FIXED-INCOME SECURITIES

Chapter 5

Hedging Interest-Rate Risk with

Duration
 Outline

• Pricing and Hedging

– Pricing certain cash-flows
– Interest rate risk
– Hedging principles
• Duration-Based Hedging Techniques
– Definition of duration
– Properties of duration
– Hedging with duration
 Pricing and Hedging
Motivation

• Fixed-income products can pay either

– Fixed cash-flows (e.g., fixed-rate Treasury coupon bond)
– Random cash-flows: depend on the future evolution of interest
rates (e.g., floating rate note) or other variables (prepayment rate
on a mortgage pool)
• Objective for this chapter
– Hedge the value of a portfolio of fixed cash-flows
• Valuation and hedging of random cash-flow is a
somewhat more complex task
– Leave it for later
 Pricing and Hedging
Notation

• B(t,T) : price at date t of a unit discount bond paying

off $1 at date T (« discount factor »)
• Ra(t,) : zero coupon rate
– or pure discount rate,
– or yield-to-maturity on a zero-coupon bond with maturity date t + 

1
B(t , t  θ ) 
(1  Ra (t , θ ))θ
• R(t,) : continuously compounded pure discount rate
with maturity t + : B(t, t  θ )  exp  θ  R(t, θ )
– Equivalently,
1
R(t , θ )   lnB(t , t  θ )
θ
 Pricing and Hedging
Pricing Certain Cash-Flows

• The value at date t (Vt) of a bond paying cash-flows

F(i) is given by:
m m Fi
V (t )   Fi B(t , t  i)  
i 1 
i 1 1  Ra (t , i ) 
i

• Example: $100 bond with a 5% coupon

 Fi  cN  5% 100  5

 Fm  cN  N  5% 100  100  105
• Therefore, the value is a function of time and interest
rates
– Value changes as interest rates fluctuate
 Pricing and Hedging
Interest Rate Risk

• Example
– Assume today a flat structure of interest rates
– Ra(0,) = 10% for all 
– Bond with 10 years maturity, coupon rate = 10%
– Price: $100
• If the term structure shifts up to 12% (parallel shift)
– Bond price : $88.7
– Capital loss: $11.3, or 11.3%
• Implications
– Hedging interest rate risk is economically important
– Hedging interest rate risk is a complex task: 10 risk factors in this
example!
 Pricing and Hedging
Hedging Principles

• Basic principle: attempt to reduce as much as

possible the dimensionality of the problem
• First step: duration hedging
– Consider only one risk factor
– Assume a flat yield curve
– Assume only small changes in the risk factor
• Beyond duration
– Relax the assumption of small interest rate changes
– Relax the assumption of a flat yield curve
– Relax the assumption of parallel shifts
 Duration Hedging
Duration

• Use a “proxy” for the term structure: the yield to

maturity of the bond
– It is an average of the whole terms structure
– If the term structure is flat, it is the term structure
• We will study the sensitivity of the price of the bond
to changes in yield:
– Change in TS means change in yield
• Price of the bond: (actually y/2)
m
Fi
V 
i 1 1  y i
 Duration Hedging
Sensitivity

• Interest rate risk

– Rates change from y to y+dy
– dy is a small variation, say 1 basis point (e.g., from 5% to 5.01%)
• Change in bond value dV following change in rate
value dy dV  V ( y  dy)  V ( y)

• For small changes, can be approximated by

dV  V ' ( y)dy
• Relative variation
dV V ' ( y )
 dy  Sens  dy
V V ( y)
 Duration Hedging
Duration

• The relative sensitivity, denoted as Sens, is the

partial derivative of the bond price with respect to
yield, divided by the bond price
• Formally  1 m iFi 
 
V ' ( y )  1  y i 1 1  y i 

Sens   /
V ( y) V ( y )
• In plain English: tells you how much relative change
in price follows a given small change in yield impact
• It is always a negative number
– Bond price goes down when yield goes up
 Duration Hedging
Terminology

• The opposite of the sensitivity Sens is referred to as

« Modified Duration »
• The absolute sensitivity V’(y) = Sens x V(y) is
referred to as « $ Duration »
• Example:
– Bond with 10 year maturity
– Coupon rate: 6%
– Quoted at 5% yield or equivalently $107.72 price
– The $ Duration of this bond is -809.67 and the modified duration is
7.52.
• Interpretation
– Rate goes up by 0.1% (10 basis points)
– Absolute P&L: -809.67x.0.1% = -$0.80967
– Relative P&L: -7.52x0.1% = -0.752%
 Duration Hedging
Duration

 Fi 
• Definition of Duration D: m i 
 i
  
(1 y )
D
 V 
i 1  
 
• Also known as “Macaulay duration”
• It is a measure of average maturity
• Relationship with sensitivity and modified duration:

D   Sens  (1  y)  MD  (1  y)
 Duration Hedging
Example
Time of 1 Fi
Cash Flow (i) Cash Flow wi  
V 1  y i
i wi Example: m = 10, c = 5.34%,
Fi y = 5.34%
1 53.4 0.0506930 0.0506930
2 53.4 0.0481232 0.0962464
3 53.4 0.0456837 0.1370511
4 53.4 0.0433679 0.1734714 m
5 53.4 0.0411694 0.2058471 D   i  wi  8
6 53.4 0.0390824 0.2344945 i 1
7 53.4 0.0371012 0.2597085
8 53.4 0.0352204 0.2817635
9 53.4 0.0334350 0.3009151
10 1053.4 0.6261237 6.2612374
Total 8.0014280
 Duration Hedging
Properties of Duration

• Duration of a zero coupon bond is

– Equal to maturity
• For a given maturity and yield, duration increases as
coupon rate
– Decreases
• For a given coupon rate and yield, duration increases
as maturity
– Increases
• For a given maturity and coupon rate, duration
increases as yield rate
– Decreases
 Duration Hedging
Properties of Duration - Example

Bond Maturity Coupon YTM Price Sens D

Bond 1 1 7% 6% 100.94 -0.94 1
Bond 2 1 6% 6% 100 -0.94 1
Bond 3 5 7% 6% 104.21 -4.15 4.40
Bond 4 5 6% 6% 100 -4.21 4.47
Bond 5 10 4% 6% 85.28 -7.81 8.28
Bond 6 10 8% 6% 114.72 -7.02 7.45
Bond 7 20 4% 6% 77.06 -12.47 13.22
Bond 8 20 8% 7% 110.59 -10.32 11.05
Bond 9 50 6% 6% 100 -15.76 16.71
Bond 10 50 0% 6% 5.43 -47.17 50.00
 Duration Hedging
Properties of Duration - Linearity

• Duration of a portfolio of n bonds

n
DP   Di  wi
i 1
where wi is the weight of bond i in the portfolio, and:
n

w 1
i 1
i

• This is true if and only if all bonds have same yield,

i.e., if yield curve is flat
• If that is the case, in order to attain a given duration
we only need two bonds
 Duration Hedging
Hedging

• Principle: immunize the value of a bond portfolio with

respect to changes in yield
– Denote by P the value of the portfolio
– Denote by H the value of the hedging instrument
• Hedging instrument may be
– Bond
– Swap
– Future
– Option
• Assume a flat yield curve
 Duration Hedging
Hedging

• Changes in value
– Portfolio
dP  P' ( y)dy
– Hedging instrument
dH  H ' ( y)dy
• Strategy: hold q units of the hedging instrument so
dP  qdH  qH ' ( y)  P' ( y)dy  0
that

• Solution
P' ( y)  P  Sens P  P  DurP
q  
H ' ( y) H  Sens H H  DurH
 Duration Hedging
Hedging

• Example:
– At date t, a portfolio P has a price $328635, a 5.143% yield and a
7.108 duration
– Hedging instrument, a bond, has a price $118.786, a 4.779% yield
and a 5.748 duration
• Hedging strategy involves a buying/selling a number
of bonds
q = -(328635x7.108)/(118.786x5.748) = - 3421
• If you hold the portfolio P, you want to sell 3421 units
of bonds
 Duration Hedging
Limits

• Duration hedging is
– Very simple
– Built on very restrictive assumptions
• Assumption 1: small changes in yield
– The value of the portfolio could be approximated by its first order Taylor
expansion
– OK when changes in yield are small, not OK otherwise
– This is why the hedge portfolio should be re-adjusted reasonably often
• Assumption 2: the yield curve is flat at the origin
– In particular we suppose that all bonds have the same yield rate
– In other words, the interest rate risk is simply considered as a risk on the
general level of interest rates
• Assumption 3: the yield curve is flat at each point in time
– In other words, we have assumed that the yield curve is only affected only
by a parallel shift