Chapter 1: Interest Rates and Related Contracts

1.4 Duration and Convexity

Interest Rate Models

Damir Filipović
1.4 Duration and Convexity

• Duration
• Convexity
• Bond portfolio risk management

Interest Rate Models

Sensitivity of Bond Prices

We consider a fixed coupon bond with

• cash flow dates 0 < T1 < · · · < Tn
• cash flows ci at Ti (for simplicity cn contains the principal).
Its price at t = 0 is
Xn
p= e −yi Ti ci
i=1

where we write yi = y (0, Ti ).

How does the price change under parallel shift of the yield curve, yi 7→ yi + s?

Interest Rate Models

Duration

The duration of the bond is defined as relative first-order sensitivity with respect
to a parallel shift of the yield curve:
n
! Pn
1 d X −(yi +s)Ti Ti ci e −yi Ti
D=− ci e |s=0 = i=1 .
p ds i=1 p

Duration is a weighted average of the coupon dates T1 , . . . , Tn .

∆p
Obtain first-order approximation for relative bond price change p
with respect
to a parallel shift ∆y of the yield curve:
∆p
≈ −D∆y
p
Interest Rate Models
Duration: Example 1

Assume a flat yield curve y (0, T ) ≡ 3%.

Price of a 10Y 6% bond with annual coupon and principal 100 is

10
X
p10 = 6 × e −0.03×i + 100 × e −0.03×10 = 125.14
i=1

Its duration is
P10
i=1 i × 6 × e −0.03×i + 10 × 100 × e −0.03×10
D10 = = 8.06
p

Interest Rate Models

Duration: Example 2

Assume a flat yield curve y (0, T ) ≡ 3%.

Price of a 5Y 3% bond with annual coupon and principal 100 is

5
X
p5 = 3 × e −0.03×i + 100 × e −0.03×5 = 99.79
i=1

Its duration is
P5
i=1 i × 3 × e −0.03×i + 5 × 100 × e −0.03×5
D5 = = 4.72
p5

Interest Rate Models

Duration Hedging

Aim: immunize the value of a bond portfolio with respect to small parallel shifts
of the yield curve!
• Π(s) value a portfolio to be hedged as function of yield shift s
• H(s) value of the hedging instrument as function of s
Find q such that
d
(Π(s) + q H(s)) |s=0 = 0.
ds
The solution is given by
−DΠ × Π(0)
q=
DH × H(0)
where DΠ = duration of Π, DH = duration of H.
Interest Rate Models
Duration Hedging: Examples 1 and 2 revisited

Immunize a long position in one 10Y 6% bond by holding q 5Y 3% bonds.

The solution is given by

−D10 × p10
q= = −2.14.
D5 × p5
This means that one should short 2.14 units of the 5Y bond in order to hedge
one long unit of the 10Y bond.

Interest Rate Models

Hedging Performance

Value change (Π(s) − 2.14 H(s)) − (Π(0) − 2.14 H(0)) of immunized portfolio as
function of yield shift s.
Interest Rate Models
Convexity

The convexity of the bond is defined as relative second-order sensitivity with

respect to a parallel shift of the yield curve:
n
! n
1 d 2 X −(yi +s)Ti 1 X −yi Ti
C= 2
ci e |s=0 = ci e (Ti )2 .
p ds i=1
p i=1

∆p
Obtain second-order approximation for relative bond price change p
with
respect to a parallel shift ∆y of the yield curve:
∆p 1
≈ −D∆y + C (∆y )2
p 2

Interest Rate Models

Convexity Hedging

Aim: immunize the value of a bond portfolio with respect to small and not so
small parallel shifts of the yield curve!
• Π(s) value a portfolio to be hedged as function of yield shift s
• H1 (s) value of 1st hedging instrument as function of s
• H2 (s) value of 2nd hedging instrument as function of s
Find q1 and q2 such that
d
(Π(s) + q1 H1 (s) + q2 H2 (s)) |s=0 = 0
ds
d2
(Π(s) + q1 H1 (s) + q2 H2 (s)) |s=0 = 0
ds 2

Interest Rate Models

Convexity Hedging: Solution

The above system is equivalent to

−q1 DH1 H1 (0) − q2 DH2 H2 (0) = DΠ Π(0)

q1 CH1 H1 (0) + q2 CH2 H2 (0) = −CΠ Π(0)

The solution is
   −1  
q1 −DH1 H1 (0) −DH2 H2 (0) DΠ Π(0)
=
q2 CH1 H1 (0) CH2 H2 (0) −CΠ Π(0)

where DΠ (CΠ ) = duration(convexity) of Π, DHi (CHi ) = duration(convexity) of Hi .

Interest Rate Models

Convexity Hedging: Example

Portfolio: price Π = 32, 863.5

Duration 6.76
Convexity 85.329

1st hedging instrument: price H1 = 97.962

Duration: 8.813
Convexity: 99.081

2nd hedging instrument: price H2 = 108.039

Duration: 2.704
Convexity: 10.168

Interest Rate Models

Convexity Hedging: Example Solution

The hedging portfolio is given by

   −1  
q1 −8.813 × 97.962 −2.704 × 108.039 6.76 × 32, 863.5
=
q2 99.081 × 97.962 10.168 × 108.039 −85.329 × 32, 863.5
 
−304.8
=
140.3

In order to hedge Π against parallel shifts of the yield curve you should buy 140.3
units of H2 and sell 304.8 units of H1 short.

Interest Rate Models