Masters in Financial Analysis 2019

Investment Fundamentals
Professor Lucie Teplá

CA01
AUT18
Exercise #2:
Curve Trades

Curve Trades
• Want to set up a position:
- consisting of two bonds with different maturities
- where you are long one bond, short the other
- that will be unaffected by small parallel shifts of the yield curve
(duration-neutral)
- will make money if yield curve flattens

• Assume you have the following 2 bonds (both with face value $1,000):

Coupon Yield Price $Duration DMOD DMAC

A: 2-year 2.375% 2.5% 997.59 1,923.91 1.9286 1.9768
B: 10-year 2.75% 2.95% 982.90 8,464.6.1 8.6119 8.8660

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Price and Duration Calculations
Bond A Bond B
coupon 2.375 coupon 2.75
yield 2.5 yield 2.95
t CF PV(CF) t*PV(CF) t CF PV(CF) t*PV(CF)
1 23.75 23.1707 23.170732 1 27.5 26.712 26.711996
2 1023.8 974.42 1948.84 2 27.5 25.9466 51.893144
997.591 1972.0107 3 27.5 25.2031 75.609244
Price 1,923.91 $D 4 27.5 24.4809 97.92358
1.9286 D_MOD 5 27.5 23.7794 118.89701
1.9768 D_MAC 6 27.5 23.098 138.58807
7 27.5 22.4361 157.05301
8 27.5 21.7932 174.34595
9 27.5 21.1688 190.51889
10 1027.5 768.278 7682.7787
982.896 8714.3196
Price 8,464.61 $D
8.6119 D_MOD
8.8660 D_MAC
3

Curve Flattener
• Which bond do you buy, which one do you short?

3.5% US yield curve as of 04 May 2018

3.0%
Bond B
yield

2.5%
Bond A

2.0%

1.5%
0 2 4 6 8 10 Source: ft.com
maturity

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Curve Flattener
• Long the 10 yr bond (B), short the 2 yr bond (A)
• Assume you buy 1 unit of Bond B, in order to be duration hedged, solve:
nB = 4.40
$Duration neutral

nA · $DA + nB · $DB = 0 nA = 4.40

ie short 4.40 units
nA · 1923.91 + 1 · 8464.61 = 0 of bond A
nA · $DA + nB · $DB = 0

⇡ [ $DA · yA ] 2.920 [ $DB · ynBA] · 1923.91 + 1 · 8464.61 = 0

• Net cost (receive money, which you lend out):
⇡ 4903.36 · (· 997.59
yB ⇡ [ $DA · yA ] 2.920 [ $DB · yB ]
982.90 4.40 =yA )3, 406.19

⇡ 4903.36 · [(yB⇤ yB ) (yA⇤ yA )] ⇡ 4903.36 · ( yB yA )

nA = 4.40
⇤ ⇤
⇡ 4903.36 · [0.02 (yA⇤ yB⇤ )] ⇡ 4903.36 · [(yB yB ) (yA yA )]
nA · $DA + nB · $DB = 0 5

· 1923.91
nA P 4.88+ 1 · 8464.61 = ⇡ 0 4903.36 · [0.02 (yA⇤ yB⇤ )]
= = 4, 880
y 0.001
⇡ 4.40 · [ $DA · yA ] + 1 · [ $DB · yP B] =
4.88
= 4, 880
P/P P 1 4.88/1092.46
= · = = 4.475 y 0.001
Curve Flattener
y y P
⇡ 8464.61 · ( yA
0.001
yP/P
B) P 1 4.88/1092.46
1 X T = · = = 4.475
$D = ⇤
t · P V (CFt ) y y P 0.001
• Overall position:⇡ 8464.61(1 + y) t=1⇤
· [(yA yA ) (yB⇤ yB )] T
1 X
X T
P V ⇤ (CFt ) $D = t · P V ⇤ (CFt )
DM ACPrice
= per t· $Duration (1 + y)
$Duration
t=1
Number⇡ 8464.61 · [(y $y Invested
P ) (y ⇤
y ⇤
)]
bond
t=1 B A B per bond
A ofT position ⇤
X P V (CFt )
A: 2-year -4.40 1 dP997.59 1 X -4,389.4
T ⇤ D
1923.9
M AC = t·
-8,464.6
P V (CFt ) P
B: 10-year DM OD = ⇡ =
8464.61
+1 P dy982.90 · [0.02 t ·
(y
982.90
⇤
y ⇤
)]
t=1
(1 + y) t=1 B PA 8464.6 8,464,6
T
Cash - - 3,406.2D 0 1 dP 01 X P V ⇤ (CFt )
1 + nominal M OD = = t·
BE inflation =
Net
P yield 4.88 1 =0 1.0244 1 = 2.09% P dy (1 0+ y) t=1 P
=
1+ realy yield = 4, 880
1.0044
0.001 1 + nominal yield 1.0244
1 + r BE inflation =
1.0244 1= 1=
• Each bond leg (long/short)
P/P
BE inflation == P has
1 1=$Duration
4.88/1092.46 of 8,464.16
1 == 2.09% 1+ real yield 1.0044
y 1+y z· P = 1.0044 0.001
4.475
• Therefore for a 1bps flattening, earn 8,464.16 x 0.0001 = $0.846 1+r 1.0244
BE inflation = 1 = 1 = 2.09%
T @P 1 1+ z 1.0044
Modified Duration 1 X = · ⇤
$D = t @y
· PV P (CFt )
(1 + y) t=1 @P 1
Modified Duration = ·
r ⇡ z + i ) i ⇡ r z =X 2.44%
T 0.44% = 2.00% @y P
P V ⇤ (CFt )
DM AC = t· 6
t=1 r P⇡ z + i ) i ⇡ r z = 2.44% 0.44% = 2.00
= 0.41% 2.85%
T
1 dP 1 X P V ⇤ (CFt )
DM OD = = t· = 0.41% 2.85%
Curve Flattener
• Therefore, for small moves in yields:
- If yields move up and down together by the same amount, no change
in value
- If yield difference decreases (yield curve flattens) you make money,
specifically $0.846 for every 1bp flattening
- If yield difference increases (yield curve steepens) you lose money .
specifically $0.846 for every 1bp steepening

In the News...

8
In the News...

In the News...

10
Curve Flattener
• What happens if the yield difference stays the same but yields move by a
larger amount?
• Value of the position (long bond B, short 4.40 bond A plus 3,406.20 cash):

16
P&L ($)
13.69
12
11.29

0
-3% -2% -1% 0% 1% 2% 3%
Amount all yields move by

11

Curve Flattener
• Positive P&L comes from different convexities (curvatures) of the two
bonds, specifically Bond B has higher convexity than position in Bond A:

1400
Bond B Value ($)

1200
4.4 units Bond A - $3,406
1000

800

600
-6% -4% -2% 0% 2% 4% 6%

Amount all yields move by

12
Curve Flattener
• Convexity is approximately the weighted average time squared to
cashflows (weights equal to contribution of PV of cashflow to total price)
- Details see Appendix (not required material)

• Here Bond B has higher convexity than 4.4 units of bond A

• Therefore overall position has positive convexity
• Positive convexity (while being duration hedged) means you have positive
P&L for large (parallel) moves in yields

13

Appendix – Convexity
(not required material)
 Convexity
• Convexity is a measure of :
- the curvature in the relationship between bond prices and yields
- how interest rate/yield sensitivity (duration) changes with yields

Price 30-yr ZCB with notional 1000

1000"

Price increases 103.7

if rates decrease by 800" $D=12,000
100bps
$D=8,894
600"
$D=6,611

400" Price drops 76.9 if rates

increase by 100bps

200"

0"
0%" 2%" 4%" 6%" 8%" 10%"
15
Interest rate/yield

Convexity
MFIN Financial Markets Credit Markets
INSEAD February 2015
• TwoMarkets
MFIN Financial basic types (defined with respect to yields): Credit Markets
INSEAD - Dollar Convexity ($Conv): February 2015
d2 P d$D
$Conv = 2
=
dy
d2 P dy
d$D
$Conv = =
dy 2 dy
- Normal or “Relative” Convexity (Conv):
= $DA · (0.08 yA ) 2.920 · $DB · (0.06 yB ) = 4903.364 [(0.08 0.06) (yA yB )]
$Conv 1 d2 P
Conv = =
P P dy 2
4903.364 + nB · 1679.239 = 0 or
= $DA · (0.08 yA ) 2.920 · $DB · (0.06 yB ) = 4903.364 [(0.08 0.06) (yA yB )]

1092.458 · 4.488 + nB · 889.996 · 1.8868 = 0

4903.364 + nB · 1679.239 = 0 or
16
pf A B
$D = nA · $D + nB · $D

pf nA·P4.488
1092.458 A + nBA · 889.996 · n
1.8868
B PB = 0 B
 X T CFt X T
P =X CFt t = X P V ⇤⇤ (CFt ) $Dpfpfpf==nnAA· ·$D
$D $DAAA++nnBB· ·$D
$DBBB
P = t=1 (1 + y)t = t=1 P V (CFt ) $D = nA · $D + nB · $D
t=1 (1 + y) t=1 n nAAPPAA nnBBPPBB
pfpf AA BB
XT $D $DM OD == n P · D
· DM OD + + n P · ·DDM OD
1 XT ⇤$D
M OD
pf
=
A A M OD
A B B
nnAAPPAA++nnBBPPBB · DM OD +nnAAPPAA++nnBBPPBB · DM M
B OD
$Conv = 1 t(t + 1) · P V ⇤ (CF
M OD
t ) n A PA + n B P B n A P A + n B PB OD
$Conv = (1 + y)22 t=1 t(t + 1) · P V (CFt )
Convexity – Expressions
(1 + y) t=1
T AA BB
1 X
XT P V ⇤⇤ (CFt ) ==wwAA· ·DDM OD ++wwBB· ·DDM OD
Conv = 1 t(t + 1) · P V (CF t ) = w · D
M
A OD
+ w · D BM OD
Conv = (1 +Zero 2
y) 2 t=1 t(t + 1)
Coupon Bond P · P A
Coupon Paying Bond M OD B M OD
(1 + y) t=1

XTX
T XTXT
F CFCFt t
P = F PP== XT
CF == XPPVV⇤ (CF
T ⇤
(CFt )t )
P = (1 + y)TT P =t=1 (1(1++ t
y)y)t t
= P V ⇤
(CF
(1 + y) t=1 t
t=1
t=1 t)
t=1 (1 + y) t=1
T (T + 1) 11 X TX T
$Conv = T (T + 1) ·P $Conv =
$Conv = Xt(t
T t(t++1)1)· ·PPVV⇤⇤(CF⇤
(CFt )t )
$Conv = (1 + y)22 · P (1 + 1y) 2 2
(1 + y) $Conv = (1 + y) t=1t=1t(t + 1) · P V (CFt )
(1 + y)2 t=1
TX
11 X T PPVV⇤ (CF
⇤
(CFt )t )
Conv
Conv== 1 X T t(t
t(t + + 1)
1)· · P V ⇤
Conv =
T (T + 1) 2
Conv = (1(1++y)y)22t=1 t=1t(t + 1) ·
PP t )
(CF
(1 + y)2 (1 + y) t=1 P
FF
T
X T
X
PP== Fy)T T
CFt ⇤ P = (1(1++ y)
P = t
= P V (CFt ) (1 + y) T
t=1 (1 + y) t=1
… (approx) weighted average squared time to Treceiving
T(T(T++1)1)cashflows
$Conv
$Conv == T (T + 21)2 · ·PP
dP 1 X T
$Conv = (1(1++y)y)2 · P
$D = = t · P V ⇤ (CFt ) (1 + y) 17
dr (1 + y) t=1
T
1 dP 1 X P V ⇤ (CFt )
$DM OD = = t·
P dr (1 + y) t=1 P

T
Using Convexity
(1 + y) dP X
to P V ⇤ (CFt )
Approximate Price Changes
AC = (1 + y) · D M OD = = t ·
P dy t=1 P

MFIN •Financial
Convexity can be used to give a better estimation of bond price changes
Markets Credit as
Markets
F
interest rates 1000
change
INSEAD
P = = February 2015
(1 + r) T (1 + r) 10
MFIN Financial Markets change in price, DP, for a small change in interest
- Approximate ratesMarkets
Credit
INSEAD Dy:
dP F February 2015
$D = =T· T +1 1
dr (1 + P r)⇡ $D · y + · $Conv · ( y)2
2
1000 1
= 10 · =P 5, ⇡
846.79$D · y + · $Conv · ( y)2
r)11 r=0.05 P % change in price, DP/P:
(1-+Approximate 2 1
⇡ DM OD · y + · Conv · ( y)2
P 2
1 dP 1 P F T 1 2
$DM OD = = · T · P ⇡T +1 D =M OD · y + 2 · Conv · ( y)
P dr P (1 + r) (1 + r)d2 P d$D
$Conv = =
dy 2 dy
10 d2 P d$D
= = 9.52 $Conv = =
1.05 dy 2 dy
$Conv 1 d2 P 18
Conv = =
P P dy 2
1000 1000 $Conv 1 d2 P
P = = Conv = =
(1 + r )T (1 + y)T 2
Using Convexity to Approximate Price Changes
• For example, approximating bond price changes for the 30-yr ZCB:

Price 30-yr ZCB with notional 1,000

1000"

800" Actual Price

600"

Approximation
using Duration only 400" Approximation using Duration
and Convexity

200"

0"
0%" 2%" 4%" 6%" 8%" 10%"
Interest rate/yield
19

Properties of Convexity
• Basic properties:
- coupon and yield constant, Conv increases with time to maturity
- maturity and yield constant, Conv is higher the lower the coupon
- coupon and maturity constant, Conv is higher the lower the yield

• Portfolio aspects:
- $Conv of a portfolio is given by weighting the $Conv of the individual
bonds by the number of units held
- Conv of a portfolio is given by market-value weighting the Conv of the
individual bonds

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Convexity Example
• Consider the 6yr 10% annual coupon bond with yield of 8% from Session #2:
t CF PV*(CF) at 8% t times PV*(CF) t (t+1) PV*(CF)
1 100 92.59 92.59 185.19
2 100 85.73 171.47 514.40
3 100 79.38 238.15 952.60
4 100 73.50 294.01 1,470.06
5 100 68.06 340.29 2,041.75
6 1100.00 693.19 4159.12 29,113.84
Sum 1092.46 5295.63 34,277.83

Price 1092.46
$ Duration 4903.36
Mod Duration 4.49
Mac Duration 4.85
$Convexity 29,387.72 = 34,278/1.082
Convexity 26.90 = $Conv/Price

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Convexity Example
• Convexity of bonds in curve flattener trade:

Modified
Coupon Yield Price $Duration $Conv Conv
Duration
A: 2-year 2.375% 2.5% 997.59 1923.91 1.929 5608.91 5.622
B: 10-year 2.75% 2.95% 982.90 8464.61 8.612 168,928 171.87

• Overall $ convexity of curve flattener trade= 168,928 -4.4*5,609 = 144,251 > 0

• In summary:
- Duration-neutral: hedged against small (parallel) moves in yields
- Positive convexity: positive P&L if large (parallel) moves in yields

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