Interest Rate Risk Management

Interest Rate Risk

Interest rates change substantially over time and
their variation poses large risks to financial
institutions, portfolio managers, corporations and
the governments.
A systematic methodology is required to assess the
riskiness of a bond portfolio to movements in
interest rates.
A methodology is also required to effectively manage
such risk.

Duration
Duration of a security with price P is the (negative of the)
percent sensitivity of the price P to a small parallel shift in the
level of interest rates.
Let r(t, T) be the continuously compounded term structure of
interest rates at time t.
Due to uniform shift of size dr across rates, the price of the
security moves by dP
The duration of the asset is then defined as:

1 dP
Duration = D
P dr

Duration
Given the duration DP of a security with price P, a uniform
change in the level of interest rates brings about a change in
the value of:

Change in portfolio value= dP = - DP *P*dr

For example, if a Rs.100 million portfolio has a duration of 10,
a one basis point increase in the level of interest rates will
result in a loss of Rs.100,000 in the portfolio value as shown
below:
Change in portfolio value= dP = - 10 *Rs.100 m*0.0001

= - Rs.100,000

Duration of a Zero Coupon Bond

For a Zero Coupon Bond we get:

Pz (t,T) =100 * Z(t,T) = 100* e-r(T-t)

dPZ
100 (T t ) e r (T t )
dr
= -(T-t)*Pz (t,T)
D

1 dP
P dr

= T-t

(Time to maturity)

Example
The duration of a 5-year STRIPS is 5.
This implies that a one basis point increase in interest
rates decreases the value of the portfolio by 5 basis
points.
A portfolio of Rs.100 million will experience a decline of
approximately Rs.50,000.

dP =-DP *P*dr = -5*Rs.100 million*0.0001 = -Rs.50,000

Duration of a Portfolio
Duration of a portfolio is a weighted average of the duration
of assets, where the weights correspond to the percentage of
the portfolio invested in a given security
The duration of a portfolio of n securities is given by
n

DW wi Di
i 1

where wi is the fraction of the portfolio in security i, and Di is

the duration of security i

Duration of a Portfolio
An example:
A bond portfolio manager has Rs.100 million
invested in 5-year STRIPS and Rs.200 million
invested in 10-year STRIPS
The impact of a one basis point parallel shift of
the term structure on the value of the portfolio
can be found by computing the duration of the
portfolio
The 5-year and 10-year strips have duration of 5
and 10, respectively
The total portfolio value is Rs.300 million

Duration of a Portfolio
Duration of the portfolio:

100
200
5 10 8.3
300
300
Therefore, a one basis point increase in interest
rates generates a portfolio loss of Rs.249,000
Loss in portfolio value = Rs.300 million 8.3 0.01%
= Rs.249,000

Duration of a Coupon Bond

A coupon bond can be considered a portfolio of the coupons
and the principal, so applying the same principal we have that
the duration of a coupon bond is:
n

i 1

i 1

DW wi Dz ,Ti wT
i i
Where

wi

c / 2 Pz 0, Ti
Pc 0, Tn

for i = 1,,n-1;

1 c / 2 Pz 0, Tn

wn
Pc 0, Tn

Duration of a 10-year 6% Coupon Bond

Duration of a Floating Rate Bond

The general formula for a semi-annual floating rate bond with
zero spread s is:

PFR t , T Z t , Ti 1 100 1 r2 Ti / 2

DFR

dPFR
1
PFR t , T dr

dZ t , Ti 1
1

100 1 r2 Ti / 2
PFR t , T
dr

1
Ti 1 t Z t , Ti 1 100 1 r2 Ti / 2
PFR t , T

Ti 1 t

The duration of a floating rate bond is simply equal to the time

left to the next coupon payment date Ti+1t
In particular, if today is coupon date (but the coupon has not
been paid yet), the duration is zero

Dollar Duration
Duration implicitly assumes that the security, or the portfolio,
has non-zero value.
In many cases involving no arbitrage (Long-Short) strategies,
the security or the portfolio may have a value exactly equal to
zero.
In such cases and for certain swaps, we calculate the dollar
duration
dP
$
Dollar Duration of a security is defined by
DP
dr
For a non-zero valued security: D$P = P DP
For a portfolio of n securities (Dn$W) with Ni units of security i

D Ni D
$
W

i 1

$
i

Price Value of a Basis Point

The dollar losses due to a basis point increase in the level of
interest rates is a common measure of interest rate risk and is
called price value of a basis point
The price value of a basis point PV01 (or PVBP) of a security
with price P is defined as:
Price value of a basis point = PV 01 (or PVBP) =

D dr
$
P

Dollar Duration and PVBP

Dollar duration and PVBP are also useful when comparing
investments with unequal dollar amounts.
A 30-year 5% coupon bond with a yield of 4.646% has a
duration of 15.9 years . It sells at a price of Rs.105.58.
A 30-year zero trading at a yield of 4.6775 has a duration of 30
years. The price of the zero coupon bond is Rs.24.98.

Dollar Duration and PVBP

As the duration of the zero is much greater than the coupon
bond, the zero coupon bond might be considered much
riskier.
However, as the zero sells at a considerable discount to its par
value, the price risk of the zero for the same par value as the
coupon bond is much lower .
The dollar duration of the zero is 749.7 (Rs.24.98 x 30) and
that of the coupon bond is Rs.1,678.72 (Rs.105.58 x 15.9)
The PVBP of the zero is 0.0749 and that of the coupon bond is
0.1678.