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Outline
Interest rate risk
Duration
Bond immunization
Term structure of interest rates
Present value calculation under a yield curve
Explanations for the term structure
Using the term structure to forecast interest rates
Related readings: BKM Chapter 11, ME Chapter 3, 5.
Duration ()
The bond price as a function of YTM (CFt is the bond cash flow
at time t)
T
CFt
P(r )
t
(1
r
)
t 1
Definition of duration:
CFt / (1 r )
D t
P(r )
t 1
T
Weight
for t
1 r dP(r )
P (r ) dr
a counter-example
Duration of a portfolio
Suppose there are m fixed income securities with values and
durations of Pi and Di, i = 1,2,, m, all computed at a common yield.
The portfolio value and portfolio duration are then given by
P = P1 + P2 + + Pm
where
i 1,2,, m.
Duration of a Portfolio
dPm (r )
dP(r ) dP1 (r )
dr
dr
dr
1
D1P1 (r ) Dm Pm (r )
1 r
Pm ( r )
P(r ) P1 (r )
Dm
D1
1 r P(r )
P(r )
Compare to dP (r ) P (r ) D
dr
1 r
Example
$10 million
$40 million
$30 million
$20 million
4
7
6
2
5-year Bond
6%
5%
4%
Investment Obligation
1434.03
1407.10
1380.43
1407.10
1407.10
1407.10
Difference
26.93
0.00
-26.67
10-year Bond
After seven years, the bond will be sold to meet the obligation.
Its price = 1000(1+5%)10/(1+r)3, where r is the interest rate at
t=7.
Interest
Investment Obligation Difference
Rate
6%
1367.6513
1407.10
-39.45
5%
1407.1004
1407.10
0.00
4%
1448.0814
1407.10
40.98
Immunization
Interest
5-yr bond
Rate
10-yr bond
Total
Obligation Difference
Investment
6%
860.42
547.06
1407.48
1407.10
0.38
4%
828.26
579.23
1407.49
1407.10
0.39
PO (r ) PP (r ) PO (r )
r PP (r )
r
1 r
1 r
D Do
PO (r ) P
r
1 r
Bond Immunization
(1) the value of the bond portfolio must equal the value of the
liabilities.
(2) The proportion invested in each bond must be selected
such that the durations are matched.
In practice, the strategy we found at time zero only protects
the difference of assets and liabilities from interest rate
movements at time 0. As time moves on, the duration of the
bond portfolio and the liability no longer match, so portfolio
managers have to rebalance the bond portfolio to match
duration again.
Contents
Present value calculations under a given yield curve.
We want to study theories that explain various shapes of the
yield curve.
Expectations Theory
Liquidity Premium Theory
Spot Rates
The spot rate
is the interest rate, expressed in
annual terms, charged for money held from the
present time
until time .
You can also understand as the YTM of a zerocoupon bond with maturity .
The term structure indicates that
is not a
constant for different . The corresponding spot
rate should be used when calculating interests of
some amount of money held in a period of time.
Rate
(%/yr)
5.6
6.1
6.6
6.9
7.4
7.7
8.0
8.3
8.6
n
(1 sN ) N
n 1 (1 sn )
N
xN
x1
x2
P
...
2
1 s1 (1 s2 )
(1 sN ) N
Expectations Theory
The expectations theory assumes that bonds of different
maturities are perfect substitutes: the expected return on
these bonds is equal in a common horizon.
Example: Consider two investment strategies
Expectations Theory
Consider an investment of $1 in both strategies.
Using the definitions
= todays interest rate on a one-year bond
e
2
i
i
,
i
Ignore the very small terms t t 1 2t , we get
Expectations Theory
We will find that the interest rate of
bond must be
on an n-period
An Example
The one-year interest rate over the next 5 years are expected
to be 5%, 6%, 7%, 8%, and 9%. What is the yield curve up to 5
years according to the expectations theory?
Yield Curve under the Expectations Theory
7.50%
7.00%
6.50%
6.00%
5.50%
5.00%
4.50%
4.00%
An Example
As in the previous example, lets suppose that the one-year interest rate
over the next 5 years are expected to be 5%, 6%, 7%, 8%, and 9%.
Investors preferences for holding short-term bonds have the liquidity
premium for one-year to five-year bonds as 0%, 0.25%, 0.5%, 0.75%,
and 1.0%. What does the yield curve up to 5 years look like now and
how does it compare to the previous one under the expectations theory?
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
Expectations Theory
What do these yield curves tell us about the publics expectations of future
movements of short-term interest rates
2
(1
i
)
2t
ite1
1
1 it
(1 int ) n (1 ite n ) (1 in 1t ) n 1
ite n
(1 in 1t ) n 1
1
n
(1 int )
ite n
(1 in 1t ln 1t ) n 1
1
n
(1 int lnt )
An Example
l
)
(1
0.07
0.004)
2t
2t
ite1
1
1 7.2%
1 i1t l1t
1 0.06
The loan is not attractive to the bank as it needs to earn at least 8.2% to
be profitable.