Notional Amount Approach

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.

Notional-amount approach. This is the oldest approach to quantifying the risk of

a portfolio of risky assets. In the notional-amount approach the risk of a portfolio is
defined as the sum of the notional values of the individual securities in the
portfolio,
where each notional value may be weighted by a factor representing an assessment
of the riskiness of the broad asset class to which the security belongs. Variants of
2.2. Risk Measurement 35
this approach are still in use in the standardized approach of the Basel Committee
rules on banking regulation; see, for example, Section 10.1.2 for operational risk,
or Chapter 2 of Crouhy, Galai and Mark (2001).
The advantage of the notional-amount approach is its apparent simplicity.
However,
as we recall from Chapter 1, from an economic viewpoint the approach is
flawed for a number of reasons. To begin with, the approach does not differentiate
between long and short positions and there is no netting. For instance, the risk
of a long position in foreign currency hedged by an offsetting short position in a
currency forward would be counted as twice the risk of the unhedged currency
position.
Moreover, the approach does not reflect the benefits of diversification on the
overall risk of the portfolio. For example, if we use the notional-amount approach,
it appears that a well-diversified credit portfolio consisting of loans to m
companies
that default more or less independently has the same risk as a portfolio where the
whole amount is lent to a single company. Finally, the notional-amount approach
has problems in dealing with portfolios of derivatives, where the notional amount
of
the underlying and the economic value of the derivative position can differ widely.

What is basis point value, (BPV)?

BPV is a method that is used to measure interest rate risk. It is sometimes referred to as a delta or
DV01. It is often used to measure the interest rate risk associated with swap trading books, bond
trading portfolios and money market books.

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.

What does it show?

BPV tells you how much money your positions will gain or lose for a 0.01% parallel
movement in the yield curve. It therefore quantifies your interest rate risk for small
changes in interest rates.

How does it work?

Let's suppose you own a $10m bond that has a price of 100%, a coupon of 5.00% and matures in
5 years time. Over the next 5 years you will receive 5 coupon payments and a principal
repayment at maturity. You can value this bond by:

A. Using the current market price from a dealer quote, or

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.

This is the BPV of the bond.

How do risk managers use this?

BPV is an estimate of the interest rate risk you have. You can therefore use it to manage interest
rate exposure.

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.

How do traders use this?

Traders can use BPV in order to adjust their exposure to interest rate risk. If a dealer expects
interest rates to rise he will reduce the BPV of the portfolio. If he expects rates to fall the BPV
will be increased.

How do dealers adjust the BPV?

Dealers adjust the BPV by altering the positions they have. Here is an example. Let's suppose a
dealer expects interest rates to rise and is long the $10m, 5 year bond from the previous example.

The dealer will want to reduce the BPV being run.

The BPV can be reduced by any of the following:

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.

What are the advantages of BPV?

The main advantages of BPV are:
 • It is relatively simple to calculate.
• It is intuitively easy to understand and has gained widespread acceptance with dealers.
• You can apply the same approach to financial instruments that have known cash flows.
This means you can calculate BPVs for money market products and swaps.
• You can also amalgamate all the cash flows from a portfolio of transactions and calculate
the portfolio BPV.
• It can be used by dealers to calculate simple hedge ratios. (If you are long one bond and
short another you can calculate an approximate hedge ratio from the ratio of the two
BPVs, more on this later).

What are the disadvantages of BPV?

BPV has weaknesses, they are:

• 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.

Can anything be done to improve BPV?

Yes. Firms that use BPV recognise these weaknesses and use additional risk limits. Some of
these limits capture the risks that dealers have from a non-parallel shift in interest rates. Risk
managers alter the shape of the yield curve. They make the yield curve steeper or flatter around a
particular maturity and look at the impact that would generate on the P&L.

Many firms have moved towards statistical techniques like value at risk. This provides a
probability of loss. BPV cannot do this.

A quick approximation for BPV

In order to accurately calculate BPV you need a spreadsheet or front office trading system that
provides you with precise discount factors from market interest rates. However if you want a
quick approximation of basis point value the following may help, you will need a financial
calculator.

Suppose you want to find the BPV of a $10m, 5 year bond with a coupon of 5% when interest
rates are 5%.

Input the following into your calculator:

N = 5.00
I = 5.00%
PMT = 500,000
FV = 10,000,000
Press PV and the calculator will give you 10,000,000

Repeat the exercise using 5.01% as the interest rate, I.

The calculator now gives you $9,995,671.72

A difference of $4,328.28, the BPV of this bond.

And for a 3 year bond?

Use the following:

N = 3.00
I = 5.00%
PMT = 500,000
FV = 10,000,000

Press PV and the calculator will give you 10,000,000

Repeat the exercise using 5.01% as the interest rate, I.

The calculator gives you $9,997,277.26

A difference of $2,722.73, the BPV of this bond.

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.

So if you bought $10m of the 5 year bond you would sell:

4,328/2,722 (BPV 5 year/BPV 3 year )x $10m = 15.9m

of the 3 year bond.

The BPV of the two trades would be zero. You have hedged parallel changes in the shape of the
yield curve but are exposed to the non-parallel change you wanted.

Finally is BPV constant?

No. As interest rates increase, BPV falls. You can see this if you calculate the BPV for the 5 year
bond using interest rates of 10.00% and 10.01% respectively.

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

John Pierpont Morgan (1837-1913) began his career in 1857 as an

accountant, and worked for several New York banking firms until he became
a partner in Drexel, Morgan and Company in 1871, which was reorganized as
J.P. Morgan and Company in 1895. Described as a coldly rational man,
Morgan began reorganizing railroads in 1885, becoming a board member
and gaining control of large amounts of stock of many of the rail companies
he helped restructure. In 1896, Morgan embarked on consolidations in the
electric, steel (creating U.S. Steel, the world's first billion-dollar corporation,
in 1901), and agricultural equipment manufacturing industries. By the early
1900s, Morgan was the main force behind the Trusts, controlling virtually all
the basic American industries. He then looked to the financial and insurance
industries, in which his banking firm also achieved a concentration of control.
Morgan was also among the foremost collectors of art and books of his day;
his book collection and the building that housed it in New York City are now
The Pierpont Morgan Library.

Emerging Markets Bond Index – EMBI

The J.P. Morgan indexes are a popular benchmark for money managers that deal in
emerging market debt, so investors may see the index used as a comparison for
their mutual funds or exchange-traded funds. Because of their higher interest rates,
emerging market bonds can significantly outperform U.S. Treasury bonds. For
example, in the 10-year period ending in May of 2004, the J.P. Morgan Global
Emerging Markets Bond Index had a total return of 248%, greater than both U.S.
corporate bonds and the S&P 500.

What Does Emerging Markets Bond Index - EMBI Mean?

A benchmark index for measuring the total return performance of international government
bonds issued by emerging market countries that are considered sovereign (issued in something
other than local currency) and that meet specific liquidity and structural requirements.

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.