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Notional amount
Definition
The nominal or face amount that is used to calculate payments made on swaps and other risk
management products. This amount generally does not change hands and is thus referred to as
notional.
Approaches to Risk Measurement
Existing approaches to measuring the risk of a financial position can be grouped
into
four different categories: the notional-amount approach; factor-sensitivity
measures;
risk measures based on the loss distribution; risk measures based on scenarios.
It is not new. It has been used for years. In many financial institutions it has been replaced or is
used in conjunction with value at risk.
B. Discounting the individual bond cash flows in order to find the sum of the present values
Let's assume you use the second method. You will use current market interest rates and a robust
method for calculating accurate discount factors. (Typically swap rates are used with zero
coupon methodology).
For the sake of simplicity we will use just one interest rate to discount the bond cash flows. That
rate is 5.00%. Discounting the cash flows using this rate will give you a value for the 5 year bond
of $10,000,000. (How to do this using a financial calculator is explained on the second page of
this document).
We will now repeat the exercise using an interest rate of 5.01%, (rates have increased by 0.01%).
The bond now has a value of $9,995,671.72.
There is a difference of $4,328.28.
It shows that the 0.01% increase in interest rates has caused a fall in the value of the bond. If you
held that bond you would have lost $4,328.28 on a mark-to-market basis.
Some firms do this by giving traders a maximum BPV that they are permitted to run. For
example, a limit where the portfolio BPV must not exceed $20,000.
The more interest rate risk you are prepared to let dealers take the higher the limit.
1. Selling the $10m 5 year bond and investing in a 3 month deposit. The BPV of a $10m 3
month deposit is approximately $250.
2. Selling another bond so the value of the long and short positions give a lower net BPV.
3. Paying fixed interest on an interest rate swap so the BPV of the swap and bond give a
lower net BPV.
4. Selling interest rate or bond futures, again to reduce the overall BPV of the portfolio.
• You may know the BPV but you do not know how much the yield curve can move on a
day-to-day basis.
• BPV assumes that the yield curve moves up or down in a parallel manner, this is not
usually the case.
Many firms have moved towards statistical techniques like value at risk. This provides a
probability of loss. BPV cannot do this.
Suppose you want to find the BPV of a $10m, 5 year bond with a coupon of 5% when interest
rates are 5%.
N = 5.00
I = 5.00%
PMT = 500,000
FV = 10,000,000
Press PV and the calculator will give you 10,000,000
N = 3.00
I = 5.00%
PMT = 500,000
FV = 10,000,000
You can now see that longer dated bonds, (or swaps), give you higher BPVs and therefore
greater interest rate risk.
Hedge ratios
Sometimes dealers construct trades that try to take advantage of anticipated changes in shape of
the yield curve. For example they may expect short term interest rates to increase and longer
term rates to fall.
Using the 3 year and 5 year bonds how could this trade be constructed?
You sell the 3 year bond and buy the 5 year bond. Because the two bonds have different BPVs
you would want to weight or ratio the trade according to their relative risks.
The BPV falls from 4,328.28, (using 5.00% and 5.01%), to $3,305.71.
As interest rates rise the BPV falls. Sometimes this is referred to as convexity.
It can be important to traders because it can mean that the interest rate risk they have changes as
interest rates move and any hedges they are using may need to be rebalanced.
For risk managers this has important implications too. If you are using interest rates derived from
swap rates to calculate the BPV of financial instruments and those instruments trade with credit
spreads over or under swap rates then your BPV calculations will be approximations.
J.P. Morgan
The most popular indexes are the J.P. Morgan Emerging Bond Index (EMBI) and EMBI+; the
latter measures both Brady bonds and other sovereign debt while the EMBI measures only Brady
bonds. In order to qualify for index membership, the debt must be more than one year to
maturity, have more than $500 million outstanding, and meet stringent trading guidelines to
ensure that pricing inefficiencies don't affect the index.