Hedging Interest Rate Risk

Hedging Interest Rate Risk
October 10th, 2012

Fixed Income Securities
Examples:
Savings deposits (time deposits and CDs)
Money Market Instruments
US Government Bonds
bills at 13, 26 and 52 weeks
notes at 1 to 10 years
callable bonds at 10+ yrs
treasury strips
Other bonds (municipal corporate, callable,....)
Mortages
Annuities

Main Ideas to Cover Before Midterm
Fixed income pricing

Yield to Maturity (YTM)
Interest rate risk
reinvestment risk
capital gain risk
qualifying interest rate risk
Duration
Immunization

Compound Interest
Assume money can be lent and borrowed at the same constant

annual interest rate r ≥ 0.
Annual Compouding: Vt = V0 (1 + r )t
t = 0, 1, 2, 3, . . . , years
V0 : time 0 value
V1 : time t value.
k
Frequent Compounding: divide year into m equal intervals, t = m
for k = 0, 1, 2, . . .
m→∞
Vt = Vk/m = V0 (1 + r /m)tm −→ V0 e rt
where Vt = V0 e rt is continuous compounding.

Present Value of Cash Flows
Let c0 , . . . , cn be cash flows at that times 0 = t0 < t1 < . . . , tn .

Present value under
Yearly compounding: Pn
c1 c2 cn ck
PV = c0 + 1+r + (1+r )2
+ · · · + (1+r )n = k=0 (1=r )k
.
Pn ck
Frequent compounding: PV = k=0 (1+r /m)k .
Continuous compounding: PV = nk=0 ck e −rtk .
P

Internal Rate of Return (IRR)
Let P > 0 be the price of a stream of positive cash flows

c1 , c2 , . . . , cn at times t = 1, 2, . . . , n. The IRR is the unique1
number r that satisfies
n
X ck
P= .
(1 + r )k
k=1
Pn
If P ≤ k=1 ck , then
P r ≥ 0. Solve for r using Newton’s method
on function f (x) = nk=1 ck x k − P:
f (xn )
xn+1 = xn −
f 0 (xn )
1
finds root f (x0 ) = 0 and IRR is r0 = x0 − 1.
1
See proof of existence and uniqueness on page 34 of Luenberger.
IRR vs Present Value
Interest rate of 10%. Cash flows:
year 0 1 2
flow (a) -1 2 0
flow (b) -1 0 3
Present value:
(a) −1 + 2/1.1 = .82
(b) −1 + 3/(1.1)2 = 1.48
IRR
1
(a) −1 + 2c = 0 implies c = 12 = 1+r so that r = 1
√
(b) −1 + 3c 2 = 0 implies c = √13 = 1+r
1
so that r = 3 − 1 ≈ .7
Which is correct?

IRR vs Present Value
Comparison of IRR and present value is debated:

Present value has component-wise structure, and is widely
agreed to be best criterion,
IRR depends on cash flows only, not on an ambiguous interest
rate
However, in the above example, if proceeds are reinvested in the
same investment opportunity over and over again and scaled in
size, then IRR makes sense:
(a) reinvest every year, investment doubles every year.
(b) reinvest every
√ other year, investment triples every 3 years; a
factor of 3 < 2 every year.

Inflation
Inflation is a rate f such that a basket of goods that will next year
cost (1 + f )× its price this year. If the interest rate offer by the
bank for a 1 year note is r , then $1 this year will be $(1 + r ) next
year, but adjust for inflation the real interest rate will be r0 such
that
(1 + r0 )(1 + f ) = 1 + r ,
probably r0 < r because goods/services general increase in cost.

Bonds
Basic notation
P : price (1)
F : face value e.g. $100 (2)
m : periods per year e.g. m = 2 (3)
C : annual coupon payment (4)
C
: single coupon payment. (5)
m
Coupon bond is priced with present value:
n
X C /m F
P= k
+ .
(1 + r /m) (1 + r /m)n
k=1

Accrued Interest (AI)
k k+1
For m <t< m ,
k
AI = t − C
m
k
and must be subtracted from the time t = m price, to obtain the
clean price of the bond.
It’s a sort of compensation to the previous holder for the interest

accrued while they held the instrument.
Without AI, the bond price follows a saw-tooth pattern, as price

drops after each coupon payment. This is the dirty price.

Yield to Maturity (YTM)
Let P > 0 be the price of a stream of positive cash flows c1 , . . . , cn

k
at time tk = m for k = 1, . . . , n.
YTM it the number λ satisfying

n
X ck
P= .
(1 + λ/m)k
k=1
For a coupon-bond,
n
X C /m F
P= k
+
(1 + λ/m) (1 + λ/m)n
k=1

C 1 F
= 1− n
+
λ (1 + λ/m) (1 + λ/m)n

Yield Vs Price
Figure : Really simply: the relationship between bond price and YTM.

Other Yield Measures
YTM is the IRR on the bond.

C
current yield is cy = P × 100, measures annual return on bond
yield to call = IRR, assuming the bond is called at earliest
possible time
Example: 10%, 30 year bond
P = 100 (selling at par): YTM = C = 10%, cy = 10% (6)

1
P = 90 : YTM = 11.165%, cy = = 11.11% . (7)
9
In textbook: Luenberger generally assume F = $100 and m = 2,
unless otherwise stated. Exercises use dirty price.

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October 10th, 2012