Risk and Exposure by Apte
Risk and Exposure by Apte
Risk and Exposure by Apte
Eective duration
Duration
A single factor model is a good rst approximation Short rates move more than long rates Interest rate volatility moves around
Volatility is on average higher when rates are higher Rates are on average higher when ination is higher
Reliable Disadvantages: Cannot hedge complex bonds or derivatives May over-hedge and incur high costs
What portfolio of the three Treasury bonds below would immunize the liability? (Match the cash ows.) time (months out) 0 6 12 18 T-Bond 1 100 103 0 0 T-Bond 2 98 2 102 0 T-Bond 3 103 4 4 104
Cash flow
10
15
10
20
25
Proposed hedge
Cash flow
10
15
10
20
25
Difference
10
20
25
This looks at the net exposure to dierent forward rates from the liability plus candidate hedge. This plot gives the dierence between the present value of the subsequent cash ows between the liability and the candidate hedge.
Strict matching of cash ows: dierence = 0 Eective approximate hedge total area between the dierence and the axis is small areas above and below the axis are nearly matched in time
Duration
When there is a single source of interest rate risk, it is useful to think of our measure of interest rate risk being the equivalent investment in a zero-coupon bond with the same risk exposure. The traditional (Macauley) measure of duration can be derived in a world in which there is a at term structure that can move up or down. With a at term structure, a small change in the interest rate gives an approximate proportional change in the value of a zero-coupon bond with time-to-maturity T . 1/(1 + r + )T 1/(1 + r)T T 1/(1 + r)T 1+r For a bond promising cash ows cs at each future time s, ct P (r) = t=1 (1 + r)t
T
is the value of the bond. Then for a small change in the interest rate r, the proportionate change in value is approximately
The bonds duration is the value-weighted average time-to-maturity of the claim: duration =
T t=1 ct (1+r)t cs T s=1 (1+r)s
Matching risk exposures for small changes in r for the zero-coupon bond and the general bond, we see that the time-to-maturity of the zero-coupon bond is equal to the duration of the general bond.
As maturity approaches innity, the duration of a par coupon bond approaches 1/r (exact with continuous coupon and compounding, (1+r/2)/r with semiannual coupon and compounding)
40
50
Duration in years
10
20
30
10
20
30
40
50
Years to maturity
0.0
0
0.2
0.4
0.6
0.8
10
15
20
interest rate, %/year (initial rate = 10%) Long position in short and long maturities, short in an intermediate maturity
Strangely enough, having a at yield curve that moves up and down implies there is arbitrage! This is related to convexity of the bond price in the interest rate.
Eective duration
Eective duration captures the good features of duration while addressing its lack of exibility. The eective duration of an interest-sensitive security is the time-to-maturity of the zero-coupon bond with the same interest sensitivity. If we are looking at nonrandom claims, the eective duration is equal to Macauley duration. Eective duration can also be computed given dierent assumptions about interest rate shocks that do not hit all yields equally (which is good because short rates move around more than long rates). Also, eective duration can be computed for a variety of interest derivatives if we know how their prices depend interest rates. Option pricing theory is an ideal tool for performing this analysis; in the next lecture we will consider the use of option pricing tools in pricing interest derivatives. The rest of this lecture is devoted to a more traditional approach.
Sensitivity
0.8
0.0
0.4
Macauley effective
10
15 Time to maturity
20
25
30
Sensitivity
30
Macauley effective
10
20
10
15 Time to maturity
20
25
30
Sensitivity
20
25
30
Macauley effective
10
15
10
15 Time to maturity
20
25
30
What is the eective duration of a portfolio half invested in 5-year zero-coupon bonds and half invested in 25-year zero-coupon bonds? The Macauley duration is 15, while the eective duration is about 10.