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FIS: Session 4
⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 1 / 12
Session Outline
1 Risk measures
⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 2 / 12
Session Outline
1 Risk measures
⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 3 / 12
Duration
Duration the first derivative (or slope) of bond price w.r.t. YTM
∑T tCt
∑T
1 ∂P tCt e −ty 1 t=1
(1 + y /2)2t
− = ∑t=1 , or
P ∂y T
t=1 Ct e
−ty 1 + y /2 ∑T Ct
t=1
(1 + y /2)2t
Or with first principles as:
1 ∂P P(y + ∆y ) − P(y ) 1
= lim
P ∂y ∆y →0 ∆y P(y )
Useful to think in terms of shifts (∆) from the current value
In general, one can talk about diff. shifts to diff. parts of the yield
curve, say, δ ≡ (δ1 , δ2 , δ3 ), with the following possibilities:
▶ δ1 = δ2 = δ3 : Parallel shift
▶ δ1 < 0, δ2 ≈ 0, δ3 > 0: Steepener, and its reverse, Flattener
▶ δ2 > 0, δ1 , δ3 < 0: Long Butterfly, and its reverse, the Short Butterfly
1 ∂P P(r0 + δ) − P(r0 ) 1
Modified Duration = − = − lim
P ∂δ δ→0 δ P(r0 )
⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 5 / 12
Duration
But it remains that duration captures the risk of small level shifts of
the yield curve
P
Under-estimation
+∆y
−∆y
Over-estimation
Using risk-measures:
∂P 1 ∂2P 1 ∂P 1 1 ∂2P
dP ≈ ∆y + ∆y 2
= ∆y × P + ∆y 2 × P
∂y 2 ∂y 2 P ∂y 2 P ∂y 2
Excel example
Price change by duration: −Modified Duration × ∆y × P
Change including convexity (its contribution is always positive):
Modified Duration × P
Dollar value of a basis-point change: DV01 =
10000
Exact price change is, of course: Price at new yield − Old price
Python example: Comparison for different kinds of bonds
⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 8 / 12
Session Outline
1 Risk measures
⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 9 / 12
Risk measures and trading strategies
To the extent bond trades are a view on future interest rates, they are
really a bet on term structure shifts
But what makes the trades profitable? Price impact of yield changes
Risk measures
⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 10 / 12
Slope/spread trades: Flatteners and Steepners
Yield Yield
t=1 t=0
t=0 t=1
Maturity Maturity
t=0 t=1
t=1 t=0
Maturity Maturity