Professional Documents
Culture Documents
February 4, 2016
1 / 39
William C. H. Leon
2 / 39
William C. H. Leon
Overview
Bond price risk is often measured in terms of the bond interest-rate
sensitivity, or duration. This is a one-dimensional measure of the bonds
sensitivity to interest-rate movements.
The traditional hedging method that is intensively used by practitioners is
the duration hedging method. This approach is based on a series of very
restrictive and simplistic assumptions, the assumptions of a small and
parallel shift in the yield-to-maturity (YTM) curve.
There are three related notions of duration: Macaulay duration, $duration
and modied duration.
Macaulay duration is dened as a weighted average maturity for the
portfolio. The Macaulay duration of a bond or bond portfolio is the
investment horizon such that investors with that horizon will not care
if interest rates drop or rise as long as changes are small, as capital
gain risk is oset by reinvestment risk on the period.
3 / 39
William C. H. Leon
Overview
(Continue)
4 / 39
William C. H. Leon
5 / 39
5-Year
13.608%
4.292%
0.042%
0.042%
4.068%
11.585%
5% Coupon
15-Year
34.550%
10.041%
0.094%
0.094%
8.832%
23.502%
William C. H. Leon
25-Year
47.111%
12.824%
0.117%
0.117%
10.689%
27.225%
8% Coupon
5-Year
25-Year
12.988%
42.282%
4.100%
11.654%
0.040%
0.107%
0.040%
0.107%
3.890%
9.823%
11.088% 25.265%
6 / 39
William C. H. Leon
(2) Holding maturity constant, a decrease in rates will raise bond prices on a
percentage basis more than a corresponding increase in rates will lower bond
prices.
Bond price volatility can work for, as well as against, investors. Money
can be made, and lost, in risk-free Treasury securities as well as in riskier
corporate bonds.
7 / 39
William C. H. Leon
(3) All things being equal, bond price volatility is an increasing function of
maturity.
Long-term bond prices uctuate more than short-term bond prices.
Although the inverse relationship between bond prices and interest rates is
the basis of all bond analysis, a complete understanding of bond price
changes as a result of interest-rate changes requires additional
information. An increase in interest rates will cause bond prices to decline,
but the exact amount of decline will depend on important variables unique
to each bond such as time to maturity and coupon.
An important principle is that for a given change in market yields, changes
in bond prices are directly related to time to maturity. Therefore, as
interest rates change, the prices of longer-term bonds will change more
than the prices of shorter-term bonds, everything else being equal.
8 / 39
William C. H. Leon
(4) The percentage price change that occurs as a result of the direct
relationship between a bonds maturity and its price volatility increases at a
decreasing rate as time to maturity increases.
In other words, the percentage of price change resulting from an increase
in time to maturity increases, but at a decreasing rate.
Put simply, a doubling of the time to maturity will not result in a doubling
of the percentage price change resulting from a change in market yields.
9 / 39
William C. H. Leon
(5) The change in the price of a bond as a result of a change in interest rates
depends on the coupon rate of the bond.
Holding other things constant, bond price uctuations (volatility) and
bond coupon rates are inversely related.
Note that the above principle holds for percentage price uctuations; this
relationship does not necessarily hold if we measure volatility in terms of
dollar price changes rather than percentage price changes.
10 / 39
William C. H. Leon
11 / 39
William C. H. Leon
Reinvestment Risk
It is important to note that the YTM is a promised yield, because investors
earn the indicated yield only if the bond is held to maturity and the coupons
are reinvested at the calculated YTM.
Obviously, no trading can be done for a particular bond if the YTM is to
be earned. The investor simply buys and holds. What is not so obvious to
many investors, however, is the reinvestment implications of the YTM
measure.
The YTM calculation assumes that the investor reinvests all coupons
received from a bond at a rate equal to the computed YTM on that bond,
thereby earning interest on interest over the life of the bond at the
computed YTM rate.
If the investor spends the coupons, or reinvests them at a rate dierent
from the YTM, the realized yield that will actually be earned at the
termination of the investment in the bond will dier from the promised
YTM.
12 / 39
William C. H. Leon
Reinvestment Risk
(Continue)
13 / 39
William C. H. Leon
Reinvestment Risk
(Continue)
14 / 39
William C. H. Leon
William C. H. Leon
As bond yield drops, bond price rises, and vice versa. These create capital
gains and losses for bond investors.
There is an interplay between capital gain risk and reinvestment risk: if interest
rates drop and stay there, there is an immediate appreciation in the value of a
bond portfolio, but the portfolio then grows at a slower rate; on the other
hand, if interest rates rise and stay there, there is a capital loss, but the
portfolio then appreciates more rapidly.
Hence, there is some investment horizon D, such that investors with that
horizon will not care if interest rates drop or rise (as long as the changes are
small). The value of this horizon depends on the characteristics of the bond
portfolio; specically, D is the Macaulay duration of the bond portfolio.
16 / 39
William C. H. Leon
m
Fi B(t, ti ) =
i =1
m
i =1
Fi
t t ,
1 + R(t, ti t) i
17 / 39
William C. H. Leon
18 / 39
William C. H. Leon
m
i =1
Fi
t t .
1 + yt i
19 / 39
William C. H. Leon
m
i =1
20 / 39
William C. H. Leon
Fi (ti t)
t t+1 .
1+y i
$Duration
The derivative of the bond value function with respect to the YTM is known as
the $duration (or sensitivity) of portfolio P,
m
Fi (ti t)
$Dur P(y ) = P (y ) =
ti t+1 .
i =1 1 + y
Note that $Dur < 0. This means that the relationship between price and
yield is negative; higher yields imply lower prices.
21 / 39
William C. H. Leon
Modied Duration
Dividing dP(y ) by P(y ), we obtain an approximation of the relative change in
value of the portfolio as
dP(y )
P (y )
dy = MD P(y ) dy ,
P(y )
P(y )
where
m
$Dur P(y )
Fi (ti t)
P (y )
=
=
MD P(y ) =
t t+1
P(y )
P(y )
P(y
)
1+y i
i =1
is known as the modied duration (MD) of portfolio P.
22 / 39
William C. H. Leon
m
i =1
Fi
2(ti t) ,
1 + y2
we obtain the derivative of the bond price with respect to the YTM y as
P (y ) =
m
i =1
Fi (ti t)
2(ti t)+1 .
1 + y2
P (y )
.
$Dur P(y ) = P (y ) and MD P(y ) =
P(y )
23 / 39
William C. H. Leon
The $duration and the modied duration are also measures of the
volatility of a bond portfolio.
24 / 39
William C. H. Leon
$Dur
MD P
=
.
10, 000
10, 000
25 / 39
William C. H. Leon
Exercise
Consider below a bond with the following features:
Maturity: 10 years.
Coupon rate: 6%.
YTM: 5%.
Price: 107.72.
Assume that the coupon frequency and compounding frequency are annual.
26 / 39
If the YTM increases by 10 bps, what is the absolute and relative P&L?
William C. H. Leon
Answer
27 / 39
William C. H. Leon
28 / 39
Fi
P(y ) 1 + y
William C. H. Leon
ti t .
Note that the Macaulay duration is always less than or equal to the
maturity, and is equal to it if and only if the portfolio has only one cash
ow (e.g., zero-coupon bond).
The Macaulay duration of a bond or bond portfolio is the investment
horizon such that investors with that horizon will not care if interest rates
drop or rise as long as changes are small. In other words, capital gain risk
is oset by reinvestment risk.
29 / 39
William C. H. Leon
Exercise
Consider a 3-year standard bond with a 5% YTM and a $100 face value, which
delivers a 5% coupon rate. Coupon frequency and compounding frequency are
assumed to be annual. Its price is $100.
1
Suppose that the YTM changes instantaneously to the following level, and
stays at this new level during the life of the bond.
1
2
3
4
5
6
4%.
4.5%.
4.8%.
5.2%.
5.5%.
6%.
After D years, what is the bond price at the new YTM level? And what is
the amount of reinvested coupons?
30 / 39
William C. H. Leon
Answer
31 / 39
William C. H. Leon
D
,
1+y
$Dur = MD P =
D
P.
1+y
When the coupon frequency and the compounding frequency of a bond are
assumed to be semiannual, the two relationships are aected in the following
manner:
MD =
D
1+
y
2
$Dur = MD P =
33 / 39
William C. H. Leon
D
1+
y
2
P.
34 / 39
William C. H. Leon
Note that this linearity property (also holds for modied duration), is only
true in the context of a at curve. When the YTM curve is no longer at,
this property becomes false and may only be used as an approximation of
the true Macaulay duration (or modied duration).
35 / 39
William C. H. Leon
Hedging in Practice
Suppose we want to hedge a bond portfolio with YTM y and price P(y ) (in $
value).
The idea is to consider one hedging asset with YTM y1 (a priori dierent from
y ), whose price is denoted by H(y1 ), and to build a global portfolio with value
P invested in the initial portfolio and some quantity of the hedging
instrument, i.e.,
P = P(y ) + H(y1 ).
The goal is to make the global portfolio insensitive to small interest-rate
variations. Assuming that the YTM curve is only aected by parallel shifts so
that dy = dy1 , we require
dP = dP(y ) + dH(y1 ) P (y ) + H (y1 ) dy = 0.
36 / 39
William C. H. Leon
Hedging in Practice
(Continue)
Hence,
=
P(y ) MD P(y )
$Dur P(y )
P (y )
.
=
H (y1 )
$Dur H(y1 )
H(y1 ) MD H(y1 )
The optimal amount invested in the hedging asset is simply equal to the
opposite of the ratio of the $duration of the bond portfolio to be hedged
by the $duration of the hedging instrument. The hedge requires taking an
opposite position in the hedging instrument. The idea is that any loss
(gain) with the bond has to be oset by a gain (loss) with the hedging
instrument..
In practice, it is preferable to use futures contracts or swaps instead of
bonds to hedge a bond portfolio because of signicantly lower costs and
higher liquidity.
37 / 39
William C. H. Leon
Hedging Ratio
When standard swaps are used as hedging instruments, the hedge ratio (HR)
S is
$DurP
,
S =
$DurB
where $DurP and $DurB are, respectively, the $duration of the portfolio to be
hedged and that of the xed-coupon bond contained in the swap.
When futures are used as hedging instruments, the HR f is
f =
$DurP
CF ,
$DurCTD
38 / 39
William C. H. Leon
BPVH
Change in yield of the hedging instrument
where BPVB and BPVH are, respectively, the basis point value of the bond to
be hedged and that of the hedging instrument. The second ratio in the
equation is sometimes called the yield ratio.
39 / 39
William C. H. Leon