Interest Rate Sensitivity of Callable Bonds and Higher-Order Approximations

Certain fixed-income securities, such as callable bonds and mortgage-backed securities subject to prepayment, typically exhibit negative convexity at low yields and cannot be adequately immunized through duration and convexity-matching alone. To address this residual risk, we examine the concepts of...

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Bibliographic Details
Published inRisks (Basel) Vol. 13; no. 4; p. 69
Main Authors Dow, Scott S., Orfanos, Stefanos C.
Format Journal Article
LanguageEnglish
Published Basel MDPI AG 01.04.2025
Subjects
Approximation
Arbitrage
bond agility
Bond issues
bond tilt
Federal Reserve monetary policy
Fixed income securities
higher-order approximations
Interest rates
Investment analysis
Mortgage backed securities
Municipal bonds
negative convexity bonds
Portfolio management
Prices and rates
Put & call options
Valuation
Volatility
Yield curve
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Summary:Certain fixed-income securities, such as callable bonds and mortgage-backed securities subject to prepayment, typically exhibit negative convexity at low yields and cannot be adequately immunized through duration and convexity-matching alone. To address this residual risk, we examine the concepts of bond tilt and bond agility. We provide explicit calculations and derive several approximation formulas that incorporate higher-order terms. With the help of these methods, we are able to track the price-yield dynamics of callable bonds remarkably well, achieving mean absolute errors below 2.5% across a wide variety of callable bonds for parallel yield shifts of up to ±200 basis points.
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ISSN:2227-9091
2227-9091
DOI:10.3390/risks13040069