duration model above)
• As for the factor duration model from above, the curvature factor is also negative
at the short and long end but positive for medium maturities indicating that the
term structure becomes more curvy when this factor increases.

Assessing the Explanatory Power of the PCA Factor Model
• As above for the factor duration model, we are going to evaluate how much each
PC factor contributes to explaining movements in the term structure.
• Lets start with the one factor PC model first, i.e. we only assess the explanatory
power of the level factor.
βc
i1 0.3206 0.4093 0.4436 0.4492 0.4252 0.3876
SE 0.0208 0.0140 0.0094 0.0070 0.0128 0.0180
2
Radj. 0.7013 0.9064 0.9648 0.9751 0.9227 0.8226
Table 12: Estimation Results for one PC factor model dr d

= β ζtPC where
d PC d PC
ζt = ζ1t is estimated using the first PC extracted from the covariance changes in
zero rates. Bootstrapped yield data are collected over the time period January 1990
until September 2015.

Two PC Factor Model
βc
i1 0.3206 0.4093 0.4436 0.4492 0.4252 0.3876
SE 0.015 0.014 0.017 0.009 0.007 0.015
βc
i2 -0.528 -0.306 -0.135 0.167 0.330 0.472
SE 0.019 0.017 0.022 0.011 0.009 0.019
2
Radj. 0.973 0.981 0.978 0.988 0.989 0.978
Table 13: Estimation Results for one PC factor model dr d

= β ζtPC where
d PC d d PC
ζt = ζ1t , ζ2t is estimated using the first and second PC extracted from the
covariance changes in zero rates. Bootstrapped yield data are collected over the time
period January 1990 until September 2015.

Three PC Factor Model
βc
i1 0.3206 0.4093 0.4436 0.4492 0.4252 0.3876
SE 0.001 0.003 0.002 0.003 0.002 0.002
βc
i2 -0.417 -0.348 -0.222 0.083 0.321 0.583
SE 0.004 0.008 0.006 0.009 0.008 0.008
βc
i3 -0.666 0.246 0.452 0.249 -0.034 -0.478
SE 0.004 0.008 0.006 0.009 0.008 0.008
2
Radj. 0.999 0.995 0.997 0.994 0.994 0.995
Table 14: Estimation Results

for one PC factor model dr d
= β ζtPC where
d ζtPC = d ζ PCt , d ζ PCt , d ζ PCt
1 2 3 is estimated using the first three PCs extracted from the
covariance
Felixchanges
Matthys in zero rates. Bootstrapped
Fixed Incomeyield data are collectedITAM
over the time
191 / 223
Discussion of PC Factor Models
• Estimated coefficients of the first PC do not vary much across maturities,
indicating that when this factor increases, it increases the level of the term
structure at all maturities.
• First PC explains already a very significant part of the movements in yields
2
(especially at medium maturities, Radj. at three and five years are above 95%)
• First PC is very precisely estimated, as the standard errors are extremely low.
2
• Adding a second PC helps raising the Radj. at both the short and the long end
considerably.
• Estimated coefficients of the second PC are negative for short maturities and
positive for longer maturities.
• This implies that the second factor lowers the short term but increases the long
term yields, in other words, the slope of the term structure becomes steeper when
this factor increases.
• Note that all standard errors are very small indicating that this factor is
significant at any maturity.
• Also, the SEs of the first factor become even smaller compared to the SEs in
Table 12 above.

Discussion of PC Factor Models cont.
• Lastly, adding the third PC factor shows that is now close to one, meaning that
almost 100% of the variation in yields is explained by the first three PCs.
• The estimated coefficients show that when the third PC factor increases, it lowers
the short and long end of the term structure but raises the yields at medium
maturities, i.e. this factor bends the term structure.
• All coefficients are highly significant. Note that the SEs of the first and second PC
become even smaller compared to the SEs in Table 12 and 13.

Comparison: Factor Duration vs. PCA Factor Model
• The main difference between the PCA and the duration factor model is that for
the former, the factors (by construction) are independent, since the PCs form an
uncorrelated orthogonal basis set of vectors.
• Both methods explain almost all the variation in the term structure, especially the
three factor models.
• Comparing the one factor models, the factor duration model explains the data
2
better at the short end (1 to 3 years, average Radj. = 0.8653 compared to
2
Radj. = 0.8570 for the PCA factor model.)
• Adding the slope factor we see that except for the one year maturity yield, the
PCA factor model exhibits higher explanatory power compared to the duration
factor model.
• Lastly, adding the curvature factor, the PCA factor model outperforms the
duration factor model at any maturity.
• Note that the SEs for the PCA factor model are always smaller than the SEs for
the duration factor model.

Summary
Key concepts:
✓ Duration: Is a measure of bond price sensitivity. We use the formula
dP
P
= −D × dr to approximate by how much the bond price changes when interest
rates are changing
✓ Value-at-Risk: Value-at-risk is a statistical measure of the riskiness of portfolios of
assets. The value-at-risk is the number that losses should not exceed with a given
probability α and horizon n.
✓ Expected Shortfall: Is defined as the conditional average of the losses which
exceed the Value-at-risk threshold. Therefore, contrarily to the Value-at-risk, the
expected shortfall also considers the very extreme losses.
✓ Dynamic Immunization: Is a hedging strategy that uses both the duration of the
assets and the duration of the liabilities (duration matching) to neutralize the
impact of interest rate changes on a portfolio. In problems such as the
asset-liability management, uses the ideas of duration matching.
✓ Convexity: Is a measure of the curvature (non-linear) in the relationship between
bond prices and bond yields. The extended formula dPP
= −D × dr + C2 × dr 2
improves the accuracy of the predicted bond price changes

Summary cont.
Key concepts:
✓ Slope and Curvature factors: Yield curve changes are not uniform across
maturities.
: Slope and curvature of the yield curve can change as well
✓ Factor Model: Is a model that assumes that the changes in the yield curve are
determined by a set of m factors
: The most prominent factors are ”Level”, ”Slope” and ”Curvature”
✓ Principal Component Analysis (PCA): Is a technique for reducing the
dimensionality of such datasets while retaining as much information as possible.
The method produces independent factors, i.e. the principal component factors
and shows how much variation in a dataset can be attributed to each of the
principal components.
: Due to the empirical observation that yield across different maturities are highly
correlated, the PCA is a very effective method to explain much of the variation in
the yield curve with a low number of factors (typically, three factors are sufficient to
explain close to the entire movement in the yield curve)

Additional Exercises

Exercise
Level, Slope and Curvature Suppose you are given the term structures as in Table 15
below. Compute the level and curvature factor for each term structures below
(a) Which period had the highest slope?
(b) Which period had the highest curvature?
(c) Which interval saw the largest change in slope?
(d) Which interval saw the largest change in curvature?

1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10 Y
9/26/2008 0.21% 0.87% 1.54% 1.81% 2.11% 2.38% 3.05% 3.41% 3.85%
9/10/2008 1.58% 1.65% 1.87% 2.06% 2.22% 2.42% 2.91% 3.23% 3.65%
8/25/2008 1.66% 1.74% 1.96% 2.12% 2.33% 2.62% 3.04% 3.36% 3.79%
8/11/2008 1.77% 1.87% 2.05% 2.27% 2.56% 2.84% 3.27% 3.57% 3.99%
7/25/2008 1.72% 1.75% 1.95% 2.35% 2.70% 3.01% 3.45% 3.73% 4.13%
7/10/2008 1.48% 1.67% 2.01% 2.20% 2.44% 2.72% 3.10% 3.40% 3.83%
6/25/2008 1.49% 1.81% 2.22% 2.48% 2.82% 3.11% 3.54% 3.78% 4.12%
6/10/2008 2.00% 2.02% 2.24% 2.53% 2.91% 3.20% 3.54% 3.77% 4.11%
Table 15: Term Structures at various dates

Solution (Level, Slope and Curvature)
Level is computed as the average term structure, the slope is the difference
between the 10 year and the 1 month yield and the curvature is obtained as follows
C (t, TS , TM , TL ) = −1M + 2 × 5Y − 10Y
with TS = 1M, TM = 5Y and TL = 10Y .
Date Level Slope Curvature ∆ Slope ∆ Curvature
9/26/2008 2.14% 3.64% 2.04% 1.57% 1.45%
9/10/2008 2.40% 2.07% 0.59% -0.06% -0.04%
8/25/2008 2.51% 2.13% 0.63% -0.09% -0.15%
8/11/2008 2.69% 2.22% 0.78% -0.19% -0.27%
7/25/2008 2.75% 2.41% 1.05% 0.06% 0.16%
7/10/2008 2.54% 2.35% 0.89% -0.28% -0.58%
6/25/2008 2.82% 2.63% 1.47% 0.52% 0.5%
6/10/2008 2.92% 2.11% 0.97% - -

Solution (Level, Slope and Curvature)
(a) 9/26/2008
(b) 9/26/2008
(c) 9/10/2008 - 9/26/2008
(d) 9/10/2008 - 9/26/2008

Exercise (Duration and Factor Duration)
Suppose your given the following zero rates on September 2011 and factor estimates.
1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10 Y
r 4.088 3.957 4.002 4.1012 4.204 4.2852 4.35 4.4115 4.4825 4.576
β̂L 0.9925 1.0119 1.0238 1.0117 0.9925 0.9860 0.9903 0.9977 1.0010 0.9925
β̂S -0.5224 -0.4561 -0.3314 -0.1770 -0.0224 0.1088 0.2175 0.3106 0.3949 0.4776
β̂C -0.2893 0.1052 0.2188 0.2419 0.2107 0.1270 0.0107 -0.1137 -0.2218 -0.2893
Table 16: Term Structure on September 2011
Consider a 4% Coupon (paid annually) bond with time to maturity 10 years. Compute
the following
(a) The price of the bond.
(b) The duration of the bond.
(c) The level factor duration.
(d) The slope factor duration.
(e) The curvature factor duration.
Solution (Duration and Factor Duration)
In order to compute the bond price, we need to extract the discount factors Z (t, Ti ) for
i = 1, . . . , n. Since we use annual rates we have
1
Z (t, Ti ) = , i = 1, . . . , n
(1 + r (t, Ti ))(Ti −t)
and therefore we obtain
1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10 Y
Z (t, Ti ) 0.9607 0.9253 0.8889 0.8515 0.8139 0.7774 0.7423 0.7080 0.6739 0.6393
Table 17: Discount factors on September 2011.

(a) The price of the bond is Pc (t, T ) = 95.8513.
(b) The duration of the bond is Dc (t, T ) = 8.3776.
(c) The level factor duration is Dc,L (t, T ) = 8.3241.
(d) The slope factor duration Dc,S (t, T ) = 3.4322.
(e) The curvature factor duration Dc,C (t, T ) = −1.9718.

Appendix

Coupon Effect
Suppose we have two bonds with the same maturity but different coupon rates, i.e.
cl = 0.05 and ch = 0.1. Given the term structure from above, their price for a given
yield to maturity y is
5% vs 10% coupon bond Relative Price Change: 5% vs 10 % coupon bond

150 0
5% coupon bond 5% coupon bond
10% coupon bond 10% coupon bond
-0.2
100
-0.4
50 -0.6
0 0.05 0.1 0.15 0.2 0 0.05 0.1 0.15 0.2
Yield-to-Maturity y Yield-to-Maturity y

Coupon Effect cont.
Remarks:
• Percentage decline in Bond with high coupon ch , when yield to maturity increases
is always below loss of bond with low coupon cl . (For any yield to maturity, the
blue line of cl bond is always below the red line of ch bond)
• The reason for this follows from the fact that the bod with higher coupon, having
larger cash flows, returns a higher proportion of value earlier than the bond with
low coupon. This implies that that the high coupon bond is less exposed to the
the higher compounding associated with the new discount factor.
• In other words, high coupon bonds are less sensitive to changes in the term
structure of interest rates!

Changing Maturity
Suppose we have two bonds, a long - term bond with maturity of 10 years and coupon
rate 10% and a short - term bond with maturity 5 years with the same coupon rate.
How do the prices of these bonds vary in yield to maturity?
5-year bond vs 10-year bond Relative Price Change:5-year vs 10-year bond

150 0
5-year bond 5-year bond
10-year bond -0.2 10-year bond
100
-0.4
50
-0.6
0 -0.8
0 0.05 0.1 0.15 0.2 0 0.05 0.1 0.15 0.2
Yield-to-Maturity y Yield-to-Maturity y

Changing Maturity cont.
Remarks:
• The longer the maturity of a bond, the more sensitive is it’s price to a change in
interest rates. (For any yield to maturity, the red line of 10-year bond is always
below the blue line of 5-year bond)
• The price sensitivity of any bond increases with it’s maturity, but the increase
occurs at a decreasing rate. For example, a 10-year bond is much more sensitive
to changes in the term structure than a 1-year bond. However, a 30-year bond is
only slightly more sensitive than a 20-year bond.

What we have learned so far
• Bond prices and bond yields move in opposite directions.
∂Pc (t, T )
<0
∂y
As a bond’s yield increases, its price decreases!
• For a given change in a bond’s YTM, the longer the term to maturity of the bond,
the greater the magnitude of the change in the bond’s price.
∂Pc (t, T1 ) ∂Pc (t, T2 )
< , ∀T1 < T2
∂y ∂y
Long - term maturity bonds are more price sensitive!
• For a given change in a bond’s YTM, the size of the change in the bond’s price
increases at a diminishing rate as the bond’s term to maturity lengthens.
∂Pc (t, T1 ) ∂Pc (t, T2 ) ∂Pc (t, T3 ) ∂Pc (t, T4 )
− > − , ∀T1 < T2 < T3 < T4
∂y ∂y ∂y ∂y
The effect of changing maturity T on the bond price is higher for shorter -
maturities (differences in price between the 1 -year and the 2 years bond) than for
longer - maturities (differences in price between the 10 -years and the 20 years
bond)
What we have learned so far cont.
• For a given change in a bond’s YTM, the percentage loss of the resulting change
in the bond’s price is lower the higher the coupon rate. Thus for two bonds with
coupon rate ch > cl we have,
∂Pch (t, T ) ∂Pcl (t, T )
/Pch (t, T ) < /Pcl (t, T ) , ∀cl < ch
∂y ∂y
The higher the coupon rate c the less sensitive is the bond price.
• For a given absolute change in a bond’s YTM, the magnitude of the price increase
caused by a decrease in yield is greater than the price decrease caused by an
increase in yield.
∂Pc (t, T ) ∂Pc (t, T )
> , ∀y1 < y2
∂y y =y1 ∂y y =y2
In other words, the bond price is more sensitive to changes at the short-end yield
curve (y1 ) as opposed to changes at long-end yield curve (y2 ).
Go Back

Duration as the Center of Gravity
• More formally speaking, if we take a coupon bond with n-annual payments and
maturity T .
• Thus, there are n × T = m payments in total and T1 , · · · , Tm = T are the coupon
payment dates.
• Let j be the coupon date such Tj < Dc < Tj+1 the last coupon payment dates just
before (Tj ) and just after (Tj+1 ) the duration date.
To balance the payments, we must have that the duration Dc (t, T ) is the real number
that solves,
j m
X c i X c i
× Z (t, t + i/n) Dc (t, T ) − = × Z (t, t + i/n) − Dc (t, T ) (78)
i=1
n n i=j+1
n n
i i
where the term in brackets on either side, i.e. Dc (t, T ) − n
and n
− Dc (t, T ) measure
’distance’ to the duration date.

Duration as the Center of Gravity: Example
Suppose we have the following bond

• 6% Coupon bond (paid semi-annually) and face value N = 100$.
• Maturity is T = 2 and the bond trades today at Pc (t, T ) = 111.52
• The duration of the bond is Dc (t, T ) = 1.919
Given this bond data, using Equation (78) we find that

6 1 6 2 6 3
× 99.996 1.919 − + × 99.906 1.919 − + × 99.783 1.919 −
2 2 2 2 2 2

6 4
− 100 + × 99.547 − 1.919 = 0
2 2
• Because of this property, duration of a coupon bond can be interpreted as the time
period a bond needs to be held, in order to get back the invested amount.
Go Back

Macaulay Duration and YTM cont.
To show Equation (15), from the definition of modified duration we have
m
1 X
DMD (t, T ) = wi × (Ti − t)
1 + y /n j=1
where the weights are given in (14). Then we get,

" m m
#
dDMD −c/n2 X 2
y −(Ti −t)−1 X y −(Ti −t) ∂Pc
= (Ti − t) 1 + Pc + (Ti − t) 1 +
dy Pc2 i=1
n i=1
n ∂y
−(T −t)
" Pm
2 y
i
1 i=1 (Ti − t) c/n 1 + n
=− y

1+ n nPc

P m y
−(T i −t)
y ∂Pc /∂y j=1 (Ti − t)c/n 1 + n

+ 1+

n Pc nPc


| {z }| {z }
−DMD DMD
y −(Ti −t)
" Pm #
2

1 i=1 (Ti − t) c/n 1 + n 2
=− − DMD (79)
1 + yn

nPc

Macaulay Duration and YTM cont.
Since
m m
X 1X
wi = 1, wi ≥ 0, ∀ i = 1, 2, . . . , m, DMD (t, T ) = wi × (Ti − t)
i=1
n i=1
we obtain for the last term in (79) that the bracket term is
Pm y −(Ti −t) m m
− t)2 c/n 1 +

i=1 (Ti
X X
n
= (Ti − t)2 wi − DMc
2
= wi ((Ti − t) − DMc )2
nPc i=1 i=1
And therefore we obtain that
(Modified) Duration is decreasing in YTM

n
dDMD 1 X
=− y
wi ((Ti − t) − DMc )2 < 0
dy 1 + n i=1
−(Ti −t)n
Intuitively, given the discount factor Z (t, Ti ) = 1 + yn , an increase in y will
discount cash flows stronger, which are further in the future, and thus leading to a
decline in duration. Go Back

• Remember that (Macaulay) duration can be written as
n
X
DMc (t, T ) = wi × (Ti − t)
i=1
PT ×n
ci /nPz (t, Ti )
i=1
=
Pc (t, T )
T ×n
! !
1 X c/n 1 c/n + N
= i + n×T
Pc i=1 1 + yn Pc 1 + yn
• Now the coupon bond price can be expressed as
N c q − q T ×n 1
Pc (t, T ) = n×T
+ , q= y
[1 + y /n] n 1−q 1+ n
and passing to the limit T → ∞ we obtain

c q
lim Pc (t, T ) = (80)
T →∞ n1−q

Now duration, setting Ti = i and t = 0 for simplicity, can be expressed as follows
T ×n T ×n
c X c X
nDMc (t, T )Pc (t, T ) = (Ti − t)Pz (t, Ti ) = i × q i + Nq n×T (81)
n i=1 n i=1
It can be shown that

T ×n
X 1
lim i × x i−1 = , |x| < 1 (82)
T →∞
i=1
(1 − x)2
The rewriting Equation (81), and using the convergence result in (82) we obtain,
T ×n T ×n
c X c X
nDMc (t, T )Pc (t, T ) = i × q i + Nq n×T = q i × q i−1 + Nq n×T
n i=1 n i=1
and then passing to the limit we get

T ×n
c X c q
lim DMc (t, T )Pc (t, T ) = lim q i × q i−1 + Nq n×T = (83)
T →∞ T →∞ n i=1 n (1 − q)2

Finally, with the limit result in (83) and using the bond price limit in (80) we can
express the limit, as maturity T goes to infinity of the Macaulay duration as
c q
1 n 1−q 2 1 1
lim DMc (t, T ) = c q =
T →∞ n n 1−q
n1−q
Inserting the expression for q we obtain the expression in (41). Go Back

Average Wealth Evolution
• The previous Figure 17 shows that the evolution of the pension funds wealth is
highly dependent on the interest rate level.
• The variability of wealth is very large (see left Panel in Figure 17).
• Of interest to the pension fund is also what level of wealth at the end of the
investment period can we expect?.
• In other words, what is Et [Wt+T ], the expected level of wealth at maturity.
• In order to address this question, the pension fund may first calibrate a model of
the interest rates to the data and then use the estimated model to simulate
plausible interest rate paths.
• Using those simulated interest rate trajectories, the pension fund can compute the
Monte - Carlo average interest rate over time t, i.e.
M
1 X j
r¯t = r (84)
M j=1 t
where M denote the number of Monte - Carlo Simulation runs.

• Therefore, for every time t we compute the average simulated interest rate level.
Using r¯t we now compute the wealth, portfolio weight, the bond prices and durations as
above.
Wealth Evolution Wt Portfolio weight wt
1000000 0.7
900000
800000 0.65
700000
600000 0.6
500000
400000 0.55
300000
200000 0.5
100000
0 0.45
0 5 10 15 20 25 30 0 5 10 15 20 25 30
Figure 35: Wealth Wt and portfolio wt evolution based on average interest rate r¯t
Observation
• Average Terminal Wealth is always greater than zero.
• No variability in either Wt and wt

Long term bond Pc (t, TL ) Short Term Bond Pz (t, TS )
105 98.5
100
98
95
90
97.5
85
80 97
75
96.5
70
65
96
60
55 95.5
0 5 10 15 20 25 30 0 5 10 15 20 25 30
Figure 36: Short - and long term bond price evolution based on based on average
interest rate r¯t
Observation:
• Price of short term bond decreases over time because interest rates approach long
run level θ > r0

Duration D(t, TL ) of Long Term Bond Duration DL (t, TL ) of Liabilities
18 14
16
12
14
10
12
10 8
8 6
6
4
4
2
2
0 0
0 5 10 15 20 25 30 0 5 10 15 20 25 30
Figure 37: Short - and long term bond duration evolution based on average interest rate
r¯t
Observation:
• Smooth monotone decline of duration over time.

Problems with immunization approach

• Requires frequent rebalancing of bond portfolio.
• High trading frequency increases the hedging cost (the more so the higher the
bid-ask spread)
• It is only approximately true since
• it assumes a flat term structure throughout the entire investment period.
• The only risk that changes is the level of interest rates. However, in reality
also the slope and curvature of the term structure may change

Is there a Simpler Strategy?
We can address the costly re-balancing by just simply taking a fixed weight w , ∀t ≥ 0
This approach reduces trading significantly and therefore also transaction costs.
However, in using this simplified approach, the pension fund is no longer
completely hedged against adverse interest rate scenarios.
In other words, we expect to see in some cases that the terminal wealth might be
negative!
Now the questions is: Which constant weight w shall we pick?
Recall that, since we are simulating the interest rate path, we can compute the
Monte - Carlo average interest rate over time t, i.e. r¯t (see Equation (84))
But r¯t is still varying over time. Let’s just take the time series average of r¯t
T
1 X
r¯ = r¯t (85)
T t=1
Now r¯ is just one number from which we can compute the average w
Go Back

Lecture 3 Int Rate Risk MGT

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Fixed Income

Lecture 3: Interest Rate Risk Management

Felix Matthys Fixed Income ITAM 2 / 223

Felix Matthys Fixed Income ITAM 3 / 223

1Y 1 0.993 0.982 0.952 0.927 0.896

2Y 1 0.997 0.979 0.961 0.936

3Y 1 0.991 0.979 0.958

Table 1: Yield Correlation Matrix

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1990 1995 2000 2005 2010

Definition: Level of Interest Rates

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Key observation: Bond price is decreasing in yield to maturity!

Felix Matthys Fixed Income ITAM 9 / 223

Felix Matthys Fixed Income ITAM 10 / 223

4 Liquidity Risk: A market is liquid if a security can be sold/bought with low

Felix Matthys Fixed Income ITAM 11 / 223

Felix Matthys Fixed Income ITAM 12 / 223

General Definition Duration

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Remark: Duration of a Zero Coupon Bond

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Felix Matthys Fixed Income ITAM 17 / 223

Duration of a portfolio of N securities

where wi is given in Equation (4) and asset i’s duration is denoted by Di .

• More specifically, duration is a weighted average of individual maturities of all the

Felix Matthys Fixed Income ITAM 19 / 223

Felix Matthys Fixed Income ITAM 20 / 223

Duration: An intuitive explanation

Felix Matthys Fixed Income ITAM 21 / 223

From the above analysis we can deduce the following fact,

Comparing Duration: Zero vs. Coupon Bond

Felix Matthys Fixed Income ITAM 22 / 223

Exercise (Duration Formula for a coupon bond)

Pz (t, Ti ) = N × Z (t, Ti ) = N × e −r (Ti −t) , i = 1, . . . , n (6)

Felix Matthys Fixed Income ITAM 23 / 223

from which we obtain Pm

Then, from Equation (9) we immediately obtain

Felix Matthys Fixed Income ITAM 25 / 223

dPc = −D × dr /100 × N × 1′ 000′ 000

Thus the bond portfolio will loose about $ 50’000.

Felix Matthys Fixed Income ITAM 26 / 223

Bond Price Sensitivity and Duration

Felix Matthys Fixed Income ITAM 27 / 223

How price sensitive is a floating rate bond?

Felix Matthys Fixed Income ITAM 29 / 223

Assuming that Ti < t < Ti+1 :

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Felix Matthys Fixed Income ITAM 31 / 223

Coupon c Price Pc Duration Interest Rate r2 Price Pc Duration

0 61.03 10 1% 147.47 8.13

2% 76.62 8.85 3% 125.75 7.95

4% 92.21 8.26 5% 107.79 7.76

6% 107.79 7.76 7% 92.89 7.56

8% 123.38 7.39 9% 80.49 7.35

10% 138.97 7.11 11% 70.12 7.12

12% 154.56 6.88 13% 61.44 6.9

Table 2: 6% coupon bond (semi-annual) with maturity T = 10 years.

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