Econ 174 FINANCIAL RISK MANAGEMENT LECTURE

OUTLINE & SUPPLEMENT

Foster, UCSD
July 21, 2011
INTEREST RATE RISK
A. Bond Yields, Risk, and Duration [Review: BKM, Ch. 14]
1. Bonds and Fixed-Income Securities:
a) Fixed-income securities.
b) Basic bond value equation and definitions.
2. Yield to Maturity:
1
a) YTM -- pure discount bonds (zeros).
b) YTM -- semi-annual coupon interest.
c) r
y
= compound annual rate of return on
investment of $B
0
if bond held to
maturity.
3. Bond Prices:
a) Initial issue bond pricing and convergence to
M.
b) Accrued interest, and day-count conven-
tions:
4. Bond Risk:
a) Sources of risk in bond investments:
b) Interest rate risk and term to maturity:
5. Measuring Interest Rate Risk with Bond Duration:
a) Average maturity.
b) Duration.
2
c) Duration, elasticity, and
interest rate risk.
d) Modified duration D*.
e) Illustration.
f) Extra notes.
B. Term Structure of Interest Rates
1. Yield Curves:
a) Many different rates.
[Table 1]
1
See the Appendix for EXCEL spreadsheet formulas to compute YTM, accrued interest, and bond
duration.
2
See the Appendix for the EXCEL spreadsheet formula for computing duration and modified
duration.
Bond Notation
B
0
current price of bond ($)
M par or face value (usually
$1,000)
T term to maturity (years)
r
c
coupon interest rate (%/yr)
I annual coupon interest ($)
r
y
yield to maturity (YTM,
%/yr)
Table 1. ANNUAL RATES & YIELDS 17
Jun 08
FED
Discount
2.25
%
U.S. Core Inflation 2.30
%
Federal
Funds
2.10
%
Five-year CD 3.85
%
T-Bills (6
mo.)
2.35
%
Fixed 30-yr
Mortgage
6.39
%
T-Notes (5
yr)
3.63
%
U.S. Prime Rate 5.00
%
T-Bonds (30-
yr)
4.70
%
Money Market 2.41
%
TIPS (7 yr) 1.39
%
Comm. Paper (90-
day)
2.52
%
State &
Local
4.59
%
Corporate Aaa 5.68
%
r
y
Normal
Humped
Flat
Inverted
T
Fig.
2
M
B
t
t
T
Fig.
1
Ec 174 INTEREST RATE RISK OUTLINE
p. 2 of 14
b) Definition term structure of interest rates.
c) Yield curves. [Fig. 2]
2. Using Term Structure to Deduce Forward Interest Rates:
a) Simplifying assumptions for a pure yield curve.
3
b) Definitions and notation.
c) Why zero rates and pure yield curves?
d) Term structure equation.
e) Explanation.
f) The shape of the pure yield curve is
dictated by the forward rates.
C. Forward Rate Agreements and Related
Strategies
1. Yield Play:
a) If bond YTM contains a
liquidity/maturity
premium MP that
increases with term to
maturity, then r
y
(T)
increases as T increases.
b) If a yield curve is rising
but short rates will be
steady, a risky
speculative investment
strategy called yield play
is possible.
c) Procedure and result.
2. Synthetic Forward Loan:
a) Assumptions.
b) Setting or situation.
c) Procedure and result.
d) Generalization.
3. Forward Rate Agreements:
a) Definition.
b) Gains and losses on FRAs.
c) Example #1 -- FRA.
3
Yields for zero-coupon bonds are called pure yield curves, and for coupon bonds, on-the-
run yield curves.
Table 2. Treasury Yields
(Feb 22, 09)
Maturity = Feb 15, 2015
Bond Issued r
c
(%)
r
y
(%)
T-
bond
1985 (30-
yr)
11.2
5
4.25
0
T-note 2005 (10-
yr)
4.00 4.22
7
T-zero 2005 (10-
yr)
0 4.34
1
Table 3. T-
Zeros
Yea
r
T r
y
%
f%
200
9
201
0
201
1
201
2
201
3
1
2
3
4
5
2.0
0
2.1
5
2.4
7
2.7
6
3.0
5
2.0
0
2.3
0
3.1
1
3.6
3
4.2
1
Notation (FRAs)
T
1
,
T
2
Beginning and ending of loan
period
$A Notional principal (amount of
loan)
r
k
Interest rate specified by FRA
f forward rate today for future loan
period
r Actual spot rate at time T
1
Ec 174 INTEREST RATE RISK OUTLINE
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d) Balance sheet valuation of FRAs.
e) Example #2 FRA valuation.
Ec 174 INTEREST RATE RISK OUTLINE
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D. Interest Rate Futures
1. Interest Rate Futures Contracts:
a) Investors trade standardized
futures contracts on bonds
and short-term interest
rates.
b) The T-Bond contract.
c) How they work (delivery).
d) If position is closed before
delivery.
Long
L
= (F

F
0
)
units
Short
S
= (F
0

F

) units
2. Spot-Futures Parity:
3. Hedging Interest Rate Risk with
T-Bond Futures:
a) Hedging with interest rate
futures.
b) Preliminary assumptions.
c) Hedge ratios and PVBP.
d) Illustration.
E. Interest Rate Swaps
1. Introduction to Swaps:
a) Definition.
b) A swap arrangement
is like a multi-period
series of forward
contracts.
c) Three common types
of swaps.
Table 4. INTEREST RATE FUTURES
WSJ
for 10 NOV
08
SETTLE CHG
OPEN
INTEREST
Treasury Bonds (CBT) - $100,000; pts
32nds of 100%
March 09 116-
105
1-09.0 15,382
2 Yr. T-Notes (CBT) - $200,000; pts
32nds of 100%
Dec 108-
067
6.5 700,234
30 Day Fed. Funds (CBT) - $5,000,000;
100 daily avg.
Nov
Dec
99.610
99.555
.040
.025
96,983
69,945
1 Month Libor (CME) - $3,000,000; pts
of 100%
Jan 09 98.535
0
.1450 1,320
Notation (Interest Rate
Swaps)
$
A
Notional principal
r

Floating rate (LIBOR)

r
x
Fixed (swap) rate
X party RECEIVING fixed
CF
F party RECEIVING
floating CF
Table 5 Two-Year
Swap
r
x
= 2.757%/yr
Date
LIBOR
r

Fl. CF
(to F)
Fix CF
(to X)
Net
CF
(to X)
15 Feb
08
2.969
4%
15 Aug
08
3.118
1%
$148,4
70
$137,8
50

$10,62
0
15 Feb
09
1.764
4%
$155,9
05
$137,8
50

$18,05
5
15 Aug
09
? $88,22
0
$137,8
50
$49,63
0
15 Feb
10
? ? $137,8
50
?
Ec 174 INTEREST RATE RISK OUTLINE
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2. The Mechanics of
Interest Rate Swaps:
a) Plain Vanilla swaps.
b) Who swaps?
c) Numerical example.
[Table 5; Fig 3]
d) Swaps are done thru
OTC dealers. [Fig.
4]
r

+
0.1%
r

0.2%
3.0
%
2.5
%
X F
r
x
=
2.757%
Libo
r
Fig.
3a
X
F
r
x
=
2.757%
Libo
r
Fig.
3b
r

Dealer X F
Bid
r
x
=
6.95%
r

Ask
r
x
=
7.05%
r

7%
Fig.
4
Ec 174 INTEREST RATE RISK OUTLINE
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APPENDIX I. BOND FORMULAS
YIELD TO MATURITY
Settlement date
November 28,
2008 =date(yyyy,mm,dd)
Maturity date
November 15,
2018 =date(yyyy,mm,dd)
Annual coupon rate 3.750% (decimal)
Bond price
(clean/flat/quoted) 106.7800 (% of M)
Redemption value 100 (% of M)
Coupon payments/year 2
YTM = 2.959% =yield(b4,b5,,b9)
BOND INVOICE PRICES
Settlement date January 1, 2000 =date(yyyy,mm,dd)
Maturity date
September 11,
2015 =date(yyyy,mm,dd)
Annual coupon rate 6.000% (decimal)
YTM 4.000% (decimal)
Redemption value 100 (% of M)
Coupon payments/year 2
Basis (b) 1
Clean (flat/quoted) Price
(% of M) = 123.1382
=price(b13,b14,b15,b16,b
17,b18)
Days since last coupon = 112
=coupdaybs(b13,b14,b18
,b19)
Days in coupon period = 182
=coupdays(b13,b14,b18,
b19)
Accrued Interest (% of M)
= 1.846153846 =(b21/b22)*(b15/2)*100
Invoice (dirty) Price (% of
M) = 124.9844 =b20+b23
b = basis:
M =
$
1,000.00
0 = US 30/360
(Corporate; munis)
Flat price =
$
1,231.38
1 = actual/actual (T-
Bonds/Notes)
Invoice price =
$
1,249.84 2 = actual/360 (T-Bills)
Accrued interest =
$
18.46 3 = actual/365
4 = Euro 30/360
BOND DURATION
Settlement date January 1, 2000 =date(yyyy,mm,dd)
Maturity date January 1, 2020 =date(yyyy,mm,dd)
Annual coupon rate 6.000% (decimal)
YTM 4.000% (decimal)
Ec 174 INTEREST RATE RISK OUTLINE
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Coupon payments/year 2
Macaulay duration = 12.8758
=duration(b33,b34,b35,b
36,b37))
Modified duration = 12.6233
=mduration(b33,b34,b35,
b36,b37))
Ec 174 INTEREST RATE RISK OUTLINE
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APPENDIX II
Part I. Risk-Free Rates
A) Risk-Free Interest Rates.
1) The risk-free rate plays an important role in financial theory.
a) It is a rate of return that investors can obtain without bearing any
investment risk.
b) It is a rate at which perfectly credit-worthy institutions can both borrow and
lend.
c) In practice, r
f
is an amalgam of a number of short-term rates:
LIBOR
RP rates
T-Bill yields
2) London Interbank Offered Rate (LIBOR).
a) Libor is the rate at which large AA-rated European banks will lend money to
one another for short periods of time (up to 1 year). It is similar to the US
Federal Funds rate, but is set by market forces rather than purely by central
bank policy.
b) Increasingly, the Libor rate (r

) is used as the risk-free benchmark rate

because the T-bill rate is too low to represent the rate at which non-
government entities can borrow, since T-bill interest is tax-free at the state
level in the U.S.
3) Repurchase Agreements (RPs or Repos) and other short-term rates.
a) A bank or securities dealer (B) sells government and other securities to firm
(L), but guarantees to buy them back for a higher price at a future date. L is
making a short-term (often overnight) loan to B. Repo rates are considered
to be risk because if B defaults on the buy-back, L keeps the securities, and
if L defaults, B keeps the cash.
b) Rates on RPs, commercial paper (CP), and short-term certificates of deposit
(CD) are often averaged in with T-bill rates and Libor to determine a useful
risk free rate r
f
.
B) T-Bills.
1) Issued by US Treasury. Bills with maturities of 91 and 182 days are auctioned
weekly; bills with 52 week-maturities are auctioned monthly. Par value =
$10,000 (perhaps lower now).
2) T-bill listings.
a) Bid, asked, and yield figures are in
straight percent.
b) Bid/ask prices are based on a 360-day
financial year. If B = bid discount, A =
ask discount, and n = days to maturity,
then:
Treasury Bills, 16 Jan 07
MATURIT
Y
DAYS
TO
MAT. BID ASK
ASK
YLD
Mar 22
07
Jul 12
07
64
176
4.9
6
4.9
5
4.9
5
4.9
4
5.0
6
5.1
3
000 , 10 $
360
1 ; 000 , 10 $
360
1
]
]
]

,
`

.
|

]
]
]

,
`

.
|

n
B P price Bid
n
A P price Ask
b a
Ec 174 INTEREST RATE RISK OUTLINE
p. 9 of 14
c) Asked yield is the bond-equivalent
yield r
bey
, an annualized YTM based on
the asking price and a 365 (or 366) day
year:
d) Example -- T-bill maturing in 64 days:
You sell at P
b
= [1 0.0496 (64/360)] 10,000 = $9,911.82.
You buy at P
a
= [1 0.0495 (64/360)] 10,000 = $9,912.00
Asked Yield r
bey
= (10,000/9912 1) 365/64 = 0.0506 = 5.06%.
Money Rates (%/yr), 20 Jan 10
Inflation
U.S.
consumer
price
index
DEC.
INDEX
LEVEL
CHG FROM (%)
NOV. 09 DEC. 08
All items
Core
215.9
220.0
-0.2
-0.2
2.7
1.8
International rates Other short-term
rates
LATEST LATEST
Prime rates Commercial Paper
U.S.
Canada
Euro zone
3.25
2.25
1.00
30 to 59
days
60 to 89
days
90 to 105
days
0.12
0.14
0.17
Overnight
repurchase
Libor
U.S.
U.K.
Euro zone
0.12
0.505
0.30
One month
Three
month
Six Month
One year
0.23063
0.24888
0.39000
0.87563
U.S. government
rates
Libor Swaps (USD)
Discount
Federal
Funds
0.50
0.12
Two year
Three year
Five year
1.148
1.767
2.711
T-bill
auction
4 weeks
13 weeks
26 weeks
0.000
0.060
0.145
Eurodollar
s
One month
Two
months
Three
months
(mid
rates)
0.20
0.30
0.40
n P
r yield Asked
a
bey
365
1
000 , 10

,
`

.
|

Ec 174 INTEREST RATE RISK OUTLINE
p. 10 of 14
Part II. Continuous Compounding and Discounting
A) Discrete Compounding.
1) Interest compounded annually.
a) If principal V
0
earns interest at annual rate r, compounded once at the end of
each year, its value at the end of t years is given by
t
t
r V V ) 1 (
0
+
.
b) Example -- V
0
= $500, r = 0.04 (4%):
V
1
= V
0
(1+r) = 500 (1.04) = $520.00
V
2
= V
1
(1+r) = V
0
(1+r)
2
= 500 (1.04)
2
= $540.80
2) Interest compounded more frequently.
a) If V
0
earns interest at periodic rate r
m
, compounded m times per year, its
value at the end of t years is given by V
t
= V
0
(1 + r
m
)
mt
.
b) Example -- V
0
= $500, r
m
= 1%, m = 4:
In 3 months: V
1/4
= V
0
(1 + r
m
)

= 500 (1.01) = $505.00
In 9 months: V
3/4
= V
0
(1 + r
m
)
3
= 500 (1.0303) = $515.15
In 1 year: V
1
= V
0
(1 + r
m
)
4
= 500 (1.0406) = $520.30
B) Continuous Compounding and Discounting.
1) Continuous compounding.
a) Much financial analysis is now done with continuous compounding and
discounting, but many interest rates and discount factors are expressed as
discrete % per annum.
b) For continuous compounding, the number of compounding periods m ,
and initial value V(0) increases at a continuous exponential growth rate. The
value at the end of t years is given by V(t) = V(0)e
rt
.
c) Example -- V(0) = $500, r = 4%:
In 2.0 years: V(2.0) = V(0)e
2.0r
= 500 e
.080
= $541.64
In 3.7 years: V(3.7) = V(0)e
3.7r
= 500 e
.148
= $579.76
2) Converting discrete into equivalent continuous compounding.
a) If V
0
grows to V
t
[ ]
mt
m
r V + 1
0
by compounding at periodic rate r
m
, and to
Rt
e V
0
at continuous rate R, then the equivalency has to be as follows:
b) Example V
0
= $500, r = 18% per year, m = 12, r
m
= 18%/12 = 1.5% per
month.
After 5 months (monthly compounding): V
5/12
= 500(1.015)
5
=
$538.64
Equivalent continuous annual rate R = 12 Ln(1.015) = 17.866% per
year
After 5 months (contin. compounding): V
5/12
= 500 e
0.17866(5/12)
=
$538.64
3) Continuous discounting and present value.
a) If V
0
grows to
rt
t
e V V
0
, then r is the compound growth rate and V
t
is the
future value of V
0
after t years.
b) Inverting this relationship, we obtain
rt
t
e V V

0
, where r is the discount rate
and V
0
is the present value of V
t
, discounted continuously back to the
present at rate r.
[ ] [ ] [ ] 1 1 1 1
/
+ + +
m R
m m m
R m
m
e r
m
R
r Ln and r mLn R e r
Ec 174 INTEREST RATE RISK OUTLINE
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Ec 174 INTEREST RATE RISK OUTLINE
p. 12 of 14
PRACTICE PROBLEMS
Problem 1
Table A shows the 15 NOV 08 YTM on Treasury zeros
(stripped coupon interest) with mid-November maturities
out to 2012.
A) Find implied forward rates f
t
. (Use continuous
compounding.).
B) Suppose your company enters an FRA to lend
$750,000 during 2010 at r
k
= f
2010
from Table A. Find
the gain or loss if r
2010
= 1.5%?
Problem 2
A $1,000-par bond pays 7%/yr coupon interest
semiannually and matures in T = 4.00 years. If YTM =
6%:
A) Find the bonds current price.
B) Compute the bonds duration and modified duration.
C) What change in bond price do you expect if yields drop by 25 basis points to 5.75%
tomorrow?
Problem 3
It is March 9, 2009.
A) At what invoice price can you buy the November
2018 T-bond listed at right if M = $1,000 and
interest is paid semiannually?
B) How much interest will you receive per year?
C) What is your annual rate of return if you hold the bond until maturity?
Problem 4
It is January 30, 2009. You are managing a bond portfolio worth $6 million. The
modified duration of this portfolio is D
a
* = 8.2 years. The September 2009 Treasury
bond futures price F
0
= 108-15, and the cheapest-to-deliver bonds will have a modified
duration D
b
* = 7.6 years. How should you hedge your portfolio value against interest
rate risk over the next 6 months?
Problem 5
Table B shows December 31, 2008, rates or yields
for loans of varying maturities, appropriate for
constructing a pure LIBOR-Zeros yield curve. A
large, credit-worthy financial institution can both
borrow and lend (including issue and purchase
zero-coupon bonds) at these rates.
A) Use continuous compounding/discounting to find
the missing yields r
y
(T) and forward rates f
t
in
Table B.
You are a hedge fund risk manager and you know
today that you will borrow $3.5 million for a one-
year period from January to December 2012. You
Table A Treasury
Zeros
Yea
r
T r
y
(T) f
t
200
9
1 0.006
2
201
0
2 0.008
3
201
1
3 0.009
8
201
2
4 0.017
9
Treasuries 28 Nov 08
RATE
MATURIT
Y PRICE YLD
3.75
0
15 Nov
18
107:
09
2.88
25
Table B LIBOR (12/31/08)
T
(Year)
r
y
(T) f
t
1
(2009)
1.890% 1.890%
2
(2010)
1.981%
3
(2011)
2.170% 2.548%
4
(2012)
2.922%
5
(2013)
2.545%
Ec 174 INTEREST RATE RISK OUTLINE
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decide that the 2012 forward rate (2.922%/yr) is attractive. Show in detail two ways
that you can lock in this rate for your future borrowing.
B) One way to lock in this forward rate is by use of a Synthetic Forward Loan. Show
exactly how you need to proceed now and in certain future periods in order to
accomplish your objective. Be specific as to how many zero-coupon securities you
would need to buy and/or issue at LIBOR rates, quantify your relevant cash flows,
and determine your actual borrowing rate.
C) Another way to lock in this borrowing rate is by entering into a Forward Rate
Agreement (FRA) with a willing counterparty. If you do enter such an FRA, what will
your gain or loss be if it turns out that 1-year borrowing rates for 2012 are 3.2%
instead of 2.922%. (Remember that FRAs are settled at the beginning of the loan
period.)
Problem 6
A pension fund holds a portfolio of money market securities that the manager believes
are paying excellent yields compared to other comparable-risk short-term securities.
However, the manager believes that interest rates are about to fall. What type of
swap will allow the fund to continue to hold its portfolio of short-term securities while
at the same time benefiting from a decline in rates?
ANSWERS
Problem 1
A) [See table at right]
B)
L
= -$3,442.08 = [750,000(e
0.01040.015
1]
Problem 2
A) B
0
= $1,035.10
B) D = 3.5662; D* 3.4624
C) Using modified duration, price rises by 0.8656% to
$1,044.06. Using EXCEL formulas, exact price = $1,044.11.
Problem 3
A) B
0
$1,084.62 Flat P = $1,072.81, plus (114/181)$37.50/2 = $11.81 accrued
interest
B) I = $37.50/yr
C) Return = YTM = 2.8825 %/yr
Problem 4
Go short with N* = 60 September T-bond futures. Close the position in July.
Problem 5
A) [See table at right]
B) Buy 3500 $1,000-par zeros maturing at end of 2011; pay
about $3,279,000. Issue 3500e
0.02922
= 3,604 zeros
maturing at end of 2012; get $3,279,000. At the end of
2011 you collect the $3.5 million you needed to borrow.
At end of 2012 you pay off $3,604,000 on your bond
Table A
Yea
r
f
t
200
9
0.006
2
201
0
0.010
4
201
1
0.012
8
201
2
0.042
2
Table B
T (Yr) r
y
(T) f
t
1
(2009)
1.89
0%
1.89
0%
2
(2010)
1.98
1%
2.07
2%
3
(2011)
2.17
0%
2.54
8%
4
(2012)
2.35
8%
2.92
2%
5
(2013)
2.54
5%
3.29
3%
Ec 174 INTEREST RATE RISK OUTLINE
p. 14 of 14
obligation. Your borrowing rate was 2.928% 2.922%: 3,604,000 = 3,500,000
e
0.02928(1)
.
C)
B
= $9,716
Problem 6 [See BKM, Ch. 23, Concept Check 7]