S8–

Measurement of Interest Rate Risk

B.B.Chakrabarti
Professor of Finance
 Interest Rate Risk
• Interest rate risk or price risk or market
risk of a bond is the change in its price due
to changes in the interest rate in the
market.

• Price and yield of a bond are inversely

related.

B.B.Chakrabarti: [email protected] 2
 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

B.B.Chakrabarti: [email protected] 3
 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) = p*100
 p is expressed as the change in bond
price for one basis point change in yield.

B.B.Chakrabarti: [email protected] 4
 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.

B.B.Chakrabarti: [email protected] 5
 Macaulay Duration
Macaulay Duration, D

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

B.B.Chakrabarti: [email protected] 6
 Macaulay Duration

Macaulay Duration, D (in years)

= n PV (CF )
 ( t * t)
t 0.5 TPV

B.B.Chakrabarti: [email protected] 7
 Macaulay Duration
Using MS Excel,
Macaulay Duration
=DURATION (settlement, maturity,
coupon, yield, frequency, basis)

B.B.Chakrabarti: [email protected] 8
 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.

B.B.Chakrabarti: [email protected] 9
 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
B.B.Chakrabarti: [email protected] 10
 Modified Duration
Modified Duration
= - (% change in price / change in yield)
= - P/ y*1/P
= Macaulay Duration /(1+y/2) for semi-
annual coupon bonds

B.B.Chakrabarti: [email protected] 11
 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

B.B.Chakrabarti: [email protected] 12
 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.

B.B.Chakrabarti: [email protected] 13
 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.

B.B.Chakrabarti: [email protected] 14
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

B.B.Chakrabarti: [email protected] 15
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
B.B.Chakrabarti: [email protected] 16
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.
B.B.Chakrabarti: [email protected] 17
 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.
P/ P = - Modified Duration * y
B.B.Chakrabarti: [email protected] 18
The Factors that Influence Duration
Term to maturity
• Duration is positively related to bond’s
remaining term to maturity.
• Duration increases at a decreasing rate for
coupon-bearing bonds as maturity is extended.
• For a zero coupon bond, duration increases at
a constant rate as maturity is lengthened.
• Duration and term to maturity are identical for
zero coupon bonds.

B.B.Chakrabarti: [email protected] 19
The Factors that Influence Duration
Coupon rate
Duration is inversely related to a bond’s
coupon rate of interest.
Accrued interest
Duration is inversely related to the amount
of accrued interest attached to a bond.
Market yield level
Duration is inversely related to the market
yield level at which a bond trades.
B.B.Chakrabarti: [email protected] 20
 Estimating Portfolio Duration
N
• Portfolio duration =  (Di * Wi )
i 1

• Portfolio mod. duration N

=  (MDi * Wi )
i 1

• Portfolio effective N
duration =
 (EDi * Wi )
i 1
B.B.Chakrabarti: [email protected] 21
 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.

B.B.Chakrabarti: [email protected] 22
 Convexity
• Convexity is the second-order derivative
of the price-yield function.

• Convexity = ½*1/P*2P/ y2

• Convexity is positive for conventional

vanilla bonds.

• Convexity of a floating rate bond is zero.

B.B.Chakrabarti: [email protected] 23
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.

B.B.Chakrabarti: [email protected] 24
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.
B.B.Chakrabarti: [email protected] 25
 Approximate Duration and
Convexity for Any Security

Plo  Phi
Approximate Duration =
2 Po y

Phi  Plo  2 Po
Approximate Convexity measure =
2 Po y 2

B.B.Chakrabarti: [email protected] 26
 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 y = 10 bps.

Po = 75.055, Plo = 74.070, Phi = 76.062

Approx. Modified Duration = 13.27

Approx. Convexity measure = 146.55
B.B.Chakrabarti: [email protected] 27
 Delta and Gamma:
Dollar Duration and Convexity
Delta (Dollar duration) = P / y
Gamma (Dollar convexity) = 1/2*2P / y2

Using the data in the previous example,

Delta (Dollar duration) = 13.27*75.055 =

$996.00
Gamma (Dollar convexity) = 140.18*75.055
= $10,521.45
B.B.Chakrabarti: [email protected] 28
 Portfolio Convexity
N
Portfolio convexity =  (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

B.B.Chakrabarti: [email protected] 29
Duration, Convexity and Bond Price

Using Taylor series expansion,

 dP   1 d2P 2  1 d 3P 3
P  * y    * y    * y   ......
 dy   2! dy   3! dy
2 3

Ignoring 3rd. order and higher terms,
P  1 dP   1 1 d2P 2
 * * Δy    * * 2 * y   MD * Δy  C * y 2
P  P dy   2! P dy 

B.B.Chakrabarti: [email protected] 30
Duration, Convexity and Bond Price

New bond price

Old price
- Old price * Mod. duration * Change in yield
2
 Old price * Convexity * Change in yield

B.B.Chakrabarti: [email protected] 31
 Change in Yield Direction and
Convexity
Convexity is not uniform. It varies
depending on the size and direction of
change in yield.
Ex.
9% US T-Bond due on 5/15/2019 priced at
par on 5/15/2009 with modified duration of
6.51 years.

B.B.Chakrabarti: [email protected] 32
 Change in Yield Direction and
Convexity
YTM Bond Act. % Pred.% Conv.
% Price Change Change %
6 122.32 +22.32 +19.53 +2.79
7 114.21 +14.21 +13.02 +1.19
8 106.80 +6.80 +6.51 +0.29
9 100 0 0 0
10 93.77 -6.23 -6.51 +0.28
11 88.05 -11.95 -13.02 +1.07
12 82.80 -17.20 -19.53 +2.33

B.B.Chakrabarti: [email protected] 33