4. Bond

1. Corporate Bonds

1.1 Introduction of Bonds

1.1.1 Definition

A bond is a debt instrument sold by the bond issuer(the borrower) to bondholders(the lenders). The bond issuer agrees to make payments of interest and principal to bondholders. The principal of a bond (also called its face value or par value) is the amount the issuer has promised to repay at maturity.

1.1.2 Basic Features

Issuer/Borrower

• Supranational Organizations, such as World Bank and IMF.
• Sovereign (national) governments, such as China and Japan.
• Non-sovereign (local) governments, such as city of Edmonton,
• Quasi-government entities, such as agencies that are owned by government.
• Companies, such as corporate issuers.

Par Value/Face Value/Maturity Value: The amount that the issuer agrees to repay the bondholders on the maturity date.

Maturity date; tender(time to maturity)

• Money market securities: one year or less
• Capital market securities: more than one year.
• Perpetual bond: no stated maturity date.

Coupon
Coupon Rate/Nominal Rate: The interest rate that the issuer agrees to pay each year until the maturity date.

Coupon = coupon rate $\times$ par value

Coupon Frequency: Coupon payments may be made annually, semi-annually, quarterly, or monthly, etc. Generally semi-annually paid in commonwealth countries, e.g. U.S, U.K.

1.1.3 Cash Flow Structure of A Plain Vanilla Bond

Example: A three-year bond has par value of $ $100$ and coupon rate $5\%$. Coupon payments are made semi-annually.

1.1.4 Bond Price

Discounted Cash Flow Approach: The bond will pay promised payment of coupon and principal. Use the appropriate discount rate to discount the primised cash flows.
$$P=\sum _{t=1}^n\frac{C_t}{(1+r{)}^t}+\frac{FV}{(1+r{)}^n}$$

Example: A two-year bond has par value of $$100$ and coupon rate $5\%$. Coupon payment are made semi-annually. The market discount rate is 6%, the price of the bond should be:

$$P=\frac{2.5}{(1+\frac{6\%}{2})}+\frac{2.5}{(1+\frac{6\%}{2}{)}^2}+\frac{2.5}{(1+\frac{6\%}{2}{)}^3}+\frac{1022.5}{(1+\frac{6\%}{2}{)}^4}=98.14$$

$N=4$; $PMT=2.5$; $FV=100$; $1/Y=3$ $\to PV=-98.14$

1.2 Bond Markets

1.2.1 Bond Issuance

Corporate bond issuances are typically arrangement by investment banks.

Private placement: bonds are placed with a small number of large institution.

• Fewer registration requirement
• Rating agencies are not involved
• The issuance cost is lower
• The issuance can be completed quickly
• The issuance can be relatively small

Public issue: the investment bank buys the bonds from the corporation and the tries to sell them to investors.

• The investment bank acts as the underwriter.
• The investment bank’s profit is earned from the price different, but face risks.
• The bonds are given rating by rating agencies.

Interest rates for private placement bonds are generally higher than those for equivalent publicly issued bonds.

1.2.2 Bond Trading

Bonds issued via private placements are often not traded. Instead, they are held by the original purchases until maturity.

Bonds issued in a public offering are typically traded in the over-the-counter(OTC) market.

Bond dealers buy and sell bonds, and they aim to make a profit from the price difference.(bid-ask spreads)

Liquidity is an important issue in bond trading. It is the ability to turn an asset into cash within a reasonable time period at reasonable price.

Markets where the trading volume is high tend to be highly liquid and have low bid-ask spreads(and vice versa).

Part of the yield on a bond is compensation for its liquidity risk.

1.2.3 Classification of Bonds

Classification by type of issuer
Government and government-related sector

Corporate sector(Utilities / Transportation companies / Industrials Financial institutions/ Internationals)

Classification by original maturity
Corporate bonds have an original maturity of at least one year.

• Short-term notes: up tp 5 years
• Medium-term bonds: between 5 and 12 years
• Long-term bonds: greater than 12 years

Instruments with an original maturity of less than one year are referred to as commercial paper.

Classification by interest rate
Fixed-rate bonds: pay the same rate of interest throughout their life.

Zero-coupon bonds: pay no coupons to the holder(sell at a discount to the principal amount).

Floating-rate bonds(floating-rate notes(FRNs) or variable rate bonds): coupon rate is linked to an external reference rate, such as LIBOR.

• Coupon rate = reference rate + spread
• Reference rate reset periodically, spread is usually constant.
• Coupon payments are in arrears: based on previous period’s reference rate.
• Basis point: equal to $0.01\%$

Example: A company has issued a floating-rate note with a coupon rate equal to the three-month $\text{Libor}+65$ basis points. Interest payments are made quarterly on 31 March, 30 June, 30 September, and 31 December. On 31 March and 30 June, the three-month Libor is $1.55\%$ and $1.35\%$, respectively. The coupon rate for the interest payment made on 30 June is:

The coupon rate that applies to the interest payment due on 30 June is based on the three-month Libor rate prevailing on 31 March. Thus, the coupon rate is $1.55\%+0.65\%=2.20\%$

Classification by collateral

Collateral is a way to reduce/alleviate credit risk. A default leads to either a reorganization or an asset liquidation.A bondholder with collateral should fare better than one without collateral.

• Mortgage bonds: private specific assets(e.g., homes and commercial property) as collateral.

• Collateral trust bonds: bonds where shares, bonds, or other securities issued by another company are pledged as collateral. Usually, the other company is a subsidiary of the issue.

• Equipment trust certificates(ETC): debt instruments used to finance the purchase of an asset. The title to the property vests with the trustee, who then leases it to the borrower for an amount sufficient to provide the leader with the return they have been promised. When the debt is full repaid, the borrower obtains the title to the asset.

• Debenture bonds: are unsecured bonds(no collateral). The rank below mortgage bonds and collateral trust bonds, and are likely to pay a higher interest rate. A subordinated debenture ranks below other debentures, and required a higher rate of interest than unsubordinated debentures.

• Guaranteed bonds: bonds are issued by one company are guaranteed by another company. The correlation between the financial performance of the issuer and the guarantor increases, guarantee is less valuable.

1.3 Bond Indenture

Bond Indentures are legal contracts between a bond issuer and the bondholders defining the important features of a bond issue.

• Covenant
• Debt early retirement (if any）

1.3.1 Corporate Trustee

Corporate trustee: a financial institution that look after the interests of the bondholders and ensures that the issuer complies with the bond indentures.

• Act on behalf of bondholders
• Reports periodically to the bondholders
• Its specific duties are itemized in the bond indentures and
  the trustee is under no obligation to exceed those duties.

1.3.3 Debt Retirement

Call Provisions/Callable bond): bond indenture can sometimes allow the issuer to call the bond at a certain price at a certain time.

• Can protect issuers against decline in interest rate,
  • Call price: the price to redeem the bond.
  • Call provisions are beneficial to the issuer.
  • Investors face more reinvestment risk, and will ask higher yield, and pay lower price.
• A make-whole call provision
  • Call price: equals to the present value of the remaining cash flows owed to the bondholder.

Put Provisions (Putable bond): it gives the bondholders the right to sell the bond back to the issuer at a pre-determined price on specified dates.

• Can protect investor against increase in interest rate.
• Put price: the price to sell back the bond.
• Put provisions are beneficial to the investors.
• Investors will ask lower yield, and pay higher price.

Convertible bond: it gives bondholder the right to exchange the bond for a specified number of common shares in issuing company.

• Hybrid security with both debt and equity features.
• Conversion price: the share price at which convertible bond can be converted into shares.
• Conversion provisions are beneficial to bondholder.
• Investors will ask lower yield, and pay higher price.

A sinking fund is an arrangement where it is agreed that bonds will be retired periodically before maturity. The issuer may provide funds to the bond trustee so that the trustee can retire the bonds.

• Decrease debt burden of issuer, which would decrease the default rate of issuer.
• The amount borrowed declines in lockstep with the declining value of the collateral

Maintenance and replacement funds require the issuer to maintain the value of the collateral with property additions. If property additions are not made, cash can be sued to retire debt.

Selling property: The bond indenture will normally allow a company to sell assets that have been pledged as collateral, as long as the proceeds from the sale are used to retire the bonds.

Tender offer is simply an offer to purchase the bonds. The offer can be at a fixed price or it can be calculated as the present value of future cashflow.

1.3.3 Covenant

Covenant are legally enforceable rules that borrowers and lenders agree on at the time of a new bond issue.

• Negative covenants (restrictive covenants)
• Positive covenants
• Financial covenants

Bonds issued by highly creditworthy firms generally contain few covenants.

1.4 Bond Risks

Risk Faced by Bondholders: market risk(interest rate), liquidity risk, credit risk, event risk.

1.4.1 Credit Risks

Credit ratings measure default risk.

Default occurs when a bond issuer fails to make the agreed upon payments to the bondholders.

• The issuing company may then reorganize itself or sell its assets to meet creditor claims.
• Ranking of claimants: bondholders always rank above equity holders.

Credit spread risk: another risk faced by bondholders arises from changes in how the market prices credit risk.

$$R_{\text{bond}}=R_{\text{Benchmark}}+\text{Creditspread}$$

Credit migration risk/downgrade risk: bond issuer’s creditworthiness deteriorates, or migrates lower, causing the yield spreads wider and the price lower.

1.4.2 Credit Rating and High-yield Bonds

Ratings agencies, such as Moody’s, S&P, and Fitch provide opinions on the credit worthiness of bond issuers.

High-yield bonds/junk bonds are those bonds rated below investment grade by ratings agencies.

Circumstances that give rise to high-yield bonds:

• Sold by young and growing companies
• Fallen angels: the financial situation of the firm that issued investment-grade bonds deteriorate
• A company with stable cashflows increases its debt burden to benefit shareholders

High-yield bonds sometimes have unusual features:

• A deferred-coupon bond is a bond that pays no interest for a specified time period, after which time a specified coupon is paid in the usual manner.
• A step-up bond is a bond where the coupon increases with time.
• A payment-in-kind bond is a bond where the issuer has the option of providing the holder with additional bonds in lieu of interest.
• An extendable reset bond is a bond where the coupon is reset annually (or more frequently) to maintain the price of the bond at some level.
• The issuer may have rights to call the bond from the proceeds of an equity issue,

1.4.3 Event Risk

There are many events (e.g., natural disasters or the death of a CEO) that could adversely affect bonds. An important type of event risk is that of a large increase in leverage (e.g., leveraged buyouts, share buyback, etc).

2. Pricing Conventions, Discounting, and Arbitrage

2.1 US Treasury

2.1.1 Classification of the U.S. Treasuries

T-Bills: original maturity is one year or shorter.
T-Notes: original maturity is longer than one year and up to 10 years.
T-Bonds: orginal maturity is longer than 10 years.

2.1.2 Treasury Bills

Treasury bills are instruments issued by government to finance its short-term funding needs. They last one year or less.

Quotes for U.S. Treasury Bills

• The bid quote(买价) gives the price at which a market maker is prepared to buy the Treasury bill.
• The ask quote(卖价) (or the offer quote) gives the price at which a market maker is prepared to sell the Treasury bill.
• The mid-market price is the average of bid and ask prices.

The quoted price ($Q$) and the cash price ($C$)
$$C=100-\frac{n}{360}\times Q$$

• where $n$ is the number of calendar days until the maturity of the Treasury bill, whose face value is USD $100$.
• The quote $Q$ is the interest earned over a 360-day period as a percentage of the face value.

Example: Consider a Treasury bill and there are 90 days until the maturity. The bid quote is 1.640 and the ask quote is 1.630. What is the bid and ask cash price?

The bid cash price $=100-\frac{90}{360}\times 1.640=99.5900$

The ask cash price $=100-\frac{90}{360}\times 1.630=99.5925$

Investors can sell the Treasury bill to the market marker for $99.5900$ per USD 100 of face value.

Investors can buy the Treasury bill from the market maker for $99.5925$ per USD 100 of face value.

The mid-market price is the average of the bid and ask prices, which is USD $99.59125=(99.5900+99.5925)/2$

2.1.3 Treasury Bonds

Bonds with a maturity lasts more than one year are treasury bond.
Bonds with a maturity between one and ten years are sometimes referred to as treasury notes.

“32nds” quotation convention

Example: The bond quoted as 83-5.
$$(83+\frac{5}{32})\%\text{FaceValue}$$
If par value is $ $1,000,000$, the price of bond is $ $83,156.25$.

The quoted price ($Q$) and the cash price ($C$)

• Cash price(Dirty price) = Quoted price(Clean) + accrued interest
• Accrued interest(AI): is the interest earned between the most recent coupon date and the settlement date.
  

Day-count conventions:

• Actual/actual: most commonly for government bonds
• 30/360: most commonly for corporate and municipal bonds

Example: The price of a U.S. Treasury bond is quoted as $98.0$. It is sold in a transaction settled on June 27. Coupons are paid at the rate of $6\%$ per year on March 16 and September 15. What is the cash price?

There are 184 days between payments and 104 days between the last coupon and the settlement date.

$AI=3\times 104/184=1.6957$

Cash price: $98+1.6957=99.6957$

2.1.4 STRIPS

STRIPS is an acronym separate trading of registered interest and principal of securities.

STRIPS are created by investment dealers when a coupon-bearing bond is delivered to the Treasury and exchanged for its principal and coupon components.

• C-STRIPS(or TINTs, INTs): The securities created from the coupon payments.
• P-STRIPS(or TPs, Ps): The securities created from principal payments.

Example: Creation of C-STRIPS and P-STRIPS from the May 15, 2030 $6.25\%$ bond on March 9,2018 (Par value is 1 million).

Date	C-STRIP Face Value	P-STRIP Face Value
May 15, 2018	$31,250$
November 15, 2018	$31,250$
May 15, 2019	$31,250$
November 15, 2018	$31,250$
…	…	…
November 15, 2029	$31,250$
May 15, 2030	$31,250$	$1,000,000$

2.2 The Law of One Price

2.2.1 The Law of One Price and Arbitrage

If two portfolios provide the same future cash flows, they should sell for the same price. If the law of one price did not hold, there would be theoretical arbitrage opportunities.

The existence of traders pursuing arbitrage opportunities will usually cause market prices to move until the existence of the arbitrage opportunity is eliminated.

The highly liquid bond have a higher price than the relatively illiquid bond.

A convergence arbitrage: an arbitrageur can buy illiquid bond and sell liquid bond. The prices of two portfolios are expected to converge to the same value because they promise the same cash flow.

2.2.2 Replicating Bond Cash Flows

Example: You can trade bonds lasting $0.5$ years(Bond A) and one year (Bond B) that have coupons of $3\%$ and $4\%$, respectively. If these bonds pay their coupons on a semi-annual basis, how could you use them to replicate the cash flows on a one-year bond paying a $5\%$ semi-annual coupon(Bond C)?

The cash flow structure is shown below:

$$\{\begin{array}{l}101.5\times A+2\times B=2.5\\ 102\times B=102.5\end{array}\to \{\begin{array}{l}A=0.00483\\ B=1.0049\end{array}$$

If Bond A is trading at USD $99.5$ and Bond B is trading at USD $100.9$. Is there any arbitrage opportunities if Bond C is trading at USD $101$? What should we do?

$0.00483\times 99.5+1.0049\times 100.9=101.875$

Bond C is undervalued if trading at USD $101$, so we can buy Bond C and sell Bond A and Bond B.

3. Interest Rates

3.1 Fundamentals

3.1.1 Compounding Frequency

Future value with different compounding frequencies. Initial investment $ $100$ at an $8\%$ rate grows.

Compounding Frequency	Number of times per year	Future value in one year
Annual	1	$108=100\times (1+8\%)$
Semi-annual	2	$108.16=100\times (1+\frac{8\%}{2}{)}^2$
Quarterly	4	$108.24=100\times (1+\frac{8\%}{4}{)}^4$
Monthly	12	$108.30=100\times (1+\frac{8\%}{12}{)}^{12}$
Weekly	52	$108.32=100\times (1+\frac{8\%}{52}{)}^{52}$
Daily	365	$108.33=100\times (1+\frac{8\%}{365}{)}^{365}$

Present value with different compounding frequencies $ $100$ received in five years when the interest rate is $8\%$.

Compounding Frequency	Number of times per year	Present value in five year
Annual	1	$68.06=100\times (1+8\%{)}^{-5}$
Semi-annual	2	$67.56=100\times (1+\frac{8\%}{2}{)}^{-5\times 2}$
Quarterly	4	$67.30=100\times (1+\frac{8\%}{4}{)}^{-5\times 4}$
Monthly	12	$67.12=100\times (1+\frac{8\%}{12}{)}^{-5\times 12}$
Weekly	52	$67.05=100\times (1+\frac{8\%}{52}{)}^{-5\times 52}$
Daily	365	$67.03=100\times (1+\frac{8\%}{365}{)}^{-5\times 365}$

3.1.2 Continuous Frequency

In the limit of the compounding frequency, we obtain continuous compounding.

Future value: If an interest rate $R$ is continuously compounded, it can be shown that an amount $A$ grows to $A{e}^{RT}$ by time $T$.

Present value: The present value of an amount $A$ received at time $T$ is $A{e}^{-RT}$.

3.1.3 Equivalent Rate

Convert $R_1$ (compounded $m_1$ times per annum) to the equivalent rate $R_2$(compounded $m_2$ times per annum):
$$(1+\frac{R_1}{m_1}{)}^{m_1}=(1+\frac{R_2}{m_2}{)}^{m_2}$$

Convert $R_m$ (compounded $m$ times per annum) to the equivalent rate $R_c$ (continuously compounded rate).

$$e^{R_c}=(1+\frac{R_m}{m}{)}^m$$

In the United States and some other countries, bonds which last longer than one year from date of issue normally pay interest every six months. The yield provided by a bond is therefore normally expressed with semi-annual compounding.

3.1.4 Discount Factor

Discount Factor is the present value of one unit of currency to be received at the end of that term. The discount factor is a declining function of maturity due to the time-value of money phenomenon)

$d(1.5)=0.9825$, means that the present value of $1 to be received in 18 months is $0.9825 today.

Discount factor from T-bills(零息债券)

A Treasury bill maturing in 6 months is worth USD $995,912.50$ now, and its par value is USD 1 million.What is the six-month discount factor?

$d(0.5)=\frac{995,912.50}{1,000,000}=0.9959125$

Discount factor from coupon-bearing bonds(付息债券)

A six-month bond that pays coupons at the rate of $5\%$ per year is currently worth $100.5$. What is the six-month discount factor?

$d(0.5)=\frac{100.5}{100+2.5}=0.980488$

In addition to the bond in the example above, a one-year bond that pays coupons every six months at the rate of $3\%$ per year is currently worth $98.5$. What is the one-year discount factor?

$1.5\ast d(0.5)+101.5\ast d(1)=98.5\to d(1)=0.955953$

3.1.5 Annuity

Annuity is a finite set of level sequential cash flows.

An investor deposits $ $2000$ at the beginning of the following four years into an account that pays nominal annual interest of $6\%$ (compounding monthly). The value of the account at the end of four years is closest to:

The equivalent annual rate = $(1+6\%/12{)}^{12}-1=6.1678\%$

Calculator: [2nd][PMT], [2nd][ENTER] $\to$ BGN mode

$N=4$, $1/Y=6.1678$, $PV=0$,$PMT=2000$ $\to$ $CPTFV=9312$

Annuity Factor: The sum of the discount factors, assume semi-annual basis
$$AT=\sum _{t=1}^{2n}d(\frac{t}{2})$$

Perpetuity is a security that pays coupons forever. The price of a perpetuity is simply the coupon divided by the yield.

$$\text{Perpetuity}=\frac{C}{y}$$

3.2. Spot Rates

The spot rate is the interest rate earned when cash is received at just one future time. It is also referred to as the zero-coupon interest rate, or just the “zero”.

3.2.1 Determine Spot Rates

Direct way: derive spot rates from money market instruments lasting less than one year.

Bootstrap: instruments lasting longer than one year usually make regular payments prior to maturity.

One way of calculating the zero-coupon rates implied by these instruments is by working forward and fitting the zero-coupon rates to progressively longer maturity instruments.

Calculate the zero rates for 6 months, one year, 18 months and two years using bootstrapping.

Time to Maturity	Bond Par Value($)	Coupon Rate (semi-annual)	Bond Price($)
$0.5$	$100$	$0\%$	$98.5$
$1$	$100$	$0\%$	$95.9$
$1.5$	$100$	$4\%$	$98$
$2$	$100$	$6\%$	$100.6$

$\frac{100}{1+z_{0.5}/2}=98.5\to z_{0.5}=3.05\%$

$\frac{100}{(1+z_1/2{)}^2}=95.9\to z_1=4.23\%$

$\frac{2}{1+z_{0.5}/2}+\frac{2}{(1+z_1/2{)}^2}+\frac{102}{(1+z_{1.5}/2{)}^3}=98\to z_{1.5}=5.44\%$

$\frac{3}{1+z_{0.5}/2}+\frac{3}{(1+z_1/2{)}^2}+\frac{3}{(1+z_{1.5}/2{)}^3}+\frac{103}{(1+z_{1.5}/2{)}^3}=100.6\to z_2=5.73\%$

3.2.2 Spot Rates v.s. Discount Factors

Spot rate give the same information as discount factors.

Suppose the discount factor for $t$ years is $d(t)$ and that the $t$-year spot rate is $z(t)$ with semi-annual compound
$$d(t)=\frac{1}{(1+\frac{z(t)}{2}{)}^{2t}}\to z(t)=2[(\frac{1}{d(t)}{)}^{\frac{1}{2t}}-1]$$

Computing spot rates from STRIPS prices or discount factors for semi-annual compounding.

Terms in years	0.5	1	1.5	2	2.5	3
STRIP Price	$99.206349$	$97.932618$	$96.413232$	$94.683986$	$92.826033$	$90.915462$
Discount Factor	$0.992063$	$0.979326$	$0.964132$	$0.946840$	$0.928260$	$0.909155$

$d(0.5)=\frac{1}{(1+\frac{Z_{0.5}}{2})}=0.992063\to Z_{0.5}=1.6\%$

$d(1)=\frac{1}{(1+\frac{Z_1}{2}{)}^2}=0.979326\to Z_1=2.1\%$

$d(1.5)=\frac{1}{(1+\frac{Z_{1.5}}{2}{)}^3}=0.964132\to Z_1=2.45\%$

3.2.3 Bond Valuation Based on Spot Rates

Law of one price assets that produce identical future cash flows regardless of future events should have the same price.

The valuation of bond involves identifying its cash flows and discounting them at the interest rates corresponding to their maturities.

Use a sequence of spot rates that correspond to the cash flow dates to calculate the bond price.
$$P=\sum _{t=1}^n\frac{C}{(1+Z_t{)}^t}+\frac{FV}{(1+Z_n{)}^n}$$

• $Z_n$: spot rate for period $n$.

Assume a 1.5-year bond with a face value of $ $100$ pays a $3.5\%$ coupon on a semiannual basis. What is the price of the bond according to the following spot rates?

Maturity(years)	$0.5$	$1$	$1.5$	$2$
Spot rate	$2.2\%$	$2.25\%$	$2.30\%$	$2.35\%$

$$\text{Price}=\frac{1.75}{(1+2.2\%/2)}+\frac{1.75}{(1+2.25\%/2{)}^2}+\frac{101.75}{(1+2.3\%/2{)}^3}=101.7611$$

3.3 Forward and Par Rates

3.3.1 Forward Rates

Forward rates are interest rates corresponding to a future period implied by the spot curve.

All forward rates are computed using spot rates.

Annual compounding $z_1$ is 3%, $z_2$ is 4%. The implied forward rate from the end of year one to the end of year two is:

$(1+3\%)(1+F)=(1+4\%{)}^2\to F=5.01\%$

Semi-annual compounding $z_{0.5}$ is 1.6%, $z_1$ is 2.1%. The implied forward rate from the end of half-year to the end of year one is:

$(1+\frac{1.6\%}{2})(1+\frac{F}{2})=(1+\frac{2.1\%}{2}{)}^2\to F=2.6\%$

Continuous compounding $z_3$ is 4.5%, $z_4$ is 5%. The implied forward rate from the end of year three to year four is:

$e^{0.045\times 3}\times e^{F\times 1}=e^{0.05\times 4}\to F=6.5\%$

When rates are expressed with ordinary compounding, the forward rate for the period between time $T_1$ and $T_2$ is

$$(1+R_1{)}^{T_1}(1+F_{1,2}{)}^{T_2-T_1}=(1+R_2{)}^{T_2}$$

When rates are expressed with continuous compounding, the forward rate for the period between time $T_1$ and $T_2$ is
$$F=\frac{R_2{T}_2-R_1{T}_1}{T_2-T_1}$$

3.3.2 Trading Strategies

An investor can borrow funds for time $T_1$ and invest for $T_2$. If the rates for the period between $T_1$ and $T_2$ are less than the forward rate, the investor’s total financing cost will be less than the investor’s return, producing a profit.

Suppose the two-year rate is $4\%$ and the three-year rate is $5\%$, with both rates continuously compounded. So the forward rate for the third year is $7\%$.

• If an investor feels confident that the rate for the third year will be less than $7\%$, the investor can borrow for two years at $4\%$ and invest for three years at $5\%$。
• If the realized rate is expected to be greater than the forward rate, the investor should borrow for three years and invest for two years.

3.3.3 Bond Valuation Based on Forward Rates

Forward rates can be used to value a bond in the same manner as spot rates because they are interconnected.

Discount bond cash flows one period by one period with forward rates.

Example: suppose an analyst needs to value a 1.5 year, 3% semi-annual coupon payment bond.What is the price of the bond according to the following forward rates?

Term in Years	0-0.5	0.5-1	1-1.5
6-month Forward Rates	2.5%	3.5%	3.78%

$$\frac{1.5}{1+\frac{2.5\%}{2}}+\frac{1.5}{(1+\frac{2.5\%}{2})(1+\frac{3.5\%}{2})}+\frac{101.5}{(1+\frac{2.5\%}{2})(1+\frac{3.5\%}{2})(1+\frac{3.78\%}{2})}=99.6327$$

3.3.4 Par Rates

Par rate is the coupon rate which bond is priced at par value.

For an asset with a par amount of one unit that makes semiannual payments and matures in $T$ years

$$\frac{p}{2}\sum _{t=1}^{2t}d(\frac{t}{2})+d(T)=1\to A(T)=\sum _{t=1}^{2t}d(\frac{t}{2})$$

• $p$: the par rate
• $A(T)$: the annual factor

Assume a 1.5-year bond pays semiannual coupons and has a par value of $ $100$, please compute the 1.5-year par rate.

Maturity	0.5	1	1.5
Discount factor	$0.992063$	$0.979326$	$0.964132$

$$\frac{p\times 100}{2}[d(0.5)+d(1)+d(1.5)]+d(1.5)\times 100=100\to p=2.44\%$$

3.3.5 Relationship among Spot, Forward and Par Rates

Based on the assumption of semi-annual compounding, calculate the spot rate in 1.5 years

Term in Years	Discount Factor	Spot Rate	Forward Rate	Par Rate
0.5	$0.992063$	$1.60\%$	$1.6000\%$	$1.60\%$
1	$0.979326$	$2.10\%$	$2.6012\%$	$2.10\%$
1.5	$0.964132$	$2.45\%$	$3.1518\%$	$2.44\%$
2	$0.946840$	$2.75\%$	$3.6537\%$	$2.74\%$
2.5	$0.928260$	$3.00\%$	$4.0031\%$	$2.98\%$
3	$0.909155$	$3.20\%$	$4.2030\%$	$3.18\%$
3.5	$0.888696$	$3.40\%$	$4.6041\%$	$3.37\%$
4	$0.863598$	$3.70\%$	$5.8124\%$	$3.65\%$

From discount factor

$$d(1.5)=\frac{1}{(1+\frac{Z_{1.5}}{2}{)}^3}\to Z_{1.5}=2.45\%$$

From forward rate
$$(1+\frac{Z_{1.5}}{2}{)}^3=(1+\frac{f_{0-0.5}}{2})(1+\frac{f_{0.5-1}}{2})(1+\frac{f_{1-1.5}}{2})$$

From par rate
$$100=\frac{2.44/2}{(1+\frac{1.6\%}{2})}+\frac{2.44/2}{(1+\frac{2.1\%}{2}{)}^2}+\frac{100+2.44/2}{(1+\frac{Z_{1.5}\%}{2}{)}^3}$$

Term structure
If spot curve is upward-slopping

If spot curve is downward-slopping

If the term structure is flat(with all the spot rates the same), all par rates and all forward rates equal to the spot rate.

3.4. Other Rates

3.4.1 Government Borrowing Rates

Government borrowing rates is interest rate paid by a government on its borrowings in its own currency. In the U.S., this is referred to as the Treasury Rate.

Government debt from developed countries is considered to be risk-free and the interest rates on these borrowings are generally below those on other borrowings in the same currency.

3.4.2 Repo Rate

In a repo agreement, securities are sold by Party A and Party B for a certain price with the intention of being repurchased at a later time at higher price.

If Party A fails to repurchase the securities as agreed, Party B can simply keep the securities. This means that Party B takes very little risk, provided that:

• The value of the securities equals (or is very close to) the initial price for the security.
• This value is fairly stable.

3.4.3 Libor

Libor (London Interbank Offered Rate): an unsecured borrowing rate between banks. Libor rates are quoted for several different currencies and for borrowing periods ranging one day to one year.

• AA-rated global banks estimate the rates (forward-looking estimates for rates at which banks think they could borrow money) .
• the highest 25% and lowest 25% of the estimates are
  discarded.

Libor is a less than ideal benchmark because it is based on estimates that can be manipulated.

Two replacement benchmark rate:
The repo overnight rate: The United States has proposed the use of the repo-based Secured Overnight Financing Rate (SOFR).

Overnight interbank borrowing rate: arises from unsecured borrowing and lending between banks at the end of each day to keep cash in reserve with central bank.

• Effective federal funds rate: In the United States, the weighted average of the rates in brokered transactions
• Sterling overnight index average (SONIA): In the U.K.
• Euro overnight index average (EONIA): In the Eurozone

3.4.4 Swap Rates

Swap rate is the fixed portion of a swap as determined by its particular market and the parties involved.

Floating rates are based on some short-term reference interest rate, such as three-month or six-month dollar Libor(London Interbank Offered Rate).

The swap market therefore defines par rates. For example, the five-year swap rate defines a five-year bond selling for par. The par rates can be used to determine discount factors and therefore spot rates.

• Frequency: swap - every three months; par bonds - usually considered in Treasury markets pay coupons every six months.
• Swap rates also include a degree of counter-party default risk, whereas Treasury rates are usually free of default risk.

3.4.5 Overnight Indexed Swap

Overnight index swap(OIS): the geometric average of overnight rates is exchanged for a fixed rate every three months for five years.

OIS rates are the fixed rates in overnight indexed swaps.

The floating rate per three-months is
$$(1+r_1{d}_1)(1+r_2{d}_2)\dots (1+r_n{d}_n)-1$$

• $r_i$: is the overnight rate per day on day $i$.
• $d_i$: is the number of calendar days where rate r_i applies
• $n$: is the number of trading days in the three-month period.

The risk-free rates used to value derivatives are determined from overnight interbank rates using overnight indexed swaps. Treasury rates are not used because they are considered to be artificially low.

• Banks are not required to keep capital to support an
  investment in Treasury instruments, but they are required
  to keep capital for other very low risk instruments.
• In some countries, the income from Treasury instruments is given favorable tax treatment.

3.5 Term Structure

3.5.1 Term Structure Shift

Parallel shift: The yields on all maturities increase or decrease by the same number of basis points maintaining its prior slope and shape.

Non-Parallel Shift: The yields on all maturities increase or decrease by different number of basis points and non-parallel shift changes the slope of the yield curve

A flattening term structure occurs

• long- and short-maturity rates both move down, but long-maturity rates move down by more (bull flattener)
• long- and short-maturity rates both move up, but short-maturity rates move up by more (bear flattener)
• short short-maturity, long long-maturity.
  

A steepening term structure occurs

• long- and short-maturity rates both move down, but short-maturity rates move down by more (bull steepening).
• long- and short-maturity rates both move up, but short-maturity rates move up by less(bear steepening).
• long short-maturity, short long-maturity.
  

3.5.2 Theories of the Term Structure

The market segmentation theory: argues that short-, medium-, and long-maturity instruments attract different types of traders.

• Short-maturity rates would only attract traders interested in short-maturity investments.
• Medium- and long-maturity instruments would only attract traders interested in those investments.
• Unrealistic: Market participants do not focus on just one segment of the interest rate term structure.

The expectations theory: argues that the interest rate term structure reflects where the market is expecting interest rates to be in the future.

• If the market expects interest rates to rise, then the term structure of interest rates will be upward-sloping.
• If the market expects interest rates to decline, then the term structure will be downward-sloping.
• The expectations theory argues that forward rates should be equal to expected future spot rates.

The liquidity preference theory: if the interest rate term structure reflects what the market expects interest rates to be in the future, most investors will choose a short-term investment over a long-term investment. This is because of liquidity consideration. Liquidity considerations therefore lead to lenders wanting to lend for short periods of time and borrowers wanting to borrow for long periods of time.

In order to match borrowers and lenders, financial intermediaries must increase long-term rates relative to the market’s expectations about future short-term rates.

• Long-term borrowing becomes less attractive, because short-term rates are more attractive to borrowers
• Short-term lending becomes less attractive because long-term rates are more attractive to lenders

4. Bond Yields and Return Calculations

4.1. Yield to Maturity

4.1.1 Definition

Yield to maturity is a single discount rate which if applied to all the bond’s cash flows, would make the cash flow’s present value equal to the bond’s market price.

When YTM expressed with semi-annual compounding, the bond’s market price is :

$$P=\frac{c/2}{1+y/2}+\frac{c/2}{(1+y/2{)}^2}+\cdots +\frac{c/2+100}{(1+y/2{)}^{2T}}$$

Suppose that a 2-year, $8\%$ semi-annual coupon bond is priced at $105$. The YTM of the bond is:

$$105=\frac{4}{(1+\frac{YTM}{2})}+\frac{4}{(1+\frac{YTM}{2}{)}^2}+\frac{4}{(1+\frac{YTM}{2}{)}^3}+\frac{104}{(1+\frac{YTM}{2}{)}^4}$$

The calculator solution is:
$N=4$, $PMT=4$, $PV=-105$, $FV=100$ $CPT\to 1/Y=2.6625$, $YTM=2.6625\times 2=5.33\%$

4.1.2 Properties of YTM

The bond price is inversely related(反向相关) to YTM.

• At premium: coupon rate > YTM
• At par: coupon rate = YTM
• At discount: coupon rate < YTM (e.g,.zero coupon bond)
  

“Pull to par” effect(回归面值): If no default and the yield keep constant, bond price approaches par value as its time-to-maturity approaches zero.

4.1.3 The Relationship between Spot Rates and YTM

YTM is a kind of average of all the spot rates.
$$P=\frac{C{F}_1}{(1+YTM)}+\frac{C{F}_2}{(1+YTM{)}^2}+\cdots +\frac{C{F}_n}{(1+YTM{)}^n}$$
$$P=\frac{C{F}_1}{(1+z_1)}+\frac{C{F}_2}{(1+z_2{)}^2}+\cdots +\frac{C{F}_n}{(1+z_n{)}^n}$$

Coupon effect: The fact that correctly priced bonds with same maturity but different coupons have different yield to maturity.

As coupon rises, the average time it takes bondholders to recover their cash flow flows falls. Therefore, the spot rates for the early payment dates is becoming more important in determining the yield to maturity.

• Spot curve is upward-sloping (negative relationship): The higher the coupon rate, the lower the YTM (with the same maturity)

• Spot curve is downward-sloping (positive relationship):The higher the coupon rate, the higher the YTM (with the same maturity)

• Spot curve is flat (equal): YTM = spot rate

Yield Spreads: The market price of a security is recovered by discounting a bond’s cash flows using a appropriate term structure plus a spread.

• G-spread: yield spread over an actual or interpolated government bond.
• Zero volatility spread(Z-spread, static spread): a constant yield spread over a government spot curve.
  $$PV=\frac{PMT}{(1+z_1+Z{)}^1}+\frac{PMT}{(1+z_2+Z{)}^2}+\cdots +\frac{PMT+FV}{(1+z_n+Z{)}^n}$$

Japanese yields: in Japan, yields are quoted on a simple yield basis, which means that there is no compounding in the yield measurement.
A five-year bond has a coupon of $2\%$ and the price of the bond is $99$, the Japanese yield is
$$\text{Japanyield}=\frac{c}{p}+\frac{100-p}{pT}=2.22\%$$

Question 1: Fiona Johnson, FRM, is a risk manager for a fund. She is analyzing a US Treasury bond position in a client’s portfolio. This bond is a straight bond with a face value $$100,000$ and $5$ years maturity. The coupon rate is $6\%$ on a semi-annual basis and yield to maturity is $5\%$. Fiona thinks that US Treasury yield curve will shift and the yield of this bond will decrease $25$ bps. What will the approximate price change of this bond?

$N=10$, $1/Y=2.5$, $PMT=3000$, $FV=100,000$, $\to F{V}_{\text{original}}=104,376$

$N=10$, $1/Y=(5-0.25)/2=2.375$, $PMT=3000$, $FV=100,000$, $\to F{V}_{\text{new}}=105,505.5$

$\text{Price change}=105,505.5-104,376=1129.5$

Question 2: Thomas buys a three-year zero-coupon bond for $87.0$. Based on the information from Yahoo Finance, he notices that the three-year spot rate is $4\%$ (semi-annually compounded). What is the spread of the bond?

$$87=\frac{100}{(1+0.04/2+s/2{)}^6}\to s=0.0070$$

4.2 Conventions for Quotation

Bond dealers usually quote flat price while the full price will be paid, and there can be a difference between them.

Full price = Flat price + Accrued Interest (AI)
Dirty price = Clean price + Accrued Interest (AI)

$$\text{FullPrice}=\left[\frac{PMT}{(1+r{)}^1}+\frac{PMT}{(1+r{)}^2}+\cdots +\frac{PMT}{(1+r{)}^n}\right](1+r{)}^{t/T}$$

Accrued Interest(AI): the proportional share of the next coupon payment.

$$AI=\frac{t}{T}\times PMT$$

Day-count conventions:

• Actual/actual: most commonly for government bonds
• 30/360: most commonly for corporate and municipal bonds.

An investor is considering buying a corporate bond with $8\%$ coupon rate and $$100$ par value. This bond matures on September 1st 2032 with semi-annual coupon payment. The payment is made on March 1st and September 1st every year. Suppose today is May $15^{th}$ 2020 and required yield is $6\%$. How much should the investor pay and what should be the price quoted?

1. 计算AI，注意日期模式
   $AI=74/180\times 4=1.6444$

2. 计算上一个票息支付日的债券价格
   Bond price for previous coupon date (2020/3/1)

   $PMT=4$, $FV=100$, $N=25$, $1/Y=3$, $CPT$ $PV=117.4131$

3. 复利到交割日（脏价）
   Dirty price for 2020/5/15: $117.4131\times (1+3\%{)}^{74/180}=118.8486$

4. 计算净价
   Clean price = dirty price - AI = $118.8486-1.6444=117.2042$

关注日期模式

4.3 Decomposition of P&L

4.3.1 Gross and Net Realized Returns

Gross Realized Return: including capital gain or loss and coupon, and if we want to look at the return over a longer period, we must consider the coupon reinvestment.

$$R_{t,t+1}=\frac{P_{t+1}+c-P_t}{P_t}$$

Suppose there is a 4-year bond with $6\%$ semi-annual coupon rate. The initial price is $104.9$ and turns to be $104$ after one year. The first coupon is reinvested at $5.5\%$. Calculate the gross returns.
$$R_{t,t+1}=\frac{104+3+3\times (1+5.5\%/2)-104.9}{104.9}=4.9\%$$

Net Realized Return: The return after financing costs have been subtracted.

Suppose there is a 4-year bond with $6\%$ semi-annual coupon rate. The initial price is $104.9$ and turns to be $104.32$ after six month. The investor finances the purchase of the bond and a rate of $0.2\%$ would be charged on the amount borrowed. Calculate the net returns.
$$R_{t,t+1}=\frac{104.32+3-104.9}{104.9}-\frac{0.2\%}{2}=2.21\%$$

4.3.2 Decomposition of P&L for a Bond

The bond’s profit and loss consist of both price appreciation/depreciation(capital gain or loss) and cash-carry(cash flows such as coupon payments).

Price appreciation can be decomposed into three components: carry roll-down, rate change and spread change.

The carry roll-down: the return achieved due to the passage of time if there is no change to some aspect of the interest rate environment. The most common assumption when the carry roll-down is calculated is

• Forward rates are realized( the forward rate for a future period remain unchanged as we move through time).
• The interest rate term structure stays unchanged.
• A bond’s yield to maturity remain unchanged.

Rate changes: the return realized when realized rates differ from those assumed in the carry roll-down.

Spread changes: the return realized when a bond’s spread changes.

Consider a bond provides an annual coupon rate of $2\%$. Forward rates are annually compounded and shown below. The investor earns a spread of $50$ bp per years. Calculate the carry roll-down, assuming that forward rates are realized and the spread is unchanged.

Start Period	0-1	1-2	2-3
Forward Rate	3%	4%	5%
Spread	0.5%	0.5%	0.5%

$P=\frac{2}{1.035}+\frac{2}{1.035\times 1.045}+\frac{102}{1.035\times 1.045\times 1.055}=93.1720$

$P_{\text{carry roll-down}}=\frac{2}{1.045}+\frac{102}{1.045\times 1.055}=94.4330$

Suppose now that forward rates are not realized. The forward rates in one year are shown in the table below. If the spread had remained the same, what is the impact of the term structure change?

Start Period	0-1	1-2	2-3
Forward Rate	-	3%	4%
Spread	-	0.5%	0.5%

$P_{\text{rate change}}=\frac{2}{1.035}+\frac{102}{1.035\times 1.045}=96.2392$

Suppose now that the spread increases to $100$ bp, If the forward rates are realized, what is the impact of spread changes?

Start Period	0-1	1-2	2-3
Forward Rate	-	3%	4%
Spread	-	1%	1%

$P_{\text{spread change}}=\frac{2}{1.04}+\frac{102}{1.04\times 1.05}=95.3297$

These results are summarized in the table below:

Initial Price of Bond	$93.1720$
Carry Roll-Down	$94.4330-93.1720+2=3.261$
Rate Changes	$96.2392-94.433=1.8063$
Spread Changes	$95.3297-96.2392=-0.9096$
Final Value of Bond	$95.3297$
Gain	$4.1577=3.261+1.8063-0.9096$

5. Duration and Convexity

5.1 Duration

Duration(久期): The sensitivity of bond’s full price to changes in the bond’s YTM or in benchmark interest rates.

• Longer time-to-maturity usually leads to higher duration.
• Higher coupon rate leads to lower duration.
• Higher yield-to-maturity leads to lower duration.

5.1.1 Yield Duration

Macaulay duration: the average time the bond holder has to wait before receiving the present value.

$$\text{MacDur}=\frac{{\sum }_{t=1}^{n}t\times PVC{F}_t}{\sum PVC{F}_t}$$

For a plain bond, the Macaulay duration is less than or equal to its maturity.

For a zero coupon bond, the Macaulay duration equals to its maturity.

Consider a two-year bond that provides annual coupons at the rate of $6\%$. The YTM of the bond is $5\%$.

$N=2$, $1/Y=5\%$, $PMT=6$, $FV=100$ $\to PV=-101.8594$

$$\text{MacDur}=1\times \frac{\frac{6}{1+5\%}}{101.8594}+2\times \frac{\frac{106}{(1+5\%{)}^2}}{101.8594}=1.9439$$

Modified duration: provides a linear estimate of the percentage price change for a bond given a change in yield.

$$\text{ModDur}=-\frac{\Delta P/P}{\Delta y}=\frac{\text{MacDur}}{1+y/m}$$

$$\Delta P\approx -\text{ModDur}\times \Delta y\times P$$

The Macaulay duration applies in the situation where $y$ is measured with continuous compounding.

$$\Delta P\approx -\text{MacDur}\times \Delta y\times P$$

Dollar duration: a measure of the dollar change in a bond’s value to a change in the yield.

$$\text{DollarDur(D)}=-\frac{\Delta P}{\Delta y}=\text{ModDur}\times P$$

$$\Delta P\approx -\text{DollarDur(D)}\times \Delta y$$

DV01: describes the impact of a one-basis-point($0.0001$)change in interest rates on the value of a portfolio.
$$\text{DV01}=-\frac{\Delta P}{10,000\times \Delta y}=\frac{\text{DollarDur}}{10,000}=\text{ModDur}\times P\times 0.0001$$

5.1.3 Curve Duration

The One Factor Assumption: assumes that all interest rates move by the same amount, which means the shape of the term structure never changes(parallel shift).

Curve Duration: used for bonds with embedded option due to uncertain future cash flow.

Effective Duration: describes the percentage change in the price of a bond, due to a small change in all rates.

$$D^E=-\frac{\Delta P/P}{\Delta r}=\frac{P_{-\Delta y}-P_{+\Delta y}}{2P_0\Delta y}$$

• $P_0$: initial observed bond price
• $\Delta y$: change in required yield

Consider a portfolio consists of a Treasury bond with a face value of USD 1 million paying a $10\%$ per annum coupon semi-annually. The tenor of this bond is one year. Suppose that spot rates are as shown in the table below. Calculate the DV01 and effective duration, if spot rates move $5$ bp.

Maturity(Years)	Rate(%)	+5bp Rate(%)	-5bp Rate(%)
0.5	7.0	7.05	6.95
1.0	7.5	7.55	7.45

The value of the bond is:
$\frac{50,000}{1.035}+\frac{1,050,000}{1.0375^2}=1,023,777.32$

The rates increase by five basis points, the value of the bond:
$\frac{50,000}{1.03525}+\frac{1,050,000}{1.03775^2}=1,023,295.72$

$DV01^{\prime }=\frac{1,023,777.32-1,023,295.72}{5}=96.32$

The rates decrease by five basis points, the value of the bond:
$\frac{50,000}{1.03475}+\frac{1,050,000}{1.03725^2}=1,024,259.26$

$DV01^{\prime \prime }=\frac{1,024,259.26-1,023,777.32}{5}=96.39$

The two estimates of DV01 differ slightly because the bond’s price is not exactly a linear function of interest rates. We can get a good estimate of DV01 by averaging the two estimates:

$DV01=(96.32+96.39)/2=96.355$

$$D^E=\frac{P_{-\Delta y}-P_{+\Delta y}}{2P_0\Delta y}=\frac{1,024,259.26-1,023,295.72}{2\times 1,023,777.32\times 0.05\%}=0.9412$$

5.1.4 Limitations of Duration

Duration provides a good approximation of the effect of a small parallel shift in the interest rate term structure.

But these equations cannot be relied upon, if the change in the bond yield arises from a non-parallel shift in the interest rate term structure or the change is large.

5.2 Convexity

5.2.1 Convexity

Convexity(凸度) measures the non-linear relationship of bond prices to changes in interest rates and the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes.

The duration plus convexity approximation fits a quadratic function and captures some of the curvature, which provides a better approximation.

• Duration overestimates(高估) the magnitude of price decreases
• Duration underestimates(低估) the magnitude of price increases
  

5.2.2 Macaulay Convexity

$$\text{MacConvexity}=\frac{{\sum }_{t=1}^n{t}^2\times {PVCF}_t}{\sum {PVCF}_t}$$

Consider a bond that provides annual coupons at the rate of $6\%$. The maturity is 2 years. The YTM is $5\%$. Calculate the Macaulay convexity of it.

$N=1$, $1/Y=5$, $PMT=6$, $FV=100\to PV=-101.8594$

$$\text{MacCovexity}=1^2\times \frac{\frac{6}{(1+5\%)}}{101.8594}+2^2\times \frac{\frac{106}{(1+5\%{)}^2}}{101.8594}=3.8317$$

5.2.3 Modified Convexity

$$\text{ModifiedConvexity}=\frac{\text{MacConvexity}}{(1+y/m{)}^2}$$

Example: Consider a bond a bond’s Macaulay Convexity is $8.13904$. If the bond is compounded semi-annually and YTM is $5.2455\%$, calculate the modified convexity of it.
$$\text{ModifiedConvexity}=\frac{8.13904}{(1+5.2455\%/2{)}^2}=7.7283$$

5.2.4 Effective Convexity

Effective convexity measures the sensitivity of the duration measure to changes in interest rates. The effective convexity($C^E$) of a position worth $P$ can be estimated as

$$C^E=\frac{1}{P}\left[\frac{P^{+}+P^{-}-2P}{(\Delta y{)}^2}\right]$$

5.2.5 Price Approximation

Duration provides a good approximation when there is small parallel shift in the interest rate term structure. However, it will provide a poor approximation if there’s non-parallel shift or the change is large.

The effect of parallel shifts of interest rate term structure can be more accurate by adding convexity analysis to the analysis of duration.

With continuous compounding

$\Delta P/P\approx -\text{MacDur}\ast \Delta y+\frac{1}{2}\ast \text{MacConvexity}\ast (\Delta y{)}^2$

$\Delta P\approx -\text{MacDur}\ast P\ast \Delta y+\frac{1}{2}\ast \text{MacConvexity}\ast P\ast (\Delta y{)}^2$

With discrete compounding frequencies
$\Delta P/P\approx -\text{ModDur}\ast \Delta y+\frac{1}{2}\ast \text{ModConvexity}\ast (\Delta y{)}^2$

$\Delta P\approx -\text{ModDur}\ast P\ast \Delta y+\frac{1}{2}\ast \text{ModConvexity}\ast P\ast (\Delta y{)}^2$

Suppose a bond with modified duration of $31.32$ and modified convexity of $667$, when its yield is expected to fall by $50$ bps, what should be the expected percentage price change?

$\Delta P/P=-31.32\ast (-0.0050)+\frac{1}{2}\ast 667\ast (-0.0050{)}^2=16.49\%$

5.2.6 Negative Convexity

A callable bond gives the issuer the right to redeem all or part of the bond before the specified maturity date.

Most mortgage bonds are negatively convex, and callable bonds usually exhibit negative convexity at lower yield.

In a vanilla bond(without embedded options) we can typically use modified and effective interchangeably. When the bond contains embedded options, we prefer effective duration and effective convexity.

Putable bonds often have higher positive convexity, especially when interest rates are high.

The security with more convexity outperforms the less convex security in both bull (rising price) and bear(failing price) markets.

The bigger the volatility of the interest rate, the greater the gains from the positive convexity.

• Long volatility of the interest rate $\to$ choosing a security with positive convexity
• Short volatility of the interest rate $\to$ choosing a security with negative convexity

5.2.7 Portfolio Calculations

In regard to both modified(effective) duration and convexity, portfolio duration and convexity equal the weighted sum of individual, respectively, durations and convexities where each component’s weight is its value as a percentage of portfolio value.
$$D_{\text{portfolio}}=\sum _{i=1}^n{w}_i\times D_i$$

$$C_{\text{portfolio}}=\sum _{i=1}^n{w}_i\times C_i$$

$w_i$: the bond’s market value to the whole portfolio value

DV01: The DV01 for a portfolio is simply the sum of the DV01s of the components of the portfolio.

5.2.8 Barbell vs. Bullet Portfolio

Barbell portfolio: securities in this portfolio concentrate in short and long maturities but less intermediate maturities.

Bullet portfolio: has more exposure at intermediate maturities.

For bonds with same duration, the one that has the greater dispersion of cash flows has the greater convexity.

A manager purchase $1 million Bond B. The coupon payments are semi-annual. Using A and C to construct a portfolio with the same cost and duration.

Bond	Coupon-Semi	Maturity	Price	Yield	Duration	Convexity
A	2%	5	95.3889	3%	4.7060	25.16
B	4%	10	100	4%	8.1755	79
C	6%	30	115.4543	5%	14.9120	331.73

$$\{\begin{array}{l}{V}_A+V_C=1\text{million}\\ \frac{V_A\times 4.7060}{1\text{million}}+\frac{V_C\times 14.9120}{1\text{million}}=8.1755\end{array}\to \{\begin{array}{l}{V}_A=0.66\text{million}\\ V_C=0.34\text{million}\end{array}$$

${\text{Convexity}}_{A+C}=0.66\times 25.16+0.34\times 331.73=129.39$

Advantage for barbell portfolio:

• These two strategies will have the same duration and different convexity.
• The barbell strategies produces a better result when there is a parallel shift in the yield curve.

Disadvantage for barbell portfolio: The bullet investment would perform better than the barbell investment for many non-parallel shifts.

5.3 Hedging

5.3.1 Duration Hedging

To construct a portfolio that can hedge a small change in interest rates.

$\Delta$(Price change of underlying asset) + $\Delta$(Price change of hedging instrument) = 0

If $\text{DV01}$ is expressed in terms of a fixed face amount, hedging a position of $F_A$ face amount of security A required a position of $F_B$ of security B where:

$$F_B=\frac{F_A\times {\text{DV01}}_A}{{\text{DV01}}_B}$$

5.3.2 Duration and Convexity Hedging

We can make both duration and convexity zero by choosing $P_1$ and $P_2$ so that:

$V\times D_V+P_1{D}_1+P_2{D}_2=0$

$V\times C_V+P_1{C}_1+P_2{C}_2=0$

The position is hedged against relatively large parallel shifts in the term structure. However, it will still have exposure to non-parallel shifts.

An investor has a bond position worth USD $20,000$ with a duration of $7$ and a convexity of $33$. Two bonds are available for hedging. Bond A has a duration of $10$ and a convexity of $80$. Bond B has a duration of six and a convexity of $25$. How can a duration plus convexity hedge be set up?

$$\{\begin{array}{l}10P_A+6P_B+20,000\times 7=0\\ 80P_A+25P_B+20,000\times 33=0\end{array}\to \{\begin{array}{l}{P}_A=-2,000\\ P_B=-20,000\end{array}$$

A short position A of USD $2,000$ and a short position B of USD $20,000$ are required.

6. Modeling Non-Parallel Term Structure Shift and Hedging

6.1 Principal Components Analysis

6.1.1 Weakness of One-Factor Risk Metrics

One-factor risk metric focuses on parallel shift in the interest rate term structure. In practice, rate movements in different regions are not perfectly correlated and multi-factor risk metrics addresses this non-parallel shit pattern.

6.1.2 Principal Components Analysis

PCA is a statistical technique that looks at the historical data of daily movements in rates of various maturities and identifies certain factors.

Rate Maturity	Factor 1	Factor 2	Factor 3	Factor 4	Factor 5	Factor 6	Factor 7	Factor 8
1 year	-0.129
2 year	-0.258
3 year
5 year
7 year
10 year
20 year
30 year

The daily term structure movements observed are a linear combination of the factors, which are uncorrelated.

$\Delta r_f={\sum }_{i=1}^8{a}_i{f}_{ij}=a_1{f}_{1,j}+a_2{f}_{2,j}+\cdots +a_8{f}_{8,j}$

• Factor loading($f_{i,j}$): the amount by which rate $j$ moves when there is one-unit change of the $i_{th}$ factor.
• Factor score($a_i$): the number of units change of the $i_{th}$ factor in a daily term structure change.

The importance of the factors are measured by the standard deviation of the factor scores.

Factor	1	2	3	4	5	6	7	8
Standard deviation	$14.15$	$4.91$	$2.44$	$1.59$	$1.09$	$0.85$	$0.78$	$0.68$

For our data, the total variance is:
$$14.15^2+4.91^2+\cdots +0.68^2=235.77$$

The first three factors account for $97,66\%$ of the variation of the observed rate daily movements.
$$\frac{14.15^2+4.91^2+2.44^2}{235.77}=97.66\%$$

Factor 1 ($85\%$) is roughly a parallel shift in the term structure.

Factor 2 ($10\%$) corresponds to a steepening or flattening of the term structure.

Factor 3 ($3\%$) is a bowing(曲度变化) of the term structure.

6.2 Key Rate 01s

6.2.1 Key Rate Shifts

Key rate shifts are non-parallel shifts and the change in the term structure is determined by the change in several selected key rates. It assumes that the impact of the key rate shifts declines linearly and reaches zero at the term of the adjacent key rates.

2.2 Key Rate 01s

Key Rate 01s is the change in a portfolio’s value from a $1$ bp change of the key rate shifts.

Example: Suppose a portfolio consists of a $1 million investment in 1-year, 3-year, 5-year, 9-year and 15-year zero coupon bond. The decrease in the portfolio’s value for a one-basis-point increase in the relevant spot rates is shown below:

Spot Rate Maturity	1 year	3 year	5 year	9 year	15 year
Portfolio Value Decrease	$95.62$	$270.26$	$424.35$	$677.93$	$944.75$

The calculation of KR01 are listed below:

1 bp shift in the following key rate	Change in bp of the Spot Rate(Maturities)
	1 year	3 year	5 year	9 year	15 year
2 year	1	0.667	0	0	0
5 year	0	0.333	1	0.2	0
10 year	0	0	0	0.8	1

Key Rate	Change in $ value fro the zero bonds in the portfolio					Total
	1 year	3 year	5 year	9 year	15 year
KR01-2yr	95.6	180.3	0.0	0.0	0.0	275.9
KR01-5yr	0.0	90.0	424.4	135.6	0.0	649.9
KR01-10yr	0.0	0.0	0.0	542.3	944.8	1487.1

Relationship between KR01 and DV01:

DV01 is the result of shifting all rates by 1 bp while KR01 is a result of shifts in key rates.

$DV01=KR01_{2yr}+KR01_{5yr}+KR01_{10yr}=2412.9$

6.2.3 Key Rate Hedging

For a portfolio with $N$ key rate exposures, we would need $N$ assets to hedge for the key rate risk.

Example: What positions do we need for the 3 hedging instruments to hedge the key rate risk for the portfolio?

Data for Hedging Using KR01s
KR01 Measure	Portfolio	Hedging Instrument
		A	B	C
KR01-2yr	126	20	3	3
KR01-5yr	238	2	22	4
KR01-10yr	385	1	4	25

If $x_1$, $x_2$ and $x_3$ are the positions in the three hedging instruments, the equations are:
$$\{\begin{array}{c}126+20x_1+3x_2+3x_3=0\\ 238+2x_1+22x_2+4x_3=0\\ 385+x_1+4x_2+25x_3=0\end{array}\to \begin{array}{c}{x}_1=-3\\ x_2=-8\\ x_3=-14\end{array}$$

So the portfolio can be hedged with short positions of 3,8 and 14 in the three hedging instruments.

6.2.4 Portfolio Risk

Bank regulators require banks to analyze the risks in their portfolios by considering ten different $KR01s$. The standard deviation of the change in value of the portfolio in one day is:

$${\sigma }_p=\sqrt{\sum _{i=1}^{10}\sum _{j=1}^{10}{\rho }_{i,j}{\sigma }_i{\sigma }_{j}KR01_{i}KR01_j}$$

• ${\sigma }_i$ is the standard deviation of the daily movement in rate $i$.
• ${\rho }_{i,j}$ is the correlation between the daily movement in rate $i$ and rate $j$.

We can generalize the idea so that any set of term structure movement is considered:

$${\sigma }_p=\sqrt{\sum _{i=1}^n\sum _{j=1}^n{\rho }_{i,j}{\sigma }_i{\sigma }_j{w}_i{w}_j}$$

• $w_i$ is the exposure to the $i_{th}$ term structure movement.
• ${\sigma }_i$ is the standard deviation of the $i_{th}$ term structure movement.
• ${\rho }_{i,j}$ is the correlation between the $i_{th}$ and $j_{th}$ structure movement.

It is particularly easy to apply Principal Components Analysis for the calculation of the portfolio risk:

$${\sigma }_p=\sqrt{{\sigma }_1^2{f}_1^2+{\sigma }_2^2{f}_2^2+{\sigma }_3^2{f}_3^2}$$

• ${\sigma }_i$ is the standard deviation of the factor score for $i_{th}$ factor

• $f_i$ is the change in the value of the portfolio when there is a movement in the term structure corresponding to one unit of the $i_{th}$ factor.

• The first three factors as which account for about $98\%$ of the variance in the rate movement.

• The correlation efficient can be discarded in the formula as the factors are uncorrelated with each other.

Suppose a portfolio has an exposure of USD $50$ to a $1$ bp increase in the 5-year rate and USD $-100$ to a $1$ bp in the 10-year rate in the following table and no other exposures.What is the portfolio’s exposure to the first two factors? Assuming the daily standard deviation for Factor 1 and Factor 2 are 14.15 units and 4.91 units respectively. What is the portfolio’s daily standard deviation?

Rate Maturity	Factor 1	Factor 2	Factor 3	Factor 4	Factor 5	Factor 6	Factor 7	Factor 8
1 year	$-0.13$	$0.38$	$0.78$	$-0.48$	$-0.01$	$0.00$	$-0.02$	$-0.01$
2 year	$-0.26$	$0.49$	$0.08$	$0.58$	$0.59$	$0.00$	$0.03$	$0.00$
3 year	$-0.33$	$0.43$	$-0.12$	$0.24$	$-0.73$	$-0.29$	$0.15$	$0.06$
5 year	$-0.41$	$0.20$	$-0.32$	$-0.22$	$-0.07$	$0.57$	$-0.55$	$-0.10$
7 year	$-0.43$	$-0.01$	$-0.29$	$-0.40$	$0.22$	$0.10$	$0.71$	$0.11$
10 year	$-0.41$	$-0.19$	$-0.10$	$-0.20$	$0.21$	$-0.71$	$-0.34$	$-0.28$
20 year	$-0.39$	$-0.40$	$0.23$	$0.16$	$-0.02$	$0.02$	$-0.17$	$0.76$
30 year	$-0.37$	$-0.44$	$0.35$	$0.32$	$-0.16$	$0.28$	$0.19$	$0.56$

The exposure to 1 unit of the first factor is:
$50\times (-0.41)+(-100)\times (-0.41)=20.5$

The exposure to 1 unit of the second factor is:
$50\times 0.20+(-100)\times (-0.19)=29.0$

The daily standard deviation of portfolio is
${\sigma }_p=\sqrt{14.15^2\times 20.5^2+4.91^2\times 29^2}=323.14$

6.2.5 The Use of Par Yields

Besides using spot rates to define key rate shift, a more practical way is to use par yields because:

Par yield government bonds are much more actively traded instruments and we can immediately calculate the position necessary to hedge a portfolio once we have calculated the exposure of the portfolio to the key rate shifts.

6.3 Forward Bucket 01

6.3.1 Bucketing Approach

Bucketing approach is to divide the interest rate term into segments referred to as buckets, and then calculate the dollar impact of changing all the rates in a bucket by one basis point on the value of a portfolio.

Relationship between Bucket shifts and DV01:

$DV01=B_{0-2yr}01+B_{2-10yr}01+B_{10-30yr}01$

6.3.2 Forward Bucket 01

Apply the bucketing approach to the forward curve as well:

Example: there are three buckets for forward curve: 0-2 years, 2-10 years and 10-30years,

• The decrease in portfolio value after applying $1bp$ shift to forward curve in the first bucket. (The forward rates for the 6-months periods beginning in 0, 6, 12 and 18 months increase by $1bp$)
• Similarly, we can define Forward $bucke{t}_{2-10yr}$, and Forward $bucke{t}_{10-30yr}$.

Example: Consider a simple portfolio consisting of a two-year bond with a face value of USD 100 and a coupon of 6% per year. Assume the term structure is flat at 4% with semiannual compounding. Suppose there are two buckets; 0-1 years and 1-2 years. Calculate the forward bucket 01 for each bucket?

The price of the bond:

$$\frac{3}{(1+2\%)}+\frac{3}{(1+2\%{)}^2}+\frac{3}{(1+2\%{)}^3}+\frac{103}{(1+2\%{)}^4}=103.8077$$

Forward rates in the 0-1 years bucket are increased by $1bp$

$$\frac{3}{(1+2.005\%)}+\frac{3}{(1+2.005\%{)}^2}+\frac{3}{(1+2.005\%{)}^2(1+2\%)}+\frac{103}{(1+2.005\%{)}^2(1+2\%{)}^2}=103.7977$$

Forward Bucket $01_{0-1yr}=103.8077-103.7977=0.01$

Forward rates in the 1-2 years bucket are increase by $1bp$

$$\frac{3}{(1+2\%)}+\frac{3}{(1+2\%{)}^2}+\frac{3}{(1+2\%{)}^2(1+2.005\%)}+\frac{103}{(1+2\%{)}^2(1+2.005\%{)}^2}=103.7983$$

Forward Bucket $01_{1-2yr}=103.8077-103.7983=0.0094$

6.3.3 Duration Measures

We know the relationship between DV01 and duration is given as followed:
$$\text{DV01}=\frac{\text{DollarDuration}}{10,000}=\frac{\text{Duration}\times \text{Valueof Portfolio}}{10,000}$$

Similarly, we can convert any of the 01 measure to its corresponding duration measure:

$$\text{01Measure}=\frac{\text{DurationMeasure}\times \text{Valueof Portfolio}}{10,000}$$

$$\to \text{DurationMeasure}=\frac{\text{01Measure}\times 10,000}{\text{Valueof Portfolio}}$$