IMMUNIZATION OF

INTEREST RATE RISK

The Basics

WHO FACES INTEREST

RATE RISK?

Any one trading in interest

sensitive securities.
Fixed Income Securities

Money market
Government Bonds, US T-Bills
Municipal Bonds
Corporate Bonds

FIXED-INCOME
SECURITIES

Financial Instrument high degree of

liquidity, is extensively traded (bought
and sold).
Provide fixed stream of cash flows over
a predetermined span of time to the
owner of the security.
Important source of funding present and
future cash flows.
Comparison points for investors
discount rate.

BONDS

By far the most popular of all fixedincome securities.

Bond issuer pays the bond holder as
per a predetermined schedule.
Three components to the payment
schedule.

Coupon payment .
Face value.
Time to maturity.

EXAMPLE:

A payment schedule of a 5 year 9%

coupon bond with face value of Rs.
10,000:

Year 1 Year 2 Year 3 Year 4 Year 5

Rs 900 Rs 900 Rs 900 Rs 900 Rs 10,900

EXAMPLE:

A payment schedule of a 5 year 9%

coupon bond with face value of Rs.
10,000:

6 mo. 12 mo.
mo.
Rs 450 Rs 450
10,450

18 mo. .. 54 mo.
Rs 450

Rs 450

60
Rs

INTEREST RATE RISK?

Reinvestment Risk
Capital Gains Risk (Price Risk)

REINVESTMENT RISK?

You wish to fund a liability of Rs

12,800 due three years from now.
You purchase a 2-year 9% coupon
bond with a face value of Rs
10,000.
Prevailing interest rate is 9%.
How much did you have to pay for
it?
Would you be able to fund your

REINVESTMENT RISK?

Let suppose that right after you

purchase the bond, the interest
rate falls down to 6%.
Would you now be able to fund
your liability?

CAPITAL GAINS RISK?

Lets suppose that you wish to fund

your liability by purchasing a 4-year
9% coupon bond with a face value of
Rs 10,000.
Prevailing interest rate is still 9%.
How much do you have to pay for it?
Would you be able to fund your
liability?

CAPITAL GAINS RISK?

Lets suppose that after 3 years, right

before selling the bond, the interest
rate soars to 12%.
What happens to the price of the
bond?
Would you be able to fund your
liability?

MATCHING CASH
FLOWS

How about a 3-year zero coupon bond?

Or a 3-year FD?
Either option entails no risk.
Zero coupon bonds not always
available, particularly if you wish to use
high yield corporate bonds.
Not feasible if liabilities require
payments over several years with
multiple payments each year.

EXAMPLE NEW INDIA

ASSURANCE..

PRICE-YIELD
RELATIONSHIP
Yield Implied interest rate of the
bond
Also known as Yield to Maturity (YTM).
Let,
P : Price of Bond
F : Face value of Bond
C : Coupon Payment per year.
: yield to maturity

PRICE-YIELD
RELATIONSHIP
F
P

n
[1 ( / m)]

C/m
k
k 1 [1 ( / m)]

or

F
C
1
P

n
n

[1 ( / m)]
[1 ( / m)]

0.00%
5.00%
10.00%
15.00%
30000
Price

PRICE-YIELD CURVES
Price Yield Curves

60000

50000

40000

20000

10000

20.00%
19.00%
18.00%
17.00%
16.00%
15.00%
14.00%
13.00%
12.00%
11.00%
10.00%
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%

Yield

30000

20000
Price

PRICE-YIELD
RELATIONSHIPS
60000

Inverse Relationship between

Price
and Yield.
50000

40000

10000

20.00%
19.00%
18.00%
17.00%
16.00%
15.00%
14.00%
13.00%
12.00%
11.00%
10.00%
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%

Yield

PRICE-YIELD
RELATIONSHIPS
Convexity Price decreases at a
60000 decreasing rate with increasing Yield.
50000

Price

40000
30000
20000
10000
0
20.00%

19.00%

18.00%

17.00%

16.00%

15.00%

14.00%

13.00%

12.00%

11.00%

10.00%

9.00%

8.00%

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

Yield

PRICE-YIELD
RELATIONSHIPS
60000

For a given yield, price increases

with increasing coupon rates.
0.00%
5.00%
10.00%
15.00%

50000

Price

40000
30000
20000
10000
0

20.00%

19.00%

18.00%

17.00%

16.00%

15.00%

14.00%

13.00%

12.00%

11.00%

10.00%

9.00%

8.00%

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

Yield

PRICE-YIELD
SENSITIVITY
45000
40000

Longer maturity results in greater

sensitivity of price to yield.

35000
30000
Price

3
25000

10

20000

20
30

15000
10000
5000
0

Yield

DURATION

Average of times that the cash

flows occur, weighted by the
present values of cash flows.

PV (t 0 )t0 PV (t1 )t1 .... PV (t n )t n

D
PV

MACAULAY DURATION
n

( k / m)c

/[1 ( / m)]

k 1

PV

where
PV

c
k 1

/[1 ( / m)]

DURATION

What is the relation between

Duration and sensitivity of Price to
changes in Yield?
n

d PVk
dP

.
d k 1 d

DURATION
Since,

ck
PVk
k
[1 ( / m)]

therefore

dPVk
( k / m)c k

k 1
d
[1 ( / m)]

DURATION
Therefore,

d PVk
dP

d k 1 d

(k / m) PVk
1

DP
1 ( / m )
k 1 [1 ( / m)]

FIRST ORDER
APPROXIMATION
Therefore,

dP
DM P
d

P DM P

DURATION OF
PORTFOLIO
Pi : Total Value of the ith security.
Di : Duration of the ith security.

Value of Portfolio:
P = P1 + P2 +Pm.

Duration of Portfolio:
D = w1D1 + w2D2 + .wmDm,

where, wi = Pi/P for i = 1,..,m.

CONVEXITY

Convexity measures the second

order gradient.
Rate of change in Duration.
2

d P

C
P
2
d

CONVEXITY
Therefore,

1
C
P

d PVk
2
k 1 d

2
P[1 ( / m)]

ck
k (k 1)
2
k
m
[1 ( / m)]
k 1

CONVEXITY
Convexity is proportional to the
weighted average of tktk+1.

1
C
2
P[1 ( / m)]

k (k 1)
PV
k
2
m
k 1

CONVEXITY OF
PORTFOLIO

Convexity of Portfolio:
C = w1C1 + w2C2 + .wmCm,
where, wi = Pi/P for i = 1,..,m.

SECOND ORDER
APPROXIMATION

PC
2
P DM P
( )
2