Reducing/Increasing Duration of a Bond Portfolio.

CFA Level II
#1

Hi,

I tend to be thrown off by questions about reducing or increasing duration of bond portfolios.

Are there any rules for how we can increase or reduce the duration of a bond by:

  • Swaps
  • Callable and Putable Options
  • Other Derivatives
#2

swaps: receive floating pay fixed

options: short reduces duration

forwards, futures: short reduces duration

#3

First, I presume that you mean call options and put options. The options themselves are not callable or putable; it’s the underlying (bond, in this case) that’s callable or putable.

Swaps

Recall that plain vanilla interest rate swaps are equivalent to the combination of a long bond and a short bond, that the (effective) duration of a floating-rate bond is (generally) shorter than the (effective) duration of a fixed-rate bond, and that the long position adds duration while the short position subtracts duration.

If you are long the fixed rate and short the floating rate (a receive fixed, pay floating swap), then you are adding more duration than you’re subtracting; you increase your portfolio’s duration. If you are long the floating rate and short the fixed rate (a receive floating, pay fixed swap), then you are adding less duration than you’re subtracting; you decrease your portfolio’s duration.

Finally, in an equity swap, you increase duration if you pay the equity return and receive fixed or floating; you decrease duration if you pay fixed or floating and receive the equity return.

Options, Forwards, and Futures

For these three, you need to picture whether you’re buying (or may be buying) the underlying bond or selling (or may be selling) the underlying bond: if you’re buying you increase duration; if you’re selling, you decrease duration.

Options

With a long call or a short put you may be buying the underlying bond: your duration increases.

With a long put or a short call you may be selling the underlying bond: your duration decreases.

Forwards and Futures

With a long position you will be buying the underlying bond: your duration increases.

With a short position you will be selling the underlying bond: your duration decreases.

2 Likes
#4

FTFY

#5

Thank you for the reply both oy you. Much appreciated.

Yes I mean call/put options.

Regarding the options and futures.

  • I add duration by entering into positions that benefits from a rate reduction.
  • I reduce duration by entering into positions that benefits from a rate increase.

Is this correct?

Swaps:

Can I think the same way with swaps? By entering into positions that benefits from a rate reduction I add duration.

  • Fixed rate receiver. Floating rate payer.
    • Benefits from a rate reduction.
    • This adds duration to the portfolio.
  • Floating rate receiver. Pay fixed.
    • Benefits from a rate increase.
    • This reduces duration of the portfolio.
#6

In a word: yes.

And you’re quite welcome.

#7

Thank you. Very helpful and great explanation.

#8

My pleasure.