Bond Price Volatility: Dr. Himanshu Joshi FORE School of Management New Delhi
Bond Price Volatility: Dr. Himanshu Joshi FORE School of Management New Delhi
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=
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t
t
t
t t
y
CF
y P
Convexity
1
2
2
) (
) 1 ( ) 1 (
1
Correction for Convexity:
2
1
[ ( ) ]
2
P
D y Convexity y
P
A
= -A + A
Example. Convexity
Bond in the figure has a 30 year maturity, an
8% coupon, and sells at an initial yield to
maturity of 8%.
Because coupon rate equals YTM, the bond
sells at par value $1000.
Modified duration for the bond is 11.26 years,
and convexity is 212.4.
If the bonds yield increases from 8% to 10%,
bond price will fall to $811.46.
Example
Change of 18. 85%
The duration rule P/P = -D* y
=-11.26 * .02 = -22.52%.
Duration with Convexity:
P/P = -D
*
y +1/2 * Convexity* (y)
2
=11.26*.02 +1/2 * 212.4 * (.02)
2
=
-18.27%.
PASSIVE BOND PORTFOLIO
MANAGEMENT STRATEGIES: Indexing
PASSIVE BOND PORTFOLIO MANAGEMENT
STRATEGIES: Immunization
In contrast to indexing strategies many institutions try to
insulate their portfolios from interest rate risk altogether.
The net worth of the firm or ability to meet future
obligations fluctuate with interest rates.
Immunization refers to strategies used by such investors to
shield their overall financial status from interest rate
fluctuations.
Example: Pension Funds (Fixed Future obligation) and
Banks (asset Liability maturity mismatch).
The lesson is that funds should match the interest rate
exposure of assets and liabilities so that the value of assets
will track the value of liabilities whether rate rises or falls.
Immunization
The notion of immunization was introduced
by F. M. Redington, an actuary for a life
insurance company.
The idea behind immunization is that duration
matched assets and liabilities let the assets
portfolio meet the firms obligations despite
interest rate movements.
Immunization..
The procedure is termed immunization because it
immunizes the portfolio value against interest
changes.
The procedure and its refinements, is in fact one
of the most widely used analytical techniques of
investment science, shaping portfolios consisting
of billions of dollars of fixed income securities
held by pension funds, insurance companies, and
other financial institutions.
Immunization..
Let us more fully consider its purpose first. A portfolio can not be
structured meaningfully without a statement of its purpose.
Suppose you wish to invest in money now that will be used next
year for a major household expense. If you invest in 1 year T-bills
you know exactly how much money these bills will be worth in a
year, hence there is no relative risk to your purpose.
Conversely if you invest your money in 10 year T-
Bill, value of this T-Bill after one year will be quite variable. (Price
Risk)
The situation will be reversed if you were saving to pay off an
obligation that was due in 10 years, then a 10 year zero coupon
bond would provide completely predictable returns, but 1 year T-
Bill would impose (Reinvestment Risk).
Immunization..
Now suppose that you face a series of cash obligations and you wish to
acquire a portfolio that you will use to pay these obligations as they arise.
(LICs).
One way to do this is to purchase a set of zero-coupon bonds that have
maturities and face values exactly matching the separate obligations.
Not applicable with Corporate Bonds.
If perfect matching is not possible, you may instead acquire a portfolio
having a value equal to the present value of the stream of obligations.
You can sell some of your portfolio whenever cash is needed to meet
particular obligation; or if portfolio delivers more cash than needed at a
given time, you can buy more bonds.
Hence you will meet the obligations exactly.
What is the limitation of this method?
Immunization..
A problem with this value matching technique arises if the
yield change. The value of your portfolio and Present Value of
Stream of cash flows both will change, but differently.
Your portfolio will no longer be matched.
Immunization solves this problem- at least approximately-by
matching duration as well as present values.
Immunization..
If the duration of the portfolio matches that of the obligation
stream, then the cash value of the portfolio and the present
value of the obligation stream will respond identically to a
change in yield.
If yield increase present value of the asset portfolio will
decrease, but the present value of the obligations will
decrease by approximately the same amount, so the value of
portfolio will still be adequate to cover the obligation.
Pension Funds Lost Ground Despite
Broad Market Gains
With the S&P 500 providing a rate of return in
excess of 25%, 2003 was a banner year for the
stock market. Not surprisingly, this performance
showed up in the balance sheets of US pension
funds: assets in these funds rose by more than
$100 billion.
Despite this boost, the pension funds actually lost
the ground in 2003, the gap between assets and
liabilities growing by about $45 billion..
How could this happen?
Immunization
ExampleImmunizationBsheet.xlsx
Consider an example, an insurance company that
issues a guaranteed investment contract for
$10,000. if the GIC has five year maturity and a
guaranteed interest rate is 8%, the insurance co.
is obliged to pay = $10,000*(1.08)
5
= $14,693.
Suppose that insurance company chooses to fund
its obligation with $10,000 of 8% annual coupon
bonds, selling at par value, with 6 years to
maturity.
Immunization
If portfolio maturity is chosen appropriately, price
risk and re-investment rate risk will cancel out
exactly.
When the portfolio duration is set equal to the
investors horizon date, the accumulated value of
the investment fund at the horizon date will be
unaffected by interest rate fluctuations.
For a horizon equal to the portfolios duration,
price risk and reinvestment risk exactly cancel
out.
Immunization
If the obligation was immunized, why is there
any surplus in the fund?
Convexity.
Coupon bond has greater convexity than the
obligation it funds.
Immunization..
Limitations..
The method assumes that all yield are equal,
whereas in fact they usually are not. Indeed it
is quite unrealistic to assume that both long
term and short term bonds can be found with
identical yields.
Also in practice more than two bonds will be
used, partly to diversify default risk if the
bonds included are not Treasury bonds.
Figure 16.10 Immunization
Table 16.5 Market Value Balance Sheet