S 2-1

Risks Associated with Debt

Capital Markets

B.B.Chakrabarti
Professor of Finance
 Types of Risks
• Interest rate risk
• Call and prepayment risk
• Yield curve risk
• Reinvestment risk
• Credit risk
• Liquidity risk
• Exchange rate risk
• Volatility risk
• Inflation or Purchasing power risk
• Event risk
• Sovereign risk
B.B.Chakrabarti: [email protected]
 Interest Rate Risk
• Bond price and yield are inversely
proportional.
• The risk is that the bond price will fall
when interest rates increase.

B.B.Chakrabarti: [email protected]
 Interest Rate Risk
• Several measures of interest rate risk.

• PVBP (Price Value of a Basis Point) or

DV01 (Dollar Value of 0.01)
• Macaulay Duration
• Modified Duration
 PVBP
• PVBP is the change in the price of a bond
per basis point change in its yield.
• Typically PVBP is expressed in dollars per
million.
• PVBP (per $1 million) = Dp*100
• Dp is expressed as the change in bond
price for one basis point change in yield.
 Macaulay Duration

Macaulay duration is the weighted

average maturity of a bond’s cash flows,
where the present values of the cash flows
as ratios of total present value i.e. bond
price are used as the weights.
 Macaulay Duration
Macaulay Duration, D

= Price elasticity
= - (% change in price / % change in yield)
= - DP/ Dy *(1+y/2) / P with semi-annual
coupons
 Macaulay Duration

Macaulay Duration, D (in years)

= n PV(CF )
å ( t * t)
t = 0.5 TPV
 Macaulay Duration
Using MS Excel,
Macaulay Duration
=DURATION (settlement, maturity,
coupon, yield, frequency, basis)
 Macaulay Duration
• Settlement is the security's settlement date. The security
settlement date is the date after the issue date when the
security is traded to the buyer.
• Maturity is the security's maturity date. The maturity date
is the date when the security expires.
• Coupon is the security's annual coupon rate.
• Yield is the security's annual yield.
• Frequency is the number of coupon payments per year.
For annual payments, frequency = 1; for semiannual,
frequency = 2; for quarterly, frequency = 4.
• Basis is the type of day count basis to use.
 Macaulay Duration
Example:
9% Treasury Bond due on 5/15/2015.
Settled on 5/15/2005 with YTM of 8%.
Basis = Actual / Actual. Semi-annual
coupon.
Then, using MS Excel, Macaulay Duration is
found by
=DURATION(DATE(2005,5,15),DATE(2015,
5,15),9%,8%,2,1) = 6.91 years
 Modified Duration
Modified Duration
= - (% change in price / change in yield)
= - DP/ Dy*1/P
= Macaulay Duration /(1+y/2) for semi-
annual coupon bonds
 Modified Duration
For calculating Modified Duration using MS
Excel, use

=MDURATION (settlement, maturity, coupon,

yield, frequency, basis)

For the previous example,

Modified Duration = 6.64 years
 Duration of a Floating Rate Bond
• The coupon of a floating rate bond adjusts
automatically to the current interest rate level on
the reset date. Floating rate bonds trade at par
value every day. So, the duration a of floating
rate bond is zero, Since the price does not
change.
• But for practical purposes, the duration is taken
as the reset period for floating rate bonds with
no premium over reference rate.
 Duration of a Floating Rate Bond
• In case of premium over reference rate,
the duration is the duration of a portfolio of
two bonds – 1) floating rate bond with
coupon equal to the reference rate and 2)
fixed rate bond with coupon equal to the
premium over the reference rate.
Modified Duration for a Fixed Rate
Bond

• Modified Duration =
C 1 n ( M - C / y)
[1 - ]+
y2 (1 + y) n (1 + y) n +1
-
P
Modified Duration for a Fixed Rate
Bond
Where,
P = price of the bond
C = coupon interest per period
y = annual YTM divided by no. of periods
per year
n = no. of periods (no. of years times periods
per year)
M = maturity value
Modified Duration for a Fixed Rate
Bond
Example: 30-year 5% bond with semi-
annual coupons selling at 75.055 to a
yield of 7%.
P = 75.055, C = 0.05*100*1/2 = 2.5, n = 60,
y = 7%*1/2 = 0.035, M = 100
Mod. Duration = 26.54 (using formula).
Since coupons are semiannual, the above
value is by half year. So, annual mod.
duration is 13.27 years.
 Why is Duration a Key Concept?
• It is a simple summary statistic of the
effective average maturity of a bond
portfolio.
• It is an essential tool in immunizing
portfolios from interest rate risk.
• It is a measure of the interest rate
sensitivity of a portfolio.
DP/ P = - Modified Duration * Dy
 Estimating Portfolio Duration
N
• Portfolio duration = å (Di * Wi )
i =1

• Portfolio mod. duration N

= å (MDi * Wi )
i =1

• Portfolio effective N
duration = å (EDi * Wi )
i =1
 Convexity

• The bond price-yield relationship is a cup-

shaped curve i.e. non-linear and convex to
the origin.
• Convexity implies the gap between the
modified duration tangent line and the
price-yield curve.
 Convexity
• Convexity is the second-order derivative
of the price-yield function.

• Convexity = ½*1/P*D2P/ Dy2

• Convexity is positive for conventional

vanilla bonds.

• Convexity of a floating rate bond is zero.

Convexity of a Fixed Rate Bond
Convexity (by period) =

2C 1 2Cn n(n + 1)( M - C / y )

[1 - ] - +
1 y3 (1 + y ) n y 2 (1 + y ) n +1 (1 + y ) n + 2
*
2 P

The convexity measure

is in terms of periods squared.
Convexity of a Fixed Rate Bond
Example: 30-year 5% bond with semi-
annual coupons selling at 75.055 to a
yield of 7%.
P = 75.055, C = 0.05*100*1/2 = 2.5, n = 60,
y = 7%*1/2 = 0.035, M = 100
Convexity = 560.72(using formula).
Since coupons are semiannual, the above
value is by half year squared. So,
convexity is 140.18.
 Approximate Duration and
Convexity for Any Security

Plo - Phi
Approximate Duration =
2 Po Dy

Phi + Plo - 2 Po
Approximate Convexity measure =
2 Po Dy 2
 Approximate Duration and
Convexity for Any Security
Example: 30-year 5% bond with semi-
annual coupons selling at 75.055 to a yield
of 7%. Suppose Dy = 10 bps.

Po = 75.055, Plo = 74.070, Phi = 76.062

Approx. Modified Duration = 13.27

Approx. Convexity measure = 146.55
 Portfolio Convexity
N
Portfolio convexity = å (Ci * Wi )
i =1

where,
Ci = convexity of the ith. Security
Wi = market value weight of the ith. Security
N = no. securities in the portfolio
 Duration, Convexity and Bond
Price

Using Taylor series expansion,

é dP ù é 1 d2P ù é 1 d 3
P 3ù
DP = ê * Dy ú + ê * Dy ú + ê
2
* Dy ú + ......
ë dy û ë 2! dy û ë 3! dy
2 3
û
Ignoring 3rd. order and higher terms,
DP é 1 dP ù é 1 1 d2P 2ù
= ê * * Δyú + ê * * 2 * Dy ú = -MD * Δy + C * Dy 2
P ë P dy û ë 2! P dy û
 Duration, Convexity and Bond
Price

New bond price

= Old price
- Old price * Mod. duration * Change in yield
+ Old price * Convexity * Change in yield 2
 Call and Prepayment Risk
• An issuer calls back a callable bond if the
interest rates fall during the call
redemption period. The risk is that the
proceeds will then have to be reinvested at
a lower rate.
• Prepayment risk occurs in case of
mortgage backed securities when interest
rates fall.

B.B.Chakrabarti: [email protected]
 Yield Curve Risk
• Bond prices are inversely proportional to
yield changes. Also a bond has payments
at different maturities.
• Usually there are non-parallel shifts of
yield curve. The yield curve may steepen
or flatten.
• The risk is that a bond price may be
adversely affected due to the change in
yield curve.
B.B.Chakrabarti: [email protected]
 Reinvestment Risk
• Risk that the proceeds from the current
investment (interest and principal) will be
reinvested at a lower rate if the market
interest rates fall at the time of
reinvestment.
• Rollover risk is similar but faced when the
investment is rolled over in the same
institution.

B.B.Chakrabarti: [email protected]
 Credit Risk
• Three types:
- Default risk
- Credit spread risk
- Downgrade risk
• Default risk – risk of issuer not making timely payment of
interest and principal.
• Credit spread risk – it is the risk that the price of a bond
will decline due to increase in credit spread, which is the
risk premium over Treasury bond attributable to default
risk.
• Downgrade risk – credit downgrade leads to lower credit
rating with higher yield thus reducing the bond price
B.B.Chakrabarti: [email protected]
 Liquidity Risk
• Liquidity is measured by the bid ask
spread.
• Wider the bid ask spread, greater is the
volatility risk.
• Dealer bid price ↓, investor selling price ↓,
loss in mark-to-market long positions.
• Dealer ask price ↑, investor buying price ↑,
loss in mark-to-market short positions.
B.B.Chakrabarti: [email protected]
 Exchange Rate Risk
• An appreciation of the domestic currency
leads to lower domestic currency
realization of foreign bond investment.

B.B.Chakrabarti: [email protected]
 Volatility Risk
• Expected yield volatility increases option
prices.
• Increase in yield volatility decreases the
price of callable bonds.
• Decrease in yield volatility decreases the
price of puttable bonds.

B.B.Chakrabarti: [email protected]
Inflation or Purchasing Power Risk
• Inflation increases the nominal interest
rates leading to increase in bond yields.
• Bond prices as a result go down.

B.B.Chakrabarti: [email protected]
 Event Risk
• Risk that the investors’ claims on a bond
may undergo changes due to events like
- natural disaster impairing the issuer’s
ability to meet the obligations.
- corporate takeover or restructuring
resulting in credit downgrade / change of
claim seniority
- regulatory changes leading to changes in
the markets of specified bonds.
B.B.Chakrabarti: [email protected]
 Sovereign Risk
• Risk of default or adverse price changes in
case of a foreign bond investment.
• This happens generally due to the inability
of the foreign government to honor its
foreign currency commitments.

B.B.Chakrabarti: [email protected]