11b-bondman - FINA 4310 Lecture Notes 11b Bond Management...

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FINA 4310 Lecture Notes 11b: Bond Management
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Risk Management Using Duration A bond portfolio manager can control interest rate risk by changing the duration of the portfolio To reduce interest rate risk, decrease duration by selling long-term bonds and buying short- term bonds (or just keeping more in cash)
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Example You currently have $1,000,000 $750,000 invested in a 20-year bond with a duration of 16 years, $250,000 in cash (demand deposits at a bank) . The cash component has a duration of zero Portfolio weights are .75 and .25 Duration of portfolio is (.75)(16) + (.25)(0)=12
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Example, continued Now, you decide that you are bearing too much interest rate risk, and would like to decrease your duration to 8 years. How much bond would you have to sell? Solve this equation to find target weight: (WB)(16) + (1-WB)(0) = 8 Solution: WB = .50 Want to have (.5)(1,000,000) = $500,000 in bonds To get there, you need to sell $250,000 of bonds
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Duration of a perpetuity Consider a perpetuity that pays $1,000 per year forever, and its yield is .08 The price of this perpetuity would be: $1,000/.08 = $12,500 The duration of the perpetuity would be: 1.08/.08 = 13.5
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