Basics of Interest Rate Risk Management

Problem Set

(light version of the exercises in the text)1

Q2. An investor is planning a $100 million short-term investment and is going to choose among two
different portfolios. This investor is seriously worried about interest rate volatility in the market.
Compute the duration of the portfolios. Which one is more adequate for the investor’s objective?
Assume today is May 15, 2000, which means you may use the yield curve presented in the following
table:

Maturity T Yield r2 (0, T )

0.50 6.49%
1.00 6.71%
1.5 6.84%
2 6.88%

• Portfolio A
– 40% invested in 1.5-year zero coupon bond
– 60% invested in 1.5-year coupon bond paying 9% annually
• Portfolio B
– 50% invested in 2-year zero coupon bond
– 50% invested in 1.5-year floating rate bond with zero spread and annual payments.

Answer:
We will compute and compare the durations of the two portfolios.
The term structure of interest rates will imply the following discount factors (we need them to find
the PV of the cash flows to calculate the weights for portfolio duration):
2×(T −0)
Maturity T Yield r2 (0, T ) Discount Factor Z (0, T ) = 1/ (1 + r2 (0, T ) /2)
2×0.5
0.50 6.49% 1/ (1 + 0.0649/2) = 0.968 569 91
2×1
1.00 6.71% 1/ (1 + 0.0671/2) = 0.936 131 84
2×1.5
1.5 6.84% 1/ (1 + 0.0684/2) = 0.904 037 4
2×2
2 6.88% 1/ (1 + 0.0688/2) = 0.873 465 90
Portfolio A:
1 The textbook questions tend to rely too much on Excel. I have simplified the questions to make it less tedious

and doable without using Excel.

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Duration of the 1.5-year zero coupon bond is Dz = 1.5.
Duration of the 1.5-year 9% coupon bond paying annually is computed as follows:
Note that

Pc (0, 1.5) = 9 × Z (0, 0.5) + 109 × Z (0, 1.5)

= 9 × 0.968 569 91 + 109 × 0.904 037 4
= $107. 257 21

Viewing the coupon bond as a portfolio of zero coupon bond, we can find its duration as PV
weighted sum of the durations of the individual zero coupon bonds:

9 × Z (0, 0.5) 109 × Z (0, 1.5)

Dc = × 0.5 + × 1.5
Pc (0, 1.5) Pc (0, 1.5)
9 × 0.968 569 91 109 × 0.904 037 4
= × 0.5 + × 1.5
107. 257 21 107. 257 21
= 1. 418 726 8

Therefore, the duration of portfolio A is

DA = 0.4 × Dz + 0.6 × Dc
= 0.4 × 1.5 + 0.6 × 1. 418 726 8
= 1. 451 236 1

Portfolio B:
Duration of the 2-year zero coupon bond is Dz = 2.
Duration of the 1.5-year floating rate bond with zero spread and annual payments is just the time
to next coupon date Df l = 0.5. (Quick note: if the floating rate bond has non-zero spread, then we
need to find the duration of the spread component which is an annuity or a portfolio of zero coupon
bonds, and combine it with the duration of a zero-spread floating rate bond to find the duration
for the whole bond)
Therefore, the duration of portfolio B is

DB = 0.5 × Dz + 0.5 × Df l
= 0.5 × 2 + 0.5 × 0.5
= 1.25

For the risk-averse investor, portfolio B should be recommended since it has lower risk as measured
by DA > DB .

Q5. The investor in Exercise 2 is still worried about interest rate volatility. Instead of a duration
measure, the investor wants now to know the following:

2
(a) What is the dollar duration of each portfolio?
Answer:
$
DA = $100m × DA = 100 × 1. 451 236 1 = $145. 123 61m
$
DB = $100m × DB = 100 × 1.25 = $125.0m
(b) What is PV01 for each portfolio?
Answer:
0.01 0.01
P V 01$A = DA
$
× 100 = 145. 123 61 × 100 = $0.014512361m
0.01 0.01
P V 01$B = DB
$
× 100 = 125.0 × 100 = $0.012 5m
(c) Does the conclusion arrived at in Exercise 2 stand?
Answer:
Yes. The ranking of the risk doesn’t change.

Exercises 7 to 12 use the two yield curves (term structure of interest rates) at two moments in time

• On February 15,1994, the yield curve (continuously compounded) is flat at 5%

• On August 13,1994, the yield curve (continuously compounded) is flat at 7%

The following portfolio will be used:

• Long $40 million of invested in 2-year coupon bond paying 9% annually

• Short $30 million of a 1-year zero coupon bond.

Note: Simplification from the textbook version includes (1) Assume flat term structure of interest
rate (2) There are no inverse floaters in the portfolio (you should be able to price and measure the
risk of inverse floaters by breaking them down into more basic fixed income securities).
Q7. You are standing on February 15,1994:
(a) What is the total value of the portfolio? Find out the number of each bond in the portfolio (all
the bonds have face value of $100).
Answer:
Total value of the portfolio is Punhedged = 40 − 30 = $10 m
Note that the discount factor Z (t, T ) = e−r(T −t) in all the calculations below.
Price of the 2-year 9% coupon bond:

Pc = 9 × exp (−0.05 × 1) + 109 × exp (−0.05 × 2) = $107. 188 34

Number of 2-year coupon bonds in the portfolio:

40
Nc = = 0.373 174 92m
107. 188 34

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Price of the 1-year zero coupon:

Pz = 100 × exp (−0.05 × 1) = $95. 122 942

Number of 2-year coupon bonds in the portfolio:

−30
Nz = = −0.315 381 33m
95. 122 942

(b) Compute the dollar duration of the portfolio.

Answer:
Duration of the coupon bond is

9 exp (−0.05) 109 × exp (−0.05 × 2)

Dc = ×1+ ×2
Pc Pc
9 exp (−0.05) 109 × exp (−0.05 × 2)
= ×1+ ×2
107. 188 34 107. 188 34
= 1. 920 130 7

and the dollar duration is $40m × Dc

Duration of the 1-year zero coupon bond is Dz = 1, and the dollar duartion is $ − 30m × Dz
(remember it is a short position).
Dollar duration of the whole portfolio is
$
Dunhedged = 40 × Dc − 30 × Dz
= 40 × 1. 920 130 7 − 30 × 1
= $46. 805 228 m

Q8. You are worried about interest rate volatility. You decide to hedge your portfolio with a
10-year zero coupon bond (face value $100).
(a) How much should you go short/long on this bond in order to make it immune to interest rate
changes? Find out both the total dollar amount and the number of such bond.
Answer:
The hedged portfolio should have a zero dollar duration:
$ $ $
Dhedged = Dunhedged + D10−year zero
$
0 = Dunhedged + x × D10−year zero

⇒ the postion on the 10-year zero is

$
Dunhedged $46. 805 228m
x=− =− = −$4.6805228m
D10−year zero 10

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i.e. short $4.6805228m worth of the 10-year zero coupon bonds.
The price of the 10-year zero coupon bond is

P10−year zero = 100 × exp (−0.05 × 10) = $60. 653 066

therefore the # of such bonds shorted is

−4.6805228
N10−year zero = = −0.07716 877 5m
60. 653 066

(b) What is the total value of the portfolio now?

Answer:
The value of the portfolio now is

Phedged = Punhedged + x = 10 − 4.6805228 = $5. 319 477 2m

Q9. Assume that it is now August 13, 1994 and that the yield curve has changed accordingly (7%
flat).
(a) What is the value of the unhedged portfolio now?
Answer:
The 9% coupon bond has time to maturity 1.5 years. Its price:

Pc = 9 × exp (−0.07 × 0.5) + 109 × exp (−0.07 × 1.5) = $106. 825 82

The zero coupon in the unhedged portfolio has 0.5 year to maturity. Its price:

Pz = 100 × exp (−0.07 × 0.5) = $96. 560 542

The value of the unhedged portfolio on August 13, 1994

Punhedged = Nc × Pc + Nz × Pz
= 0.373 174 92 × 106. 825 82 − 0.315 381 33 × 96. 560 542
= $9. 411 324 7m

(b) What is the value of the hedged portfolio?

Answer:
The hedging instrument, previously 10-year zero coupon bond, has time to maturity 9.5 years on
August 13, 1994. Its price is:

P9.5−year zero = 100 × exp (−0.07 × 9.5) = $51. 427 353

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Therefore the value of the total hedged portfolio is:

Phedged = Punhedged + N9.5−year zero × P9.5−year zero

= 9. 411 324 7 − 0.07716 877 5 × 51. 427 353 = $5. 442 738 9m

(c) Is the value the same? Did the immunization strategy work?
Answer:
The hedged portfolio value was $5. 319 477 2 on February 15, and it changed to $5. 442 738 9m on
August 13. It is unclear whether the immunization strategy worked.
There are two effects that can change the portfolio’s value. (1) interest rates change (2) time change.
We need to separate out each effect to see how effective the immunization strategy was. This is
accomplished in Q10 and Q11.

Q10. Instead of assuming that the change took place 6 months later, assume that the change in
the yield curve occurred an instant after February 15,1994.
(a) What is the value of the unhedged portfolio?
Answer:
If the interest rate change took place instantaneously, then the 9% coupon bond still has time to
maturity 2 years. Its price:

Pc = 9 × exp (−0.07 × 1) + 109 × exp (−0.07 × 2) = $103. 151 59

The zero coupon in the unhedged portfolio has 1 year to maturity. Its price:

Pz = 100 × exp (−0.07 × 1) = $93. 239 382

The value of the unhedged portfolio on August 13, 1994

Punhedged = Nc × Pc + Nz × Pz
= 0.373 174 92 × 103. 151 59 − 0.315 381 33 × 93. 239 382
= $9. 087 626m

(b) What is the value of the hedged portfolio? Did the immunization strategy work?
Answer:
The hedging instrument, 10-year zero coupon bond, has price:

P10−year zero = 100 × exp (−0.07 × 10) = $49. 658 53

Therefore the value of the total hedged portfolio is:

Phedged = Punhedged + N10−year zero × P10−year zero

= 9. 087 626 − 0.07716 877 5 × 49. 658 53 = $5. 255 538 1m

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Compared to the original hedged portfolio value of $5. 319 477 2, the percentage change is
5. 255 538 1 − 5. 319 477 2
= −1.2%
5. 319 477 2
Without hedging, the percentage change is
9. 087 626 − 10
= −9.1%
10
The immunization strategy worked in reducing the downside risk. If one views the 1.2% hedging
error to be too big, there are ways to improve on the hedging performance (to be covered in next
chapter).

Q11. Now use the February 15,1994 yield curve to price the stream of cash flows on August 13,
1994.
(a) What is the value of the unhedged portfolio?
Answer:
Here only time changes, and interest rate stay at 5% level.
The 9% coupon bond has time to maturity 1.5 years. Its price:
Pc = 9 × exp (−0.05 × 0.5) + 109 × exp (−0.05 × 1.5) = $109. 901 83

The zero coupon in the unhedged portfolio has 0.5 year to maturity. Its price:
Pz = 100 × exp (−0.05 × 0.5) = $97. 530 991

The value of the unhedged portfolio on August 13, 1994

Punhedged = Nc × Pc + Nz × Pz
= 0.373 174 92 × 109. 901 83 − 0.315 381 33 × 97. 530 991
= $10. 253 153m

(b) What is the value of the hedged portfolio?

Answer:
The hedging instrument, previously 10-year zero coupon bond, has time to maturity 9.5 years on
August 13, 1994. Its price is:
P9.5−year zero = 100 × exp (−0.05 × 9.5) = $62. 188 506

Therefore the value of the total hedged portfolio is:

Phedged = Punhedged + N9.5−year zero × P9.5−year zero
= 10. 253 153 − 0.07716 877 5 × 62. 188 506 = $5. 454 142 2m

Compare it to the answer in 9(b). We can see the change in hedged portfolio value is due to time
change.