RISK ASSESSMENT AND MANAGEMENT

LECTURE 4
INTEREST RATE RISK

EBS Universität
MASTER LEVEL
Dr. V. Stemann
Agenda

1 Introduction

2 Definition and Typology of Market Risk

3 Interest Rate Risk

4 Yield Curve Construction

5 High dimensional IR-Risk - Partial Duration and PCA

Dr. V. Stemann
1
Agenda

1 Introduction

2 Definition and Typology of Market Risk

3 Interest Rate Risk

4 Yield Curve Construction

5 High dimensional IR-Risk - Partial Duration and PCA

Dr. V. Stemann
1
Definition of Market Risk

▪ Market risk can be defined as the risk of losses in on and off-

balance sheet positions arising from adverse movements in
market prices.

▪ From a regulatory perspective, market risk stems from all the

positions included in banks' trading book as well as from
commodity and foreign exchange risk positions on the whole
balance sheet.

Dr. V. Stemann
3
Types of Market Risk

Dr. V. Stemann
4
Types of Market Risk

▪ Interest Rate (IR) Risk

▪ Risk that the value of an interest-rate-sensitive assets will fall as
a result of increase in IR
▪ Also can arise due to difference in maturities of assets/liabilities
▪ Equity Price Risk
▪ Associated with volatilities in the stock markets
▪ F/X Risk
▪ Arises from open or imperfectly hedged positions in foreign
currency denominated assets/liabilities
▪ Leads to adverse Profit/Loss (P/L) fluctuations, measured in
local currency
▪ Commodity Price Risk
▪ Risk from changing commodity prices on firm’s positions:
precious metals, agricultural products, energy products etc.

Dr. V. Stemann
5
Agenda

1 Introduction

2 Definition and Typology of Market Risk

3 Interest Rate Risk

4 Yield Curve Construction

5 High dimensional IR-Risk - Partial Duration and PCA

Dr. V. Stemann
1
Types of Interest Rates

• The Rate an investor earns on T-Bills and

Treasury Rates
Treasury bonds.

• The Rate at which banks are prepared to make

LIBOR
deposits with other banks.

• Swap Rates are the fixed rates exchanged for

Swap Rates
floating in an interest rate swap.

• The rate swapped for the geometric average of

OIS Rates
overnight borrowing rates.

Repo Rates • Secured borrowing rate

Dr. V. Stemann
7
Measuring Interest Rates

▪ When we compound m times per year at rate 𝑅 an amount 𝐴

grows to 𝐴 𝑥 (1 + 𝑅/𝑚)𝑚 in one year

▪ 100€ grows to 100𝑒 𝑅𝑇 when invested at a continuously

compounded rate 𝑅 for time 𝑇 (here 𝑇 = 1)

Dr. V. Stemann
8
Conversion Formulas

Define

▪ Rc: continuously compounded rate

▪ Rm: same rate with compounding m times per year

𝑚
𝑅𝑚
1+ = 𝑒 𝑅𝑐
𝑚

▪ or:
𝑅𝑚
𝑅𝑐 = 𝑚 𝑙𝑛 1 +
𝑚

𝑅𝑚 = 𝑚(𝑒 𝑅𝑐 /𝑚 − 1)

Dr. V. Stemann
9
Compounding and Discounting

▪ Compounding an amount “A” of money at a continuously

compounded rate R for T years involves multiplying it by 𝑒𝑅𝑇.

▪ Discounting “A” at a continuously compounded rate R for T

years involves multiplying it by 𝑒−𝑅𝑇

Discounting Compounding
A x e-RT A x eRT

Dr. V. Stemann
10
Zero Rates

▪ The t-year zero coupon interest rate is the rate of interest

earned on an investment that starts today and lasts for t years.

▪ All the interest and principal is realized at the end of t years.

▪ Also referred to as spot rate

Dr. V. Stemann
11
Forward Rates

▪ No arbitrage condition states the following: an investor must

be indifferent between these two choices (if 𝑇1 < 𝑇2):

▪ To invest its funds until time 𝑇2 at rate 𝑅0,2

▪ To invest its funds until time 𝑇1 at rate 𝑅0,1 and then
reinvest them until time 𝑇2 at rate 𝑅1,2

▪ No arbitrage condition implies the following

𝑒 𝑇2 𝑅0,2 = 𝑒 𝑇1𝑅0,1 𝑒 𝑇2 −𝑇1 𝑅1,2

▪ 𝑅1,2 represents the future spot rate from period 𝑇1 to period 𝑇2.
We do not know it at the moment, and it represents our
expectation about that future rate. That is a forward rate.
Dr. V. Stemann
12
Forward Rates

▪ Suppose that the zero rates for time periods T1 and T2 are R1
and R2 with both rates continuously compounded.

▪ The forward rate for the period between times T1 and T2 is

𝑅2 𝑇2 − 𝑅1 𝑇1
𝑅1,2 =
𝑇2 − 𝑇1

▪ This formula is only approximately true when rates are not

expressed with continuous compounding

Dr. V. Stemann
13
Bond Pricing

▪ Most bonds pay coupons to the holder periodically. The bond’s

principal (par or face value) is paid at the maturity.

▪ The theoretical price of a bond can be calculated as the

present value of all the cash flows that will be received by the
owner of the bond

▪ Spot rates are used to discount cash flows. In case of discrete

discounting, we use the following formula:

𝐶1 𝐶2 𝐶𝑁 𝐹𝑉
𝑃= + 2
+ ⋯+ 𝑁
+ 𝑁
(1 + 𝑖1 ) 1 + 𝑖2 1 + 𝑖𝑁 1 + 𝑖𝑁

Dr. V. Stemann
14
Bond Pricing Illustration

▪ Bond pricing can also be computed using continuous discounting.

Suppose that a 2-year Treasury bond with a principal of 100€
provides coupons at the rate of 6% per annum semiannually.

▪ The theoretical price of the bond is:

𝑃 = 3𝑒 −0.05∗0.5 + 3𝑒 −0.058∗1.0 + 3𝑒 −0.064∗1.5 + 103𝑒 −0.068∗2.0 = 98.39

Dr. V. Stemann
15
Bond Yield

▪ A bond’s yield is the single discount rate that, when applied to

all cash flows, gives a bond price equal to its market price.

▪ Suppose that the theoretical price of the bond is also its market
value. If the 𝑦 is the yield on the bond, then:

3𝑒 −𝑦∗0.5 + 3𝑒 −𝑦∗1.0 + 3𝑒 −𝑦∗1.5 + 103𝑒 −𝑦∗2.0 = 98.39

▪ This equation can be solved using an iterative procedure to

give 𝑦 = 6.76%

Dr. V. Stemann
16
Agenda

1 Introduction

2 Definition and Typology of Market Risk

3 Interest Rate Risk – Duration and Convexity

4 Yield Curve Construction

5 High dimensional IR-Risk - Partial Duration and PCA

Dr. V. Stemann
1
Duration

▪ The duration of a bond 𝑃 with yield 𝑦 is defined as

1 ∆𝑃
𝐷=−
𝑃 ∆𝑦

▪ Duration measures the sensitivity of percentage changes in the

bond’s price to changes in its yield.

▪ So that

∆𝑃 = −𝐷𝑃∆𝑦

Dr. V. Stemann
18
Duration

▪ An alternative approach is to define duration as a measure for

how long a bondholder has to wait for cash flows.

▪ A zero coupon bond that lasts n years has duration n

▪ The duration of a bond that provides cash flows Ci at ti is:

𝑁
𝐶𝑖 𝑒 −𝑦𝑡𝑖
𝐷 = ෍ 𝑡𝑖
𝑃
𝑖=1
where P is its price and y the cont. comp. yield.

▪ The duration is therefore a weighted average of times when

payments are made.

Dr. V. Stemann
19
Duration Illustration

▪ Consider a 3-year 10% coupon (semi-annual payment) bond

with a face value of 100€. Suppose that the yield on the bond is
12% per annum with continuous compounding.

Dr. V. Stemann
20
Key Duration Relationship

▪ Example continued:

∆𝑃 = −𝑃 ∗ 𝐷 ∗ ∆𝑦

∆𝑃 = −94.213 ∗ 2.653∆𝑦 = −249.95∆𝑦

▪ When the yield of the bond increases by 10 basis points

(0.1%), the duration relationship predicts that the bond price will
decrease by 0.25.

▪ How accurate is this?

Dr. V. Stemann
21
Convexity

Dr. V. Stemann
22
Convexity

▪ The duration relationship applies only to small changes in

yields.

▪ For large yield changes, the portfolio behaves differently. A

factor known as convexity measures the additional response of
a bond portfolios to a bigger change in the yield.

▪ We measure convexity by:

1 𝑑2 𝑃 σ𝑛𝑖=1 𝑡𝑖2 (𝐶𝑖 𝑒 −𝑦𝑡𝑖 )

𝐶= 2
=
𝑃 𝑑𝑦 𝑃
▪ That leads to:
∆𝑃 1 2
= −𝐷∆𝑦 + 𝐶 ∆𝑦
𝑃 2
Dr. V. Stemann
23
Convexity

Consider again the bond from the previous example.

The bond price is 94.213 and the duration D is 2.653

1. Compute the bond convexity

2. Generate the convexity relationship

3. Predict the impact of a 2% change in the bond yield from 12%

to 14% on the bond price.

Dr. V. Stemann
24
Agenda

1 Introduction

2 Definition and Typology of Market Risk

3 Interest Rate Risk

4 Yield Curve Construction

5 High dimensional IR-Risk - Partial Duration and PCA

Dr. V. Stemann
1
Constructing the Yield Curve -
Bootstrap method

▪ Use Treasury bonds and coupon-bearing bonds. The bootstrap

method is applied as follows

▪ Consider data provided for the bootstrap method.

Dr. V. Stemann
26
Constructing the Yield Curve -
Bootstrap method

▪ An amount 0.4 can be earned on 99.6 during 3 months.

▪ Because 100 = 99.6 e0.01603×0.25: the 3-month rate is 1.603%

with continuous compounding

▪ Similarly the 6 month and 1 year rates are 2.010% and 2.225%
with continuous compounding

▪ To calculate the 1.5 year rate we solve

2𝑒−0.02010∗0.5 + 2𝑒−0.0225∗1 + 102𝑒−𝑅∗1.5 = 102.5

to get R = 0.02284 or 2.284%

▪ Similarly the two-year rate is 2.416%

Dr. V. Stemann
27
Constructing the Yield Curve -
The Zero Curve

Dr. V. Stemann
28
Smoothing Methods

Exact methods:

▪ Discount curve / Zero Curve is sensitive to small changes in

input data.
▪ Discount factors of similar maturity can be very different.
▪ Leads to ragged forward curves.

Smoothing methods:

▪ Estimate a smooth forward curve from market rates at the cost

of not exactly matching data.

Dr. V. Stemann
29
Smoothing Methods

Smoothing methods mainly used by central banks.

▪ Smoothness: supply a market expectation for monetary policy

purposes rather than precise pricing of all bonds in the market.

▪ Flexibility: sufficiently flexible to capture movements in the

underlying term structure.

▪ Stability: small changes in data at one maturity do not have

disproportionate effect on forward rates at other maturities.

Dr. V. Stemann
30
Constructing the Yield Curve
Nelson Siegel Model Spot Rates
𝑚 𝑚
−𝜏 −𝜏
1 −𝑒 1 −𝑒 𝑚
−𝜏
𝑅 0, 𝑚 = 𝛽0 + 𝛽1 + 𝛽2 −𝑒
𝑚 Τ𝜏 𝑚 Τ𝜏
Where

▪ 𝛽0 - accounts for parallel movements of interest rates

▪ 𝛽1 - accounts for changes in the curve slope

▪ 𝛽2 - accounts for changes in the curvature of the term

structure (changes in the level of rates for short term and long
term maturities is opposite to changing the level of rates for the
mid term maturities).

▪ 𝜏 – scaling parameter
Dr. V. Stemann
31
Nelson Siegel Svensson Model Calibration

▪ Fit Nelson Siegel model directly on a universe of bonds.

▪ How to do this?

▪ Step 1: Get a set of bonds with different maturities and

prices

▪ Step 2: Set up the NS model and use excel solver to find

parameters that generate the best fit with the observed
bond prices i.e. minimize squared difference between
actual and estimated yields.

Dr. V. Stemann
32
Constructing the Yield Curve
Nelson Siegel Svensson Model Spot Rates

𝑚 𝑚 𝑚
−𝜏 −𝜏 𝑚 −𝜏 𝑚
1−𝑒 1 1−𝑒 1 −𝜏 1−𝑒 2 −𝜏
𝑅 0, 𝑚 = 𝛽0 + 𝛽1 + 𝛽2 − 𝑒 1 + 𝛽3 −𝑒 2
Τ
𝑚 𝜏1 Τ
𝑚 𝜏1 Τ
𝑚 𝜏2

Where

▪ 𝛽0 - accounts for parallel movements of interest rates

▪ 𝛽1 - accounts for changes in the curve slope
▪ 𝛽2 - accounts for changes in the curvature of the term
structure (changes in the level of rates for short term and long
term maturities is opposite to changing the level of rates for the
mid term maturities).
▪ 𝛽3 - does not have a good economic interpretation
▪ 𝜏1 , 𝜏2 – scaling parameters
Dr. V. Stemann
33
Agenda

1 Introduction

2 Definition and Typology of Market Risk

3 Interest Rate Risk

4 Yield Curve Construction

5 High dimensional IR-Risk - Partial Duration and PCA

Dr. V. Stemann
1
Parallel Shift

4
Zero Rate (%)

0
0 2 4 6 8 10 12

Maturity (yrs)

Dr. V. Stemann
35
Partial Duration

A partial duration calculates the effect on a portfolio of a change

to just one point on the zero curve
6

4
Zero Rate (%)

0
0 2 4 6 8 10 12

Maturity (yrs)

Dr. V. Stemann
36
Partial Duration

Maturity 1 2 3 4 5 7 10 Total
yrs
Partial 0.2 0.6 0.9 1.6 2.0 −2.1 −3.0 0.2
duration

▪ Partial Duration can be used to investigate the impact of any

yield curve change

▪ Any yield curve change can be defined in terms of changes to

individual points on the yield curve

▪ For example, to define a rotation we could change the 1-, 2-, 3-,
4-, 5-, 7, and 10-year maturities by −3x, − 2x, − x, 0, x, 3x, 6x

Dr. V. Stemann
37
Example

Dr. V. Stemann
38
Principal Component Analysis

▪ It is an empirical fact that yields tend to move together

▪ There exist a high correlation among them

▪ So, instead of modelling each yield separately in our risk

analysis, we try to model the whole yield curve

Dr. V. Stemann
39
Principal Component Analysis

▪ Factor Loadings for Swap Data

▪ Standard Deviation of Factor Scores

Dr. V. Stemann
40
Principal Component Analysis

▪ Attempts to identify standard shifts (or factors) for the yield

curve so that most of the movements that are observed in
practice are combinations of the standard shifts

▪ The first factor is a roughly parallel shift

(90.9% of variance explained)

▪ The second factor is a twist

(6.8% of variance explained)

▪ The third factor is a bowing

(1.3% of variance explained)

Dr. V. Stemann
41
The Three Factors

0,8
Factor Loading

0,6

0,4

0,2
Maturity (years)

0
0 5 10 15 20 25 30

-0,2

PC1
-0,4
PC2

-0,6 PC3

Risk Management and Financial Institution, Copyright © John C. Hull 2018

Dr. V. Stemann
42
Alternatives to Calculate Deltas

▪ Shift individual points on the yield curve by one basis

point (the partial duration approach)

▪ Shift segments of the yield curve by one basis point

(the bucketing approach)

▪ Shift quotes on instruments used to calculate the

yield curve

▪ Calculate deltas with respect to the shifts given by a

principal components analysis.

Dr. V. Stemann
43
References

▪ John [Link], « Risk Management and Financial Institutions »,

6th edition, Wiley Finance, 2023.

▪ John [Link], « Options, Futures and Other Derivatives »,

11th edition, Pearson, 2021.

▪ Jon Danielsson « Financial Risk Forecasting »,

Wiley Finance, 2011.

Dr. V. Stemann
44