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, 155 Ankur Agrawal, 205 Gaurav Kumar, 230

1. 2. 3.

**Interest Rate Risk Ways of measuring Interest Rate Risk Full valuation approach
**

Example

1.

**Duration/Convexity Approach
**

Duration

What is duration? Calculation Properties Application Limitations

Convexity

Introduction Predicting percentage price change using convexity Examples Convexity for callable and putable bonds Applications

**Changes in Bond prices due to interest rates fluctuations
**

Formula of Bond Value calculation.

Where Po=value of bond c1,c2,…,cn=cash flows

periods r=discount rate

expected from bond over ‘n’

Full

Valuation Approach - Convexity Approach

Duration

The

full valuation approach to measuring the interest rate risk involves using a pricing model to value individual bonds and can be used to find the price impact of any scenario of interest rate/yield curve changes. of this approach:

Advantages

Precision Complex Flexibility

B ond X C oupon Maturity (yr) F V($) YTM 8% 5 100 6.00%

B ondY 5% 15 100 7.00%

The Full Valuation Approach Scenari Yield ∆ Bond X Bond Y Portfol Portfol o (in (in io io millions) millions) Value ∆% Current +0 bp ($108.42) ($81.78) ($190.2 1) 1 +50 bp ($106.23) ($77.93) ($184.1 -3.18% 7) -2.02% -4.71% 2 +100 bp ($104.10) ($74.32) ($178.4 -6.20% 2)

-3.99% -9.12%

This

approach provides an approximation of the actual interest rate sensitivity of a bond or a bond portfolio. main advantage is its

Time for calculation

Its

Simplicity Lesser

1.

Duration is the slope of the price-yield at the current YTM.

2.

Weighted average of time until each cash flow would be received. Weights are proportions of total bond value that each cash flow presents

3.

Approximate percentage change in price for 1% change in yield

Example:

If

20yr, 8% coupon PV=908

yield decreases by 50 bps, price=952.3 If yield increases by 50 bps, price=866.8

1. 2.

Coupon Rate: Lower Coupon rate means Higher duration Maturity: Longer Maturity means Higher duration

The Full Valuation Approach Scenari Yield ∆ Bond X Bond Y Portfol Portfol o (in (in io io millions) millions) Value ∆% Current +0 bp ($108.42) ($81.78) ($190.2 1) 1 +50 bp ($106.23) ($77.93) ($184.1 -3.18% 7) -2.02% -4.71% 2 +100 bp ($104.10) ($74.32) ($178.4 -6.20% 2)

-3.99% -9.12%

3.

**Higher market yield means lower duration.
**

Price Yield Curve for an option free bond 8% coupon rate, 20 year bond

It

is a good measure of sensitivity of a portfolio, and can be used to reduce or increase the exposure to a particular term interest rate risk

1) Large changes in interest rates

2) This approach is applicable for a portfolio of bonds with only parallel yield curve shifts.

Measures how much a bond’s price-yield curve deviates from a straight line Second derivative of price with respect to yield divided by bond price Allows us to improve the duration approximation for bond price changes

**Duration underestimates actual prices Previous Example: 20yr, 8% coupon PV=908
**

Duration : 9.42

Recall

**approximation using only duration:
**

∆P * × 100 = −Dm × ∆y × 100 P

The

predicted percentage price change accounting for convexity is:

∆P 1 * × 100 = (− Dm × ∆y × 100) + × Convexity (∆y)2 × 100 × P 2

Comparison of bonds:

A

bond with greater convexity is less affected by interest rates A bond with greater convexity will have higher prices than bonds with lower convexity, regardless of interest rate rise or fall

Consider a 20-year 9% coupon bond selling at $134.6722 to yield 6%. Coupon payments are made semiannually. 10.66 convexity of the bond is 164.106.

Dm= The

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**If yields increase instantaneously from 6% to 8%, the percentage price change of this bond is given by:
**

First approximation (Duration):

**–10.66 × .02 × 100 = –21.32
**

Second approximation (Convexity)

**0.5 × 164.106 × (.02)2 × 100 = +3.28
**

Total predicted % price change: –21.32 + 3.28 (Actual price change = –18.40%.) = –18.04%

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What if yields fall by 2%? If yields decrease instantaneously from 6% to 4%, the percentage price change of this bond is given by:

First approximation (Duration):

–10.66 × –.02 × 100 = 21.32

Second approximation (Convexity)

0.5 × 164.106 × (–.02)2 × 100 = +3.28 Total predicted price change: 21.32 + 3.28 = 24.60% Note that predicted change is NOT SYMMETRIC.

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With a callable or prepayable debt, the upside price appreciation in response to decreasing yields is limited. When the price begins to rise at a decreasing rate in response to further decreases in yield, the price yield curve bends over to the left and exhibits negative convexity.

Compared to an option-free bond, a putable bond will have less price volatility at higher yields.

Convexity is a interest rate risk management tool, which is used in managing bond portfolios If the combined convexity and duration of a trading book is high, so is the risk. However, if the combined convexity and duration are low, the book is hedged, and little money will be lost even if fairly substantial interest movements occur.

Fixed

Income, Derivatives, and Alternative Investments – CFA L 1, Kaplan Schweser Valuation of Financial Assets – A.S.Ramasastri Presentation on the session “Duration and Convexity” by Prof. Jonathan Karpoff www.investopedia.com

THANK YOU

The presentation is about two methods to measure interest rate risk - Full valuation approach and Duration/Convexity approach

The presentation is about two methods to measure interest rate risk - Full valuation approach and Duration/Convexity approach

- Interest Rate Risk Management
- Bond Portfolio Management
- Asset Valuation
- Ch05 Mini Case
- Lecture 5-Bond Management
- Relationship Between Bond Prices and Yields
- 342 Chapter 10
- US Treasury
- FinQuiz - Smart Summary_ Study Session 16_ Reading 55
- Homework Solutions (Fundamental of Financial Management)
- Bonds and Their Valuation
- Lecture 07-08 Fixed Income Valulation
- CH03
- 07 Chapter Model
- Hull_OFOD9e_MultipleChoice_Questions_Only_Ch04.doc
- FIN 440_Case 5
- CHAPTER 7 Bonds and Their Valuation
- bond advanced topic
- Chapter 9
- Bond Basic
- Bond Mini Case
- Chapter 010
- Bonds Finman
- Bond Portfolio Mgt
- Bond Valuation
- Risk of Bond Investment
- Chapter 7
- C7 Prob& Sol
- Duration Convexity Bond Portfolio Management
- Chap 006

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