Intro to fin market

Hang Zhou

School of Finance, SUFE

Lecture 5: Bond Market Risk Hedging

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
Motivating quote

The best investors do not target return; they focus first on risk, and only
then decide whether the projected return justifies taking each particular
risk.

Seth Klarman

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Hedge interest risk in the bond market

I One key objective for financial market is risk hedging (对冲风险).

I But, what is the definition of “hedge”?
I In this lecture, we study how to hedge the interest risk in bond
market.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 3
Hedge risk

Definition of a hedge
A hedge is an investment that tries to remove the risk of adverse price
movements in an asset. Normally, a hedge consists of taking an
offsetting or opposite position in a related security.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 4
Hedge risk

Definition of a hedge
A hedge is an investment that tries to remove the risk of adverse price
movements in an asset. Normally, a hedge consists of taking an
offsetting or opposite position in a related security.

I In the bond market, the risk could come from the fluctuation of the
interest rate.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 4
Hedge risk

Definition of a hedge
A hedge is an investment that tries to remove the risk of adverse price
movements in an asset. Normally, a hedge consists of taking an
offsetting or opposite position in a related security.

I In the bond market, the risk could come from the fluctuation of the
interest rate.
* To see this, let’s recall the bond pricing formula.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 4
Bond price and interest rate: inversed related

I Recall:
X
T
C F
P0 = t
+
(1 + y) (1 + y)T
t=1

C: Annual coupon payments; F: face value of the bond.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 5
Bond price and interest rate: inversed related

I Recall:
X
T
C F
P0 = t
+
(1 + y) (1 + y)T
t=1

C: Annual coupon payments; F: face value of the bond.

I The YTM is on the denominator, we have:

dP0
<0
dy

(利率上市，债券价格下降)
I The magnitude depends on the value of (C F T ) as well. ,,

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 5
Graphic illustration

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 6
Computation example
I For simplicity, suppose we price zero-coupon bonds. Consider bond
,
1: F = 1000; T = 2, and bond 2:F = 1000 T = 10.
I Assume the initial interest rate is y0 = 8%. Bond prices are:

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 7
Computation example
I For simplicity, suppose we price zero-coupon bonds. Consider bond
,
1: F = 1000; T = 2, and bond 2:F = 1000 T = 10.
I Assume the initial interest rate is y0 = 8%. Bond prices are:

P1 =
1000
(1 + 8 )2 %
= 857 34 .
P2 =
1000
(1 + 8 )10 %
= 463 19 .
I Suppose now, market interest rate rises by 1 percentage points. The
new bond prices are:

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 7
Computation example
I For simplicity, suppose we price zero-coupon bonds. Consider bond
,
1: F = 1000; T = 2, and bond 2:F = 1000 T = 10.
I Assume the initial interest rate is y0 = 8%. Bond prices are:

P1 =
1000
(1 + 8 )2 %
= 857 34 .
P2 =
1000
(1 + 8 )10 %
= 463 19 .
I Suppose now, market interest rate rises by 1 percentage points. The
new bond prices are:

~ 1000
.
P1 =
(1 + 9 )2 %
= 841 68

~ 1000
.
P2 =
(1 + 9 )10 %
= 422 41

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 7
Sensitivity

Percentage change in bond prices:

~
%∆P1 =
P1 − P1
P1
= −1 83 . %
~
%∆P2 =
P2 − P2
P2
= −8 8 .%

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 8
Sensitivity

Percentage change in bond prices:

~
%∆P1 =
P1 − P1
P1
= −1 83 . %
~
%∆P2 =
P2 − P2
P2
= −8 8 .%
It seems that long-term zero-coupon bonds are affected more by interest
rate fluctuations. But why?

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 8
Suppose interest rate decreases
I Recall at 8% rate, the prices for 2-year bond and 10-year bond are

P1 =
1000
(1 + 8 )2 %
= 857 34 .
P2 =
1000
(1 + 8 )10 %
= 463 19 .

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 9
Suppose interest rate decreases
I Recall at 8% rate, the prices for 2-year bond and 10-year bond are

P1 =
1000
(1 + 8 )2
= 857 34
% .
P2 =
1000
(1 + 8 )10
= 463 19
% .

I Now, if the rates decrease to 7%, we have

^
1000
.
P1 =
(1 + 7 )2
= 873 44
%
^
1000
.
P2 =
(1 + 7 )10
= 508 35
%

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 9
Suppose interest rate decreases
I Recall at 8% rate, the prices for 2-year bond and 10-year bond are

P1 =
1000
(1 + 8 )2
= 857 34
% .
P2 =
1000
(1 + 8 )10
= 463 19
% .

I Now, if the rates decrease to 7%, we have

^
1000
.
P1 =
(1 + 7 )2
= 873 44
%
^
1000
.
P2 =
(1 + 7 )10
= 508 35
%
~
%∆P1 =
P1 − P1
P1
. %
= 1 88
~
%∆P2 =
P2 − P2
P2
. %
= 9 75
Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 9
Facts about bond price and yield

1 Bond price and yield are inversely related.

2 Decrease in yield has a larger impact on prices than increase in yield.
(Convexity)
3 Long-term bond are more price sensitive than short-term bond.
4 Interest rate risk is inversely related to coupon rates.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
Interest rate risk and coupon rate

Figure: 1-year bond with initial YTM = 5%

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
Analysis

Let’s study the derivative of the bond pricing formula:

F
P0 =
(1 + y)t

implies
dP0 F
= −t ·
dy (1 + y)t+1
Linear approximation:
F
P(y0 + ∆y) = P(y0 ) − t · × ∆y
(1 + y0 )t+1

(As maturity increases, zero-coupon bond price are more sensitive to

interest rates.)

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
Duration
I We could generalize the idea of linear approximation with the
following equation.
1 First, let CFt denote the cash flow for each time period t.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
Duration
I We could generalize the idea of linear approximation with the
following equation.
1 First, let CFt denote the cash flow for each time period t.
I Bond pricing implies

X
T
CFt
P(y) =
(1 + y)t
t=1

I Applying the previous method, we have

X
T
CFt
∆P(y) ≈ (−t) · · ∆y
(1 + y)t+1
t=1

∆P X
T
CFt /(1 + y)t ∆(1 + y)
≈ (−t) · ·
P P 1+y
t=1

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
Duration

I We shall find a way to define the effective maturity of this coupon

bond. Let
CFt /(1 + y)t ← PV of cash flow
wt =
P0 ← Bond price

* We define a bond’s duration (久期) as:

CFt /(1 + y)t

wt = (1)
P0
XT
D = wt × t (2)
t=1

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
Intuition for duration

1 Duration (D) is a weighted average of maturity.

2 wt : PV of cash flow over bond price. Fraction of the cash flow
obtained at date t.
3 Duration (D) averages the time weighted by the percentage of cash
flow.
* Duration is an important measure of interest rate sensitivity.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
Computation example
Suppose we have a coupon bond: (F = 1000 C = 80 T = 3 y = 10 ). , , , %
Bond price is

P0 =
80
+
.
80
+
.
80
+
1000
1 + 0 1 (1 + 0 1)2 (1 + 0 1)3 (1 + 0 1)3.= 950 263
. .
Duration computation:

Year CF PV of CF wt t × wt
1 80 72 727 . .
0 0765 .
0 0765
2 80 66 116 . .
0 0696 .
0 1392
3 80 60 1052 . .
0 0633 .
0 1899
3 1000 751 3148 . .
0 7906 .
2 3719

. . .
D = 0 0765 + 0 1392 + 0 1899 + 2 3719 = 2 7775 . .

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
Duration

1 Long-term bonds are affected more by interest rate fluctuations.

2 Duration measures the weight-average maturity.
* Duration measures price elasticity to gross interest rate.

∆P ∆(1 + y)
= −D ·
P (1 + y)

* We define Modified duration as:

D ∆P
D∗ = ⇔ = −D∗ × ∆y
(1 + y) P

* Interpretation: as interest rate increase by 1 percentage points, price

drop by D∗ percent.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
A general form of duration

I When coupon payments are paid semi-annually, we modify our

computation of duration as
X
n
CFf tf
D= y f ×
(1 + k ) P
f=1

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
A general form of duration

I When coupon payments are paid semi-annually, we modify our

computation of duration as
X
n
CFf tf
D= y f ×
(1 + k ) P
f=1

I f denotes the cash flow number. k is the compounding periods per

year. tf is the time in years when until the cash flow is payed. y is
the annual YTM.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
A general form of duration

I When coupon payments are paid semi-annually, we modify our

computation of duration as
X
n
CFf tf
D= y f ×
(1 + k ) P
f=1

I f denotes the cash flow number. k is the compounding periods per

year. tf is the time in years when until the cash flow is payed. y is
the annual YTM.
I For semi-annual payments, use k = 2.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
Duration determinants

1 Duration = Maturity for zero-coupon bonds.

2 A bond’s duration is inversely related to coupon rates, all else
constant.
3 A bond’s duration generally increases with maturity. It always
increases with maturity when P0 > F, all else constant.
4 A bond’s duration is higher when its YTM is lower, all else constant.
5 The duration of perpetuity is

D=
1+y
y
.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 1
Duration of perpetuity

Assume we have a perpetual bond with constant cash flow C and YTM
y. Bond price is

P0 =
C
+
C
1 + y (1 + y)2
+ ... + (1 +Cy)T + ... = Cy
Weights are:

C/(1 + y)t C/(1 + y)t y

wt = = =
P0 C/y (1 + y)t

Duration is:
D=1×
y
(1 + y) 1
+2×
y
(1 + y)2
+ ...

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
 Multiply D by 1/(1 + y) yields:

...
 
D 1 1
=y× 1× 2
+2× +
1+y (1 + y) (1 + y)3

Take the difference between D and D/(1 + y):

...
 
y 1 1 1
D× =y× + 2
+ + =1
1+y (1 + y) (1 + y) (1 + y)3

Therefore,
1+y
D=
y

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Immunization

I Passive investments in bond market: hedge the risk from interest

rate fluctuations.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Immunization

I Passive investments in bond market: hedge the risk from interest

rate fluctuations.
I For instance: banks and pension funds have mismatched maturities
of assets and liabilities.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Immunization

I Passive investments in bond market: hedge the risk from interest

rate fluctuations.
I For instance: banks and pension funds have mismatched maturities
of assets and liabilities.
I To hedge this interest rate risk, we introduce immunization.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Immunization

I Passive investments in bond market: hedge the risk from interest

rate fluctuations.
I For instance: banks and pension funds have mismatched maturities
of assets and liabilities.
I To hedge this interest rate risk, we introduce immunization.

* Key idea: Dur(Asset) = Dur(Liability)

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Computation example
An insurance company pays $19487 in 7 years. The current market rate
is 10%. The CFO of this firm decides to use a 3 year zero-coupon bond
and a perpetuity to fund this payment. How can this CFO immunize the
obligation?

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Computation example
An insurance company pays $19487 in 7 years. The current market rate
is 10%. The CFO of this firm decides to use a 3 year zero-coupon bond
and a perpetuity to fund this payment. How can this CFO immunize the
obligation?
I The duration of the liability: 7 (a one-time payment in 7 years)

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Computation example
An insurance company pays $19487 in 7 years. The current market rate
is 10%. The CFO of this firm decides to use a 3 year zero-coupon bond
and a perpetuity to fund this payment. How can this CFO immunize the
obligation?
I The duration of the liability: 7 (a one-time payment in 7 years)
I Duration of the assets:

Duration for the zero-coupon bond = 3

1+y 1 + 10 % = 11
Duration of the perpetuity =
y
=
10 %

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Computation example
An insurance company pays $19487 in 7 years. The current market rate
is 10%. The CFO of this firm decides to use a 3 year zero-coupon bond
and a perpetuity to fund this payment. How can this CFO immunize the
obligation?
I The duration of the liability: 7 (a one-time payment in 7 years)
I Duration of the assets:

Duration for the zero-coupon bond = 3

1+y 1 + 10 % = 11
Duration of the perpetuity =
y
=
10 %
I Match the duration:

3x + 11(1 − x) = 7 ⇔ x=05 .
Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
 I To fully fund this expenditure in 7 years, the PV of liability should
equal the PV of assets.
I
19487
PV of Liability =
(1 + 10 )7 %
= 10000 = PV of the Assets

.
I We have computed x = 0 5: the CFO invest 50% in zero-coupon
bond and 50% in perpetuity.
I Portfolio: $ 5000 in 3-year ZCB; $ 5000 in perpetuity

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Bond convexity

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
 I The actual relation between bond price and interest rate is
non-linear.
I As we observe from the graph, duration or modified duration
captures the linear part.
∆P
= −D∗ × ∆y
P

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
 I The actual relation between bond price and interest rate is
non-linear.
I As we observe from the graph, duration or modified duration
captures the linear part.
∆P
= −D∗ × ∆y
P

I A second order proximation yields the following formula:

∆P 1
= −D∗ × ∆y + × Convexity × (∆y)2
P | {z } |2 {z }
linear part
quadratic part

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
 I The actual relation between bond price and interest rate is
non-linear.
I As we observe from the graph, duration or modified duration
captures the linear part.
∆P
= −D∗ × ∆y
P

I A second order proximation yields the following formula:

∆P 1
= −D∗ × ∆y + × Convexity × (∆y)2
P | {z } |2 {z }
linear part
quadratic part

I Convexity formula:

1 X
T 
CFt

2
Convexity = · (t + t)
P0 × (1 + y)2 (1 + y)t
t=1

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Which bond do you prefer?

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Why do investors like convexity

1 Convexity measure the curvature of bond price and interest rates.

2 Bonds with higher convexity enjoys a larger price gain when rate
falls; a smaller price drop when rate rises.
∆P 1
= −D∗ × ∆y + × Convexity × (∆y)2
P 2 | {z } | {z }
>0 >0

3 Convexity doesn’t come for free. Must accept a lower yield.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Hedge interest rate risk using yield curve

I We could use bonds with different maturities to lock down a interest

rate.
1 Suppose you are the CFO of Corporation XYZ. Your firm has a will
receive a payment of $10M from your client in 1 year.
2 You worry about future interest rate fluctuation. You’d like to lock
into a lending rate one year from now for a period of 1 year. What’s
the strategy?
3 The interest rates are:
t 1 2
rates 0.05 0.07

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 2
Strategy

I Borrow
10M
1 + 0 05 .
= 9 524M .
from the bond market for 1 year.
I Invest the cash raised from borrowing at a rate of 7% for 2 years.
I At year 1, repay you debt with the received payments.

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 3
Strategy

I Borrow
10M
1 + 0 05 .
= 9 524M .
from the bond market for 1 year.
I Invest the cash raised from borrowing at a rate of 7% for 2 years.
I At year 1, repay you debt with the received payments.
I The effective interests from year 1 to 2 is:

.
1 072
%
r=
.
1 05
−1≈9

Hang Zhou (School of Finance, SUFE) Intro to fin market Lecture 5: Bond Market Risk Hedging 3