FINANCIAL ENGINEERING

Duration, Immunization, and Convexity

by Dr. Aditya Sharma

Interest Rate Risk
• Price Risk
• Reinvestment Rate Risk
• Interest Rate Sensitivity
• Inverse relationship between price and yield
• An increase in a bond’s yield to maturity results in a smaller price decline than the gain
associated with a decrease in yield
• Long-term bonds tend to be more price sensitive than short-term bonds
• Sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity
increases
• Interest rate risk is inversely related to bond’s coupon rate
• Sensitivity of a bond’s price to a change in its yield is inversely related to the yield to maturity
at which the bond currently is selling
• Yield Elasticity
Interest Rate Risk
Duration and Modified Duration
• Effective Maturity of a Bond (Debt)
• Duration is shorter than maturity for all bonds except zero coupon
bonds
• Duration is equal to maturity for zero coupon bonds
Duration and Modified Duration

w t = [CF t ( 1 + y ) ] Price
t

T
D =  t w t
t =1

CF = Cash Flow for period t

t

𝐷 ∗ = 𝐷 × 1ൗ 1 + 𝑦
Duration and Modified Duration
Duration and Modified Duration
Duration and Modified Duration
Issue Date 01-03-2024
Start Date 03-03-2024
End Date 01-03-2034
Coupon 0.0825
Interest Rate 0.0775
Coupon pmt frequency 1
Price 105

YTM 0.0752038 YIELD(settlement, maturity, rate, pr, redemption, frequency, [basis])

DURATION 7.2503412 DURATION(settlement, maturity, coupon, yld, frequency, [basis])
Modified DURATION 6.7432252 MDURATION(settlement, maturity, coupon, yld, frequency, [basis])
What Determines Duration?
Duration – Price Relationship
• Price change is proportional to duration and not to
maturity
DP/P = -D x [Dy / (1+y)]
D* = modified duration
D* = D / (1+y)
DP/P = - D* x Dy
Immunization
• Immunization
• Net worth immunization
• Target date immunization
• Contingent Immunization (Active Bond Portfolio Mgmt)
What happens if do not Immunize?
• In 2003 S&P 500 gave returns of 25%
• Pension Funds in the USA increased by more than $ 100 b

• Still, they ended up with a shortfall of $45 b

• The reason, the obligations had longer maturity than the
investments
Example
Example
Convexity
Price

Pricing Error from

Convexity

Duration

Yield
Convexity
Modify the pricing equation:

DP
= - D  D y + 1  Convexity  ( D y ) 2
P 2
Convexity is Equal to:

 CF t 
( + t )
N
1

2
 t
P  (1 + y)  (1 + y )
2 t
t =1 
Where: CFt is the cash flow (interest and/or
principal) at time t.
Bond Price Convexity
Bond Price Convexity
Bond Price Convexity
Bond Price Convexity
Bond Price Convexity
Bond Price Convexity
Bond Price Convexity
Bond Pricing with Convexity
Using PDEs similar to Balck Scholes we can work out no-arbitrage risk-
neutral pricing for the bonds such that it considers their convexity

Assumptions:
1. There is a short and a long default-free discount bond with maturities T
s

and T, respectively and both bonds are liquid and can be traded
without any transaction costs.
2. The two bond prices depend on the same risk factor denoted by r . This
t

can be interpreted as a spot interest rate that captures all the

randomness at time t, and is the single factor assumption
Bond Pricing with Convexity

Since the position in Long Bond resembles an option position we can use
the concept of delta hedging to hedge the downside risk of the portfolio.

A delta-hedged portfolio will be

{Long maturity T bond, Borrow B(t, T) funds and Short delta units of maturity S Bond}
Bond Pricing with Convexity
Bond Pricing with Convexity
Bond Pricing with Convexity

The change in the value of this portfolio due to a small change in the spot rate Δrt
only is given by
Bond`s Partial Differential Equations
𝑟𝑡 = 𝜇 + 𝜎𝑤𝑡
ⅆ𝑟𝑡 = 𝜇 ⅆ𝑡 + 𝜎 ⅆ𝑤𝑡
ⅆ𝑟𝑡 = 𝜇𝑟𝑡 ⅆ𝑡 + 𝜎𝑟𝑡 ⅆ𝑤𝑡
ⅆ𝑟𝑡 = 𝜆(𝜇 − 𝑟𝑡 ) ⅆ𝑡 + 𝜎𝑟𝑡 ⅆ𝑤𝑡

ITO`s Lemma

1
ⅆ𝑓(𝑟𝑡 ) = 𝑓𝑟 ⅆ𝑟𝑡 + 𝑓𝑟𝑟 𝜎 2 𝑟𝑡2 ∆
2
Bond`s Partial Differential Equations
Convexity gains for a small Δ

1 𝜕 2 𝐵(𝑡, 𝑇) 2𝑟2∆
2 𝜎(𝑟𝑡 , 𝑡) 𝑡
2 𝜕𝑟𝑡
Where 𝜎(𝑟𝑡 , 𝑡) is a % short rate volatility
The risk-neutral dynamics says

ⅆ𝑟𝑡 = 𝜇(𝑟𝑡 , 𝑡) ⅆ𝑡 + 𝜎𝑟𝑡 ⅆ𝑤𝑡 for all t ∈ 𝑜, 𝑇

Where 𝜎 is constant. Therefore, gamma gains can simply be
1
𝐵𝑟𝑟 𝜎 2 𝑟𝑡2 ∆
2
Bond`s Partial Differential Equations
The interest paid on borrowing will be

𝑟𝐵(𝑡, 𝑇)∆
The change in Bond`s value with time will be

𝜕𝐵(𝑡, 𝑇)
∆ = 𝐵𝑡 ∆
𝜕𝑡
The last component will be due to the impact of drift in 𝑟𝑡 on the underlying

𝜇(𝑟𝑡 , 𝑡) 𝐵𝑟 ∆
Bond`s Partial Differential Equations
Therefore, the total gains/losses will be
1
𝐵𝑟𝑟 𝜎 2 𝑟𝑡2 ∆ − 𝑟𝐵 𝑡, 𝑇 ∆ + 𝐵𝑡 ∆ + 𝜇(𝑟𝑡 , 𝑡) 𝐵𝑟 ∆
2
This term should be equal to 0 to ensure no-arbitrage

1
𝐵𝑟𝑟 𝜎 2 𝑟𝑡2 ∆ − 𝑟𝐵 𝑡, 𝑇 ∆ + 𝐵𝑡 ∆ + 𝜇 𝑟𝑡 , 𝑡 𝐵𝑟 ∆ = 0
2
1
𝐵𝑟𝑟 𝜎 2 𝑟𝑡2 − 𝑟𝐵 + 𝐵𝑡 + 𝜇 𝑟𝑡 , 𝑡 𝐵𝑟 = 0
2
With the boundary condition as B(T,T) = 1
Bond Pricing with Convexity (Vasicek Model)

Where,

α = speed of reversion; Ϗ = Long Term Mean; rt = short rate; σ = volatility at time t

Bond Pricing with Convexity
(Cox-Ingersoll-Ross Model)

Where,
α = speed of reversion; Ϗ = Long Term Mean; rt = short rate; σ = volatility at time t
Sources of Convexity
Mark-to-Market

• Futures contracts are convex in nature whereas Forward

contracts are not.
• Convexity is the outcome of the correlation between future
rates and interest rates
• Future rates are positively correlated with interest rates and
therefore are always greater than the forward rates
• Futures prices on the other hand depend on the positive or
negative correlation of the underlying with the interest rates.
Sources of Convexity
By the Design of Contract

Bonds
• Contract prices are specified as a non-linear function of the
underlying risks.
Sources of Convexity
Swaps

• Plain vanilla fixed payer IRS.

𝑄
𝑉𝑡0 = 𝐸𝑡0
Sources of Convexity
Assuming flat and parallel shifting rate curve.
Sources of Convexity
Sources of Convexity
CBOT in the Mid-90s had to delist an IRS swap futures contract.
They made 2 mistakes while listing the swap futures
• Convexity of the contract was ignored and was priced as a linear
instrument
• It was based on the 3 and 5-year swaps whereas more popular ones
are 5 and 10-year swaps.

Relisted the contract with due consideration of the underlying maturity

and convexity.

The primary reason for delisting and relisting is that it was observed that
such swap curves are frequently used for pricing other instruments.
Sources of Convexity
FRAs
Sources of Convexity

Mortgage Loans with prepayment options like callable

bonds

MBS securities with mortgages as underlying more often

than not these mortgages have a prepayment option.

What is the nature of convexity in the above two

instruments?