Fixed Income

YIELD CURVE
CONSTRUCTION,
TRADING STRATEGIES,
AND RISK ANALYSIS
Fixed-Income Analysis
YIELD CURVE
CONSTRUCTION,
TRADING STRATEGIES,
AND RISK ANALYSIS
2011 CFA Institute
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ISBN 978-0-938367-42-0 (PDF)

March 2011
CONTENTS
MODULE 1
Interest Rate Measures

Par, Spot, Forwards, and Future Implied Spot Yields 1
MODULE 2
Full Valuation Approach

Effective Duration/Convexity and Key Rate Duration 21
MODULE 3
Yield Curve Trades

Computing and Decomposing Expected Returns 37
MODULE 4
Hedging Interest Rate Risk Using Caps and Floors 53

MODULE 5
Option-Adjusted Spreads (OAS) and Other Yield Spreads 71
Yield Curve Construction, Trading Strategies, and Risk Analysis

CONTRIBUTORS
Bernd Hanke, CFA, currently works as a consultant in the investment management
field. Until 2009, he was an asset manager at GSA Capital Partners LLP, a London-based
hedge fund; while there, he researched quantitative equity and portfolio management
in a market-neutral context. Prior to his time at GSA Capital, Dr. Hanke served as a vice
president in Quantitative Investment Strategies at Goldman Sachs Asset Management
in New York City, where he focused on quantitative equity return and risk modeling
that was used to manage long-only mutual funds as well as market-neutral hedge funds.
He received his PhD in finance from the London Business School, concentrating on
empirical asset pricing and the impact of liquidity on asset prices. Dr. Hanke became a
CFA charterholder in 2003.
Gregory G. Seals, CFA, is the director of Fixed Income and Behavioral Finance at
CFA Institute in Charlottesville, Virginia, where he develops educational content,
programming, conferences, and publications related to fixed income and behavioral
finance for charterholders. Prior to joining CFA Institute in May 2008, Mr. Seals spent
14 years at Smith Breeden Associates, most recently in the position of senior portfolio
manager and principal of the firm. He managed institutional core fixed-income
portfolios and specialized in investment-grade corporate debt. Mr. Seals has also
traded and managed portfolios of mortgage-backed securities. Prior to his money
management career, Mr. Seals taught introductory finance courses at California State
University and St. Josephs College in Indiana. Mr. Seals has a BS in finance and an
MBA from California State University.
Note: Biographical information is accurate as of the time of writing.
Yield Curve Construction, Trading Strategies, and Risk Analysis

5
MODULE 1
INTEREST RATE MEASURES

PAR, SPOT, FORWARDS, AND FUTURE IMPLIED SPOT YIELDS
Overview of Yield Measures

In your daily job of analyzing, trading, or managing bond portfolios,
you probably spend most of your time looking for new opportunities LEARNING OBJECTIVES
for the portfolio or going about your daily business in your specialty
without thinking much about the underpinnings of many of the
valuation models that you use. Perhaps you use a commercial system
1 Explain why spot rates
where bond cash flows are stored and a variety of valuation yield (zero-coupon rates) are
curves are offered for you to choose from. Alternatively, you may work appropriate rates for valuing
at a firm where you have proprietary valuation software. In either case, bond and derivative security
it may be helpful to you to dig a little deeper into how bonds are valued cash flows.
and the important relationships among yield measures commonly
used in the fixed-income world. This module on the yield curve and 2 Explain how implied future
risk analysis aims to provide that background and will hopefully cause spot rates are calculated.
you to understand better the methods behind the numbers that you
see nearly every day in your job. It will begin by reviewing some 3 Describe implied future spot
popular yield measures and will allow you to experiment with a rates as break-even rates.
Microsoft Excel spreadsheet designed to illustrate the linkages
between popular yield measures. This first module will also place a 4 Compute a barbellbullet
great deal of emphasis on the importance of forward rates for trade profit/loss given the
understanding how the yield curve is linked together as well as on
understanding the markets collective pricing of future interest rates.
spreadsheet.
For simplicity, the assumption throughout this module is that we are
discussing default-free government bond yields.
5 Mathematically show that
duration-neutral self-
A key concept in fixed-income analysis is the yield or interest rate, financing trades break even if
which many investors use either as a measure of a bonds expected forward rates are realized.
return or as a metric to measure relative value among bonds. A
number of different yield or rate measures, however, are commonly 6 Explain why interest rate
used, so our first job is to review these measures and discuss the
benefits and limitations of each interest rate measure. We hope this
views need to be carefully
review will provide you with a better understanding of the analyzed in the context of
interrelationships between yield measures and which measures are forward and implied future
most appropriate for valuation purposes. spot rates.
Some of the most common measures used are yield to maturity, par
yield, spot rate, and forward rate. Each of these measures will be
discussed in detail. It is commonly known that a yield curve is a graph
of bond yields plotted against their maturities or durations. But what
type of yield should an investor use to come up with the graph, and
how do yield curves based on different yield measures differ? In
addition, which yields are most appropriate to use when valuing
bond cash flows?
1
MODULE 1
Yield to Maturity. Yield to maturity (YTM) is the easiest place to start. YTM is the discount
rate that makes the bonds sum of discounted future cash flows equal to its market price.
Every bond has only one YTM. Although it is a simple and convenient measure, it has limiting
assumptions and many drawbacks. The biggest drawback of YTM is that it assumes bond
cash flows are reinvested at the YTM, which is an unrealistic assumption. In addition, YTM
ignores valid information contained in the term structure of interest rates (rates unique to
each maturity in the future).
Furthermore, constructing a yield curve from different maturities based on YTM ignores the
fact that bonds can trade at a different YTM based on whether they are discounts or
premiums. A partial improvement to this drawback is to use the par yield.
Par Yield. The par yield of a bond is the yield on a hypothetical or real bond whose price is
equal to par. In other words, it is the coupon rate required for a bond to trade at par for a
given maturity. Generally, the most recently issued bonds (the so-called on-the-run issues)
trade at prices close to par because their coupon rates tend to be set close to the current
market level of interest rates. So, par yield is a slight improvement over YTM, but it still suffers
from one significant drawback: It assumes investors can reinvest cash flows at the par yield.
Par Yield Summary
The par yield:

Is an improvement over YTM because it can produce a curve of yields for
equal (par) priced bonds.
Eliminates yield differences that may arise for premium and discount
priced bonds.
Is still inadequate for valuing unique cash flows because of the
reinvestment assumption.
Spot Rates (Zero-Coupon Rates). The spot rate measure addresses the problems
associated with YTM and par yield. A spot rate can be thought of as a zero-coupon bond
(zero) rate for a given maturity.
Zero-coupon bond rates (yields) do not depend on reinvestment assumptions. Another way
of saying this is that an investor can guarantee a return (yield) by purchasing a zero and
holding it to maturity. By graphing the yields on zero-coupon bonds, a spot rate curve can
be created. To price a bond, each cash flow can then be discounted at the prevailing spot
rate corresponding to the timing of the cash flow. For convenience, we are ignoring some
technical details regarding the construction of an arbitrage-free spot rate curve in order to
focus on concepts rather than the cumbersome process of term structure modeling.
2 2011 CFA Institute Yield Curve Construction, Trading Strategies, and Risk Analysis
2
MODULE 1
Spot Rate (Yield) Summary

The spot rate:
Is not subject to reinvestment risk.
Reflects the pure term structure of interest rates.
Is appropriate for discounting cash flows (bond and derivative security pricing).
Forward Rates and Implied Future Spot Rates. A spot rate, being a multiperiod rate, can,
in turn, be unbundled even further into a product of one-period forward rates. A forward rate
is a rate agreed upon today for a loan between any two future dates. Hence, a loan contract
may specify an interest rate of 6 percent on an amount borrowed one year from now and to
be repaid in two years. The 6 percent interest on the loan is called a one-year forward rate
starting one year from now. As a result, an n-year spot rate is simply a special case of an n-year

forward rate on a loan that starts today, at year t = 0, and matures n years from now.
In the same way that a current spot rate can be broken down into a product of one-period
forward rates, a future implied spot rate can be obtained using the one-period forward rates.
A future implied spot rate is a synthetic rate created by taking existing spot rates and
generating a future spot rate given current forward rates. For example, if the three one-year
forward rates beginning one, two, and three years from today are 6 percent, 6.5 percent,
and 7 percent, respectively, the implied future three-year spot rate one year from today can
be computed as a product of these forward rates, namely:
1/ 3
(1 + 0.06 ) (1 + 0.065 ) (1 + 0.07 ) 1 = 6.50%. (1.1)
Summary. Par yield and yield to maturity represent a one-rate summary measure of a
bonds yield. In practice, bond valuation models use a different spot rate to discount each
unique cash flow according to its timing. Forward rates are implied by existing spot or zero-
coupon rates. Forward rates can be very powerful tools for understanding the markets
collective pricing of future interest rates, which we will cover later in this module.
Yield Curves and Their Interpretation: Linkages between Par, Spot,

and Forward Rates
Each of the interest rate measures discussed earlier can be used to construct a yield curve,
and we should stress that all these yield curves contain the same information in the sense
that each type of yield curve can be computed from each other type. An intuitive
understanding of the relationship between the different yield curves and their interpretation
is crucial for fixed-income analysis.
Yield Curve Construction, Trading Strategies, and Risk Analysis 2011 CFA Institute 3
MODULE 1
To that effect, we will take a closer look at the spreadsheet used for this module. The
spreadsheet will allow you to obtain one type of yield curve from another and then examine
their interrelationships.
The first input box on your spreadsheet, labeled Please specify your type of inputs, allows
you to specify which type of bond information or interest rate you would like to input in
order to generate different types of yield curves.
The first option on the list (Bond Characteristics) requires that a set of bond prices,
corresponding coupons (in percent), and years to maturity be entered to generate yield
curves based on spot rates, forward rates, par yields, and implied future spot rates. The bond
maturity inputs should range from 1 year or less to 30 years, because this is the range used
for the yield curves that the program generates. Because the accuracy of the yield curves
generated increases as more bond maturities are entered, the algorithm requires that you
input at least four bonds of different maturities.
Alternatively, you may specify a set of spot rates, forward rates, or par yields (by choosing
the second, third, or fourth option listed in the first input box) to generate yield curves. For
convenience, the rest of the analysis and examples will assume that we are beginning with
spot or zero-coupon rates.
4
MODULE 1
One more input is needed to compute the implied future spot rate curve, namely its base
date. Any base date ranging from 1 year to 10 years from today may be selected using the
second input box:

Once these inputs are entered, Figure 1.1 shows the four yield curvesspot rate, one-period
forward rate (in the spreadsheet one period is one year), par yield, and implied future spot
rate. Note that in the graph, the horizontal axiss label, Maturity, corresponds to the
maturity of each rate measured in years from today. It is not necessarily equal to the period
covered by a certain rate. For example, a five-year maturity covers a period of five years
from today for a spot rate or par yield. However, it corresponds to a forward rate covering
a one-year period starting four years from today and maturing five years from today.
Figure 1.1. Rate Measures for Upward-Sloping Yield Curve
Rate Level (%)

8
7
6
5
4
3
2
1
0
1 2 3 4 5 6 7 8 9 10 15 20 25 30
Maturity (years)
Spot Rate One-Year Forward Rate
Par Yield Implied Future Spot Rate
MODULE 1
Similarly, the implied future spot rate at a five-year maturity covers a period starting N
years from today (with N specified by the user and being less than five years) and maturing
five years from today.
If you examine Figure 1.1, the first thing you will notice is that unless you entered a flat
yield curve to begin with (i.e., all rates were the same), the curves differ from each other.
Lets start with an upward-sloping spot rate curve. Either enter a monotonically upward-
sloping spot rate curve directly into the gray input box or enter the corresponding bond
characteristics that result in such a yield curve. As you will remember, upward sloping is the
most common yield curve shape observed empirically. Table 1.1 provides an example to
guide the discussion.
Table 1.1. Rate Table

Years to One-Year Implied Future

Maturity Spot Rate Forward Rate Par Yield Spot Rate
1 3.00% 3.00% 3.00%
2 3.60 4.20 3.59 4.20%
3 4.10 5.11 4.07 4.65
4 4.52 5.79 4.47 5.03
5 4.88 6.33 4.80 5.36
6 5.18 6.69 5.07 5.62
7 5.43 6.94 5.29 5.84
8 5.65 7.20 5.48 6.03
9 5.84 7.37 5.64 6.20
10 6.00 7.45 5.78 6.34
15 6.10 7.11 5.86 6.42
20 6.20 7.31 5.94 6.50
25 6.25 6.85 5.99 6.53
30 6.30 6.95 6.03 6.56
Notice that the forward rate curve lies above all other yield curves, followed by the current
spot rate curve and the par yield curve (in that order). The ordering is reversed for an inverted
(or downward-sloping) yield curve as shown in Figure 1.2.
This pattern makes intuitive sense. Forward rates magnify any variation in the slope of the
spot curve because they represent the marginal reward for extending the maturity by one
period (one year in our case). In contrast, spot rates, because they are the product of the
corresponding one-period forward rates, measure the average return from today until
maturity. Similarly, par yields are averages of different spot rates because they are a one-value
summary measure of a bonds yield. Therefore, the par curve is the flattest of all yield curves.
6
MODULE 1
Figure 1.2. Rate Measures for Downward-Sloping Yield Curve
Rate Level (%)

8
7
6
5
4
3
2
1
0

1 2 3 4 5 6 7 8 9 10 15 20 25 30
Maturity (years)
From the calculation of implied future spot rates illustrated in Equation 1.1, the location of
the implied future spot rate curve relative to the other yield curves is not as clear. It will
always lie above (below) the current spot rate curve if the spot rate curve is upward
(downward) sloping. The implied future spot rate curve, however, may lie above or below
the forward rate curve. Its relative location depends on the curvature of the spot rate curve.
If the spot rate curve is upward sloping but concave (i.e., it flattens out over the maturity
range), then the implied future spot rate curve portion toward the long end of the maturity
spectrum may lie above the forward rate curve because the marginal reward of extending
the maturity that is captured by the forward rate becomes very small (the corresponding
portion of the spot rate curve may be almost flat). Otherwise, the implied future spot rate
curve will lie above the forward rate curve if spot rates are upward sloping. Similar arguments
apply to downward-sloping spot rate curves. You can verify these relationships by entering
spot rate curves with different curvatures/concavities.
You will also notice from Figures 1.1 and 1.2 that the implied future spot rate curve always
touches the forward rate curve at its starting point, regardless of the base date chosen.
This is definitional. The first implied future spot rate covers the same period as the
corresponding forward rate. So, for example, if your implied future spot rate base date is
two years from today, then the first point on the curve will show up for a maturity of three
years from today (i.e., the first implied spot rate will start two years from now and mature
three years from now)the same as the corresponding one-period forward rate. All
subsequent points, however, will differ between the implied spot rate and the forward rate
curve because the former covers increasingly longer periods whereas the latter is a constant
maturity curveeach rate corresponds to the same interval, one year in our case.
MODULE 1
Role and Implications of Forward Rates

Forward rates have a useful interpretation that plays an important role in fixed-income
analysis: They can be viewed as break-even rates. Their interpretation can be easily seen
from the relationship between spot and forward rates. By construction, the future spot rates
one year from today implied by the corresponding forward rates, if realized, make all
government bonds earn the same return over the next year as the riskless one-year zero-
coupon bond. Near-term returns are equalized if all bonds with higher yields than the short-
term rate suffer capital losses that offset their yield advantage. Practically, this means that
any bet on interest rates is not a bet against the observed yield curve (whether par or
spot) but a bet against forward rates implied by the yield curve. An upward-sloping yield
curve and correspondingly higher forward rates may or may not mean that the market
expects higher future rates because it could be that the market is demanding higher risk
premiums to hold longer-term bonds relative to short-term bonds. We will not attempt to
answer questions regarding various term structure theories in this course but instead will
focus on practical applications of relationships and trades that consider forward rates and
implied future spot rates objectively.
For example, suppose you are considering either investing over the next two years in a
one-year zero (with spot rate s0,1) and then reinvesting the proceeds for a further year (at
rate s1,2) or investing in a two-year zero-coupon security (at spot rate s0,2). For $1 invested
now, the former investment generates a final value of (1 + s0,1) (1 + s1,2), whereas the
latter generates a value of (1 + s0,2)2 after two years. For the two alternative final portfolio
values to be the same, the following has to hold:
1 + s1,2 =
(1 + s0,2 )
2
. (1.2)
1 + s0,1
The right-hand side of the equation is just the definition of a forward rate ( f ), so the equality
holds whenever s1,2 = f1,2 , or in other words, when the realized one-year spot rate one year
from now equals the corresponding forward rate. Hence, the two alternative positions earn
the same return whenever the forward rate is equal to the subsequently realized spot rate.
Suppose the one-year spot rate, s0,1, equals 5.5 percent and the two-year spot rate, s0,2 ,
equals 6 percent, which implies a forward rate, f1,2 , of approximately 7 percent. The yield
premium of the forward rate above the spot rate is:
f1,2 s0,2 = 7% 6% = 1%. (1.3)
The positive difference between the two spot rates means that an investor is able to earn
a positive carry if he or she buys a two-year zero and finances this position by selling a
one-year zero. The investors profit will be equal to the carry plus any capital gains or losses
8
MODULE 1
caused by yield changes. The investor makes money on this position unless the two-year
spot rate rises above f1,2 over the next one year, causing the position to suffer capital losses.
Hence, the break-even yield change is f1,2 s0,2 , which would offset the carry effect. If the
yield curve does not change, then the carry, s0,2 s0,1, is equal to the rolling yield or horizon
return of a zero (the zeros maturity shortens by one year, or in other words, it rolls down
the yield curve to a shorter maturity).
As such, the forward rate is termed the break-even rate. So, if the yield changes implied by
the forward rates are subsequently realized, government bonds of all maturities earn the
same holding-period return. In addition, all self-financing positions break even (i.e., they
generate a zero return). Although in practice forward rates may not be great predictors of
future spot rates, it is imperative to understand that this is what is implied by the pricing
of bonds at any given time in the marketplace.
To illustrate these relationships further, enter the following spot rate curve on the

spreadsheet:
As Figure 1.3 shows, the spot rate curve is upward sloping but has a concave shape; it
flattens out over the maturity range.
Suppose an investor expects the spot curve to flatten between the three-year and the five-
year maturity over the next year. He could exploit his interest rate view by entering a
barbellbullet tradefor example, he could sell a four-year zero (say for $1 million) and
use the proceeds to buy equal market values ($500,000 each) of the two-year and six-year
zeros so that his aggregate position is duration neutral (i.e., unaffected by parallel yield curve
shifts and only affected by changes in the shape of the yield curve). Because the spot rate
curve is expected to flatten over a one-year horizon, the securities transacted are those
whose maturities correspond to the view after one year has passed.
MODULE 1
Figure 1.3. Example of Buying Two- and Six-Year Zeros and

Selling Four-Year Zero BarbellBullet Trade
Rate Level (%)
8
7
Buy
6
5
4 Sell
3
2
1
0
1 2 3 4 5 6 7 8 9 10 15 20 25 30
Maturity (years)
Spot Rate
Exercise:
Compute the carry of the just-mentioned barbell trade using the following
formula (carry is simply the yield differential between the long and short positions
in this trade):
Carry = Weight of two-year leg Two-year rate + Weight of six-year leg
Six-year rate Four-year rate.
Answer:
The position has a carry of 13 bps, which is computed as:
Carry = 0.5 3.60% + 0.5 5.18% 4.52% = 0.13%.
In dollar terms, this carry corresponds to $1,300 (0.13% $1 million) for the position
sizes just given. This negative carry is the result of the spot rate curve being concave and,
hence, the yield on the barbell portion of the portfolio (the long positions in the two-year
and six-year zeros) being lower than the yield on the bullet (the short position in the four-
year zero). Thus, to break even on the trade, the investor has to have capital gains of at least
13 bps, or $1,300, to overcome the negative carry of the position.
10
MODULE 1
In the second input box on the spreadsheet, choose to display the implied spot curve one
year forward:
Table 1.2 shows the same rates generated as in Table 1.1 but with a focus on the final
column (implied future spot rate) for this part of the discussion.
Table 1.2. Rate Table: Focus on Implied Future Spot Rate


1 3.00% 3.00% 3.00%
2 3.60 4.20 3.59 4.20%
3 4.10 5.11 4.07 4.65
4 4.52 5.79 4.47 5.03
5 4.88 6.33 4.80 5.36
6 5.18 6.69 5.07 5.62
7 5.43 6.94 5.29 5.84
8 5.65 7.20 5.48 6.03
9 5.84 7.37 5.64 6.20
10 6.00 7.45 5.78 6.34
15 6.10 7.11 5.86 6.42
20 6.20 7.31 5.94 6.50
25 6.25 6.85 5.99 6.53
30 6.30 6.95 6.03 6.56
The implied future spot curve (implied by the current forward rates) shows the rates at
which the barbellbullet position would exactly break even, which follows directly from our
previous discussion. As we mentioned, the future spot rates implied by the corresponding
forward rates, if realized, make all government bonds earn the same return over a given
horizon as the corresponding riskless zero-coupon bond. As a result, the realized returns on
each of the components of the duration-neutral barbellbullet trade offset each other so
that the combined trade breaks even.
Because the position starts with a negative carry, the implied future spot rate curve, as the
break-even curve, shows the amount of implied flattening in the spot rate curve.
MODULE 1
Exercise:
Perform the same carry calculation made earlier but this time using implied future
spot rates.
Answer:
Carry = Weight of two-year leg Two-year rate + Weight of six-year leg
Six-year rate Four-year rate.
Carry = 0.5 4.20% + 0.5 5.62% 5.03% = 0.1191%.
In dollar terms, this carry is equal to $1,191. This carry of 0.1191 percent is smaller (less
negative) than the carry of 0.13 percent calculated from spot rates. Why?
The carry implied by the future implied spot rate curve is smaller (less negative) because
the implied future spot curve needs to be flatter than the current spot rate curve for capital
gains on the position to offset its negative carry. Because the barbellbullet trade is set up
in a way that is duration neutral, parallel yield curve shifts will not affect the value of the
position. Positive capital gains can come only from a flattening spot rate curve.
Before we continue to analyze this trade further, a few definitions will help:
Rolldown return = Return generated on a bond as its maturity shortens. This will be
positive with an upward-sloping yield curve.
Rolling yield = A bonds horizon return given a scenario of unchanged yield curve; it is
the sum of the yield and roll-down return.
The return on the barbellbullet position can be obtained by decomposing it into a

rolldown return (i.e., the return achieved if the spot rate curve remains unchanged over
the next year) and the capital gains implied by the difference in the implied spot rate and
the unchanged spot rate curve scenario.
Now, lets look at the one-year forward rates (the third column in Table 1.3). From this
curve, we can calculate a rolling yield differential between the barbell and the bullet of
34.50 bps, computed as:
Rolling yield differential = Weight of two-year forward rate

Rate + Weight of six-year forward rate (1.4)
Rate Rate of four-year forward rate.
Rolling yield differential = 0.5 4.20% + 0.5 6.69% 5.79% = 0.3450%.
Thus, the four-year bullets rolling yield exceeds the barbells by 34.5 bps, or $3,450, on our
position. This is the loss we will suffer if the spot rate curve does not change over the one-
year horizon.
12
MODULE 1
Table 1.3. Rate Table: Focus on One-Year Forward Rate

1 3.00% 3.00% 3.00%
2 3.60 4.20 3.59 4.20%
3 4.10 5.11 4.07 4.65
4 4.52 5.79 4.47 5.03
5 4.88 6.33 4.80 5.36
6 5.18 6.69 5.07 5.62
7 5.43 6.94 5.29 5.84
8 5.65 7.20 5.48 6.03
9 5.84 7.37 5.64 6.20
10 6.00 7.45 5.78 6.34

15 6.10 7.11 5.86 6.42
20 6.20 7.31 5.94 6.50
25 6.25 6.85 5.99 6.53
30 6.30 6.95 6.03 6.56
This loss can be offset only if the yields on each of the zeros change as implied by the future
spot curve. Compared with an unchanged spot curve, this would imply the following capital
gains at the end of the one-year horizon:
Capital gains relative to unchanged spot curve

0.5 ( One-year implied spot rate Unchanged one-year spot rate )
( Duration at horizon ) + 0.5 (Five-year implied spot rate
Unchanged five-year spot rate) (1.5)
( Duration at horizon ) (Three-year implied spot rate
Unchanged three-year spot rate)
( Duration at horizon ) .
Capital gains relative to unchanged spot curve

0.5 ( 4.20% 3.00% )
( 1) + 0.5 ( 5.62% 4.88% )
( 5 ) ( 5.03% 4.10% )
( 3)
= 0.3400%.
MODULE 1
Note that Equation 1.5 uses durations, which for zero-coupon bonds equal their maturities.
As you will remember, duration is the approximate price sensitivity of a bond to a change
in interest rates. The relationship is only approximate because the priceyield relationship
is not exactly linear. Especially for long-duration bonds, convexity plays an important role
as well, which we ignore here for simplicity but will capture in Module 3.
To illustrate which inputs are needed for Equation 1.5, lets look at the shorter leg of the barbell.
The two-year zero has one year remaining to maturity at the end of our one-year holding
horizon. Therefore, its duration will be one year as well at that time. To compute the capital
gains on this zero-coupon bond relative to the unchanged spot curve scenario, we need to
compute the difference between its implied one-year future spot rate one year from now
(which is 4.20 percent) and the current one-year spot rate (which is 3.00 percent). This yield
difference is equal to the one-year spot rate one year from now if the spot curve remains
unchanged. This yield difference multiplied by the weight of the shorter leg in the barbell
and its duration after the one-year horizon gives the approximate capital gains on this
position relative to an unchanged spot rate scenario.
Performing these calculations on each of the legs of the barbellbullet trade results in an
approximate capital gain of 0.34 percent, or $3,400, for the entire position. This capital gain
approximately offsets the negative rolling yield differential, which illustrates that the trade
breaks even if the implied future spot rate curve is realized after one year.
Rather than breaking up the return on the barbellbullet trade into these two components,
we can illustrate the break-even relationship by simply revaluing the zero-coupon bonds
that make up the position after one year has passed and assuming that the implied future
spot rate curve is subsequently realized.
In particular, we can compute the value of the position as shown in Table 1.4 for a $1,000
zero-coupon bond face value.
Table 1.4. Alternative Example Showing Realized Forward Rates

Zero-Coupon Position Zero-Coupon Position
Years to Spot Implied Spot Rate Value Number of Value Value Value
Maturity Rate (1 year from now) (t=0) Bonds (t=0) (t=1) (t=1) Profit/Loss
2 3.60% 4.20% $931.71 536.65 $500,000 $959.66 $515,000 $15,000
4 4.52 5.03 837.92 1193.43 1,000,000 863.06 1,030,000 30,000
6 5.18 5.62 738.59 676.97 500,000 760.74 515,000 15,000
Total P/L $0.00
14
MODULE 1
In Column 4, Table 1.4 shows the zero-coupon bond values today (t = 0), which can be
computed from the spot curve (e.g., $1,000/(1 + 0.036)2 = $931.71 for the first bond). With
the position values given earlier for each of the three bonds, the number of bonds can be
computed as shown in Column 5. When we re-compute the bond values using the implied
future spot rate curve, we obtain the values shown in Column 7 (e.g., $1,000/(1 + 0.042) =
$959.66 for the first bond). The new position values and profit/loss on each position can
then be computed and are shown in the two last columns. The table demonstrates that if
the yield changes implied by the forward rate (and thus by the implied future spot rate) are
subsequently realized, then our self-financing barbellbullet trade earns a zero return (i.e.,
it breaks even).
In this sense, the forward curve and the implied spot rate curve can be viewed as break-even
conditions for a trade as well as a cheapness indicator. If the implied change of the yield
curve necessary for a trade to break even is historically wide, the trade can be considered
expensive, and vice versa.

Practice Questions
Question 1:
Choose the answer that best describes the relative location of the different yield curves for
an inverted spot rate curve (i.e., the spot rate curve is sloping downward).
A. Forward curve is above spot curve and par curve, in that order.
B. Forward curve, spot curve, and par curve are all equal.
C. Par curve, spot curve, and forward curve are in this order.
Question 2:
Suppose investors perceive longer-term bonds as being higher risk than short-term bonds,
and therefore, they require a higher yield on those securities as a risk premium. In that case,
choose the best statement regarding forward rates as break-even rates.
A. Forward rates can still be viewed as break-even rates.

B. If one accepts the risk premium hypothesis, then forward rates are not
break-even rates.
C. Forward rate analysis does not apply to the calculation of break-even rates.
Question 3:
Can forward rates be used in an informal way to spot cheap maturity segments?
A. No. All maturity segments are priced equally.

B. Yes. Forward rates magnify variations in spot rates, which can help to identify cheap
maturity segments.
C. Yes. You can guarantee profits using forward rate analysis.
MODULE 1
Question 4:
Suppose two-year and three-year spot rates are currently 6 percent and 6.5 percent, respectively.
Based on that information, compute the one-year forward rate one year from now.
A. 7.00%.
B. 7.51%.
C. 7.01%.
Question 5:
Suppose the current spot rate curve is as follows:
And suppose you expect the spot rate curve to steepen between the four-year and the six-
year maturity over the next year and you plan to capitalize on your yield curve view by entering
a barbellbullet position using zero-coupon bonds with initial maturities of three years, five
years, and seven years. Choose the answer that best describes how to set up this trade.
A. Buy equal market values of three-year and seven-year zeros and finance these
purchases by selling the five year, which equals the sum of the three year and
seven year.
B. Sell equal market values of three-year and seven-year zeros and use the proceeds
to buy the five-year zeros.
C. You cannot accomplish this trade with the instruments given.
16
MODULE 1
Answers
Question 1:
C is the correct answer. If the spot rate curve is inverted, the forward rate curve lies below
the spot rate curve, which lies below the par yield curve. Because forward rates represent
the marginal reward for extending the maturity by one period, they magnify any variation
in the slope of the spot curve (i.e., they will always be less than the corresponding spot
rates). In contrast, spot rates are computed as the product of the corresponding one-period
forward rates. They measure the average return from today until a cash flow is received, so
they will be higher. In turn, par yields are averages of different spot rates. Therefore, the par
curve is the flattest of the three yield curves and thus lies above the spot and forward rate
curves if the spot rate curve is inverted.

A is incorrect. This pattern coincides with an upward-sloping yield curve.
B is incorrect because these conditions would hold only if the spot rate curve were flat (same
rate at each maturity).
Question 2:
A is the correct answer. The fact that forward rates are break-even rates does not depend
on such assumptions as expectations, risk premiums, or convexity bias. If forward rates are
realized, all positions earn the same holding return and all self-financed positions earn a
zero return.
B is incorrect because the risk premium hypothesis is simply a conjecture about the shape
of the yield curve; it does not invalidate the mathematical truth of forward rates as break-
even rates.
C is incorrect because forward rates do represent a path of break-even future rates and
spreads. They provide a clear yardstick for an active portfolio managers subjective yield
curve view.
Question 3:
B is the correct answer. Because forward rates represent the marginal reward for extending
the maturity by one period, they magnify any variations in the spot rates. Therefore, they
can easily be used in an informal manner to visually identify cheap maturity segments in a
MODULE 1
yield curve graph because they magnify the cheapness/richness of different maturity
segments. To see this, enter the following spot rate curve on the spreadsheet as an example:
As Figure 1.4 shows, this spot curve is almost flat. The forward rate curve indicates, however,
that the 10-year maturity is relatively cheap. An investor could exploit this local cheapness
by buying a bond that matures 10 years from today and selling a bond that matures in 9 years.
Figure 1.4. Question 3 Rate Measures
Rate Level (%)

5.8
5.6
5.4
5.2
5.0
4.8
4.6
1 2 3 4 5 6 7 8 9 10 15 20 25 30
Maturity (years)
18
MODULE 1
A is incorrect because it is not true that there are never spikes in forward rates. There are
areas of the yield curve that are not smooth, and this lack of smoothness is highlighted by
using forward rates as a tool.
C is incorrect. Simply because a potentially cheap maturity sector has been identified does
not mean that profits will be realized through a trading strategy designed to exploit this
cheapness. There may be supply or demand reasons that are persistent for certain
maturities that cause unusual shapes in certain parts of the forward curve. Identification of
an abnormal shape does not guarantee profits.
Question 4:
B is the correct answer. The implied forward rate is 7.51 percent, computed as:
(1 + 0.065)3
1.

(1 + 0.06)2
A is incorrect. A simple additive process was used to arrive at a 7.0 percent forward rate.
(1 + 0.065)2 were used to arrive at a 7.01 percent
C is incorrect. Incorrect powers of 1
forward rate. (1 + 0.06 )1
Question 5:
B is the correct answer. To capitalize on your view using a barbellbullet trade, you would
sell equal market values (say $500,000) of the three-year and seven-year zeros and use the
proceeds (i.e., $1 million) to buy the five-year zero so that the overall position is duration
neutral (i.e., its value will not change if the spot curve shifts in a parallel manner).
A is incorrect because a steepening barbell trade is set up to buy the bullet and sell the
wings, or the shorter and longer maturities. A is an example of a setup for a flattening trade.
C is incorrect. Adequate securities and maturities are given to carry out this trade.
BIBLIOGRAPHY
Fabozzi, Frank. 2007. Fixed Income Analysis. 2nd ed. New York: John Wiley & Sons.
Geske, Teri. 2004. Effective Duration: Subtleties and Considerations. On the Edge, Interactive Data
Fixed Income Analytics quarterly newsletter (Third Quarter).
Ilmanen, Antti. 1995a. Overview of Forward Rate Analysis. Understanding the Yield Curve: Part 1.
New York: Salomon Brothers.
. 1995b. Markets Rate Expectations and Forward Rates. Understanding the Yield Curve:
Part 2. New York: Salomon Brothers.
MODULE 2
FULL VALUATION APPROACH

EFFECTIVE DURATION/CONVEXITY AND KEY RATE DURATION
Overview of Effective Duration and Convexity

(Full Valuation Approach) LEARNING OBJECTIVES
You are probably using duration and convexity measures on a daily
basis. However, have you ever asked yourself which type of duration 1 Explain how effective
is most appropriate for different types of securities and what are duration and convexity are
the various limitations of each? Duration measures the price computed and interpret
sensitivity of a bond for parallel interest rate movementsthat is, these risk measures.
the entire yield curve is assumed to shift by a given amount, such
as 25, 50, or 100 bps. 2 Explain the advantages of
the full valuation approach.
Whereas modified duration measures bond price changes for very
small shifts in a bonds yield to maturity, effective duration, or 3 Discuss the differences
between modified duration
elasticity, can be computed using any sensible yield curve shift that
and effective duration (elas-
the investor specifies. To compute the effective duration, the yield
ticity) and their usefulness
curve is shifted up by a certain amount, say 100 bps, and down by
for different bond structures.
the same amount; then bonds are valued in the shifted-case
scenarios to arrive at present value prices. The duration is then 4 Explain the differences
computed as a price elasticity or sensitivity to yield curve shift between historical and
scenarios. Throughout these modules, we will use effective duration implied interest rate
and elasticity synonymously to describe price sensitivity calculated volatility.
in this way. To value bonds with embedded options in this manner,
5 Show the effect of changing
an interest rate model needs to be used. An interest rate model
volatility on embedded
makes certain assumptions about interest rate behavior to create a option prices.
probabilistic description of how interest rates can change over the
life of a bond. Binomial interest rate trees are most commonly used 6 Explain and interpret key
for this purpose. rate durations and show how
they are computed and used
A binomial interest rate tree models how short-term interest rates in portfolio management.
change over time. Given an interest rate as well as an interest rate
volatility assumption, the binomial model assumes that interest
rates can realize one of two possible states over a given interval of
time. By breaking up the time to maturity of a bond into shorter
time intervals (such as one year or half a year), the interest rate
21
MODULE 2
behavior over the life of the bond can be modeled using a binomial interest rate tree.
Following is an example of such a tree:
If the steps in the tree are annual, then this interest rate tree can be used to value a bond
with a four-year maturity and annual coupon payments. Here, the current one-year rate is
5.00 percent, and according to the interest rate model used, the one-year rate can either
increase to 6.24 percent or decrease to 4.18 percent over the next year, and so on. Again,
the values in the tree are based on the current yield curve as well as the interest rate volatility
assumption in order to generate possible future interest rates.
Once an interest rate tree has been generated, the next step is to construct a bond price
tree using the interest rate tree. Following is an example of a bond price tree:
The bond price tree is constructed by successively discounting the bonds par value and
coupon payments using the rates from the interest rate tree and allowing for any
embedded options.
22
MODULE 2
A full description of different interest rate models that can be used to price bonds with
embedded options is beyond the scope of this text, and most fixed-income practitioners do
not need to know all the details and assumptions behind these models because they are
generally provided by standard commercial packages. As a result, we take the interest rate
model as given and describe how it is used in order to compute effective durations/convexity
metrics and key rate durations.
As described earlier, interest rates are shifted by a certain amount and bonds are
subsequently revalued under these different scenarios to come up with the effective
duration or elasticity. The formula is as follows:
V V +
Effective duration = , (2.1)
2V 0 y

where V + = bond value if yield is increased by y
V = bond value if yield is decreased by y
V 0 = original bond value
y = yield shift
To obtain each of the bond values required when the yield curve is shifted, investors need
to go through the following steps each time:
1. Using an interest rate model based on a yield curve obtained from on-the-run
government bonds, obtain the estimated bond value. Then compare the estimated bond
value with its market price and determine the spread that needs to be added to each
spot rate in the interest rate tree so that the estimated bond value equals its market
price. This yield spread is called the option-adjusted spread (OAS). We will describe in
Module 5 how the OAS is computed. For now, we will simply take it as given.
2. Shift the yield curve up/down by the desired amount (e.g., 50 bps), and for each shift,
construct a new binomial interest rate tree.
3. Add the OAS to each rate in the binomial rate tree, and use the resulting adjusted tree
to value the bond in a corresponding bond price tree.
As can be seen, the bond has to be revalued each time the yield curve is shifted. There is no
shortcut to this requirement. Therefore, this approach of coming up with a duration measure
is called the full valuation approach.
Contrast this method to modified duration, which practitioners tend to be most familiar
with. Modified duration can be computed using just one formula without having to revalue
the bond. The full valuation requirement may thus appear to be a disadvantage. However,
MODULE 2
the full valuation approach is actually a lot more flexible than modified duration because it
can be applied to many different types of fixed-income securities: option-free bonds,
callable bonds, putable bonds, different types of mortgage structures, and so on. In contrast,
modified duration cannot be used for security types whose cash flows change depending
on the level of interest rates. For example, consider a callable bond with a 7 percent coupon
and a call price of $105. The issuer of the bond has an incentive to redeem or call the bond
if interest rates decrease enough so that the bond price increases above its call price ($105).
Once the bond is called, its owner will obviously not receive any further coupon payments.
Therefore, a callable bond can be described from the investors point of view as:
Callable bond = Noncallable bond Call option value. (2.2)
Hence, the bonds cash flows and the timing of its cash flows depend on the level of future
interest rates and the probability of different interest rate scenarios, which are driven by
volatility assumptions.
To come up with a realistic interest rate volatility assumption, investors use either historical
volatilities or implied volatilities. Historical volatilities are simply computed as the standard
deviation of a historical interest rate series over a given time period. In contrast, implied
volatilities are obtained by taking market prices of traded options (interest rate caps, floors,
options on interest rate swaps, etc.) and solving for the implied volatility given an option-
pricing model. An advantage of the implied volatility approach is that it generates forward-
looking volatilities as opposed to past volatilities, which are obtained from the historical
volatility approach.
Although modified duration is very similar to effective duration for option-free bonds
(especially if the embedded options are far out of the money), modified duration cannot
deal with options and would, therefore, give unreasonable values if applied to bonds with
embedded options.
To further examine bonds with embedded options, lets take a look at the accompanying
Microsoft Excel spreadsheet. Make the following selections using the first three input boxes.
For now, lets ignore the differences between different selections. We will deal with this
later. Also, ignore the other input boxes for the moment.
24
MODULE 2
Below that, please make the following entries:
As we discussed earlier, the OAS is a function of a bonds market price as well as the inputs
used to construct the interest rate tree. For now, however, we just specify the OAS as a user
input. The last input means that the call option on the callable bond starts two years from

now. That is, the issuer will not be able to call/redeem the bond within the next two years.
After that, enter the following spot rate and annualized volatility curve to construct the
interest rate tree:
Note that the option-free bond value is not affected by the interest rate volatilities; only
the callable bond is affected. Its embedded call option will be more valuable to the bond
issuer the more volatile interest rates are. As a result, the callable bond value will be lower.
Once you have made all these inputs, press the Build Tree button to compute the effective
duration, modified duration, and other results.
MODULE 2
The following results should be displayed:

In addition, you may want to examine the binomial interest rate trees and bond price trees
that are used to revalue the bonds to compute effective durations and convexities. The trees
are shown below the Inputs and Results sections in the accompanying spreadsheet.
For now, lets just compare the last two values in the first numerical row. The effective
duration for the option-free bond is 7.19, and its modified duration is 7.11, a relatively small
difference, which simply comes from the fact that modified duration assumes a very small
yield change and effective duration was computed using a 50 bp up and down yield shift,
so it is picking up some positive convexity. You can check out for yourself that the difference
between the two values decreases if you use smaller yield shifts.
As you can see from the last value in the second numerical row, the effective duration of
the callable bond is much smaller, only 5.31. This difference is because the issuer will have
an incentive to call the bond once interest rates have decreased sufficiently (and will be
able to refinance its liabilities at lower rates) to push the bonds price above the call price
of $105. Further decreases in interest rates will not affect the bond price any more because
it will have been called and redeemed by that time. As a result, the callable bonds effective
duration or interest rate sensitivity is lower than that of the option-free bond.
The first two numerical columns in the results labeled Down and Up show the down
and up effective durations or elasticities. The down elasticity is computed as the difference
between the bond price when the yield curve is shifted down (and the bond price goes up)
and the original bond price divided by the original bond price times the yield difference. The
same is true for the up elasticity.
26
MODULE 2
As you can see, the down and up elasticities are different. Why is that the case? The reason
is convexity. Convexity arises because the relationship between interest rates and bond
prices is not linear. Convexity measures the curvature of this relationship.
Option-free bonds increase more in price for a given interest rate decline than they fall for
the same interest rate increase, which is reflected in the results. This is positive convexity,
which is a desirable property for investors. The down elasticity (7.35) is larger than the up
elasticity (7.02)that is, the option-free bond price increases more for falling interest rates
than it decreases for interest rate rises. This characteristic results in a positive convexity of
33.67, shown in the third numerical row.
The opposite is the case for callable bonds when the embedded options are deep in the
money. As you will remember from our earlier analysis, a callable bond will be called if
interest rates decrease below a level that causes the bond value to exceed the call price.

Therefore, if interest rates decrease, the callable bond price will not increase as much as the
option-free bond price, resulting in a lower down rate elasticity. This outcome can be seen
in the results: The down rate elasticity (5.10) is lower than the up rate elasticity (5.52). The
effective convexity of the callable bond is negative (42.08).
This convexity pattern can be seen from the bond priceyield relationship for option-free
and callable bonds, which is shown in Figure 2.1. The callable bond price gets capped out
at the call price as rates fall 200 bps.
Effective convexity is thus computed as follows:
V + + V 2V 0
Effective convexity = . (2.3)
2V 0 ( y )
2
In this way it measures the curvature in the priceyield relationship for different types
of bonds.
In general, the full valuation approach, which we show here, is used to come up with an
elasticity for any desired yield curve shift. Effective duration and effective convexity are just
special cases of elasticities that can be obtained using the full valuation approach. Both are
obtained using parallel shifts to the yield curve. Effective duration measures the relative bond
price change for a parallel yield curve shift, and effective convexity measures the curvature
in the priceyield relationship (i.e., it measures how much the effective duration changes
between an upward shift and a downward shift in the yield curve). Effective duration/elasticity
already encompasses effective convexity because the bond price change for a parallel yield
curve shift is affected by the convexity in the priceyield relationship. Nevertheless, to gain
a better understanding of the price dynamics of a bond, it is useful to break out the convexity
component and look at it separately from effective duration/elasticity.
MODULE 2
Figure 2.1. Bond PriceYield Relationship for Option-

Free and Callable Bonds
Price
120
115
Noncallable
110
105
Callable
100
95
90
85
300 200 100 0 100 200 300
Rate Change (bps)
Full Valuation Approach Summary

Modified duration, although computationally convenient, can be used only for option-
free bonds.
The full valuation approach is much more flexible and can be used for any type of bond.
Any type of elasticity can be computed using the full valuation approach and for any
desired yield curve shift.
Effective duration and effective convexity are the most commonly used special cases
of elasticities. Both are computed using parallel yield curve shifts.
Key Rate Durations

Effective duration is a bonds price sensitivity to parallel shifts in the yield curve. Although
yield changes across different points of the yield curve tend to be highly positively
correlated, they will generally not be the same. Hence, the yield curve is unlikely to shift in
a parallel manner.
28
MODULE 2
In a bond portfolio, a particular portfolio duration can be achieved using various sensitivities
to the short, medium, and long end of the yield curve. To effectively manage a portfolios
interest rate risk, the manager needs to be able to measure the portfolios sensitivity to
nonparallel shifts in the yield curve. This analysis is done using key rate durations (KRDs).
KRDs measure a bonds (or a portfolios) price sensitivity to a yield shift at one particular
point on the yield curve examined in isolation. A KRD is computed by shifting a specified
key spot rate by a certain amount (for example, 50 bps) while leaving all other spot rates
unchanged. Hence, the steps to compute a KRD are exactly the same as the ones for effective
duration; the only difference is that just a portion of the yield curve is shifted while the rest
of the curve is held unchanged.
Because only one key rate is shifted at a time to compute a KRD, it can easily be seen that
the sum of these partial durations has to equal a bonds effective duration. As a result,

KRDs decompose a bonds effective duration into its component parts, thereby providing
the portfolio manager a more detailed picture of the portfolios interest rate sensitivity to
nonparallel yield curve shifts.
Lets look at a KRD example in the accompanying spreadsheet. To compute a KRD, select
Key Rate Duration (KRD) in the second input box:
In the next few input boxes, make the following selections:
In this way, we shift only the five-year spot rate up and down by 50 bps. By specifying a
lower boundary of four years and an upper boundary of six years, we keep all spot rates up
to and including the four-year spot rate unchanged as well as all spot rates corresponding
to maturities of six years and beyond. Instead of these limits, we could have chosen a wider
boundary. For example, we could have specified 3 years as the lower boundary and 7
MODULE 2
years as the upper boundary. As a result, not only would the five-year rate have been shifted
but also the four-year and six-year rates would have been shifted in a proportional manner.
Figure 2.2 shows the yield curve shift that we have specified graphically.
Figure 2.2. Illustration of Shift in Five-Year Spot Rate
Rate (%)
7
6
4
1 2 3 4 5 6 7 8 9 10
Maturity (years)
Original Shifted Up Shifted Down
If you leave all other inputs unchanged and press the Build Tree button,
the following results are obtained:
30
MODULE 2
As you can see in the column labeled Total, the KRD is 0.24 for the option-free bond and
0.19 for the callable bond. This is the relative price sensitivity of each of the two bond types
to a 50 bp change in the five-year spot rate. Because all other maturity segments of the yield
curve are assumed to remain unchanged, the KRD is considerably smaller than the effective
duration we computed earlier and may be interpreted as a partial duration. At this point,
you may want to verify that all the individual KRDs add up to the effective duration.
In general, KRDs are particularly informative for bonds with embedded options. Consider
the callable bond we have been looking at in the accompanying spreadsheet. The callable
bond has a 10-year maturity, but it will be callable at a call price of $105 starting 2 years
from now. The bonds price will be particularly sensitive to a shift in the yield curve at the
2-year and the 10-year points. The change in the 2-year rate will greatly affect the likelihood
of the bond being called/redeemed by the issuer long before its maturity, and a shift in the
10-year rate will affect the present value of the principal payment expected at the final

maturity date. Although we know that the bonds effective duration will be somewhere
between 2 years (the call start date) and 10 years (the final maturity), examining the 2-year
and 10-year KRDs sheds additional light on the price sensitivities to shifts in particular key
yield curve segments.
Uses of KRDs include hedging applications, matching portfolio interest rate sensitivities to
those of a benchmark, and constructing trading strategies to exploit yield curve views that
a portfolio manager may have.
Because a bond portfolio managers performance is typically measured against some

benchmark index, the manager has an incentive to reduce sources of risk that she does not
expect to be compensated for relative to her benchmark. By matching her portfolios effective
duration with the benchmark, she will be protected only against parallel yield curve shifts
but not against shifts that are different for different maturities. A KRD analysis helps uncover
certain structural mismatches between the portfolio and the benchmark that are not readily
identified by using more crude summary measures, such as effective duration only.
Although it is unlikely that only certain key rates would change and all other spot rates
would remain exactly the same, comparing KRDs between a portfolio and its benchmark
helps find maturity sectors where duration mismatches exist, which the portfolio manager
can subsequently address by restructuring the portfolio.
In addition, KRDs can be used to optimally construct yield curve trades. Suppose a portfolio
manager expects the yield curve to steepen. He would like to adjust the weights of different
bonds in his portfolio to be able to capitalize on his view if it materializes. KRDs can help in
this case to find those bond issues with particularly high sensitivities to the desired segments
of the yield curve maturity spectrum. We will discuss these trading strategies in more detail
in Module 3.
MODULE 2
Practice Questions
Question 1:
Suppose you are given the following information: The yield curve is shifted up and down
by 100 bps. A bond has an original bond value of 101.13, a bond value of 104.45 if yields
are shifted down, and a bond value of 98.56 if yields are shifted up. What is the bonds
effective duration?
A. Cannot answer given the information provided.

B. 2.91.
C. 5.82.
Question 2:
Which of the following is a true statement? Modified duration:
A. Is computed in the same way as effective duration but can be used only for option-
free bonds.
B. Can be used only for bonds whose cash flows change with interest rate changes.
C. Can more easily be computed than effective duration, but it can be used only for
option-free bonds.
Question 3:
Which of the following is a true statement? Key rate durations:
A. Can be used only for option-free bonds.

B. Decompose the effective duration into bond price sensitivities to specific parts of
the yield curve.
C. Are more realistic than effective durations because the yield curve usually does not
change in a parallel manner.
Question 4:
Using the inputs specified below, compute the effective duration and convexity of
the callable bond:
32
MODULE 2

After you have computed the effective duration and convexity, increase the callability start
by three years
and then recompute the effective duration and convexity.
Which of the following is true? The callable bonds effective duration:
A. Increases by 1.29, and its effective convexity increases by 66.88.

B. Decreases by 1.29, and its effective convexity increases by 66.88.
C. Increases by 1.29, and its effective convexity decreases by 66.88.
MODULE 2
Answers
Question 1:
B is the correct answer. The effective duration is computed as follows:
V V +
Effective duration = .
2V 0 y
So we have:
104.45 98.56
Effective duration = = 2.91.
2 (101.13)( 0.01)
A is incorrect. The data needed to compute effective duration are given: beginning bond
value, up and down shifted bond values, and the amount of the interest rate shift.
C is incorrect. The answer 5.82 could be arrived at by leaving out the 2 in the denominator
of the effective duration calculation.
Question 2:
C is the correct answer. Modified duration is computed without having to revalue a bond
under different yield curve environments (as in the full valuation approach), but it can be
used only for bonds whose cash flows do not depend on interest rates (i.e., option-free bonds).
A is incorrect. Modified duration is computed differently from effective duration based on

the full valuation approach.
B is incorrect. Modified duration can be used only for option-free bonds, and it only works
well in isolation for very small yield curve shifts.
Question 3:
B is the correct answer. Key rate durations measure the price sensitivity of a bond to a shift
in a specific key rate chosen by the user with all other rates along the yield curve remaining
the same. The sum of all the key rate durations for different maturities equals the effective
duration. Hence, key rate durations decompose the effective duration into price sensitivities
to specific segments of the yield curve.
A is incorrect. Key rate durations, or partial durations, are useful for both option-free and
option-embedded bonds. They measure the distribution of duration across the yield curve.
C is incorrect. Although it is true that the yield curve does not routinely change in a parallel
fashion, it is incorrect to say that key rate durations are more realistic. Both effective and
key rate durations are useful analyses, and neither one dominates the other as a useful metric.
34
MODULE 2
Question 4:
A is the correct answer. Because the callability of the bond starts later, its effective duration
increases because it will be more sensitive to interest rate changes and more similar to the
option-free bond. In the original scenario, the effective convexity is negative because of the
call option. Because the callability will be more restricted if the callability starts later, the
effective convexity increases (i.e., it becomes less negative and closer to the convexity of
the option-free bond).
B is incorrect. Effective duration would not decrease when the beginning of the call period
is extended; it would increase. Another way to see this is that the option-free period is
now longer, which makes the bond more like a noncallable bond than it was previously.
C is incorrect. Effective convexity does not decrease when the option-free call period is

extended but increases. As the bond becomes more like an option-free bond, its convexity
profile should improve (increase).
BIBLIOGRAPHY
Geske, Teri. 2004. Effective Duration: Subtleties and Considerations. On the Edge, Interactive Data
Fixed Income Analytics quarterly newsletter (Third Quarter).
. 2007. Back-to-Basics: Key Rate Durations. On the Edge, Interactive Data Fixed Income
Analytics quarterly newsletter (Third Quarter).
MODULE 3
YIELD CURVE TRADES

COMPUTING AND DECOMPOSING EXPECTED RETURNS
Expected Returns on Bond Positions

Fixed-income portfolio managers and traders tend to have views
LEARNING OBJECTIVES
on the likely future changes in the yield curve. They attempt to
capitalize on these views by trading accordingly; for example, they
might use a barbellbullet trade. When evaluating different trading
1 Explain the importance of
thinking in terms of expected
strategies, it is vital to think in terms of expected returns and to
returns rather than just
understand the different sources of expected returns. As we will
yields.
show in this module, looking only at yields and yield spreads ignores
additional sources of return. Hence, an investor should care about 2 Outline how expected
expected returns rather than only yields. returns can be decomposed.
To compute the expected return of a trading strategy and a 3 Explain the benefits of the
corresponding bond position, a portfolio manager can simply revalue expected return decomposi-
the bond position under the expected yield curve scenario at the end tion and any uncertainty
of the strategy/investment horizon. The manager can then compute associated with estimating
the change in the value of the bond position given his or her expected the individual components.
change in the yield curve.
4 Explain how volatility
In addition to the total expected return that can be computed in this affects expected bond
way, the different sources of expected returns can be examined. In returns.
other words, the manager is able to break up return expectations
into their individual components.
Decomposing Expected Returns

One of the benefits of breaking up expected returns into different
components is that if a portfolio managers view changes, he is
able to pinpoint exactly how this change will affect his expected
return. Moreover, this decomposition facilitates breaking up the
expected return on a bond position into a component for an
unchanged yield curve (a useful base case) and a component for
a portfolio managers yield view relative to an unchanged yield
curve. The decomposition should thus help investors better
understand their own investment positions and any implicit bets
that are reflected in their positions.
37
MODULE 3
Equation 3.1 shows how the expected bond return can be decomposed into different
components:1
Expected return Yield income + Return on reinvested income

+ Rolldown return + Value of convexity
+ Expected capital gains/Losses based on (3.1)
investors interest rate view.
The yield income is simply the income that an investor receives from coupon payments
relative to the bonds price. Hence, it is equal to a bonds current yield times the strategy
horizon (h):
Coupon in $
Yield income = h. (3.2)
Current bond price
The return on reinvested income is the return that can be earned by reinvesting coupon
YIELD CURVE TRADES
payments at a bonds yield to maturity:
h 1 t
Return on reinvested income = Coupon in $ (1 + yn ) 1 , (3.3)
t =1
where yn is the bonds yield to maturity with the bond maturing n years from now. This
relationship assumes that a bondholder invests in a bond right after its coupon has been
paid so that the first coupon the bondholder receives will be paid a year after she invests in
the bond.
Rolldown Return. If the yield curve were certain to remain unchanged over the investment
horizon, then the investors total expected return would be the yield income plus the return
on reinvested income plus the rolldown return. The rolldown return was already discussed
in Module 1 and results from the capital gains/losses that are caused by the bond rolling
down the yield curve over the investment horizon toward a shorter remaining maturity.
The rolldown return is simply equal to the bonds percentage price change resulting from
an unchanged yield curve over the strategy horizon, h. Thus, the bond has to be revalued at
the end of the strategy horizon. If yields do not change, the rolldown return is:
Rolldown return = ( Bond pricen h Bond pricen ) / Bond pricen , (3.4)
where Bond pricenh is the bonds price at the end of the strategy horizon, h, for an
unchanged yield curve and n h years remaining until the bonds maturity.
1 Note that this decomposition is only an approximation, as we outline later.
38
MODULE 3
Value of Convexity. The value of convexity comes into play if the yield curve is not constant
but changes over time in level and shape. The higher the interest rate volatility, the higher the
value of convexity for an option-free bond.2 An investor with a long position in a bond always
benefits from convexity. If a bond has positive convexity (cx), then the bond price will increase
more if interest rates decrease and it will decrease less if interest rates increase compared
with a theoretical bond with zero convexity. This relationship can be seen in Figure 3.1.
Figure 3.1. Bond PriceYield Relationship
Price
Price/Yield Curve
YIELD CURVE TRADES

Linear Approximation
Yield
Therefore, whatever the future path of interest rates is, the expected return of a bond with
positive convexity will be higher than the expected return for a zero-convexity bond. This
return premium can be computed as the value of convexity:
2
Value of convexity = 0.5 100 cxn h Vol(yn h / yn h ) yn h h1/ 2

(3.5)
h
(1 + Rolling yield ) .
2 For
this analysis, we will only look at option-free bonds, such as U.S. Treasury bonds.
MODULE 3
Yield Volatility. Because yield volatilities (particularly implied volatilities obtained from
option prices) are typically quoted as relative volatilities[Vol(y/y)], where y is the yield
and y is a yield changethe volatility must be multiplied by the corresponding yield level
to obtain the type of volatility required.
As we have shown in Module 2, investors tend to use either historical volatilities or implied
volatilities to come up with an expected volatility. Historical volatilities are simply
computed as the standard deviation of a historical interest rate series. In contrast, implied
volatilities are obtained from an option-pricing model. To come up with an implied volatility,
an option embedded in a bond has to be assumed to be trading at its fair price and an option-
pricing model has to be assumed to be the model that will generate that fair price. In this
case, the implied volatility is the volatility that will result in the option-pricing model
producing the fair price of the option if the implied volatility is used as an input. An
advantage of the implied volatility approach is that it generates forward-looking volatilities
as opposed to the backward-looking volatilities that are obtained from the historical
YIELD CURVE TRADES
volatility approach. As mentioned earlier, the volatility estimate obtained is generally

quoted in relative terms.
Expected Return from Interest Rate View. Finally, the expected return component result-
ing from the investors interest rate view is added on to the relationship. This term would be
zero if the investor expected the yield curve to remain unchanged.
This expected return component is computed as follows:
h
Expected return from view = Dn h E ( yn h ) yn h (1 + Rolling yield ) , (3.6)
where Dnh is the modified duration of a bond at the end of the strategy horizon (i.e., a
bond with n h years remaining to maturity) and E(ynh) is the bonds expected n h-year
yield to maturity h years from now (as opposed to the current n h-year yield to maturity,
which is denoted by simply ynh).
We need to stress that the Equation 3.6 return decomposition is only approximate. For
example, only duration and convexity are used to summarize the priceyield relationship,
and all higher-order terms are ignored. Although the approximation of the expected return
decomposition is generally precise for zero-coupon bonds, for coupon-paying bonds, the
return decomposition is more inaccurate, particularly for longer-term bonds. The reason for
the lack of accuracy is that in addition to ignoring higher-order terms in the priceyield
relationship, the return decomposition uses a different coupon reinvestment rate for
different bonds because the yield-to-maturity measures that are used implicitly assume
that all intermediate cash flows of the bond are reinvested at the same rate, namely the
yield to maturity.
40
MODULE 3
There are two potential components in the expected return decomposition that we have
ignored so far, namely local richness/cheapness effects as well as potential financing
advantages. Local richness/cheapness effects are deviations of individual maturity sectors
from the fitted yield curve obtained using a curve estimation technique. Because yield curve
estimation techniques are designed to produce relatively smooth curves, there will be slight
deviations along the curve. In addition to local richness/cheapness effects are financing
advantages to certain maturity sectors in the repo market. In most cases, these two effects
tend to be relatively small, and often, the two effects at least partially offset each other.
Therefore, we have not included these effects in the expected return decomposition shown
in Equation 3.6.
In general, the impact of the yield view often dominates the other components, particularly
if an assets duration is relatively long and the strategy/investment horizon is short.
Decomposing Expected Returns Summary
YIELD CURVE TRADES

Expected returns on bond positions can be broken up into the following components:
Yield income,
Return on reinvested income,
Rolldown return,
Value of convexity, and
Expected capital gains/losses based on the investors interest rate view.
Estimating the Inputs Used to Decompose Expected Returns

There are differences regarding how easily each of the individual components of the
expected return can be measured. The expected return component that is easiest to measure
is the yield income. The rolldown return and the return on reinvested income, although still
relatively straightforward to measure, depend on the curve-fitting technique used. Even
more uncertainty is associated with the value of convexity, which depends on the interest
rate volatility and thus the volatility estimation technique. The most uncertainty is, of
course, associated with an investors own personal view on future changes in interest rates.
This view can be based on purely qualitative/subjective criteria or, alternatively, on a
quantitative model. Although the quantitative approach may sound more objective, the
choice of quantitative model itself remains largely subjective, especially because a
multitude of quantitative models are available that can be used.
MODULE 3
Decomposing Expected Returns: A Practical Example

Lets take a look at a practical example to illustrate how the total expected return of a
trading strategy can be computed and how it can be broken up into different components.
Suppose an investor has a barbellbullet position in bonds with remaining maturities of 2

years, 5 years, and 10 years. The investor is long and short an initial value of $1,000,000,
and the strategy horizon is one year.
Make the following inputs in the accompanying spreadsheet to reflect this scenario:
YIELD CURVE TRADES
The investor has computed the current spot rate curve and expected future spot rates and
has obtained the corresponding yield volatilities.
42
MODULE 3
As Figure 3.2 shows, these inputs correspond to an expected steepening in the spot
rate curve.3
Figure 3.2. Current and Expected Future Spot Rates
Spot Rate (%)

4.5
4.3 Expected Future Spot Rate
4.1
3.9
3.7
YIELD CURVE TRADES

3.5 Current Spot Rate
3.3
3.1
2.9
2.7
2.5
1 2 3 4 5 6 7 8 9 10
Years from Now Until Maturity
Analysis of Decomposing Expected Returns Example. Given these inputs, the investor
is able to compute bond prices and other bond characteristics both now and at the end of
the strategy horizon based on how she expects the spot rate term structure to change. By
3 Remember the maturity convention being used in the spreadsheet. Yields are aligned in number of years
from now until maturity. Therefore, a bond with a remaining maturity of one year at the end of the strategy
horizon one year from now will be shown as having two years from now remaining until maturity.
MODULE 3
comparing current with future expected bond values, she is able to compute total expected
returns or expected profits and losses on her positions as can be seen in the following:
YIELD CURVE TRADES
44
MODULE 3
The total expected return (or expected profit/loss) can be decomposed as follows:
YIELD CURVE TRADES

With weights of 0.5, 1, and 0.5 in Bond 1, 2, and 3, respectively, the total expected return
of the position computed from the individual return components is:
Total expected return = 0.5 3.20% + 1 3.05% 0.5 0.46% = 1.22%.. (3.7)
In contrast, the total expected return computed from revaluing each of the bonds at the
end of the strategys horizon based on the expected interest rate scenario and adding the
future value of the coupon payments (Vnh) is:
V V
Total expected return = 0.5 1,n h 1 + 1 2 ,n h 1
V V
1,n 2 ,n
V
0.5 3,n h 1
V
3,n
$500, 943 $15, 028
= 0.5 1 (3.8)
$500, 000
$991, 289 + $38, 915
+ 1 1
$1, 000, 000
$479, 624 $22, 803
0.5 1
$500, 000
= 1.18%,
MODULE 3
where, for example, V1,nh is the value of the position in Bond 1 at the strategy horizon, which
is the sum of the value of the bond position plus the future value of the reinvested coupon.
Clearly, the two expected return values differ slightly in Equations 3.7 and 3.8. This difference,
however, is expected because the return decomposition used is only an approximation.
Analysis of Individual Return Components. In the following, we will go through each

component of the total expected return and illustrate how it is computed. As an example,
we will focus on Bond 2.
1. Yield income: The yield income for Bond 2 is just its current yield times the strategy
horizon in years (i.e., its coupon divided by the bond price times the strategy horizon):
Coupon in $ 4
Yield income = h = 1 = 0.0389 or 3.89%.
Current bond price 102.79
2. Return on reinvested income: This is the return that can be earned by reinvesting the
YIELD CURVE TRADES
coupon payments at the bonds yield to maturity:
h 1 t
Return on reinvested income = Coupon in $ (1 + yn ) 1 = 4 (1 1) = 0.00%,
t =1
where yn is the bonds yield to maturity. This term is 0 for Bond 2 because the strategy
horizon is only one year. Therefore, the first coupon payment arrives at the end of the
strategy horizon, too late to earn any return over the strategy horizon.
3. Rolldown return: As outlined earlier, the rolldown return equals the capital gains/losses
that are the result of the bond rolling down the yield curve over the investment horizon
toward a shorter remaining maturity. It is simply computed as the bonds percentage
price change resulting from an unchanged yield curve over the strategy horizon, h:
Rolldown return = ( Bond pricen h Bond pricen ) / Bond pricen

= (1011.87 102.79 ) / 102.79 = 0.90%
0.89% from the Decomposition of Expected Horizon
Returns table given earlier; differrence due to rounding.
4. Rolling yield: The rolling yield is simply the sum of the yield income, the return on
reinvested income, and the rolldown return:
Rolling yield = 3.89% + 0.00% 0.89% = 3.00%.
46
MODULE 3
5. Value of convexity: For option-free bonds, the curvature in the priceyield relationship
of a bond is always positive (i.e., the relationship is convex). Therefore, if interest rates
change, an investor with a long position in a bond benefits from convexity (cx). The
value of convexity for Bond 2 is computed as follows:
2
Value of convexity = 0.5 100 cxn h Vol(yn h / yn h ) yn h h1/ 2

(1 + Rolling yield ) h
(
= 0.5 100 0.17 0.1722 0.0348 11/22 )2 (1 + 0.03)1
= 0.0003 or 0.03%.
Note that the yield volatility (17.22 percent), as given in the Bond Position Values table
shown earlier, is obtained by linear interpolation from the volatility term structure
specified by the user. It is the volatility that corresponds to a duration of 3.78 years,
YIELD CURVE TRADES

which is the duration of Bond 2 at the end of the strategy horizon (again as shown in
the Bond Position Values table given earlier).
6. Duration impact from view (or expected return from view): This is the impact of the
expected spot rate curve change on the return of the bond position:
Expected return from view = Dn E ( yn h ) yn h (1 + Rolling yield ) h
= 3.65 ( 0.0348 0.0349 ) (1 + 0.03)

1
= 0.04%
0.02% from the Decomposition of Expected Horizon
Returns table given earlier; difference due to rounding.
This information is shown graphically for all three bonds in Figure 3.3.
Summary of Main Points

Bond positions/trading strategies should be evaluated by examining their
total expected return rather than only yield income.
Decomposing total expected returns allows investors to differentiate
between expected returns given static market conditions and expected
returns resulting from their own yield view.
The expected return decomposition further helps investors understand
their bond positions and any implicit bets associated with them.
The expected return decomposition is only an approximation, and some
components are more difficult to estimate than others.
MODULE 3
Figure 3.3. Expected Return Given Rate View of Bond 1, 2, and 3

Expected Return (%)
5
3
YIELD CURVE TRADES
4
2 5 10
Maturity (years)
Yield Income Rolldown Return Value of Convexity

Duration Impact of Yield View Total Expected Return
Practice Questions
Question 1:
Suppose you have a long position in an option-free bond. As the yield volatility across the
maturity spectrum increases, how does the expected return on your bond position change?
The expected return on the bond position:
A. Increases as the value of convexity increases.
B. Increases because yields are more likely to rise than fall.
C. Decreases because yields are more likely to rise and bond prices more likely to fall now.
Question 2:
Suppose the current spot rate curve is flat and equal to 4 percent. If you are holding a zero-
coupon bond with five years remaining to maturity and you expect no yield changes over
the following year, which of the following is a true statement?
The total expected return over the following year is:
A. Less than 4%.
B. Equal to 4%.
C. More than 4%.
48
MODULE 3
Question 3:
Which of the following is the best answer for why the approximation of the expected return
decomposition given earlier in this module is less precise for coupon bonds than for zero-
coupon bonds?
The approximation is less precise for coupon bonds because:
A. The yield income is more ambiguous for coupon bonds.

B. Richness/cheapness effects tend to be larger for coupon bonds.
C. The priceyield relationship is approximated by using only duration and convexity.
Question 4:
Suppose the yield curve remains unchanged from the scenario discussed earlier in this
modulethat is, make the following entries on the accompanying spreadsheet:
YIELD CURVE TRADES
MODULE 3
What is the total expected return of the barbellbullet strategy?

The total expected return is closest to:
A. 0.58%.
B. 0.06%.
C. 0.35%.
Question 5:
Suppose you hold a long position in a bond with one year remaining to maturity. Your
holding horizon of the bond is one year. The current spot rate curve is flat and equal to 5
percent. All other inputs are as in Question 4 above. What is the total expected return on
the bond with one year remaining to maturity?
A. 4.80%.
B. 4.90%.
YIELD CURVE TRADES
C. 5.00%.
Answers
Question 1:
A is the correct answer. An investor with a long position in a bond always benefits from
convexity. If a bond has positive convexity, then the bond price will increase more if interest
rates decrease and it will decrease less if interest rates increase compared with a theoretical
bond with zero convexity.
B is incorrect. An increase in yield volatility is unrelated to the likelihood of rates increasing
or decreasing. Furthermore, a rise in interest rates would decrease the return of a long
position in an option-free bond.
C is incorrect. An increase in yield volatility is unrelated to the likelihood of rates increasing

or decreasing.
Question 2:
C is the correct answer. Although you do not expect the yield curve to change, the value
of convexity is still positive because there is uncertainty associated with future yield
movements. Therefore, the total expected return is larger than the yield income.
A is incorrect. Because the value of convexity is always positive for a zero-coupon bond, the
total expected return cannot be less than 4 percent.
B is incorrect. The value of convexity for a zero-coupon bond is positive, and this answer
ignores any value for convexity.
50
MODULE 3
Question 3:
A is the correct answer. The return decomposition approximation is less precise for coupon
bonds because to come up with a yield summary measure for coupon bonds, a particular
reinvestment rate has to be assumed for all coupons. The most commonly used yield
income measure, yield to maturity, implicitly assumes that all coupons are reinvested at
the same rate, namely the yield to maturity. This assumption is unrealistic except when
the yield curve is flat.
B is incorrect. Richness/cheapness effects are deviations of individual maturity sections from

the fitted yield curve. Whether the richness/cheapness effects are larger for coupon bonds
or zero-coupon bonds depends on the estimation techniques used to set the yield curve.
They could be larger or smaller.
C is incorrect. The priceyield relationship is approximated by using only duration. Including

convexity increases the precision of the priceyield relationship.
YIELD CURVE TRADES

Question 4:
B is the correct answer. The total expected return of the individual bonds is:
Therefore, the total expected return is:
Total expected return = 0.5 3.10% + 1 3.41% 0.5 3.84% = 0.06%..
A is incorrect. The total expected return of the bulletbarbell strategy equals the total
expected return on the intermediate-term bond less the equally weighted average total
expected return of the short-term and long-term bond.
MODULE 3
C is incorrect. The total expected return of the bulletbarbell strategy equals the total
expected return on the intermediate-term bond less the equally weighted average total
expected return of the short-term and long-term bond.
Question 5:
C is the correct answer. In this case, the one-year bond is held until maturity, so the yield
income from the bond is equal to the total expected return. There is no uncertainty
associated with the bond return because yields are locked in once the bond is purchased
and then held to maturity.
A is incorrect. In this case, the total expected return of the bond is equal to its yield
to maturity.
B is incorrect. In this case, the total expected return of the bond is equal to its yield
to maturity.
YIELD CURVE TRADES
BIBLIOGRAPHY
Ilmanen, Antti. 1995a. Convexity Bias and the Yield Curve. Understanding the Yield Curve: Part 5.
. 1995b. A Framework for Analyzing Yield Curve Trades. Understanding the Yield Curve: Part 6.
52
MODULE 4
HEDGING INTEREST RATE RISK USING CAPS AND FLOORS
Overview of Caps and Floors

In many instances, a fixed-income portfolio manager may wish to
LEARNING OBJECTIVES
protect the portfolio against interest rate movements. For example,
if the manager has a long position in a floating-rate bond (i.e., a bond
whose coupon varies with the level of some reference rate, such as
1 Explain how caps and floors
can be used to hedge interest
three-month LIBOR), he may wish to protect against interest rate
rate risk.
decreases, which would reduce the coupon income received from
the bond. In contrast, if the manager has a floating-rate liability, he 2 Outline the valuation of
may want to protect against interest rate increases, which would these instruments.
increase his cost of borrowing. By using caps and floors, the manager
can accomplish these goals. 3 Explain the payoff profile of
bond positions combined
Similarly, complex fixed-income securities contain embedded
with caps, floors, and collars.
interest rate caps and/or floors, which investors may wish to hedge
by purchasing a cap or floor in the over-the-counter derivatives 4 Demonstrate how zero-cost
market. A cap gives its holder a positive payoff if a reference interest collars can be obtained.
rate exceeds a certain strike rate and no payoff if it remains below
the strike rate. The payoff in this case is equal to the difference 5 Compare caps and floors
between the interest rate and the strike rate times the notional with options on bonds.
amount of the agreement. A floor is just the opposite of a cap. It
gives the holder a positive payoff if the interest rate is below the 6 Describe the price behavior
strike rate and no payoff otherwise. Again, if there is a positive of embedded caps and floors
payoff, it is equal to the difference between the interest rate and the in floating-rate securities.
strike rate times the notional principal of the agreement.
Caps and floors provide this payoff at the end of each agreed-upon
period for the tenor of the cap/floor agreement. Usually, these periods
are matched with a coupon payment frequency when the cap or floor
is combined with a bond position. This payoff structure makes caps/
floors equivalent to packages of European interest rate options, called
caplets and floorlets, respectively, where each caplet/floorlet expires
at the end of a period corresponding to the cap/floor frequency.
Note that a cap/floor is not simply equal to one interest rate option
but, rather, a package of independent options, each with the same
strike rate, where each option makes a single payoff once it has been
exercised and then ceases to exist. For example, a three-year cap on
53
MODULE 4
six-month LIBOR contains six caplets. The first caplet expires in 6 months, the second expires
in 12 months, and so on. Unlike a cap/floor, a single option makes a single payoff once it
has been exercised and then ceases to exist. We will examine the relationship between caps/
floors and the corresponding caplets/floorlets more closely in the next section.
Because we are dealing with packages of options whose values depend on volatility levels,
we need to again estimate interest rate volatilities and construct interest rate trees in order
to value the caps and floors.
In Module 2, we outlined how either historical volatilities or implied volatilities can be used
to come up with a volatility estimate to value caps and floors. For the purposes of this
discussion, we will simply take interest rate volatility estimates as given, but not because
volatility is unimportant. Volatility is a key driver of interest rate option values, and serious
traders and hedgers study volatility patterns extensively in deciding when to buy and sell
interest rate options for hedging or speculative purposes. Our focus here is to look at the
drivers of cap and floor values rather than to have a detailed discussion of estimating
volatility, which tends to be an experienced-based art.
Valuation of Caps and Floors

Lets use a practical example to illustrate how caps and floors are valued. Suppose we have
the following interest rate tree, which we obtained from a term structure model as in
previous modules. A binomial interest rate tree models how short-term interest rates change
over time. Given an interest rate as well as an interest rate volatility assumption, the
binomial model assumes that interest rates can realize one of two possible states over a
given interval of time. By breaking up the time to maturity of a bond into shorter time
intervals (such as one year or half a year), the interest rate behavior over the life of the bond
can be modeled using a binomial interest rate tree.
Based on this interest rate tree, we would like to value a three-year cap with a strike rate
of 6 percent, annual payment frequency, and a $100 notional amount.
54
MODULE 4
The value of the three-year cap is equal to the sum of the values of the corresponding caplets,
or European interest rate options with one of them expiring at the end of every period:
Value of three-year cap = Value of one-year caplet + Value of two-year caplet

+ Value of three-year caplet. (4.1)

The corresponding cap price tree is as follows:
To compute the caplet values and the resulting cap values, we can again use backward
induction (i.e., we go through the interest rate tree starting from the last period, Year 3 in
this case). In Year 3, the value of the cap is simply equal to the value of the three-year caplet
because the one-year and two-year caplets will have expired by the time we get to Year 3.
So, for example, the value of the cap in Year 3 at the top interest rate node can be calculated
as follows:
Max ( Rate Strike rate, 0 ) Notional

Cap value =
1 + Rate
(4.2)
Max ( 0.0883 0.06, 0 ) $100
= = $2.60.
1 + 0.0883
Note the term (1 + Rate) in the denominator. This term is needed because the payoff of the
cap is not received until one period later. The settlement payments for caps and floors are
in arrears. As a result, the cap payoff in Year 3 does not take place until the end of Year 3,
or four years from now. Hence, the payoff has to be discounted back one period using the
appropriate interest rate.
MODULE 4
To obtain the values of the cap one period earlier (i.e., Year 2), we need to discount the Year
3 cap values and add the value of the two-year caplet at that time to the discounted value.
Thus, using the cap values in Year 3 from the tree just given, the Year 2 cap value at the
highest node is computed as follows:
0.5 Cap3up + 0.5 Cap3down

Cap value = + Caplet 2

1 + Rate
0.5 Cap3up + 0.5 Cap3down
= (4.3)
1 + Rate
Max ( Rate Strike rate, 0 ) Notional
+ .
1 + Rate
So, we have:
0.5 $2.60 + 0.5 $0.36

Cap value =
1 + 0.0754
(4.4)
Max ( 0.0754 0.06, 0 ) $100
+ = $2.81.
1 + 0.0754
In Year 1 (i.e., one period earlier), the cap value is again obtained by discounting the
appropriate cap values from Year 2 and adding the one-year caplet value to it. Hence, the
cap value at the top node in Year 1 is:
0.5 $2.81 + 0.5 $0.17

Cap value =
1 + 0.0624
(4.5)
Max ( 0.0624 0.06, 0 ) $100
+ = $1.63.
1 + 0.0624
This calculation is repeated until we have obtained the current value of the cap. The value
of a floor is computed using exactly the same methodology. The only difference is that the
payoff of the floor is Max(Strike rate Rate, 0). Hence, it pays off a positive amount if the
interest rate is below the strike rate rather than above.
56
MODULE 4
The price tree for a floor with a 6 percent strike rate and a notional amount of $100 based
on the interest rate tree just given is as follows:

For example, the floor value at the lowest node in Year 3 is computed as:
Max ( Strike rate Rate, 0 ) Notional

Floor value =
1 + Rate
(4.6)
Max ( 0.06 0.0334, 0 ) $100
= = $2.57.
1 + 0.0334
Again, earlier floor values are obtained by discounting the probability-weighted sum of later
floor values and successively adding the values of the shorter-term floorlets. For example,
the floor value at the lowest node of Year 2 is computed as:
0.5 $1.32 + 0.5 $2.57 Max ( 0.06 0.0366, 0 ) $100

Floor value = +
1 + 0.0366 1 + 0.0366 (4.7)
= $4.13.
If a cap or floor is combined with a floating-rate bond, the cash flows (coupon payments)
from the floater can be modified as is illustrated in Figure 4.1.
The coupon of a pure floating-rate bond is equal to the relevant LIBOR reference rate at
the time. So, the relationship between LIBOR and coupon payments/cash flows is just a
straight line. If the floater is combined with a long position in a floor that has a 5 percent
strike rate, then the cash flows from this position are as shown by the dotted red line. With
a 5 percent floor, the minimum coupon rate is 5 percent, whereas the maximum rate is still
unlimited. In contrast, combining a floater with a short position in a cap that has a 5 percent
strike rate gives the cash flow profile depicted by the solid green line. With a 5 percent cap,
the maximum coupon payment/cash flow for this structure is 5 percent. So, if we hold a
floating-rate bond and combine it with a short cap, we give up the potential to earn a coupon
rate above 5 percent. At the same time, however, we are able to collect the option premium
from selling the cap.
MODULE 4
Figure 4.1. Cash Flows of Different Structures
Cash Flow of Structure (%)

12
10
0
0 1 2 3 4 5 6 7 8 9 10
LIBOR (%)
Floating-Rate Coupon Floater plus Long Floor (Strike Rate = 5%)
Floater plus Short Cap (Strike Rate = 5%)
The value of a structure that combines a floating-rate bond with a cap or floor is simply
equal to the value of the floater plus or minus the value of the cap/floor depending on
whether we have a long or a short position in the cap/floor. The value of the floating-rate
bond in isolation is always equal to its notional value, which will normally be 100 because
the floating-rate coupon is equal to the rate used to discount cash flows.1 For the purposes
of this analysis, we are assuming a floating-rate bond with no credit or prepayment risk.
Lets use a practical example to illustrate this relationship. Using the accompanying
Microsoft Excel spreadsheet, make the following entries:
1 Floating-rate bonds with credit or prepayment risk can trade above or below par depending on the markets
assessment of their risk relative to their floating-rate margin.
58
MODULE 4

Then press the Build Tree button:
You should get the following results in the Results box on the spreadsheet:
For the moment, ignore the entry labeled Collar Cost. We will defer the discussion of collars
until the next section. As you can see, for the interest rate scenario and strike rates chosen,
the cost/value of the cap is higher than the cost/value of the floor. The floating-rate bond in
isolation is worth $100. If we combine the floating-rate bond with a long 5 percent floor
position to protect against decreasing interest rates below 5 percent, we need to add the
value of the floor to the value of the floater to obtain a total value of the structure of $101.57.
If we combine a short position in a cap with a floater, the value of the structure is equal to
the value of the floater reduced by the value of the cap, resulting in a total value of $96.18.
MODULE 4
Combining Caps and Floors: Collars

Market participants with a floating-rate liability often combine caps and floors into a collar
by buying an interest rate cap and selling an interest rate floor with a lower strike rate. The
purchase of a cap protects against rising interest rates, and its purchase price can be wholly
or partially offset by the sale of an interest rate floor. By selling an interest rate floor,
however, the borrower gives up any interest rate savings that could otherwise have been
obtained if the reference rate had fallen below the floor strike rate. In this case, the seller
of the floor has to make a payout to the buyer equal to the difference between the interest
rate and the strike rate.
As a result of the collar, the net interest rate a borrower has to pay is restricted to the
range between the floor and the cap strike rates. Therefore, the interest rate risk is reduced.
Figure 4.2 shows the cash outflows of a floating-rate borrower who has a short position
in a floating-rate bond, or a short floater, combined with a long collar with strike rates of
the cap and floor of 6 percent and 4 percent, respectively.
Figure 4.2. Borrowing Cost Using Floater and Floater plus Collar
Borrowing Cost (%)

12
10
0
0 1 2 3 4 5 6 7 8 9 10
LIBOR (%)
Short Floating-Rate Bond Short Floater and Long Collar
If the cap and floor strike rates are the same, all the interest rate uncertainty has been
eliminated. In that case, the short position in the floating-rate bond plus the collar is
equivalent to a short position in a fixed-rate bond. Equivalently, a long position in a floater
combined with a short position in a collar (called a reverse collar) is the same as a long
position in a fixed-rate bond. Therefore, the value of the combination of the floating-rate
bond and the collar has to equal the corresponding fixed-rate bond value.
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MODULE 4
To check this relationship, use the same inputs on the spreadsheet as just given but set both
the cap and the floor strike rates equal to 6 percent so that they are in-line with the fixed-
rate bond coupon of $6.
Next, press the Build Tree button:

You should see in the last two rows of the Results table that the value of the long floater
plus reverse collar combination equals the fixed-rate bond value:
By selling a floor and buying a cap with the same strike rate, we have eliminated any
uncertainty regarding the cash flow/coupon we receive from the structure. In the example
just given, the cash flow is always going to be 6 percent regardless of the level of the LIBOR
reference rate. Hence, the structure has exactly the same payoff as a fixed-rate bond with
a $6 (or 6 percent) coupon. Therefore, its value has to be the same as well.
As we have shown, a collar is a way of obtaining interest rate protection for a borrower in
a cost-efficient way. From a bondholders (or lenders) perspective, we can obtain interest
rate protection using a reverse collar as just shown. A reverse collar involves combining a
short position in a cap with a long position in a floor. This combination guarantees a
minimum coupon rate equal to the strike rate of the floor. By giving up the potential to earn
a coupon rate of more than the cap strike rate, we are able to obtain interest rate protection
in a cost-efficient way. Shorting the cap (partially) finances the floor purchase.
Floating-Rate Bonds Containing Embedded Caps and Floors

Floating-rate bonds are often structured with a coupon rate that is capped at a certain level,
or a floor is placed on their coupon rate. Sometimes a security contains both a cap and a floor.
Capped floaters are equivalent to a combination of a long position in a floater and a short
position in a cap. A capped floater has a lower value than a pure floater because its coupon
rate is limited to the cap rate. Therefore, its value is equal to par minus the value of the cap.
In other words, an investor in a capped floater is able to obtain a pure floater by buying back
the cap that she has implicitly shorted. The price discount for the capped floater is
compensation for the investor because she will receive below-market yields if the LIBOR
reference rate rises above the cap rate. At this point, a floater becomes like a fixed-rate bond
because its coupon rate no longer fluctuates.
MODULE 4
Similar reasoning applies to floaters that come with floor rate protection. For an investor
in these structures, they are equivalent to a floating-rate bond combined with a long floor.
Therefore, a floater with floor rate protection has a value above par. Its value is equal to the
pure floater value (i.e., par) plus the value of the floor. If the LIBOR reference rate falls below
the floor, then the floater with floor rate protection becomes like a fixed-rate bond because
its coupon rate no longer fluctuates.
Some floaters are both capped and have a floor rate. Hence, they are equivalent to a pure
floater combined with a reverse collar (or short collar). Therefore, this type of structure
retains floating-rate bond characteristics only as long as the LIBOR reference rate is between
the floor and the cap rate; otherwise, the structures characteristics will be more similar to
those of a fixed-rate bond.
The values of these different structures are shown in Figure 4.3. Using the interest rate and
volatility scenario from earlier, we shift the spot rate curve up and down in a parallel manner
using 50 bp increments. Under each rate shift scenario, we record the values of a pure
floating-rate bond and a fixed-rate bond as well as a capped floater with a 6 percent cap, a
floater with a 5 percent floor, and a floater with both a cap and a floor.
Figure 4.3. Values of Different Structures
Bond Price ($)

115
110
105
100
95
90
85
150 100 50 Base Case 50 100 150
Rate Change (bps)
Floating-Rate Bond Value Capped Floater Floater with Floor

Floater with Cap and Floor Fixed-Rate Bond Value
62
MODULE 4
Figure 4.3 shows that as interest rates decline, the capped floaters value is very similar to
the floating-rate bonds value because the cap is out of the money. As interest rates increase,
the capped floater becomes like a fixed-rate bond and thus has a similar value. The floater
with a floor becomes very similar to a pure floater when interest rates increase and,
therefore, has a similar value. As interest rates decrease, the floater becomes more similar
to a fixed-rate bond and its value approaches the fixed-rate bond value.

Zero-Cost Collars
A collar that is often of particular interest is the so-called zero-cost collar. For a zero-cost
collar, the cap and floor strike rates are chosen in such a way that the values of the cap and
the floor are equal. Therefore, by selling the floor and buying the cap, a floating-rate
borrower is able to obtain some protection against interest rate increases at zero cost.
Numerical procedures can be used to solve either for the floor strike rate (given a desired
cap strike rate) that results in a zero-cost collar or for the cap strike rate (given a desired
floor strike rate) that produces a zero-cost collar.
Lets take a look at a practical example. Use the previous example again where we had the
following inputs:
These inputs give the following cap, floor, and collar costs:
MODULE 4
The cost of the cap exceeds the cost of the floor. Therefore, the cost of the collar is positive.
In order to produce a zero-cost collar, we could either solve for a floor strike rate that (for
a cap strike rate of 6 percent) makes the collar costless or we could solve for the cap strike
rate that (for a floor strike rate of 5 percent) makes the collar costless.
Lets try both approaches. First, leave the cap strike rate at 6 percent and solve for the floor
strike rate that produces a zero-cost collar by pressing the button:
You should see the following result:
Now, reset the floor strike rate to 5.00 percent and then press the button:
You should see the following output:
Hence, if you wanted protection against rising interest rates exceeding a strike rate of 6.00
percent, you would be able to obtain this type of protection at no cost if you combine your
cap purchase with selling a floor with a strike rate of 5.66 percent. Therefore, the price you
pay for the protection against rising rates is offset by giving up the lower borrowing costs
that would result if interest rates fell below 5.66 percent.
Alternatively, if you wanted to benefit from potential interest rate decreases down to a level
of 5.00 percent, you would have to accept interest rate increases up to 7.05 percent if you
wanted to obtain costless protection. Better interest rate protection can be obtained only
by paying a positive amount for the collar or by giving up more interest rate savings if
interest rates decline.
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MODULE 4
Caps and Floors vs. Options on Bonds

Caps and floors, as packages of interest rate options, are very similar to options on bonds.
Both types of options are influenced by interest rates. The important difference between
these two option types is that the value of caps and floors depends directly on the level of
the interest rate whereas the value of options on bonds depends on the bond price, which,
in turn, is affected by interest rates. As a result, the values of each type of option move in

different directions as interest rates change.
This distinction can be summarized as follows:
Bond Options Interest Rate Options

Scenario Call Value Put Value Cap Value Floor Value
Interest rates rise Decreases Increases Increases Decreases
Interest rates fall Increases Decreases Decreases Increases
Therefore, buying a cap is equivalent to buying a package of puts on a bond, and buying a
floor is equivalent to buying a package of calls on a bond.
Summary
Fixed-income market participants are able to protect themselves against adverse interest
rate moves by using caps and floors. Caps pay out a positive amount if the reference interest
rate exceeds the strike rate, and floors pay out a positive amount if the reference rate falls
below the strike rate. Combined with floating-rate bond positions, they provide interest rate
protection. However, they can also be combined with a fixed-rate bond to allow the holder
to benefit from rising interest rates or to allow the borrower to benefit from the savings
provided by falling interest rates.
To provide interest rate protection at a lower cost, caps and floors are often combined in a
collar or reverse collar, where shorting one component (cap or floor) partially or fully offsets
the cost of the component (cap or floor) that is purchased.
As we have shown, caps and floors, being options on interest rates, are equivalent to
packages of options on bonds, which are options on bond prices that are, in turn, affected
by interest rates.
MODULE 4
Practice Questions
Question 1:
Suppose the interest rate volatility increases. How will this increase affect the value of a
cap and a floor?
A. Both the cap and the floor value will increase.

B. The cap value will increase, and the floor value will decrease.
C. The answer depends on the characteristics of the cap and the floor, such as their
strike rates, and so on.
Question 2:
Again, suppose the interest rate volatility increases. How will this increase affect the cost
of a collar that was a zero-cost collar in the original volatility environment?
The value of the collar:
A. Decreases.
B. Increases.
C. May increase or decrease.
Question 3:
Suppose you have a long position in a fixed-rate bond with a 6 percent coupon and 10 years
remaining to maturity. You would like to use a cap and/or a floor to convert this position
to a long position in a floating-rate bond. What would be the cost of this under the following
scenario for a $100 notional amount?
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MODULE 4

The cost would be:
A. $1.46.
B. $3.82.
C. $5.27.
Question 4:
Suppose you are a borrower paying a fixed borrowing rate of 6 percent on a notional amount
of $100. Because you expect interest rates to decrease, you would like to benefit from the
expected decrease by lowering your borrowing costs. Which type of transaction (and at which
cost) would be able to achieve your objective under the same scenario as in Question 3?
You could:
A. Buy a cap at a cost of $3.82.
B. Buy a floor at a cost of $5.27.
C. Buy a collar at a cost of $1.46.
Question 5:
Using the same inputs as in Question 3, a floating-rate borrower would like to obtain interest
rate protection on a notional amount of $100. He would like to avoid paying a borrowing
rate of more than 6 percent. How could he achieve his objective at zero cost?
The floating-rate borrower could buy a:
A. Cap with a 6 percent strike rate.
B. Collar with a 6 percent strike rate for both the cap and the floor.
C. Collar with a 6 percent strike rate for the cap and a 5.66 percent strike rate for
the floor.
MODULE 4
Answers
Question 1:
A is the correct answer. Because caps and floors are packages of interest rate options that
provide a limited downside to the option holder and almost unlimited upside potential, their
value always benefits from increasing volatility. Although the chance of a large payoff to
the option holder increases, the downside remains limited.
B is incorrect. The cap value will increase, but so will the floor value. Caps and floors are
packages of interest rate options that provide a limited downside to the option holder and
almost unlimited upside potential. Their value always benefits from increasing volatility
because the chance of a large payoff to the option holder increases but the downside
remains limited.
C is incorrect. The cap and floor characterstics are irrelevant. Caps and floors are
packages of interest rate options that provide a limited downside to the option holder
and almost unlimited upside potential. Their value always benefits from increasing
volatility because the chance of a large payoff to the option holder increases but the
downside remains limited.
Question 2:
C is the correct answer. A zero-cost collar is a combination of a short position in a floor
and a long position in a cap that is self-financing (i.e., the value of the floor sold short is
equal to the value of the cap purchased). We know from Question 1 that the value/cost of
a cap and a floor increases if interest rate volatility increases. However, the relative
magnitude of the increase depends on the characteristics of the cap and the floor as well
as on the interest rate environment.
A is incorrect. The value of the short position in the floor will decrease as volatility increases.
The value of the long position in the cap, however, will increase. The net effect is ambiguous
depending on the characteristics of the cap and the floor.
B is incorrect. The value of the long position in the cap will increase. The value of the short
position in the floor, however, will decrease as volatility increases. The net effect is
ambiguous depending on the characteristics of the cap and the floor.
Question 3:
A is the correct answer. To convert the long position in the fixed-rate bond to a long
position in a floating-rate bond, a collar has to be purchased with both the cap and the floor
strike rate equal to the fixed-rate bond coupon rate, in this case 6 percent. Once you make
68
MODULE 4
these inputs on the accompanying spreadsheet and press the Build Tree button, the Results
table shows a cost for the collar of $1.46 (i.e., you would get paid by entering this
agreement). This is because the floating-rate bond has a lower value than the fixed-rate
bond, which can also be seen from the Results table. The floating-rate bond value is $100,
and the fixed-rate bond value is $101.46, a difference of $1.46.

B is incorrect. Making these inputs in the accompanying spreadsheet and pressing the Build
Tree button yields a floating-rate bond value of $100 and a fixed-rate bond value of
$101.46. Therefore, the short floor position produces more option premium than the long
cap position costs, and the collar has a negative rather than a positive cost. Whether the
collar produces income or costs money depends in part on the relationship between the
coupon rate and interest rates.
C is incorrect. Making these inputs in the accompanying spreadsheet and pressing the Build
Tree button yields a floating-rate bond value of $100 and a fixed-rate bond value of
$101.46. Therefore, the short floor position produces more option premium than the long
cap position costs, and the collar has a negative rather than a positive cost. Whether the
collar produces income or costs money depends in part on the relationship between the
coupon rate and spot rates.
Question 4:
B is the correct answer. A long position in a floor gives you a positive payoff if interest rates
fall below the strike rate. Therefore, buying a floor allows you to benefit from falling interest
rates. Under the scenario from Question 3, we obtain a floor cost of $5.27 using the
accompanying spreadsheet.
A is incorrect. Buying a cap gives its holder a positive payoff if interest rates rise above
its strike rate. Therefore, buying a cap does not provide a benefit to the borrower if interest
rates fall.
C is incorrect. Buying the collar involves purchasing a cap to protect against rising interest
rates and selling a floor. By selling a floor (rather than buying a floor), the borrower gives up
any interest rate savings associated with a fall in interest rates below the floor strike rate.
MODULE 4
Question 5:
C is the correct answer. The borrower is able to obtain protection against rising interest
rates at zero cost by purchasing a collar where the short position in the floor fully finances
the long position in the cap. Because we need a 6 percent cap strike rate to avoid paying a
borrowing rate that is greater than 6 percent, we need to solve numerically for the floor
strike rate so that the floor is worth the same as the cap. We can do this in the accompanying
spreadsheet by pressing the button:
We can see that a floor strike rate of 5.66 percent produces a zero-cost collar.
A is incorrect. Buying a cap does, indeed, provide a payoff if the interest rate rises above the
cap strike rate. It cannot be done, however, at zero cost. A self-financing strategy requires
that the long be combined with a short floor in the form of a collar. The respective strike
rates can be designed for a net zero cost.
B is incorrect. Buying a collar can, indeed, use the proceeds from selling the floor to offset
the cost of purchasing the cap. When the strike rates are both equal to 6 percent, however,
the strategy is not self-financing (i.e., zero cost). In this case, it has a negative cost (i.e.,
produces a positive net cash flow). The strike rate on the short floor must be lowered to
make the floor less attractive and the collar self-financing because spot rates are less than
the coupon rate.
BIBLIOGRAPHY
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MODULE 5
OPTION-ADJUSTED SPREADS (OAS) AND OTHER YIELD SPREADS
Overview of OAS
Corporate bonds need to offer investors a return premium over
LEARNING OBJECTIVES
default-free benchmark bonds because of the existence of credit,
liquidity, and option risk. This return premium can be measured in
various ways. The three most common measures are nominal yield 1 Explain how OAS and other
spreads, zero-volatility spreads (Z-spreads), and option-adjusted spread measures are intui-
spreads (OAS). tively computed.
2 Outline under which circum-

In the following, we outline the computation of each of these metrics
stances each measure is used
and explain their uses. Certain types of spreads are more appropriate
appropriately.
than others depending on the type of bond.
3 Explain how OAS depends on
Nominal Spreads the interest rate volatility
The nominal yield spread is the difference between a corporate estimate and embedded
bonds yield to maturity and the yield of a corresponding option characteristics.
government bond with the same maturity. Note that we treat the
corporate bond as if it were a default-free government bond with 4 Explain how OAS are used
guaranteed coupon and principal payments and thus ignore the fact for different types of
that it may default and bondholders may not receive any further securities.
payments at some point.
5 Discuss strengths and weak-
nesses of the OAS concept.
For example, if a corporate bond has five years remaining to maturity
and a yield to maturity of 6.5 percent and the corresponding
government bond with the same maturity yields 5.4 percent, then the
nominal spread is equal to 110 bps (6.5 percent minus 5.4 percent).
A drawback associated with this type of spread measure is that it

does not take into account the term structure of spot rates for both
bonds. In other words, all cash flows are discounted using the same
rate. As shown in Figure 5.1, the nominal spread is added to the point
on the yield curve that corresponds to the maturity of the bond being
analyzed (10 years in this example). As a result, the nominal spread
does not allow proper comparison of two bonds with different
coupons even if the maturities or durations are the same.
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MODULE 5
Figure 5.1. Par Yield Curve and Nominal Spread
Rate (%)
7
Nominal Spread
4
1 2 3 4 5 6 7 8 9 10
Maturity (years)
Par Yield Curve Par Yield plus Nominal Spread
Moreover, for bonds with embedded options, changing interest rates may alter the cash
flows of the corporate bond, a fact that is ignored by the nominal spread. Generally, bonds
with embedded options are callable, so in the following, we will focus on callable bonds.
However, the following discussion refers to any type of embedded option (e.g., a put option
in a putable bond).
If the bond issuer decides to exercise the call option, the bondholder will forgo any further
coupon payments, which will change the bond yield (in most cases, it will reduce bond
yields). Therefore, nominal spreads are generally not particularly meaningful for bonds with
embedded options.
Zero-Volatility Spreads (Z-Spreads)
The Z-spread, also called the static spread, is the spread that when added to each rate of
the spot rate term structure makes the present value of a corporate bonds cash flows equal
to its market price. In other words, it is the yield spread over the spot rate curve that an
investor in the corporate bond would realize. It is computed by trial and error. This type of
spread is called the zero-volatility spread because it implicitly assumes that the interest
rate volatility is zero, which means that the embedded option in a callable bond has zero
value because it is not exercised. Hence, in a similar way as the nominal spread discussed
earlier, the Z-spread assumes that the bonds cash flows do not change with the level of
72
MODULE 5
interest rates. Clearly, this is an unrealistic assumption for bonds with embedded options.
As a result, the Z-spread should generally be used only for option-free bonds.
The difference between the Z-spread and the nominal spread is the benchmark that is
being used. The nominal spread is added to the point on the yield curve that corresponds

to the maturity of the bond being analyzed. In contrast, the Z-spread is a constant that is
added to each spot rate over the life of the bond being analyzed. Therefore, in the Z-spread
calculation, each cash flow is discounted with a different interest rate, as can be seen in
Figure 5.2.
Figure 5.2. Spot Rates and Z-Spread
Rate (%)
9
6 Z-Spread
4
1 2 3 4 5 6 7 8 9 10
Maturity (years)
Spot Rate Curve Spot Rate plus Z-Spread
In most cases, the nominal spread and the Z-spread are of similar magnitude. If the spot
rate curve is completely flat, then the two spread measures are actually the same. The
difference between the two measures increases as the spot rate curve steepens.
Option-Adjusted Spreads (OAS)

The OAS is computed in a similar manner as the Z-spread. In fact, one can think of it as the
Z-spread that has been adjusted for any option embedded in the bond.
For a callable bond (or any bond with an embedded option), the bond value usually cannot
be computed simply by discounting its future scheduled cash flows. Instead, an interest rate
model has to be used to value this type of bond, as shown in Module 2. This type of model
takes into account the interest rate volatility and the fact that the bonds cash flows may
change with the level of interest rates because the embedded option may be exercised.
In general, an interest rate model makes certain assumptions about interest rate behavior
to create a probabilistic description of how interest rates can change over the life of a bond.
Binomial interest rate trees are most commonly used for this purpose.
MODULE 5
As shown in previous modules, a binomial interest rate tree models how short-term interest
rates change over time. Given an interest rate as well as an interest rate volatility assumption,
the binomial model assumes that interest rates can realize one of two possible states over a
given interval of time. By breaking up the time to maturity of a bond into shorter time
intervals (such as one year or half a year), the interest rate behavior over the life of the bond
can be modeled using a binomial interest rate tree. Following is an example of such a tree:
If the steps in the tree are annual, then this interest rate tree can be used to value a bond
with a four-year maturity and annual coupon payments. Here, the current one-year rate
is 5.00 percent, and according to the interest rate model used, the one-year rate can either
increase to 6.24 percent or decrease to 4.18 percent over the next year, and so on. Again,
the values in the tree are based on the current yield curve as well as the interest rate
volatility assumption.
Once an interest rate tree has been generated, the next step is to construct a bond price
tree using the interest rate tree. Following is an example of a bond price tree:
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MODULE 5
The bond price tree is constructed by successively discounting the bonds par value and coupon
payments using the rates from the interest rate tree and allowing for any embedded options.
A full description of the different interest rate models that can be used to price bonds with
embedded options is beyond the scope of this text, and most fixed-income practitioners do

not need to know all the details and assumptions behind these models because they are
generally provided by standard commercial packages. As a result, we take the interest rate
model as given for our OAS analysis.
The OAS is based on an interest rate model and takes future interest rate volatility into
account. Hence, it recognizes the fact that if the bond includes an embedded option, the
bonds cash flows will change depending on the future path of interest rates.
Just as with the Z-spread, the OAS is computed by trial and error and is the yield spread
that when added to all the spot rates equates the bond value obtained from an interest rate
model with the market price of the bond. In this sense, as opposed to the nominal spread
and the Z-spread, the OAS is model dependent. The different interest rate models used will
produce different OAS values for the bond with embedded options. More importantly, the
interest rate volatility estimates used as inputs to the interest rate model have a significant
impact on the value of the embedded option and thereby on the OAS.
In essence, the OAS is computed in the same way as the Z-spread. However, the OAS accounts
for the impact of volatility on the value of a bond with an embedded option. Because the
Z-spread does not take this into account, one could label it the zero-volatility OAS.
Alternatively, one can think of removing or stripping the call option from the callable bond
and thus creating a hypothetical option-free bond that is otherwise equivalent to the
callable bond. The Z-spread makes the model value of the hypothetical bond equal to the
callable bonds market price, and the OAS makes the callable bond value obtained from the
interest rate model equal to its market price.
Hence, we have the following relationship:
Option cost = Z-spread OAS, (5.1)
or equivalently,
OAS = Z-spread Option cost. (5.2)
Because these types of spread measures are used for corporate bonds and are computed
either relative to the government yield curve (nominal spread) or to the government spot
rate curve (Z-spread and OAS), they always have to be positive. If a government benchmark
is used and the resulting spreads for corporate bonds end up being negative, then there must
be an error in the valuation model or the methodology used to compute the spread.
Corporate bonds always have higher credit risk, liquidity risk, and option risk than default-
free government bonds, which are option-free bonds.
MODULE 5
Summary of Yield Spreads

Three types of yield spreads are commonly used: nominal spreads, zero-volatility
spreads, and option-adjusted spreads. They differ in the benchmark relative to
which they are computed, and they reflect compensation for different types of risk.
Nominal spreads: Are computed relative to the government yield curve and
reflect compensation for credit risk, liquidity risk, and option risk.
Zero-volatility spreads: Are computed relative to the government spot rate curve
and reflect compensation for credit risk, liquidity risk, and option risk.
Option-adjusted spreads: Remove the impact of the embedded options on the
bonds Z-spread. OAS reflects compensation only for credit and liquidity risk.
Yield Spreads: A Practical Example

Lets look at a practical example of how yield spreads can be computed and used in a
portfolio managers analysis.
Make the following inputs on the accompanying Microsoft Excel spreadsheet:
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MODULE 5
After you have made those entries, press the Build Tree button and then the Solve for
Z-Spread and Solve for OAS buttons:

Doing so causes the spreadsheet to generate the interest rate tree, price the bonds based
on that tree, and then obtain the Z-spread and OAS that make the option-free and callable
bond values equal to their market prices.
The resulting values are as follows:
The resulting nominal yield spread for the option-free bond is 179.18 bps. Because the
nominal yield spread cannot accommodate changing cash flows for changing interest rates,
it does not make sense to compute this measure for bonds with embedded options.
Interestingly, the Z-spread is 179.86 bpsvery similar to the nominal spread. The similarity
between these two metrics is expected because the spot rate curve that was used is almost
flat. At this point, you might want to experiment with the spreadsheet to see how different
shapes of the spot rate curve affect the difference between the nominal spread and the
Z-spread. As the spot rate curve steepens, the difference between the two should increase.
The OAS for the callable bond, which has the same characteristics as the option-free bond
except for the callability, is 166.02 bps. It is smaller than the corresponding Z-spread because
for nonzero interest rate volatilities, the value of the embedded option is positive. Instead
of the option value, the yield spread that corresponds to the value of the option (labeled
MODULE 5
Embedded Call Option Cost) is shown in the last row of the previous table. The embedded
call option cost is 13.85 bps, which is equal to the difference between the Z-spread and the
OAS as shown earlier. Thus:
Call option cost = Z-spread OAS = 179.86 bps 166.02 bps = 13.85 bps. (5.3)
It is important to emphasize again that the call option cost is heavily affected by the interest
rate volatility estimate used to price the option. Higher volatilities lead to higher option
values and, therefore, higher option costs in yield space. From Equation 5.3, the OAS will
decrease with higher volatility assumptions.
As shown in Module 2, investors tend to use either historical volatilities or implied volatilities
to come up with an expected volatility. Historical volatilities are simply computed as the
standard deviation of a historical interest rate series. In contrast, implied volatilities are
obtained from an option-pricing model. To come up with an implied volatility, an option
embedded in a bond has to be assumed to be trading at its fair price and an option-pricing
model has to be assumed to be the model that would generate that fair price. In this case,
the implied volatility is the volatility that will result in the option-pricing model producing
the fair price of the option if the implied volatility is used as an input. An advantage of the
implied volatility approach is that it generates forward-looking volatilities as opposed to
the backward-looking volatilities that are obtained from the historical volatility approach.
Other types of interest rate options that can be used to extract implied volatilities are caps/
floors and collars as well as swaptions (i.e., options that grant the holder the right to enter
an interest rate swap).
Yield volatilities (particularly implied volatilities obtained from option prices) are typically
quoted as relative volatilitiesVol(y/y), where y is the yield and y is a yield change.
The volatility must be multiplied by the corresponding yield level to obtain the type of
volatility required.
As a next step, increase the call strike price from $100 to $102 in cell C8 and press the Build
Tree button and then the Solve for Z-Spread and Solve for OAS buttons:
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MODULE 5
What do you see?
We expect the value of the embedded option or the call cost to decrease because the bond
issuer now has to pay $102 instead of $100 to call the bond. Therefore, the call option will
be less valuable to him. The moneyness of the option has been reduced.

The new results confirm this expectation:
Because of the higher call strike price, the option cost (to the bondholder) has been reduced
from 13.85 bps to 3.97 bps, resulting in an increase of the OAS from 166.02 bps to 175.90 bps.
OAS Analysis for Mortgage-Backed Securities

In addition to being used on relatively straightforward callable corporate bonds, OAS is
frequently used for mortgage-backed securities (MBS). However, for MBS there is an extra
step involved. In addition to modeling the probabilistic behavior of government spot rates,
the homeowners tendency to prepay their mortgage has to be modeled using prepayment
models. Therefore, we have an additional layer of uncertainty, and the OAS is a good
measure of value only if homeowners exercise their prepayment option in a consistent and
predictable manner.
Whether homeowners actually decide to prepay depends on a number of factors, not only
the future interest rate path. First, prepayment depends on whether it makes economic
sense for homeowners to do so, which, in turn, depends, among other things, on the
development of interest rates as well as the homeowners tax situation. Second, the decision
to prepay depends on homeowners ability to refinance their mortgages at an advantageous
rate. In some cases, this might not be feasible, for example, if their own credit situation has
deteriorated. Third, even if it makes economic sense for homeowners to prepay and they
are able to do so, many homeowners choose not to for personal reasons.
As a result, the decision to prepay is a lot more idiosyncratic than a corporate bond issuers
decision to call a bond, which is almost exclusively determined by interest rate factors.
Again, the extent to which OAS is helpful to value MBS is highly dependent on how well
prepayments can be modeled.
MODULE 5
Advantages and Drawbacks of Different Yield Spread Measures

Exhibit 5.1 gives an overview of the advantages and drawbacks of the different yield spread
measures just discussed.
Exhibit 5.1. Advantages and Drawbacks of the Different Yield Spread Measures
Yield Spread
Measure Advantages Drawbacks
Nominal yield Quantifies risk as implied by Adds the spread to the yield to maturity
spread the market of the bond; thus, bonds with different
coupons cannot be compared
Does not accommodate any embedded
options
Cannot be computed if market prices are
unavailable
Quantifies overall risk of bond relative to
Treasury benchmark but cannot be used
to isolate particular risk types
Z-spread Quantifies risk as implied by Does not accommodate any embedded
the market options
Adds a constant spread to Cannot be computed if market prices are
each spot rate; thus, bonds unavailable
with different coupons can Quantifies overall risk of bond relative to
be compared Treasury benchmark but cannot be used
to isolate particular risk types
Option-adjusted Quantifies risk as implied by Dependent on the interest rate model
spread the market used and the volatility estimates
Adds a constant spread to Cannot be computed if market prices are
each spot rate; thus, bonds unavailable
with different coupons can Quantifies overall risk of bond relative to
be compared Treasury benchmark but cannot be used
Is able to accommodate to isolate particular risk types
embedded options
Nominal spreads are commonly used because of their simplicity and ease of computation.
Traders often compare comparable securities by discussing their relative nominal spreads.
For more precise valuation, even when dealing with bullet bonds, Z-spreads are
technically superior.
For option-free bonds, market participants use both nominal and Z-spreads. We have
discussed why Z-spreads are a more precise measure of spread across the entire curve, but
nominal spreads are a common and easy first step. For bonds where options are present,
market participants look at all three spread measures discussed but spend more time refining
their analysis of OAS. The main advantage of OAS analysis for option-embedded bonds is
80
MODULE 5
that it allows comparison across different bond structures on a risk-adjusted basis.

Theoretically, one could compare the OAS on a mortgage- or asset-backed security with a
noncallable corporate bond and make some relative value judgments. In practice, portfolio
managers tend to use OAS models within sectors of the market to gauge relative value.

Practice Questions
Question 1:
Which of the following is a true statement? In theory, corporate bond option-adjusted
spreads should not be negative because they:
A. Reflect the embedded option cost, which is always positive.
B. Solely reflect the credit risk of corporate bonds, which is higher than for Treasury
bonds.
C. Reflect credit risk, liquidity risk, and option risk, which are higher for corporate
bonds than for Treasury bonds.
Question 2:
Suppose we have the same scenario as in the text, that is:
MODULE 5
Now, however, the volatility term structure shifts up by 1 percentage point. How is the OAS
affected and why?
A. It decreases by 4.25 bps as the Z-spread decreases.
B. It decreases by 4.25 bps as the option cost increases.
C. It increases by 4.25 bps as the nominal yield spread decreases.

Question 3:
Suppose you use the original scenario from Question 2. How is the difference between the
Z-spread and the nominal yield spread for the option-free bond affected when we switch
from spot rates to par yields? Why does the difference change in this way?
The difference between the Z-spread and the nominal yield spread:
A. Decreases from 0.77 bps to 0.68 bps because spot rates decrease.
B. Decreases from 0.77 bps to 0.68 bps because the bond duration increases.
C. Increases from 0.68 bps to 0.77 bps because the steepness of the resulting spot
curve increases.
Question 4:
Using the original scenario from Question 2, increase the callability start date from two
years to five years from now and then press:
How does the OAS change?

A. It decreases by 8.52 bps.
B. It decreases by 7.12 bps.
C. It increases by 9.27 bps.
Question 5:
Which of the following is the best explanation for why mortgage-backed securities (MBS)
are more difficult to value using OAS than standard callable corporate bonds?
A. Prepayment rates do not solely depend on interest rates.
B. MBS generally have more credit risk than corporate bonds.
C. Prepayment for MBS is more likely than a call option exercise for corporate bonds.
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MODULE 5
Answers
Question 1:
C is the correct answer. OAS reflect the credit risk, liquidity risk, and option risk of corporate
bonds. All three sources of risk are larger for corporate bonds than for Treasury bonds. Hence,

OAS are always positive.
A is incorrect. Although it is true that corporate OAS reflect embedded option costs, they
reflect other risks as well, including liquidity risk and potential option risk (call risk).
B is incorrect. OAS reflect liquidity and option risk as well as credit risk.
Question 2:
B is the correct answer. As the interest rate volatility increases, the value of the embedded
option increases. Hence, the embedded option becomes more valuable to the bond issuer,
and correspondingly, the option cost to the bondholder increases. Because the OAS can be
computed as:
OAS = Z-spread Option cost,
the OAS has to decrease. We have:
OAS = Z-spread Option cost = 0 bps (18.10 bps 13.85 bps) = 4.25 bps.
A is incorrect. In this example, we are holding the Z-spread constant and looking at the
effects on OAS of changes in volatility to the embedded option cost.
C is incorrect. An increase in volatility, holding all other variables constant, will decrease
the OAS, not increase it.
Question 3:
C is the correct answer. As we saw in Module 1, par yields are averages of different spot
rates because they are a one-value summary measure of a bonds yield. Therefore, the par
curve is the flattest of all yield curves, and the steepness of the resulting spot rate curve
increases. As shown earlier, the steeper the spot rate curve, the larger the difference between
the nominal spread and the Z-spread. The two measures will be the same if the spot rate
curve is flat.
A is incorrect. Par curves are always flatter than spot curves because they are averages
of spot rates. Thus, the difference between the Z-spread and the nominal yield spread
cannot decrease.
B is incorrect. Bond duration has nothing to do with the question. Also, the direction of
change has not been correctly identified given the fact that par curves are always flatter
than spot curves.
MODULE 5
Question 4:
C is the correct answer. We know that a later callability start date, and thus a shorter life,
will make the call option less valuable to the issuer. Therefore, the option cost to the
bondholder will decrease. Because OAS = Z-spread Option cost, the OAS has to
increase because of the lower option cost. From the spreadsheet we have:
OAS = OASnew OASold = 175.29 bps 166.02 bps = 9.27 bps.
A is incorrect. The OAS will increase when the call date moves further into the future. A
later call date reduces the value of the call option to the issuer, which increases the bond
value to the investor.
B is incorrect. The OAS will increase when the call date moves further into the future. A
later call date reduces the value of the call option to the issuer, which increases the bond
value to the investor.
Question 5:
A is the correct answer. As discussed earlier, the decision to prepay is a lot more
idiosyncratic than a corporate bond issuers decision to call the bond, which is almost
exclusively determined by interest rate factors.
B is incorrect. Credit risk is not the issue here; prepayment risk is what we are attempting
to value.
C is incorrect. A prepayment on an MBS is not necessarily more likely than a call on a

corporate bond. The likelihood depends on the particular security characteristics and
interest rate scenario.
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YIELD CURVE

All rights reserved. No part of this publication may be reproduced or

ISBN 978-0-938367-42-0 (PDF)

Interest Rate Measures

Full Valuation Approach

Yield Curve Trades

Hedging Interest Rate Risk Using Caps and Floors 53

Option-Adjusted Spreads (OAS) and Other Yield Spreads 71

Yield Curve Construction, Trading Strategies, and Risk Analysis

Note: Biographical information is accurate as of the time of writing.

Yield Curve Construction, Trading Strategies, and Risk Analysis

INTEREST RATE MEASURES

Overview of Yield Measures

Par Yield Summary

The par yield:

Spot Rate (Yield) Summary

INTEREST RATE MEASURES

Yield Curves and Their Interpretation: Linkages between Par, Spot,

INTEREST RATE MEASURES

Figure 1.1. Rate Measures for Upward-Sloping Yield Curve

Rate Level (%)

Table 1.1. Rate Table

Years to One-Year Implied Future

Figure 1.2. Rate Measures for Downward-Sloping Yield Curve

Rate Level (%)

INTEREST RATE MEASURES

Role and Implications of Forward Rates

f1,2 s0,2 = 7% 6% = 1%. (1.3)

INTEREST RATE MEASURES

Figure 1.3. Example of Buying Two- and Six-Year Zeros and

Table 1.2. Rate Table: Focus on Implied Future Spot Rate

INTEREST RATE MEASURES

The return on the barbellbullet position can be obtained by decomposing it into a

Rolling yield differential = Weight of two-year forward rate

Rolling yield differential = 0.5 4.20% + 0.5 6.69% 5.79% = 0.3450%.

Table 1.3. Rate Table: Focus on One-Year Forward Rate

INTEREST RATE MEASURES

Capital gains relative to unchanged spot curve

Capital gains relative to unchanged spot curve

Table 1.4. Alternative Example Showing Realized Forward Rates

Total P/L $0.00

INTEREST RATE MEASURES

A. Forward rates can still be viewed as break-even rates.

A. No. All maturity segments are priced equally.

INTEREST RATE MEASURES

Figure 1.4. Question 3 Rate Measures

Rate Level (%)

INTEREST RATE MEASURES

FULL VALUATION APPROACH

Overview of Effective Duration and Convexity

FULL VALUATION APPROACH

V = bond value if yield is decreased by y

V 0 = original bond value

Callable bond = Noncallable bond Call option value. (2.2)

Below that, please make the following entries:

FULL VALUATION APPROACH

The following results should be displayed:

FULL VALUATION APPROACH

Effective convexity is thus computed as follows:

Figure 2.1. Bond PriceYield Relationship for Option-

Full Valuation Approach Summary

Key Rate Durations

FULL VALUATION APPROACH

In the next few input boxes, make the following selections: