Chapter 5
Chapter 5
Chapter 5
Chapter 5
1
B(t , t θ )
(1 Ra (t , θ ))θ
• R(t,) : continuously compounded pure discount rate
with maturity t + : B(t, t θ ) exp θ R(t, θ )
– Equivalently,
1
R(t , θ ) lnB(t , t θ )
θ
Pricing and Hedging
Pricing Certain Cash-Flows
• Example
– Assume today a flat structure of interest rates
– Ra(0,) = 10% for all
– Bond with 10 years maturity, coupon rate = 10%
– Price: $100
• If the term structure shifts up to 12% (parallel shift)
– Bond price : $88.7
– Capital loss: $11.3, or 11.3%
• Implications
– Hedging interest rate risk is economically important
– Hedging interest rate risk is a complex task: 10 risk factors in this
example!
Pricing and Hedging
Hedging Principles
Fi
• Definition of Duration D: m i
i
(1 y )
D
V
i 1
• Also known as “Macaulay duration”
• It is a measure of average maturity
• Relationship with sensitivity and modified duration:
D Sens (1 y) MD (1 y)
Duration Hedging
Example
Time of 1 Fi
Cash Flow (i) Cash Flow wi
V 1 y i
i wi Example: m = 10, c = 5.34%,
Fi y = 5.34%
1 53.4 0.0506930 0.0506930
2 53.4 0.0481232 0.0962464
3 53.4 0.0456837 0.1370511
4 53.4 0.0433679 0.1734714 m
5 53.4 0.0411694 0.2058471 D i wi 8
6 53.4 0.0390824 0.2344945 i 1
7 53.4 0.0371012 0.2597085
8 53.4 0.0352204 0.2817635
9 53.4 0.0334350 0.3009151
10 1053.4 0.6261237 6.2612374
Total 8.0014280
Duration Hedging
Properties of Duration
w 1
i 1
i
• Changes in value
– Portfolio
dP P' ( y)dy
– Hedging instrument
dH H ' ( y)dy
• Strategy: hold q units of the hedging instrument so
dP qdH qH ' ( y) P' ( y)dy 0
that
• Solution
P' ( y) P Sens P P DurP
q
H ' ( y) H Sens H H DurH
Duration Hedging
Hedging
• Example:
– At date t, a portfolio P has a price $328635, a 5.143% yield and a
7.108 duration
– Hedging instrument, a bond, has a price $118.786, a 4.779% yield
and a 5.748 duration
• Hedging strategy involves a buying/selling a number
of bonds
q = -(328635x7.108)/(118.786x5.748) = - 3421
• If you hold the portfolio P, you want to sell 3421 units
of bonds
Duration Hedging
Limits
• Duration hedging is
– Very simple
– Built on very restrictive assumptions
• Assumption 1: small changes in yield
– The value of the portfolio could be approximated by its first order Taylor
expansion
– OK when changes in yield are small, not OK otherwise
– This is why the hedge portfolio should be re-adjusted reasonably often
• Assumption 2: the yield curve is flat at the origin
– In particular we suppose that all bonds have the same yield rate
– In other words, the interest rate risk is simply considered as a risk on the
general level of interest rates
• Assumption 3: the yield curve is flat at each point in time
– In other words, we have assumed that the yield curve is only affected only
by a parallel shift