Full valuation approach

We will discuss two approaches for assessing the interest rate risk exposure of a bond or a portfolio. The first approach is the full valuation approach that involves selecting possible interest rate scenarios for how interest rates and yield spreads may change and revaluing the bond position. The second approach entails the computation of measures that approximate how a bond s price or the portfolio s value will change when interest rates change. The most commonly used measures are duration and convexity. We will discuss duration/convexity measures for bonds and bond portfolios. Finally, we discuss measures of yield curve risk. 

EXHIBIT 4.2 Illustration of Full Valuation Approach to Assess the Interest Rate... 

In the illustration in Exhibit 4.5, it is assumed that both the 2-year and 30-year yields change by the same number of basis points. The full valuation approach can also handle scenarios where the yield curve does not change in a parallel fashion. Exhibit 4.6 illustrates this for our portfolio that includes the 2-year and the 30-year Italian government securities. The scenario analyzed is for a change in the yield curve s slope combined with changes in the level of yields. In the illustration in Exhibit 4.6, the following yield changes are assumed for the 2-year and the 30-year yields ... 

DIHBir 4.5 Illustration of Full Valuation Approach to Assess the Interest Rate Risk of a Bond Portfolio for Four Scenarios Assuming a Parallel Shift in the Yield Curve, 2-Bond Portfolio (hoth bonds option-free)... 

Given the background about a bond s price volatility characteristics, we can now turn our attention to an alternate approach to full valuation ... 

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