Fixed Income Risk - Sensitivity Based
Overview
Sensitivity based measures are measures that indicate hom much the value of an instrument changes with respect to the change
of some underlying variable, in this case, a specified interest rate.
The two measures can be used to approximate the change in price of a fixed income instrument with the
following formulate for the approximate change in the price of the instrument.
{% \Delta P / P \approx -D \times \Delta y + \frac{1}{2} \times C \Delta y^2 %}
The mathematical basis of this type of analysis can be viewed at
taylor series foundation.
Hedging
Hedging
refers to the process of trading instruments in
a portfolio in order to make the portfolio immune to
fluctuations in the interest rate curve.
As a general rule, a portfolio of long only fixed income
instruments is only hedged if all the instruments are
floating rate instruments. This is because any simple bond will
lose value as rates go up, and gain if rates go down, so a portfolio
with these types of bonds will lost value as rates go up. The only
instrument which does not lose value is a floating rate instrument.
Therefore in general, you will only hedge a portfolio that
contains both assets and liabilities, or a portfolio with
optionality.
