Risk measures and trading strategies

FIS: Session 4

Prof. Vineet Virmani

Indian Institute of Management, Ahmedabad

⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 1 / 12
Session Outline

1 Risk measures

2 Trading on term structure shifts

⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 2 / 12
Session Outline

1 Risk measures

2 Trading on term structure shifts

⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 3 / 12
Duration
Duration the first derivative (or slope) of bond price w.r.t. YTM
∑T tCt
∑T
1 ∂P tCt e −ty 1 t=1
(1 + y /2)2t
− = ∑t=1 , or
P ∂y T
t=1 Ct e
−ty 1 + y /2 ∑T Ct
t=1
(1 + y /2)2t
Or with first principles as:
1 ∂P P(y + ∆y ) − P(y ) 1
= lim
P ∂y ∆y →0 ∆y P(y )
Useful to think in terms of shifts (∆) from the current value

With spot rates the price is written as:

P(r0 ) = C1 e −r1 + C2 e −2r2 + C3 e −3r3
And we may also think of changes w.r.t the shifts in the yield curve
⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 4 / 12
Duration

In general, one can talk about diff. shifts to diff. parts of the yield
curve, say, δ ≡ (δ1 , δ2 , δ3 ), with the following possibilities:

P(r0 + δ) = C1 e −(r1 +δ1 ) + C2 e −2(r2 +δ2 ) + C3 e −3(r3 +δ3 )

▶ δ1 = δ2 = δ3 : Parallel shift
▶ δ1 < 0, δ2 ≈ 0, δ3 > 0: Steepener, and its reverse, Flattener
▶ δ2 > 0, δ1 , δ3 < 0: Long Butterfly, and its reverse, the Short Butterfly

For the case of parallel shift (δ1 = δ2 = δ3 ), Modified Duration is the

same as when working with YTM, i.e. weighted average time

1 ∂P P(r0 + δ) − P(r0 ) 1
Modified Duration = − = − lim
P ∂δ δ→0 δ P(r0 )

Excel example with constant YTM

⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 5 / 12
Duration

But it remains that duration captures the risk of small level shifts of
the yield curve
P

Under-estimation

+∆y
−∆y

Over-estimation

So we have to also worry about convexity for any large changes

⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 6 / 12
Convexity
In terms of Taylor series approximation, and using YTM, convexity
captures the second derivative:
∂P 1 ∂2P
dP = P(y + ∆y ) − P(y ) ≈ ∆y + ∆y 2
∂y 2 ∂y 2
With the same logic as for duration, convexity also captures
not-so-small level shifts of the yield curve
The expression is the nicest for continuous compounding:
∑T 2 −ty
1 ∂2P t=1 t Ct e
Convexity ≡ = ∑ ,
P ∂y 2 T
C e −ty
t=1 t
And not so much for semi-compounding:
∑T t(t + 1/2)Ct
2 t=1
1∂ P 1 (1 + y /2)2t
=
P ∂y 2 (1 + y /2)2 ∑T Ct
t=1
(1 + y /2)2t
⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 7 / 12
Dollar value of price changes

Using risk-measures:

∂P 1 ∂2P 1 ∂P 1 1 ∂2P
dP ≈ ∆y + ∆y 2
= ∆y × P + ∆y 2 × P
∂y 2 ∂y 2 P ∂y 2 P ∂y 2
Excel example
Price change by duration: −Modified Duration × ∆y × P
Change including convexity (its contribution is always positive):

−Modified Duration × ∆y × P + 0.5 × Convexity × ∆y 2 × P

Modified Duration × P
Dollar value of a basis-point change: DV01 =
10000
Exact price change is, of course: Price at new yield − Old price
Python example: Comparison for different kinds of bonds
⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 8 / 12
Session Outline

1 Risk measures

2 Trading on term structure shifts

⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 9 / 12
Risk measures and trading strategies

To the extent bond trades are a view on future interest rates, they are
really a bet on term structure shifts

So a model (or a world view) for the term structure, or even a

segment of it, and trading strategies go hand in hand

But what makes the trades profitable? Price impact of yield changes

Risk measures

Given some understanding of the term structure, need to get more

sophisticated and move beyond YTM-based measures

⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 10 / 12
Slope/spread trades: Flatteners and Steepners
Yield Yield

t=1 t=0

t=0 t=1

Maturity Maturity

Steepner : Long 2 year, Short 30 year

Flattener : Short 2 year, Long 30 year
Choice of maturity buckets market/liquidity dependent: 2 − 10,
5 − 30 etc.
⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 11 / 12
Convexity trades: Butterflies
Yield Yield

t=0 t=1
t=1 t=0

Maturity Maturity

Long Butterfly : Long 2 year + Long 30 year (Barbell), Short 10 year

(Bullet)
Short Butterfly : Short 2 year + Short 30 year (Barbell), Long 10 year
(Bullet)
Choice of maturity buckets market/liquidity dependent: 2 − 5 − 10,
5 − 10 − 30 etc.
Excel example: Convexity of Barbell vs Bullet
⃝Prof.
c Vineet Virmani, IIMA FIS (2018-19), Session 4 July 11, 2018 12 / 12