Bond instruments and interest rate risk

Chapter 1 described the basic concepts of bond pricing. This chapter discusses the sensitivity of bond prices to changes in market interest rates and the key related concepts of duration 

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Chapter 2—Bond Instruments and Interest Rate Risk... 

Each corporate bond will only be exposed to one of these factors, with an exposure that will typically increase with the bond s maturity. A rule of thumb is that it will be comparable to the bond s exposure to the shift factor. The spread risk of almost all AAA, AA, and A rated bonds will be less than their interest rate risk, and it is only for BBB rated bonds and in some very specific market sectors such as Energy and Telecoms that spread risk starts exceeding benchmark risk. Spread risk is by far the dominant source of systematic risk for high-yield instruments. 

Bond traders wishing to hedge the interest rate risk of their bond positions have several tools to choose from, including other bonds, bond futures, and bond options, as well as swaps. Swaps, however, are particularly efficient hedging instruments, because they display positive convexity. As explained in chapter 2, this means that they increase in value when interest rates fall more than they lose when rates rise by a similar amount—just as plain vanilla bonds do. 

A fixed-rate bond pays fixed coupons during the bond s life known with certainty. Conversely, a floating-rate note ox floater pays variable coupons linked to a reference rate. This makes the coupon payments uncertain. The main pim-pose of this debt instrument is to hedge the risk of rising interest rates. Although the financial crisis and liquidity provided by central banks have decreased the level of interest rates, they will at some point of course rise in future years. 

This discussion covers the main factors affecting bond returns in the European fixed income market, namely, the random fluctuations of interest rates and bond yield spreads, the risk of an obligor defaulting on its debt, or issuer-specific risk, and currency risk. There are also other, more subtle sources of risk. Some bonds such as mortgage-backed and asset-backed securities are exposed to prepayment risk, but such instruments still represent a small fraction of the total outstanding European debt. Bonds with embedded options are exposed to volatility risk. However, it is not apparent that this risk is significant outside derivatives markets. 

A number of option-pricing models exist. Market participants often use variations on these models that they developed themselves or that were developed by their firms. The best-known of the pricing models is probably the Black-Scholes, whose fundamental principle is that a synthetic option can be created and valued by taking a position in the underlying asset and borrowing or lending funds in the market at the risk-free rate of interest. Although Black-Scholes is the basis for many other option models and is still used widely in the market, it is not necessarily appropriate for some interest rate instruments. Fabozzi (1997), for instance, states that the Black-Scholes model s assumptions make it unsuitable for certain bond options. As a result a number of alternatives have been developed to analyze callable bonds. 

All bond instruments are characterized by the promise to pay a stream of future cash flows. The term structure of interest rates and associated discount function is crucial to the valuation of any debt security and underpins any valuation framework. Armed with the term structure, we can value any bond, assuming it is liquid and default-free, by breaking it down into a set of cash flows and valuing each cash flow with the appropriate discount factor. Further characteristics of any bond, such as an element of default risk or embedded option, are valued incrementally over its discounted cash flow valuation. 

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