Week 3 – Duration and convexity-based strategies for risk management

MIT Sloan School of Management

Outline

• Duration and convexity: basic and generalized measures

• Motivation, basic definitions and extensions
• Application to bonds, forwards, futures and swaps

• Duration-based risk-management strategies

• delta and gamma hedging in the spot (cash) market
• delta and gamma hedging with forwards, futures and swaps

© 2021 Lucas
Overview and objectives
Duration and convexity are two fundamental concepts for
measuring, hedging, and speculating on interest rate risk

You will become familiar with:

§ Some basic and advanced definitions of duration and convexity
§ Basic mathematical formulas and spreadsheet calculations
§ Graphical interpretations
§ Applications in risk management

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Short term yields have historically been volatile

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Long term yields are also volatile, but less so than

short-term yields when compared over similar horizons
Yield volatility => price volatility

• Interest rate or yield volatility translates in to price volatility for fixed income
securities
• Recall that bond prices and yields are inversely related
• For a zero coupon bond F
P=
(1 + r ) N
• Financial institutions like commercial and investment banks, and fixed
income portfolio managers, are highly exposed to interest rate volatility

• These institutions manage interest rate risk in a variety of ways that include
forward, future and swap contracts, and dynamic hedging strategies

© 2021 Lucas
Duration and convexity: basic and generalized measures

© 2021 Lucas
Recall the formula that relates a bond’s price to its yield:
A bond’s yield (YTM) answers the question: “What is the constant rate of return that
makes the bond price equal to the present value of promised future payments?”

or C1 C2 Cn
p= + + ... +
(1 + y ) (1 + y ) 2 (1 + y ) n

n Ci
p= å
i
i = 1 (1 + y )
p = price
Ci = cash flow at end of period i
y = yield to maturity (per period)
p

Given the price and cash flows, you can solve for the yield using a financial calculator or Excel. y
• =pv(rate, nper, pmt, fv) gives price for coupon bond
• =rate(nper,pmt,pv,fv) gives YTM for a coupon bond
Remember that bond prices depend on all the relevant yields in the spot yield curve; the YTM
abstracts from the shape of the spot yield curve. 8
The big question: Approximately how much will a
security’s price change for a small change in its yield?
A security’s price “p” is function of its yield “y” and other factors:
§ Other factors include maturity, coupon, embedded options, default risk, market
conditions, etc.

p = f(y; other factors)

Duration measures are related to the first partial derivative: ∂f/∂y

Convexity measures are related to the second derivative: ∂2f/∂y2

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Three main factors affect a bond’s price
sensitivity to yield changes (∂P/∂Y):

• Remaining maturity
• Coupon rate
• Level of interest rates

• Duration and convexity take into account all 3 factors.

• Credit risk and attached options also affect ∂P/∂Y. We’ll incorporate these
effects using the more general concept of “effective duration.”

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Example 3-1:
The Effect of Maturity and Coupon on Price Sensitivity
Four bonds; each priced to yield 9% (b.e.b), semiannual payments. Two have
9% coupon, two have 5% coupon; two mature in 5 years, two mature in 20 years

[Prices at 9% yield are $100, $100, $84.175, and $63.1968]

Instantaneous Percentage Price Changes

New Yld (%) BP 9% 9% 5% 5%
change 5 yr 20 yr 5 yr 20 yr
6.00 -300 12.80 34.67 13.73 39.95
8.00 -100 4.06 9.90 4.35 11.26
8.90 -10 0.40 0.93 0.42 1.05
9.01 1 -0.04 -0.092 -0.042 -.104
9.50 50 -1.95 -4.44 -2.09 -5.01
10.00 100 -3.86 -8.58 -4.13 -9.64
12.00 300 -11.0 -22.6 -11.9 -25.1

Link to Excel calculations

Duration Basics
Duration measures the first order bond price sensitivity to interest rate changes.
§ Higher duration means higher price sensitivity to interest rate changes (more price volatility).
§ More precisely, it is the elasticity of a bond price with respect to its yield

Basic duration measures take into account yield, coupon, and maturity.

æ - dP (1 + Y / k ) ö
D=ç × ÷
è dY P ø “Y” is an annual percentage rate APR

(Note: k is the number of compounding periods per year.

For continuous compounding k=∞)

§ For Macaulay duration, dP/dY is based on the standard formula relating bond price to promised
cash flows. As such, it is only accurate for risk-free bonds with no embedded options. See
Appendix Slides for derivation.

Duration is a property of a security or a portfolio at a point in time.

It changes over time.
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The formula for Macauley duration can be written as:

Ct
y t
T (1 + )
D= å k ´t
t =1 PB k
D = Macauley duration
Ct = period t cash flow
T = total number of periods
y = yield as an APR
k = assumed compounding periods in a year
PB = bond price (or present value of cash flows)

That formula implies that Macaulay duration is a weighted average arrival time of
cash flows, where the weights are the fraction of present value represented by that
cash flow:

æ1ö æ2ö æT ö
ç ÷ ´ PVCF1 ç ÷ ´ PVCF2 ç ÷ ´ PVCFT
è kø è kø k
D= + + ... + è ø
PVTCF PVTCF PVTCF

PVCFi = present value of ith cash flow

PVTCF = present value of total cash flows
(Note in this representation, duration can be described in terms of years although it is
intrinsically unitless)
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Macauley Duration vs. Maturity for

Bonds in Example 3-1
Coupon Maturity Macaulay
Duration
9% 5 4.13
9% 20 9.61
5% 5 4.43
5% 20 10.87

Verify using calculator!

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Properties of Macauley Duration

(
D= k
1 )´ PVCF1 (2 )´ PVCF2
+ k
(T )´ PVCFT
+ ... + k
PVTCF PVTCF PVTCF

• Duration of an option-free coupon bond is less than

or equal to its time to maturity

• Duration of a zero coupon option-free bond is equal

to its time to maturity

• The higher the coupon rate the shorter the duration

• As market yield increases, duration decreases

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Using Duration to Estimate Price Volatility; and

Defining Modified Duration

Recall that D = æç - dPB × (1 + Y / k ). ö÷ Rearrange to get:

ç dY PB ÷
è ø
dPB dy
= -D
PB y
(1 + )
k
where D is Macauley duration, y is an APR, and k is the number of
compounding periods in a year. Rewrite this as:
dPB
= - DM ´ dy
PB

Definition: DM is called the “modified duration.” It is defined as:

D
DM =
y
1+
k
In words, the percentage price change is approximated by:
(modified duration) times (the change in the yield).
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Example 3-2: Using Modified Duration to Approximate Price
Changes

20 yr, 5% coupon bond (semiannual payments), P=63.1968, to yield

9% (b.e.b.).

D = 10.87 years (see table above)

DM = 10.87/(1.045) = 10.40

Say yields increase from 9% to 9.10%. What is the predicted price

change?

-10.40(.0010) = -1.04% EXCEL example

The actual change in price is -1.03% of actual change.
Say yields increase from 9% to 11%. What is the predicted price
change?

-10.40(.020) = -20.80%
The actual change in price is -17.94%

A general conclusion is that duration only gives an accurate

estimate of price change for small yield changes.
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Graphical Interpretation of Duration

Duration is a
price measure of the
steepness of the
actual price curve
price-yield
relationship
P*

duration-based prediction error

P(new) actual

P(new) estimate
tangent line at Y*

Y* Y new
yield
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Other basic duration measures
1. Dollar Duration

We have been using duration to estimate percentage price changes.

It also can be used to estimate dollar price changes:

dPB = - DM ´ PB ´ dy

Definition: Dd is dollar duration. It is defined as: Dd = DM ´ PB

• Thus, dPB = - Dd ´ dy
• Dollar duration is useful in hedging strategies and for
understanding risk of zero NPV portfolios.
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2. Portfolio Duration
One can prove that
(1) The modified duration of a bond portfolio is the value-
weighted average modified duration of bonds in the
portfolio
(2) The dollar duration of a portfolio is the sum of the
dollar durations of the bonds in the portfolio
• Added flexibility in duration-targeting comes from the fact
that a short position contributes negative duration.
• For a zero-value portfolio, only dollar duration is defined.

If the bonds have different yields, this means that the duration of
each bond in the portfolio will be based on a different yield.
Example 3-3: Two-bond portfolio. P(1) = $8,000, DM(1) = 4.3
years. P(2) = $12,000, DM(2) = 3.6 years.

DM(portfolio) = (8/20)(4.3) + (12/20)(3.6) = 3.88

Later we will see that portfolio duration can be changed using
forward, futures and swap contracts.
Generalized duration measures
These measures increase the accuracy of sensitivity estimates, which in turn
makes risk assessment and hedging strategies more robust
§ For example, partial durations are inputs into statistical analyses, such as value-at-risk

“Effective Duration” is the most important generalized measure

of price sensitivity
For risk-free securities, effective duration and modified duration are the same thing
For securities with uncertain cash flows (like MBS or securities with credit risk),
effective duration is defined as the true price sensitivity of the security to changes
in yield.
It may be based on a theoretical model, or it may be estimated empirically.
The standard duration formulas are inaccurate when cash flows are highly
uncertain. In such cases effective duration is the better measure.

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Generalized duration measures, continued
Traditional duration measures price sensitivity to small changes in
the general level of interest rates.

But other factors also influence bond prices.

Generalized measures of duration can be used to describe the total

% change in bond price as the sum of the partial effects of multiple
factors in a linear model:

dP 1 é ¶P ¶P ¶P ù
= ê Df1 + Df 2 + ... + Df n ú
P P ë ¶f1 ¶f 2 ¶f n û

where fi is the ith factor that influences price.

¶P
Df i is the sensitivity of price to the ith factor times a unit change in
¶f i
the ith factor. This is sometimes called a “partial duration.”

When the factors of interest are rates along the yield curve, the
resulting partial durations are called “key rate durations.”
Convexity
• Convexity measures the degree of inward curvature of the price-yield relationship. It is
based on the second derivative of a security price with respect to yield
• As for duration, there are basic and generalized convexity measures
• It is used to improve upon duration-based approximations and hedging strategies
• A long position in non-callable bonds always has positive convexity
• Positive convexity is a desirable property for a long position; negative convexity is a
bad thing
§ Positive convexity means that duration underestimates the price increase resulting from a
drop in yields, and overestimates the price decrease from an increase in yields.

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Calculating Convexity

Convexity is found by taking the second derivative of the bond price

function and then dividing by the price. An explicit expression for
convexity of an option-free bond is:

T t ( t +1) X
C0 = å t + 2 2 / PB
t
(1+ y / k ) k
t =1

T = number of periods ( = maturity in years ´ k)

PB = bond price (present value of cash flows)
Xt = time t cash flow
y = quoted annual percentage rate (so y/k = effective yield per period)
k = number of compounding periods per year

Note that convexity is measured in terms of years squared. The units

have no intuitive interpretation.

Dollar Convexity = C0PB

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Graphical Interpretation of Convexity

actual price curve

price

Positive Convexity

P*

P predicted with both

corrections
P new duration-based prediction error is
slightly more than offset by convexity
P predicted correction
with duration
tangent line at Y*

Y* Y new
yield
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Graphical Interpretation of Negative Convexity

price

Negative Convexity

P*

P new estimated
duration-based prediction error is
P new offset by convexity correction

tangent line at Y*

Y* Y new
yield
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Using Convexity to Improve Price Sensitivity Estimates

The prediction equation with duration and convexity is:

dPB
= - DM ( dy ) + 12 C 0 ( dy )2
PB
(This is a 2nd order Taylor’s Series expansion of the price-yield function.)

Example 3-4: Approximating price change with duration and convexity

Estimate the percent price change of a 6% coupon bond with 25 years to

maturity, selling to yield 9% if there is a 200 basis point increase in
required yield.

DM = 10.62
C0 = 182.92

dPB
= -10.62(.02) + 12 182.92(.02)2 = -2124%
. + 366%
. = -17.58%
PB
Contrast to the actual change = -18.03%.

Using convexity gets much closer than the estimate using

duration alone!
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Duration and Convexity-Based Hedging Strategies

• Delta Hedging (duration-based hedging)
• Gamma Hedging (duration and convexity-based hedging)
• Delta & gamma hedging with forwards, futures and swaps
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Using Duration and Convexity to Structure a
Hedge œDelta and Gamma Hedging

How much does a bond price change with a change in

interest rates?

This is approximated by:

dP = -Dm(P)dy + .5(P)C0(dy)2

Definitions

Dm = modified duration (also can use effective duration)

P = price
C0 = convexity
Hedge Ratio = -Dm(P) (= — dollar duration“)
Gamma = (P)C0 (= — dollar convexity“)

A delta neutral portfolio equates the hedge ratio of

assets and liabilities:

PassetDm,asset = PliabilityDm,liability

A gamma neutral portfolio is delta neutral, and also

equates the gammas of assets and liabilities.
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Example 3-5: Hedging Dealer Portfolio Risk

A dealer in corporate bonds finds herself with an inventory of $1mm in a 5 year 6.9% bonds
(semiannual payments) at the end of the trading day, priced at par. The bonds are illiquid, so
selling them would entail a loss. Holding them overnight is risky, since their price might fall if
rates rise.

An alternative to selling the corporate bonds is to short more liquid Treasury bonds. The
following bonds are available:

1. 10 yr 8% Treasury, p = $1,109.0 per $1,000 face

2. 3 yr 6.3% Treasury, p = $1,008.1 per $1,000 face

a. How much of the 10 year bond would she need to short to hedge? How much of the 3 year
bond?

b. If yields rise by 1% overnight on all the bonds, show the result of the transactions the next
day when the short position is closed out.
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Plan to answer (a):

1. Find modified duration of the bond to be hedged

2. Find modified duration of the bonds to be shorted
3. Use this to find hedge ratios.

For 5 year 6.9% bond, y = 6.9% b.e.b., Dm = 4.1688

For 10 year 8% bond, y=6.5% b.e.b, Dm=7.005

For 3 year 6.3% bond y = 6.00% b.e.b., Dm = 2.700

Amount of 10 year bond to sell, x, solves: x(7.005) =

$1mm(4.1688). x = $593,861.5

Amount of 3 year bond to sell, y, solves: y(2.7) =

$1mm(4.1688) y = $1.54072 mm
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Part b: If yields rise by 1% overnight on all the bonds, show the
result of the transactions the next day when the short position is
closed out.

For 5 yr, yield to 7.9%, => price to $959.344/$1000. Loss on long Note: You
position = $1mm(1-.959344) = $40,656 can also find
price change
by first finding
For 10 yr, yield to 7.5% => price to 1034.74/$1000. 1034.74/1109 =
face value
.933. (1-.933)(593,861.5) = $39,765.7 gain. and then
rediscounting
For 3 yr, yield to 7% => price to 981.35/$1000. 981.35/1,008.1 = cash flows at
.97346. (1-.97346)(1,540,720) = $40,891 gain. new rate.
Example 3-5 extended to gamma hedging
"What if the dealer wants the added protection of doing a gamma neutral hedge?"
§ Let bond 1 be the bond to be hedged (5 year 6.9% corporate)
§ Let bond 2 be the 10 year 8% Treasury
§ Let bond 3 be the 3 year 6.3% Treasury
Investment must be both delta neutral and gamma neutral. This requires matching deltas and gammas, and requires
investments in both bonds.
§ P1 = $1 million by assumption. D1 = 4.1688, C1 = 21.038
§ P2 = ?, D2 = 7.005, C2 = 62.98
§ P3 = ?, D3 = 2.700, C3 = 8.939
Match hedge ratios:
§ $1m(4.1688) = P2(7.005) + P3(2.700)
Match gamma:
§ $1m(21.038) = P2(62.98) + P3(8.939)
2 linear equations in two unknowns. Solve for P2 and P3. (Full solution is posted on the class web page.)

Practice exercise: Redo calculation of what happens when rates move (as in example in notes), and verify that
hedge is better than with delta hedge.

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Duration and convexity for forwards, futures and swaps
• Interest rate forwards, futures and swaps are often used in place of cash market delta and
gamma hedging strategies
• Advantages may include lower transactions costs and more liquidity

• The logic of delta and gamma hedging is the same using these derivatives as it is using cash
instruments: The goal is to take a position whose gains or losses will offset the gains or losses
on the position being hedged.

• To implement an interest rate risk-management strategy with interest rate derivatives, we need
to know how to calculate their duration and convexity

© 2021 Lucas
Duration of a forward or futures contract for a bond
§ Recall that the dollar duration of a bond is defined as Dm(P), and that
dP/dy = -Dm(P)

§ Definition: The dollar duration of a forward bond contract is equal to

the duration of the security specified in the forward contract
multiplied by the prepaid forward price of the security.

§ Definition: The prepaid forward price is the present value of the forward
price.

Forward contracts for bonds can be replicated in the cash market with
offsetting long and short positions. You can also find the dollar duration of a
forward contract by finding the dollar duration of the replicating portfolio of
spot market positions.
§ An example of finding the duration of the replicating portfolio is in the appendix
to these slides
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Using futures in a duration-based hedge
The challenge: There are relatively few futures contracts available. Hence, the duration of
the obligation being hedged typically differs from the duration of the futures contract.
The solution: Adjust the number of futures contracts bought or sold to equate the sensitivity
to yield change. This uses the idea of delta hedging using a hedge ratio.

Recall that: dP ≈ -PDmdY

§ P = bond price; dP = change in bond price; Y = yield (APR); dY = change in yield; Dm = modified or effective duration

Similarly, if F is the contract price for an interest rate futures contract, then

dF ≈ -FDFdY
§ where DF is the modified duration of the futures contract, and F is the prepaid forward price of the security in the futures contract.

For the contract to serve as a hedge, we want dF = dP, which implies equating the hedge
ratios in a long and short position:

PDm = FDF

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Swap duration
• Recall that for a fixed rate receiver, a swap is like having a portfolio that is
long a fixed rate bond and short a floating rate bond.
- Initially the value of the long and short are equal to the notional principal F

• The effective duration of a (pure) floating rate bond is the time until the next
reset, divided by (1 + Y/k)
- Y is the APR; k is the number of compounding periods in a year.
- This is because the price of a floating rate bond between reset dates varies with
short-term interest rates, but the price at the next reset date is fixed at par.

• The modified (and also effective) duration of the fixed rate bond can be
calculated in the usual way.

It follows that for the fixed rate receiver, the dollar duration of a
swap, -dP/dY is:
+P(fixed) x Dm (fixed) - P(floating) x Deffective (floating)
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Example 3-6: Calculating the duration of a swap
Consider a new 5-year interest rate swap, offering a fixed rate of 6% (s.a.),
and a floating rate of 6-mo LIBOR, with notional principal of $1m. Assume
current 6-mo LIBOR is also 6%.
§ What is the dollar duration for the fixed rate receiver?
§ What is the dollar duration for the floating rate receiver?

Using the duration calculator, a 5-year fixed rate bond with a 6% (s.a.) coupon
selling at par has a modified duration of 4.265 years. The effective duration of
the floating rate side is .5/(1.03) = .485 years. The difference is 3.78 years.
§ The dollar duration of the swap is 3.78($1m)

The floating rate receiver’s position is the negative of the fixed rate receiver’s
position.
§ The dollar duration of the swap is -3.78($1m)

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Putting it all together
• Interest rate risk is often managed effectively and flexibly using duration and convexity-based
strategies.

• These strategies can be implemented in the cash market, or with derivatives. The choice
between different options depends on cost, availability and risk tolerance.

• To practice implementing a delta hedge with forwards, the recitation will revisit Example 3-5 of
hedging a security dealer’s overnight exposure to interest rates using (1) a bond futures
contract; and (2) using in interest rate swap.

© 2021 Lucas
Appendix: Optional derivations

© 2021 Lucas
Deriving Macaulay duration
T Ct
Bond price PB = å .
y
t =1 (1 + ) t
k
Ct is the promised cash flow in period t, T is the total number of periods (= k times maturity in years), y
is the annual percentage rate, and k is the number of compounding periods in a year.

To find change in bond price for a small change in yield differentiate:

dPB T - t y
= å ( )Ct (1 + ) -t -1
dy t =1 k k

This gives the dollar price change per small change in annual yield.

To get the percent price change, divide by PB.

To get the Macaulay duration (measured in years) multiply the percentage price change by
-(1+y/k):

T t y
D = å ( )Ct (1 + ) -t / PB
t =1 k k

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Deriving dollar duration of a forward contract
A forward bond contract is equivalent to a portfolio consisting of a long and a
short position in zero coupon bonds of equal value.
Using this fact, we can derive an expression for the yield-sensitivity of the
present value of the forward contract.
E.g., a long forward contract in a one-year bond to be delivered 3 years in the
future:
§ Equivalent to a long position in a 4-year zero coupon bond, and a short position of
equal value in a 3-year zero coupon bond.
§ Assume contract is such that P0(3) = P0(4) = $100;
§ V0=P0(4)-P0(3) = 0; Dm(4) = 4/(1+y/k); Dm(3) = 3/(1+y/k)
§ dV0/dy = dP0(4)/dy – dP0(3)/dy = -Dm(4)P0(4) + Dm(3)P0(3)
= -(Dm(4) - Dm(3))100 = -(4-3)×100/(1+y/k)

Note that the modified duration

of the security in the contract is
1/(1+y/k), and the prepaid
0 3 4 forward price, P0(3), is $100.
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