A Guide to Duration, DV01, and Yield

Curve Risk Transformations

Originally t it led Yield Curve Part ial DV01s and Risk Transformat ions
Thomas S. Coleman
Close Mount ain Advisors LLC
20 May 2011
Durat ion and DV01 (dollar durat ion) measure price sensit ivit y and
provide t he basic risk measure for bonds, swaps, and ot her fixed income
inst rument s. When valuing inst rument s off a yield curve, durat ion and
DV01 nat urally ext end t o a vect or of part ial DV01s or durat ions (key rat e
durat ions) and t hese are widely used in t he finance indust ry. But part ial
DV01s or durat ions can be measured wit h respect t o different rat es:
forwards, par rat es, zero yields, or ot hers. This paper reviews t he concept s
of part ial DV01 and durat ion and t hen discusses a simple met hod for
t ransforming part ial DV01s bet ween different rat e bases and provides
examples. The benefit of t his t ransformat ion met hod is t hat it only
requires calculat ing t he risk of a small set of alt ernat e inst rument and
does not require re-calculat ing t he original port folio risk. (This paper is
also available in an int eract ive version wit h enhanced digit al cont ent - see
references.)
Keywords: DV01, Durat ion, Key Rat e Durat ion, Int erest Rat e Risk, Yield
Curve Risk, Dollar Durat ion, Modified Durat ion, Part ial DV01
JEL Classificat ions: G10, G12, E43
Paper
Introduction
Durat ion and DV01 provide t he basic measures for evaluat ing t he sensit ivit y or risk of fixed income inst ru-
ment s and are widely used t hroughout t he financial indust ry. The DV01 (dollar value of an 01) is t he deriva-
t ive of price wit h respect t o yield:
Price = PV ( y ) DV01 =
d PV
d y
Modified or adjust ed durat ion, t he derivat ive in percent age inst ead of dollar t erms, is t he DV01 expressed in
different unit s:
Modified or Adjust ed Durat ion =
100
PV
d PV
d y
= 100
DV01
PV
One can use eit her DV01 or modified durat ion and t he choice bet ween t hem is largely a mat t er of conve-
nience, t ast e, and cust om. DV01, also called dollar durat ion, PV01 (present value of an 01), or BPV (basis
point value), measures t he derivat ive in price t erms: t he dollar price change per change in yield. Modified
durat ion measures t he derivat ive in percent t erms as a semi-elast icit y: t he percent price change per change
in yield. I will work most ly wit h DV01 t hroughout t his paper but t he ideas apply equally well t o modified
durat ion.
One can use eit her DV01 or modified durat ion and t he choice bet ween t hem is largely a mat t er of conve-
nience, t ast e, and cust om. DV01, also called dollar durat ion, PV01 (present value of an 01), or BPV (basis
point value), measures t he derivat ive in price t erms: t he dollar price change per change in yield. Modified
durat ion measures t he derivat ive in percent t erms as a semi-elast icit y: t he percent price change per change
in yield. I will work most ly wit h DV01 t hroughout t his paper but t he ideas apply equally well t o modified
durat ion.
In pract ice a bond or ot her fixed-income securit y will oft en be valued off a yield curve, and we can ext end t he
DV01 and durat ion t o part ial DV01s or key rat e durat ions - t he part ial derivat ives wit h respect t o yields for
different part s of t he curve:
Part ial DV01 s = |
o PV
o y
1

o PV
o y
k
|
Calculat ing and using part ial DV01s based on a curve is a nat ural ext ension of t he basic yield DV01, just as
part ial derivat ives are a nat ural ext ension of t he univariat e derivat ive. Part ial DV01s of one form or anot her
have been used for years t hroughout t he financial indust ry (see Ho 1992 and Reit ano 1991 for early discus-
sions). There is, however, one import ant difference. For t he basic DV01 t here is a single, effect ively unique,
yield for defining t he derivat ive. Part ial DV01s involve a full yield curve. Because t he yield curve can be
expressed in t erms of different yields and t here is no one best set of yields, part ial DV01s can be calculat ed
wit h respect t o a variet y of possible yields. The values for t he part ial DV01s will depend on t he set of rat es
used, even t hough part ial DV01s calculat ed using alt ernat e yields all measure t he same underlying risk. Using
different set s of yields - sensit ivit y t o part s of t he curve - simply measures risk from different perspect ives.
Somet imes it is more convenient t o express part ial DV01s using one set of rat es, somet imes anot her. In
pract ice it is oft en necessary t o t ranslat e or t ransform from one set of part ial DV01s t o anot her.
An example will help clarify ideas. Say we have a 10 year zero bond. Say it is t rading at $70.26 which is a
3.561% semi-bond yield. The t ot al DV01 will be
DV01
sab
=
d PV
d y
sab
= 6.904 $ l 100 bp .
This is measured here as t he price change for a $100 not ional bond per 100bp or 1 percent age point change in
yield. The modified durat ion for t his bond will be
ModD = 100
6.904
70.26
= 9.83 %l 100 bp
The modified durat ion is measured as t he percent change in price per 1 percent age point change in yield.
As point ed out above, t here is a single yield-t o-mat urit y for t he bond and so lit t le choice in defining t he DV01
or durat ion. When we t urn t o valuat ion using a curve, however, t here are many choices for t he yields used t o
calculat e t he part ial DV01s. The exact meaning of part s of t he curve is discussed more [below] [in t he
companion paper], but for now we rest rict ourselves t o a curve built wit h inst rument s wit h mat urit y 1, 2, 5,
and 10 years. A nat ural choice, but by no means t he only choice, would be t o work wit h zero-coupon yields of
mat urit y 1, 2, 5, and 10 years. Using such a curve and such rat es for our 10 year zero t he part ial DV01s would
be:
Table 1 - Part ial DV01(w.r.t . zero yields) for 10 Year Zero Bond
10year Zero Bond Zero Yield Partial DV01
1yr Zero 2yr Zero 5yr Zero 10yr Zero Total
0. 0. 0. 6.904 6.904
The 10-year part ial DV01 and t he sum of t he part ial DV01s is t he same as t he original t ot al DV01. This should
not be a surprise since bot h t he part ial DV01 and t he original DV01 are calculat ed using zero yields.
Zero yields are a convenient choice for t his part icular bond but are not t he only choice. We could equally
well calculat e t he risk using yields on par swaps or bonds, shown in t able 2.
2 temp.nb
Zero yields are a convenient choice for t his part icular bond but are not t he only choice. We could equally
well calculat e t he risk using yields on par swaps or bonds, shown in t able 2.
Table 2 - Part ial DV01(w.r.t . par yields) for 10 Year Zero Bond
10year Zero Bond Par Yield Partial DV01
1yr Swap 2yr Swap 5yr Swap 10yr Swap Total
0.026 0.105 0.54 7.597 6.926
It is import ant t o not e t hat in t he t wo examples t he exact numbers, bot h t he dist ribut ion across t he curve
and t he t ot al (a parallel shift of 100bp in all yields) are different . Nonet heless t he risk is t he same in bot h.
The part ial DV01s are simply expressed in different unit s or different co-ordinat es - essent ially t ransformed
from one set of rat es or inst rument s t o anot her.
Usually we st art wit h risk in one represent at ion or in one basis, oft en dependent on t he part icular risk syst em
we are using, but t hen want t o use t he part ial DV01s calculat ed from anot her set of yields. We might be given
t he zero-rat e part ials but wish t o see t he par-yield part ial DV01s. We would need t o t ransform from t he zero
basis t o t he par basis.
This paper describes a simple met hodology for t ransforming bet ween alt ernat e set s of rat es or inst rument s.
The essence of t he approach is:

St art wit h part ial DV01s (for our securit y or port folio) calculat ed in one represent at ion, usually based on
t he risk syst em used and t he part icular funct ional form used t o build t he curve.

Pick a set of inst rument s t hat represent t he alt ernat e yields or rat es desired for t he part ial DV01s. For
example if we wish t o t ransform t o par bond yields, choose a set of par bonds.

Perform an auxiliary risk calculat ion for t his set of alt ernat e inst rument s t o obt ain part ial derivat ives,
report ed on t he same basis as t he original risk.

Use t his mat rix of part ial derivat ives t o creat e a t ransformat ion mat rix, and t ransform from t he original
part ial DV01s t o t he new part ial DV01s by a simple mat rix mult iplicat ion.
The mat rix provides a quick, comput at ionally efficient way t o t ransform from t he original DV01s t o t he new
DV01s, essent ially a basis or coordinat e t ransformat ion. The benefit of t his t ransformat ion approach is t hat it
does not require us t o re-calculat e t he sensit ivit ies or DV01s for t he original port folio risk, a t ask t hat is oft en
difficult and t ime-consuming. The auxiliary sensit ivit y calculat ions for t he set of alt ernat e inst rument s will
generally be quick, involving valuat ion of a handful of plain-vanilla inst rument s.
Review of DV01, Duration, Yield Curves, and Partial DV01
Durat ion and DV01 are t he foundat ion for virt ually all fixed income risk analysis. For t ot al durat ion or DV01
(using t he yield-t o-mat urit y rat her t han a complet e yield curve) t he ideas are well-known. Nonet heless, it
will prove useful t o review t he basic concept s. Part ial DV01s or key rat e durat ions are used t hroughout t he
t rading communit y but are less well-known t o t he general reader. Part ial DV01s become import ant when we
value securit ies off a yield curve or forward curve. We will t hus provide a brief review of forward curves, t hen
t urn t o t he definit ion and caluclat ion of part ial DV01s. Finally we will discuss some examples of using part ial
DV01s for hedging, t o mot ivat e why it is so oft en necessary t o use part ial DV01s calculat ed using different
rat e bases and why t ransforming bet ween part ial DV01s is so import ant .
Total DV01 and Duration
The durat ion we are concerned wit h is modified durat ion, t he semi-elast icit y, percent age price sensit ivit y or
logarit hmic derivat ive of price wit h respect t o yield:
(1) Modified or Adjust ed Durat ion =
1
V
d V
d y
=
d ln V
d y
The name durat ion originat ed wit h Frederick Macaulay (1938) and his definit ion of durat ion as t he weight ed
average mat urit y of cash flows, using t he present value of cash flows as weight s:
temp.nb 3
The name durat ion originat ed wit h Frederick Macaulay (1938) and his definit ion of durat ion as t he weight ed
average mat urit y of cash flows, using t he present value of cash flows as weight s:
(2)
Macaulay Durat ion = `
i =1
n
t
i
PV
i
V
Macaulay durat ion applies t o inst rument s wit h fixed cash flows (t
i
is t he mat urit y of cash flow i, PV
i
is t he
present value of cash flow i, and V is t he sum of all PVs). Macaulay durat ion is a measure of t ime or mat urit y
(hence t he name durat ion), and is measured in years. This is in cont rast t o modified durat ion, which is a
rat e of change of price w.r.t . yield and is measured as percent per unit change in yield.
The shared use of t he t erm durat ion for bot h a mat urit y measure and a price sensit ivit y measure causes
endless confusion but is deeply embedded in t he finance profession. The shared use of t he t erm arises
because Macaulay durat ion and modified durat ion have t he same numerical value when yield-t o-mat urit y is
expressed cont inuously-compounded. For a flat yield-t o-mat urit y and cont inuously-compounded rat es t he
sum of present values is:
V = `
i =1
n
PV
i
= `
i =1
n
CF
i
e
t i y
Taking t he logarit hmic derivat ive w.r.t . y gives:
ModD =
1
V
d V
d y
= `
i =1
n
t
i
CF
i
e
t i y
V
But not e t hat t he t erm
CF
i
e
t i y
V
is just
PV
i
V
so t hat t his is also t he formula for Macaulay durat ion, and so
modified durat ion and Macaulay durat ion have t he same numerical value.
In t he more common sit uat ion where rat es are quot ed periodically-compounded, t hen t he sum of present
values will be:
V = `
i =1
n
PV
i
= `
i =1
n
CF
i
| 1 + y k ]
k t i
where k is t he compounding frequency (e.g. 1 for annual, 2 for semi-annual). Taking t he logarit hmic deriva-
t ive in t his case gives:
ModD =
1
V
d V
d y
= `
i =1
n
t
i
1
V
CF
i
| 1 + y k ]
k t i
1
| 1 + y k ]
This can be writ t en as
ModD = `
i =1
n
t
i
PV
i
V
1
| 1 + y k ]
which gives t he oft -quot ed relat ion:
(3)
ModD =
MacD
| 1 + y k ]
It is vit ally import ant t o remember, however, t hat t his expresses a relat ionship bet ween t he values of modi-
fied and Macaulay durat ion (for fixed cash flow inst rument s such as bonds) but t hat t he t wo measures are
concept ually dist inct in spit e of sharing t he name. Macaulay durat ion is a measure of t ime, denot ed in years.
Modified durat ion is a rat e of change, percent age change in price per unit change in yield. Macaulay durat ion
is limit ed in applicat ion t o inst rument s wit h fixed cash flows (such as st andard bonds) while modified dura-
t ion can be applied t o more general fixed-income inst rument s such as opt ions.
4 temp.nb
It is vit ally import ant t o remember, however, t hat t his expresses a relat ionship bet ween t he values of modi-
fied and Macaulay durat ion (for fixed cash flow inst rument s such as bonds) but t hat t he t wo measures are
concept ually dist inct in spit e of sharing t he name. Macaulay durat ion is a measure of t ime, denot ed in years.
Modified durat ion is a rat e of change, percent age change in price per unit change in yield. Macaulay durat ion
is limit ed in applicat ion t o inst rument s wit h fixed cash flows (such as st andard bonds) while modified dura-
t ion can be applied t o more general fixed-income inst rument s such as opt ions.
When we t urn t o DV01 we calculat e t he dollar (rat her t han percent age) change in price wit h respect t o yield:
(4)
DV01 =
d V
d y
DV01 is also called dollar durat ion, BPV (basis point value), Risk (on t he Bloomberg syst em), or PV01
(present value of an 01, alt hough PV01 more accurat ely refers t o t he value of a one dollar or one basis point
annuit y). The relat ion bet ween DV01 and modified durat ion is:
(5) ModD = 100
DV01
V
DV01 =
ModD V
100
The issue of unit s for measuring DV01 can be a lit t le confusing. For not ional bonds such as we are consider-
ing here, t he DV01 is usually measured as dollars per 100bp change in yields (for $100 not ional bond). This
gives a value for DV01 of t he same magnit ude as t he durat ion - on t he order of $8 for a 10 year bond. This is
convenient for not ional bonds, but for act ual port folios t he DV01 is more oft en measured as dollars per 1bp
change in yields (t hus t he t erm dollar value of an 01 or 1bp). For $1mn not ional of a 10 year bond t his will
give a DV01 on t he order of $800.
The concept s of durat ion and DV01 become more concret e if we focus on specific examples. Consider a t wo
year and a t en year bond, t oget her wit h t wo and t en year annuit ies and zero bonds. Table 3 shows t hese
bonds, t oget her wit h assumed prices and yields.
Table 3 - DV01 and Durat ions For Select ed Swaps, Annuit ies, and Zero-Coupon Bonds
Instrument Coupon Price Yield DV01 Mod Dur Mac Dur
2yr Bond 2.5 100. 2.5 1.94 1.94 1.96
5yr Bond 3. 100. 3. 4.61 4.61 4.68
10yr Bond 3.5 100. 3.5 8.38 8.38 8.52
2yr Ann 2.5 4.86 2.3 0.06 1.23 1.24
10yr Ann 3.5 29.72 3.22 1.46 4.91 4.98
2yr Zero 0. 95.14 2.51 1.88 1.97 2.
10yr Zero 0. 70.28 3.56 6.9 9.82 10.
DV01 is t he dollarchange for a $100 not ionalinst rument per100bp change in yield.Modifieddurat ionis t he percentchange per100bp
change in yield.Macaulaydurat ionis t he weight edaveraget ime t o mat urit y,in years.
The DV01 is t he change in price per change in yield. It can be calculat ed (t o a good approximat ion) by bump-
ing yield up and down and t aking t he difference; i.e. calculat ing a numerical derivat ive. For example t he t en
year bond has a yield-t o-mat urit y of 3.50% and is priced at 100. At 10bp higher and lower t he yields are 3.6%
and 3.4% and t he prices are 99.1664 and 100.8417. The DV01 is approximat ely:
DV01
10 yr bond
=
100.8417 99.1664
3.6 3.4
= 8.38
The modified durat ion can be calculat ed from t he DV01 using t he relat ion in (5). The Macaulay durat ion can
t hen be calculat ed using t he relat ion (3) or t he original definit ion (2). For t he t able above, and in most pract i-
cal applicat ions, it proves easier t o calculat e a numerical derivat ive approximat ions t o eit her DV01 or modi-
fied durat ion (1 or 4) and t hen use t he relat ions (3) and (5) t o derive t he ot her measures.
As point ed out , t he DV01 measures sensit ivit y in dollar t erms, t he modified durat ion in percent age t erms.
Anot her way t o t hink of t he dist inct ion is t hat DV01 measures t he risk per unit not ional while t he durat ion
measures risk per $100 invest ed. Comparing t he 10 year bond and t he 10 year annuit y in t able 3 help illust rat e
t he dist inct ion. The 10 year bond is $100 not ional and also $100 present value ($100 invest ed). The DV01 and
t he modified durat ion are t he same for bot h. The 10 year annuit y is $100 not ional but only $29.72 invest ed.
The risk per unit not ional (per $100 not ional as displayed in t able 3) is $1.46 for a 100bp change in yield. The
risk per $100 invest ed is $4.91, just t he $1.46 grossed up from $29.72 t o $100.
temp.nb 5
As point ed out , t he DV01 measures sensit ivit y in dollar t erms, t he modified durat ion in percent age t erms.
Anot her way t o t hink of t he dist inct ion is t hat DV01 measures t he risk per unit not ional while t he durat ion
measures risk per $100 invest ed. Comparing t he 10 year bond and t he 10 year annuit y in t able 3 help illust rat e
t he dist inct ion. The 10 year bond is $100 not ional and also $100 present value ($100 invest ed). The DV01 and
t he modified durat ion are t he same for bot h. The 10 year annuit y is $100 not ional but only $29.72 invest ed.
The risk per unit not ional (per $100 not ional as displayed in t able 3) is $1.46 for a 100bp change in yield. The
risk per $100 invest ed is $4.91, just t he $1.46 grossed up from $29.72 t o $100.
Table 3 shows t he Macaulay durat ion of t he zero bonds are equal t o mat urit y, as should be. The modified
durat ions are slight ly lower (dividing by one plus yield as per above), and t he DV01s lower st ill (mult iplying
by t he zero prices, which are below 100). For t he coupon bonds t he Macaulay durat ion is less t han mat urit y,
reflect ing t he coupons t hat are paid prior t o mat urit y.
A good way t o visualize t he Macaulay durat ion is t o imagine PVs of cash flows as weight s placed on a balance-
beam. Figure 1 shows t he Macaulay durat ion for t he t wo year annuit y. The cash flows are $1.25 each half-
year, and t he circles represent t he PVs, which gradually decline furt her out . The fulcrum of t he balance beam
is just slight ly less t han t he mid-point (1.24 years). If we drew t he diagram for t he t wo year bond t here would
be a much large cash flow (t he $100 principal) at year 2 and t his is what pushes t he Macaulay durat ion (t he
fulcrum on t he balance beam) out t o 1.96 years for t he t wo year coupon bond.
Figure 1 - Macaulay Duration for Two Year Annuity
s e cna me 2 yr Ann
INTERACTIVE VERSION
select security above
PV 1.236 1.222 1.208 1.194
1.24
Time 0.5 1. 1.5 2.
PV 1.236 1.222 1.209 1.195
1.24
Time 0.5 1. 1.5 2.
This showst he Macaulaydurat ionas t he fulcrumor balancepoint on a balancebeam,wit h weight srepresent ingt he presentvalueofcash
flows. PV is t he presentvalueoft he cash flow.Time is t he mat urit yoft he cash flow.The MacaulayDurat ion is shown at t he fulcrum.In
t he .cdf/ .nbpPlayerversiont he t ableis int eract iveand t he readercan choosewhichsecurit yis displayed.See referencesfor link t o
int eract iveversion.
The equalit y (or near-equalit y) in t he values of modified and Macaulay durat ion can be a valuable aid t o
int uit ion. Macaulay durat ion will always be less t han t he maximum mat urit y (equal only for a single cash
flow, i.e. a zero-coupon bond, as seen in t able 3 and t he definit ion in equat ion 2). This means we can oft en
make a rough guess at t he Macaulay durat ion and from t hat infer a rough value for t he modified durat ion. For
example a t en year bond will have Macaulay durat ion somewhat but not dramat ically less t han 10 years, and
so t he modified durat ion will be somewhat less t han 10%. In t able 1 we can see t hat t he t en year bond has a
Macaulay durat ion of 8.5 years and a modified durat ion of 8.4%.
6 temp.nb
The equalit y (or near-equalit y) in t he values of modified and Macaulay durat ion can be a valuable aid t o
int uit ion. Macaulay durat ion will always be less t han t he maximum mat urit y (equal only for a single cash
flow, i.e. a zero-coupon bond, as seen in t able 3 and t he definit ion in equat ion 2). This means we can oft en
make a rough guess at t he Macaulay durat ion and from t hat infer a rough value for t he modified durat ion. For
example a t en year bond will have Macaulay durat ion somewhat but not dramat ically less t han 10 years, and
so t he modified durat ion will be somewhat less t han 10%. In t able 1 we can see t hat t he t en year bond has a
Macaulay durat ion of 8.5 years and a modified durat ion of 8.4%.
Macaulay durat ion is useful as an aide for int uit ion but in measuring price sensit ivit y we must use eit her
modified durat ion or DV01. In many cases one can use eit her, convert ing bet ween t hem using equat ion (5)
depending on t he needs of t he problem. Generally, managers of real-money long-only port folios use modi-
fied durat ion while managers of t rading and derivat ives port folios t end t o use DV01. Modified durat ion is
well-suit ed for long-only port folios, where risk and ret urn can be measured as a percent of port folio value,
while DV01 is more suit ed t o port folios where t he present value of t he port folio may be zero and measuring
risk in absolut e or dollar t erms is more convenient .
In using durat ion we must be careful wit h a few point s. First , we must keep st raight t he dist inct ion bet ween
Macaulay durat ion (a measure of mat urit y) and modified durat ion (a measure of price sensit ivit y). Second,
we must remember t hat (modified) durat ion t ells us t he price sensit ivit y t o a change in rat es, but does not
t ell us what rat es we are sensit ive t o, in spit e of t he t erm durat ion. Consider t he t en year annuit y, which has
a Macaulay and modified durat ion of roughly 5. The durat ion of 5 does not mean t he annuit y is sensit ive t o
five year rat es or react s in t he same way as a five year bond. Think back t o t he fulcrum view from figure 1 - for
t he annuit y t he fulcrum is in t he middle and t he cash flows at t he far end depend on longer-dat ed rat es. For
t he t en year annuit y t he fulcrum sit s at roughly 5 years but t here are cash flows ext ending out t o t en years so
t he t en year annuit y will have sensit ivit y out t o t en years.
As a personal mat t er I usually use DV01 rat her t han durat ion. I prefer t o sidest ep t he confusion bet ween t he
different meanings of t he t erm durat ion and find t he concept of DV01 cleaner and simpler. Having st at ed
my preference, it is a personal preference and DV01 or modified durat ion can usually be used int erchange-
ably. Throughout t he rest of t his paper, however, I will use DV01 rat her t han durat ion.
Yield and Forward Curves
Part ial DV01s or key rat e durat ions are a nat ural ext ension of t he t ot al DV01 or durat ion when we move t o
pricing securit ies off a yield curve. To appreciat e t he how and why of part ial DV01s we first need t o briefly
review yield or forward curves before t urning t o t he definit ion of part ial DV01s.
The discussion above t reat ed DV01 as a funct ion of yield-t o-mat urit y, essent ially t reat ing each bond or
inst rument on it s own, having it s own yield. In many sit uat ions we will consider a set of bonds or inst rument s
t oget her, all valued by discount ing off a common market -based yield curve. Discount ing cash flows off a
yield curve or forward curve forms t he foundat ion for all t rading of fixed income inst rument s. An example
would be a collect ion of swaps valued off a yield curve derived for a small set of on-t he-run or act ive inst ru-
ment s (swaps, fut ures, libor deposit s). The value of a swap will be t he discount ed value of fut ure cash flows,
discount ing off t he yield curve.
Forward, Zero, and Discount Curves
The most const ruct ive way t o t hink of a yield curve is as a funct ion t hat provides t he discount fact or for any
day - for t he zero bond discussed above we would want t he discount fact or 10 years in t he fut ure but for more
general inst rument s it might be any dat e from t oday out t o 10 years in t he fut ure. It is part icularly convenient
t o work wit h t he forward curve f(t ), where t is t he mat urit y measured in years from t oday and f(.) is t he inst an-
t aneous forward rat e. Alt ernat ively we could work wit h t he zero-coupon yield curve z(t ), or discount curve
d(t ), but t he t hree are relat ed and so t he choice becomes one of convenience. When we express rat es cont inu-
ously-compounded, t he relat ions bet ween t he forward, zero, and discount curve are:
z ( t ) =
1
0
t
f ( u ) d u
t
temp.nb 7
d ( t ) = exp [ z ( t ) t ] = exp |

0
t
f ( u ) d u | .
In what follows I will oft en use t he t erms forward curve, yield curve, and zero curve int erchangeably; since we
can always t ranslat e bet ween t he forward, zero, and discount funct ions t his casual t erminology should be
accept able. (Coleman 1998 discusses forward curves in more det ail.)
In general we want t o be able t o get t he discount fact or for any dat e; i.e. we want f(t ) for any and all t . Market
dat a (such as in t able 4 below) never provide enough dat a t o direct ly det ermine t he discount fact or for every
day. Inst ead we generally assume some paramet ric (but flexible) funct ional form for t he forward curve,
depending on paramet ers or variables ( v
1
v
k
) . We t hen choose t he paramet ers so t hat t he curve prices
t he market dat a correct ly. This means t he forward / zero curve will be a funct ion of t he variables
( v
1
v
k
) .
Example of Forward Curve
An example helps t o explain and clarify how a yield curve is const ruct ed and used. Say t hat t he following
swaps are PV zero in t he market , and we decide t o use t hese as our market dat a:
Table 4 - Hypot het ical Market (Zero-PV) Swaps
Maturity yrs Fixed Rate
1 2
2 2.5
5 3
10 3.5
USD Swaps
In ot her words t hese are t he current -market par swap rat es. We can now build a forward or yield curve t hat is
consist ent wit h t hese par swap rat es, and which we can use t o value t hese and ot her swaps.
As an example of a funct ional form we can assume t hat inst ant aneous forward rat es are const ant bet ween
inst rument mat urit y point s (break point s or knot point s) and t hat t he forward rat es jump at mat urit y point s.
In t his case t he variables ( v
1
v
k
) are t he forward rat es bet ween knot point s. (This is, in fact , a pract ical
and useful forward curve oft en used by market pract it ioners, but it is only one among many.) Funct ionally,
t his is a piece-wise const ant funct ion:
f1 0 t && t 1
f2 1 t && t 2
f3 2 t && t 5
f4 5 t && t 10
0 True
If we choose t he forward rat es t o mat ch t he market dat a given in t able 2, we get :
0.0199 0 t && t 1
0.0299 1 t && t 2
0.0333 2 t && t 5
0.0406 5 t && t 10
0 True
and graphically t he forward funct ion is a st ep funct ion:
Figure 2 - Piece-Wise Constant Forward Curve
8 temp.nb
2 4 6 8 10
Mat urit y ( yrs)
0.01
0.02
0.03
0.04
Inst ant aneousRat es
Solid a re Ze ro Ra te s , Da s he d a re Forwa rd Ra te s
These inst ant aneous forward rat es are chosen so t hat t he market inst rument s are priced correct ly. We can
now use t his forward curve t o price arbit rary cash flows t o obt ain market -based prices of ot her inst rument s,
prices t hat are consist ent wit h t he inst rument s shown in t able 4.
In pract ice swap curves are usually built wit h a variet y of different inst rument s, including libor deposit s, libor
fut ures, and par swaps. For exposit ory purposes it will be useful t o consider a curve built wit h bot h spot and
forward inst rument s, and t hus we will build our curve wit h t he following inst rument s:
Table 5 - Market Inst rument Used for Building Sample Curve
Instrument Forward Start Underlier
yrs
Coupon
Rate
Fwd
Rate cc
1yr Swap 0 1 2. 0.0199
1y2y Fwd 1 1 3.014 0.0299
5yr Swap 0 5 3. 0.0333
10yr Swap 0 10 3.5 0.0406
These inst rument s produce t he values for t he forward curve variables, t he inst ant aneous forward rat es,
shown above in figure 2. A realist ic forward curve would be built using many more inst rument s, on t he order
of 20, but t he curve in figure 2 (using t he four inst rument s in t able 5) is simple while serving t o illust rat e t he
issues. Furt hermore, alt hough we work wit h a swap curve t hroughout t he ideas apply t o any curve used for
valuing fut ure cash flows.
PV of Instruments Off Curve
Wit h t his forward curve we can now price t he original market inst rument s (which by const ruct ion will have
PV zero) plus ot her swaps or bonds. Table 6 shows t he original PV-zero market swaps, plus a select ion of
addit ional swaps, annuit ies and zero-coupon inst rument s (all not ional 100).
Table 6 - PV For Select ed Swaps, Annuit ies, Zero-Coupon Bonds, and Forward Swaps
temp.nb 9
Instrument Forward Start Underlier yrs Coupon Rate PV
1yr Swap 0 1 2. 0.
1y2y Fwd 1 1 3.014 0.
5yr Swap 0 5 3. 0.
10yr Swap 0 10 3.5 0.
2yr Swap 0 2 2.5 0.
3yr Swap 0 3 2.8 0.06
2yr Ann 0 2 2.5 4.86
10yr Ann 0 10 3.5 29.72
2yr Zero 0 2 0. 95.14
10yr Zero 0 10 0. 70.28
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Inst rument s usedin fit t ing t he
curveare highlight ed.
Partial DV01s
Part ial DV01s, part ial durat ions, or key rat e durat ions are used t hroughout t he finance indust ry and have a
long hist ory. Ho (1992) int roduced t he t erm key rat e durat ion. Reit ano covered mult ifact or yield curve
models as early as 1991 (Reit ano 1991) and has revisit ed t he t opic in a recent review (Reit ano 2008).
When we use a yield curve t o value a set of fixed income inst rument s rat her t han a single yield-t o-mat urit y
for each bond, it is nat ural t o ext end t he concept of DV01 from a univariat e derivat ive t o a set of part ial
derivat ives. We now t urn t o t hese part ial DV01s.
Risk w.r.t. Curve Variables
Once we have a forward curve as a funct ion of t he variables ( v
1
v
k
) it is st raight -forward t o calculat e
t he part ial derivat ives (delt a risk or DV01) wit h respect t o t hese curve variables or paramet ers. In pract ice we
might do t his by simply bumping t he variables up and down and t aking a numerical derivat ive. This is, in
fact , what was done above for t he t ot al DV01 for a single yield-t o-mat urit y. Say we have a port folio consist ing
of n inst rument s or posit ions. The prices or PVs of t hese inst rument s will be funct ions of t he curve variables
( v
1
v
k
) represent ed by t he vect or
Prices =
P
1

P
n
=
P
1
( v
1
v
k
)

P
n
( v
1
v
k
)
and t he mat rix of part ial derivat ives will be:
(6) DpDv = part ial DV01 w .r .t . curve variables =
o P
1
ov
1

o P
1
ov
k

o P
n
ov
1

o P
n
ov
k
For t he piece-wise forward curve we are using, t he curve variables are forward rat es and t he part ial DV01s will
be wit h respect t o forward rat es. For t he sample market yield curve shown in t able 5 t he forward rat e part ial
DV01s for select ed inst rument s will be:
Table 7 - DV01 w.r.t . Curve Variables (Forward Rat es) for Select ed Inst rument s
10 temp.nb
f0y1y f1y2y f2y5y f5y10y Total
1yr Swap 0.99 0. 0. 0. 0.99
1y2y Fwd 0. 0.97 0. 0. 0.97
5yr Swap 0.99 0.96 2.72 0. 4.68
10yr Swap 0.99 0.96 2.68 3.87 8.5
2yr Swap 0.99 0.97 0. 0. 1.96
3yr Swap 0.99 0.97 0.94 0. 2.9
2yr Ann 0.04 0.02 0. 0. 0.06
10yr Ann 0.29 0.25 0.57 0.36 1.47
2yr Zero 0.95 0.95 0. 0. 1.9
10yr Zero 0.7 0.7 2.11 3.51 7.03
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Curvevariablesare cont inuously-
compoundedforwardrat es. Inst rument s usedin fit t ing t he curveare highlight ed.
Using Partial DV01s - Hedging
Part ial DV01s are used t hroughout t he finance indust ry and we will now t urn t o a simple example t o illust rat e
t heir use. It will also serve t o show why we so oft en need t o t ransform part ial DV01s from one form t o
anot her.
Tot al DV01 (or durat ion) provides a useful measure of a bonds int erest rat e sensit ivit y but oft en t he t ot al
DV01 is just not sufficient . The t ot al DV01 t ells us t he size of t he yield sensit ivit y, but not where t he exposure
occurs. Look back at t able 3 and not e t hat t he 5 year bond has modified durat ion 4.6% and t he 10 year annu-
it y 4.9%. For $100 invest ed t he sensit ivit y will be almost t he same - $4.6 versus $4.9 (per 100bp change in
yields). But just because t he 5 year bond and t he 10 year annuit y have t he same t ot al exposure does not mean
t hey behave t he same when t he yield curve shift s or t wist s.
Tot al DV01 or durat ion measures sensit ivit y t o each inst rument ' s own yield-t o-mat urit y. For t he 5 year bond
and t he 10 year annuit y t he sensit ivit y t o t heir own yields are roughly t he same but we have no way of direct ly
comparing t he t wo yields. In a sense, when we use t ot al DV01 and yield-t o-mat urit y we t reat different bonds
as living in different worlds and we cannot direct ly compare t he t wo. We could examine hist ory and measure
t he correlat ion of t he yields, but t his becomes impract ical as t he number of bonds and yields grows. Part ial
DV01s and a yield curve provide a common framework for mult iple bonds wit h a limit ed number of rat es. (If
we want we can of course use t he DV01s in combinat ion wit h hist orical dat a, say in a value-at -risk framework,
and t hat will oft en be a logical furt her st ep.)
Valuing bonds from a common yield curve and calculat ing part ial DV01s provides a way of comparing expo-
sures for different bonds direct ly. Wit h part ial DV01s we measure t he sensit ivit y of each inst rument t o a
common set of yields or rat es rat her t han t o separat e yields. Look back at t able 7. The sensit ivit y of t he 5 year
swap and t he 10 year annuit y are expressed wit h respect t o t he same variables or rat es, and we can direct ly
compare t hem.
1
From t able 7 we also see t hat t he sensit ivit y across t he curve is very different for t he 5 year
bond/ swap and t he annuit y: t he 5 year bond has over half it s exposure t o t he 2-5 year forward rat e and no
exposure t o t he 5-10 year rat e, while t he 10 year annuit y has only 39% of it s exposure t o t he 2-5 year rat e and
24% t o t he 5-10 year rat e.
It is inst ruct ive t o examine how a swaps t rader might use t able 7. As part of managing a port folio a swaps
t rader will put on and t ake off hedges t o adjust risk as new deals come along or old deals unwind. Let us
cont inue wit h t he 10 year annuit y and say t hat our hypot het ical t rader is going t o t ake on a new posit ion of
$100 not ional (roughly $30 up-front ) in a 10 year annuit y. The t rader will not want t o build up a large expo-
sure t o int erest rat es, or at t he least will need t o measure t he exposure t aken on. Table 7 (or t able 3) t ells us
t hat t he t ot al exposure is $1.46. (This is t he DV01 for $100, measured per 100bp change in yields. If we were
working wit h an act ual posit ion, say $1mn, t hen t he DV01 would more commonly be measured per 1bp and
would be $146.) This $1.46 exposure could be hedged wit h roughly $31 not ional of t he 5 year bond (1.46 / 4.64
= 0.3147), t he same as what we found when examining t he modified durat ions just above.
temp.nb 11
It is inst ruct ive t o examine how a swaps t rader might use t able 7. As part of managing a port folio a swaps
t rader will put on and t ake off hedges t o adjust risk as new deals come along or old deals unwind. Let us
cont inue wit h t he 10 year annuit y and say t hat our hypot het ical t rader is going t o t ake on a new posit ion of
$100 not ional (roughly $30 up-front ) in a 10 year annuit y. The t rader will not want t o build up a large expo-
sure t o int erest rat es, or at t he least will need t o measure t he exposure t aken on. Table 7 (or t able 3) t ells us
t hat t he t ot al exposure is $1.46. (This is t he DV01 for $100, measured per 100bp change in yields. If we were
working wit h an act ual posit ion, say $1mn, t hen t he DV01 would more commonly be measured per 1bp and
would be $146.) This $1.46 exposure could be hedged wit h roughly $31 not ional of t he 5 year bond (1.46 / 4.64
= 0.3147), t he same as what we found when examining t he modified durat ions just above.
Examining t able 7, however, we can see t hat hedging t he 10 year annuit y wit h t he 5 year bond will leave
considerable curve exposure; as point ed out above t he exposure across t he curve is quit e different . The
following t able shows t he exposure t o forward rat es for a posit ion of short $31.47 in t he 5 year bond and long
$100 in t he annuit y. The t ot al exposure (exposure t o a parallel shift in all rat es) is zero but t here is exposure if
forward rat es rat es do not all move in t he same direct ion.
Hedging 10 year Annuity with 5 year Bond
Partial DV01 wrt Forward Rates
1yr Swap 1y2y Fwd 2y5y Fwd 5y10y Fwd Total
5yr Bond $31 0.31 0.3 0.86 0. 1.47
10yr Ann $100 0.29 0.25 0.57 0.36 1.47
Combination 0.02 0.05 0.29 0.36 0.
Hedging means t hat we choose posit ions so t hat t here is no profit or loss as t he curve shift s or t wist s, and
using just t he 5 year bond does not accomplish t his. For our 10 year annuit y we want no profit or loss when
any of t he 0-1, 1-2, 2-5, or 5-10 year rat es move. For a swaps desk t he hedging insrument s will oft en be par
swaps and bonds, in t his case say t he 1, 2, 5, and 10 year swaps, so hedging requires t hat we choose t he swap
amount s (denot ed as N
1
, N
2
, N
5
, N
10
) so t hat t his hedge port folio has t he same exposure wit h respect t o
each rat e as t he original annuit y (but of opposit e sign - so t hat it is a hedge). Table 8 reproduces t able 7 but
shows sensit ivit ies for just t he hedge inst rument s and t he annuit y.
Table 8 - Part ial DV01 (w.r.t . forward rat es) Showing Sample New Posit ion (whit e) and Hedging Swaps (blue)
f0y1y f1y2y f2y5y f5y10y Total
1yr Swap 0.99 0. 0. 0. 0.99
2yr Swap 0.99 0.97 0. 0. 1.96
5yr Swap 0.99 0.96 2.72 0. 4.68
10yr Swap 0.99 0.96 2.68 3.87 8.5
10yr Ann 0.29 0.25 0.57 0.36 1.47
Ensuring t hat t he hedge port folio has t he same exposure t o rat es as t he annuit y posit ion means solving t he
following syst em of equat ions:
(7) ( N
1
N
2
N
5
N
10
)
o S
1
o f
0 1

o S
1
o f
5 10

o S
10
o f
0 1

o S
10
o f
5 10
= |
o Ann
o f
0 1
o Ann
o f
1 2
o Ann
o f
2 5
o Ann
o f
5 10
|
Solving t his is not overly complicat ed - it just requires inversion of a mat rix - but nor is t he solut ion obvious
from t able 8.
If we could, however, express t he part ial DV01s calculat ed using par yields inst ead of forward rat es, t he
solut ion would become simple, even t rivial. Table 9 shows t he sensit ivit ies calculat ed using t he par swap
yields. The off-diagonal element s are now zero, meaning it will be easy t o solve t he mat rix equat ion (7).
Table 9 - Part ial DV01 (w.r.t . par bond yields) Showing Sample New Posit ion (whit e) and Hedging Swaps
(blue)
12 temp.nb
1yr Swap 2yr Swap 5yr Swap 10yr Swap Total
1yr Swap 0.98 0. 0. 0. 0.98
2yr Swap 0. 1.94 0. 0. 1.94
5yr Swap 0. 0. 4.61 0. 4.61
10yr Swap 0. 0. 0. 8.38 8.38
10yr Ann 0.03 0.11 0.54 0.78 1.45
The hedging solut ion can in fact be made even more obvious. Let us t ake a slight diversion t o discuss bond
equivalent s. Traders will oft en express exposures in t erms of bond equivalent s inst ead of DV01s. The st an-
dard way of doing t his would be t o divide t he annuit ys t ot al DV01 by t he t ot al DV01 for some amount of
reference or hedging bond, t hus convert ing from t he t ot al DV01 t o a number of bond equivalent s. The
result is t he amount of reference bonds t hat give t he same risk as t he annuit y; in ot her words a hedge amount
using t he reference bond. We could do t his in t he current case by dividing t he 10 year anuit y t ot al DV01 (1.46
$/ 100bp for $100 not ional, from t able 3) by t he 5 year swap t ot al DV01 (4.61 $/ 100bp for $100 not ional, again
from t able 3). Doing so we would find t hat $1 of t he 10 year annuit y is equivalent t o $0.32 of t he 5 year swap.
In ot her words we could "hedge" $1 of t he 10 year annuit y wit h $0.32 of t he 5 year swap, just as we found
above.
But as point ed out above t his would be a hedge only if t he yield-t o-mat urit ies of t he 10 year annuit y and t he 5
year swap move always exact ly t oget her, which t hey will not do. The bet t er approach for hedging is t o use t he
part ial DV01s t o measure sensit ivit y of bot h t he hedges and t he annuit y t o each of t he common yield curve
component s, and hedge t hese component s.
The nice t hing is t hat when using par yield part ials as in t able 9, slight ly ext ending t he idea of bond equiva-
lent s present s t he hedging solut ion in a part icularly self-evident form. We can divide each of t he 10 year
annuit ys part ial DV01s by t he t ot al DV01 for t he corresponding par swap or bond. Table 10 shows t he annuit y
part ial DV01s (t he same as in t able 9), t he par swap t ot al DV01s, and t he annuit y bond equivalent s t hat result
when dividing one by t he ot her. Since t he off-diagonal element s in t able 9 are zero (and t he diagonal ele-
ment s are t he t ot al DV01), dividing by t he t ot al DV01s is act ually equivalent t o solving equat ion (7). In ot her
words, using par swap part ials (from t able 9) and calculat ing bond equivalent s means t hat in t able 10 we can
read hedge amount s direct ly. To hedge $1 of t he 10 year annuit y we need t o sell $0.09 of t he 10 year par swap,
$0.12 of t he 5 year, $0.05 of t he 2 year, and $0.03 of t he 1 year.
Table 10 - Bond Equivalent s for 10 Year Zero Bond using Par Swap Part ial DV01s
1yr Swap 2yr Swap 5yr Swap 10yr Swap
Annuity Partial DV01s 0.03 0.11 0.54 0.78
Par Swap Total DV01 0.98 1.94 4.61 8.38
Annuity Bond Eqv 0.03 0.05 0.12 0.09
The ease of reading hedge amount s direct ly from an exposure report such as t able 10 (or calculat ing t he
amount s from t he par swap DV01s in t able 9) means t hat swaps t raders oft en want t heir exposure report ed as
par swap part ial DV01s. Hedge amount s for a new t rade or an exist ing port folio can t hen be easily read from
such a sensit ivit y report .
There are a variet y of furt her reasons we may be int erest ed in part ial DV01s calculat ed using alt ernat e vari-
ables. The variables ( v
1
v
k
) t hat appear in t he forward f(t ) or zero curve z(t ) may not be financially
meaningful, and t he result ing part ial DV01s may not be easily int erpret ed. For example cubic splines are a
common choice for funct ional form, and t he variables will not have as simple an int erpret at ion as t he for-
ward rat es in t he curve used here. Anot her reason may be t hat , even if t he paramet ers have some financial
int erpret at ion, t he unit s may not be t hose desired - for our example here t he forward rat es are quot ed as
cont inuously-compounded whereas in t he U.S. market yields are usually quot ed semi-annually com-
pounded. In t he end t he reason may be somet hing as simple as our boss preferring t o see risk quot ed in some
ot her manner.
temp.nb 13
There are a variet y of furt her reasons we may be int erest ed in part ial DV01s calculat ed using alt ernat e vari-
ables. The variables ( v
1
v
k
) t hat appear in t he forward f(t ) or zero curve z(t ) may not be financially
meaningful, and t he result ing part ial DV01s may not be easily int erpret ed. For example cubic splines are a
common choice for funct ional form, and t he variables will not have as simple an int erpret at ion as t he for-
ward rat es in t he curve used here. Anot her reason may be t hat , even if t he paramet ers have some financial
int erpret at ion, t he unit s may not be t hose desired - for our example here t he forward rat es are quot ed as
cont inuously-compounded whereas in t he U.S. market yields are usually quot ed semi-annually com-
pounded. In t he end t he reason may be somet hing as simple as our boss preferring t o see risk quot ed in some
ot her manner.
The bot t om line is t hat we oft en need t o t ransform from t he original part ial DV01s t o some new form. In t he
example we have been discussing, par swap part ial DV01s are a good choice but par swap part ial DV01s are
not t he final word. A swapt ions t rader may prefer t o see exposures using forward rat es, since hedging is oft en
doen using fut ures and forward swaps. A senior manager wit h responsibilit y across desks may prefer expo-
sures in yet anot her form. There is no one form t hat is opt imal in all sit uat ions or for all users. The necessit y
for convert ing part ial DV01s from one form t o anot her arises regularly.
Partial DV01 Transformations
Now we t urn t o t he real focus of t his paper - t ransforming part ial DV01s. The goal is t o st art wit h part ial DV01s
in what ever form is supplied by t he risk soft ware syst em and t hen, using a t ransformat ion mat rix t hat is
relat ively easy t o obt ain, t ransform t he DV01s t o t he form we want . In t he example above we st art ed wit h a
risk syst em t hat supplied DV01s calculat ed using piece-wise const ant forward rat es (t able 7 or 8), but want ed
t o use DV01s using par swap rat es (t able 9).
Before t urning t o t he general t ransformat ion, however, we first discuss calculat ing DV01s using curve input s.
Here we bump t he input rat es or coupons for t he market inst rument s used in building t he curve rat her t han
bumping t he curve paramet ers. This is a nat ural alt ernat ive t o bumping t he paramet ers and a good int roduc-
t ion int o how we can view part ials using different set s of rat es. Nonet heless, bumping input s is generally
more comput at ionally expensive and less flexible t han t he t ransformat ion met hod discussed lat er.
Risk Using Curve Inputs
In t he example we have been working wit h t he curve is built using 1, 5, and 10 year swaps and t he 1-2 year
forward swap. We could bump t he input s, in t his case t he par swap rat es or fixed rat es for t he swaps. We
would bump t he rat es one-at -a-t ime, rebuild t he curve each t ime, revalue t he port folio wit h each new curve,
and t hereby calculat e numerical part ial derivat ives wit h respect t o each input . If t he k curve input rat es are
( r
1
r
k
) t hen t he mat rix of part ial derivat ives is:
(8) DpDr = Derivat ive of prices w .r .t . curve input rates =
o P
1
o r
1

o P
1
o r
k

o P
n
o r
1

o P
n
o r
k
For our hypot het ical market yield curve and t he inst rument s shown in t able 5, t he sensit ivit y will be w.r.t . t he
1 year par rat e, t he 1-2 year forward par rat e, t he 5 year and 10 year par rat es. This is shown in t able 11.
Table 11 - DV01 w.r.t . Curve Input Rat es for Select ed Inst rument s, Calculat ed by Direct Bumping of Input s
1yr Swap 1y2y Fwd 5yr Swap 10yr Swap Total
1yr Swap 0.98 0. 0. 0. 0.98
1y2y Fwd 0. 0.96 0. 0. 0.96
5yr Swap 0. 0. 4.64 0. 4.64
10yr Swap 0. 0. 0. 8.49 8.49
2yr Swap 0.98 0.95 0. 0. 1.94
3yr Swap 0.64 0.62 1.6 0. 2.87
2yr Ann 0.04 0.02 0. 0. 0.06
10yr Ann 0.08 0.05 0.54 0.79 1.46
2yr Zero 0.94 0.94 0. 0. 1.88
10yr Zero 0.08 0.05 0.54 7.7 7.03
14 temp.nb
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Inst rument s usedin fit t ing t he
curveare highlight ed.
The curve input part ial DV01s shown in t able 11 are simply a t ransformat ion of t he original curve variable
DV01s shown in t able 7. The underlying forward curve changes in exact ly t he same manner, we just measure
t he DV01s using t he curve input s rat her t han t he curve paramet ers. Nor are we rest rict ed t o t he curve input s
we originally used. We could use alt ernat e inst rument s t hat would be appropriat e for building t he curve. For
example we could subst it ut e t he 2 year swap for t he 1-2 year forward and t hen we would have t he part ials
using t he par swap inst ead of t he forward swap.
General Partial DV01 Transformation
Bumping curve input s is very useful but requires re-building t he yield curve mult iple t imes and re-calculat ing
t he risk for t he whole port folio. In many risk syst ems it is easy t o calculat e t he derivat ives using curve parame-
t ers but difficult (requiring re-programming) t o calculat e derivat ives using curve input s. We now t urn t o an
approach t hat accomplishes t he same - risk as if we re-built and bumped curve input s - but wit hout t he
burden of act ually re-building t he curve and re-valuing t he whole port folio. The t rick is t hat we can choose a
set of alt ernat e curve input s and calculat e t he risk of t hose alt ernat e input s using our original curve. We t hen
use t he mult ivariat e inverse funct ion t heorem t o calculat e t he inverse Jacobian and obt ain t he t ransforma-
t ion t hat convert s t he original part ial DV01s int o part ials w.r.t . t he alt ernat e curve input s. There are t wo huge
benefit s. First , we can infer what t he DV01s would be if we rebuilt our curve wit h t he alt ernat e inst rument s
but wit hout act ually having t o rebuild our curve or revalue t he whole port folio. Second, we can use any set of
alt ernat e inst rument s as long as we can calculat e t he risk for t hose inst rument s off our original curve (and as
long as t he alt ernat e inst rument s make sense for rebuilding our original curve).
Partial DV01s w.r.t Alternate Variables
Consider k alt ernat e variables ( x
1
x
k
) . Assume for now t hat t hese alt ernat e variables are t hemselves
t he yields or rat es we want t o use for calculat ing part ial DV01s and t hat we can calculat e t hese yields as a
funct ion of t he forward curve:
(9) Alt ernat e variables =
x
1

x
k
=
x
1
( v
1
v
k
)

x
k
( v
1
v
k
)
If we have t he same number of variables ( x
1
x
k
) as curve variables ( v
1
v
k
) t hen we can calculat e
t he derivat ives of t hese alt ernat e variables w.r.t . t he curve variables and t his will be t he Jacobian mat rix for
t he funct ion (9):
(10) DxDv = Jacobian for Curve Alt ernat e Variables =
o x
1
ov
1

o x
1
ov
k

o x
k
ov
1

o x
k
ov
k
If t his Jacobian is non-singular, t hen t he inverse funct ion t heorem t ells us t hat t here is an inverse funct ion
v
1

v
k
=
v
1
( x
1
x
k
)

v
k
( x
1
x
k
)
and t he Jacobian of t his funct ion is
temp.nb 15
(11) Inverse Jacobian = DvDx =
ov
1
o x
1

ov
1
o x
k

ov
k
o x
1

ov
k
o x
k
=
o x
1
ov
1

o x
1
ov
k

o x
k
ov
1

o x
k
ov
k
1
Using t he Jacobian of t he inverse funct ion we can t ransform t he derivat ives w.r.t . curve variables t o deriva-
t ives w.r.t . t he new variables. Consider t he first row of equat ion (6):
Derivat ive for P
1
w .r .t . Alt ernat e Variables = |
o P
1
o x
1

o P
1
o x
k
| =
|
o P
1
ov
1

o P
1
ov
k
|
ov
1
o x
1

ov
1
o x
k

ov
k
o x
1

ov
k
o x
k
= |
o P
1
ov
1

o P
1
ov
k
|
o x
1
ov
1

o x
1
ov
k

o x
k
ov
1

o x
k
ov
k
1
so t hat t he full mat rix is:
(12)
DpDx = Part ial DV01 w .r .t . Alternate Variables =
o P
1
o x
1

o P
1
o x
k

o P
n
o x
1

o P
n
o x
k
= DpDv . DvDx
= Derivat ive w .r .t . Curve Variables - Inverse Jacobian =
o P
1
ov
1

o P
1
ov
k

o P
n
ov
1

o P
n
ov
k

o x
1
ov
1

o x
1
ov
k

o x
k
ov
1

o x
k
ov
k
1
Partial DV01 w.r.t. Yield
If t he variables ( x
1
x
k
) are t he yields or rat es we want , and our risk syst em can easily produce t he
mat rix (10), t hen equat ion (12) is t he t ransformat ion mat rix we need. Most risk syst ems, however, will not
produce t he mat rix of part ials for yields direct ly. More oft en t he variables ( x
1
x
k
) will be price or PV
funct ions for t raded inst rument s. Risk syst ems are usually set up t o easily calculat e risk for t raded inst ru-
ment s, so t hat it is easy t o calculat e t he Jacobian (10) for price funct ions. But we usually want t o calculat e
risk w.r.t . yields or rat es, ( y
1
y
k
) , rat her t han prices of t raded inst rument s.
The solut ion t o t his is simple. For each inst rument we have a funct ion t hat gives t he yield as a funct ion of t he
price, and equat ion (9) is replaced by:
(13)
y
1

y
k
=
y
1
( v
1
v
k
)

y
k
( v
1
v
k
)
=
f
1
( x
1
)

f
k
( x
k
)
=
f
1
[ x
1
( v
1
v
k
) ]

f
k
[ x
k
( v
1
v
k
) ]
Using t he uni-variat e inverse funct ion t heorem we can calculat e f
i
'
as one over t he derivat ive of price w.r.t .
yield (t he basic DV01):
f
i
'
=
d x
1
d y
1
1
and by applicat ion of t he uni-variat e inverse funct ion t heorem and t he chain rule, we can get t he inverse
Jacobian for t hese yield variables:
16 temp.nb
and by applicat ion of t he uni-variat e inverse funct ion t heorem and t he chain rule, we can get t he inverse
Jacobian for t hese yield variables:
(14) Inverse Jacobian = DvDy =
ov
1
o y
1

ov
1
o y
k

ov
k
o y
1

ov
k
o y
k
=
|
d x
1
d y
1
|
1
o x
1
ov
1
|
d x
1
d y
1
|
1
o x
1
ov
k

|
d x
k
d y
k
|
1
o x
k
ov
1
|
d x
k
d y
k
|
1
o x
k
ov
k
1
The t ransformat ion (12) now becomes
(15)
DpDy = Part ial DV01 w .r .t . Alternate Variables | via yield funct ion ] = DpDv . DvDy =
o P
1
o y
1

o P
1
o y
k

o P
n
o y
1

o P
n
o y
k
=
o P
1
ov
1

o P
1
ov
k

o P
n
ov
1

o P
n
ov
k

|
d x
1
d y
1
|
1
o x
1
ov
1
|
d x
1
d y
1
|
1
o x
1
ov
k

|
d x
k
d y
k
|
1
o x
k
ov
1
|
d x
k
d y
k
|
1
o x
k
ov
k
1
The whole idea here is t hat it is generally easy t o calculat e t he Jacobian (10) for price funct ions. As long as t he
alt ernat e variables we wish t o use are yields for t raded inst rument s we have a simple mult i-st ep process
1. Choose a set of t raded inst rument s ( x
1
x
k
) t hat mat ch t he curve variables ( v
1
v
k
) in t erms of
mat urit y or ot her charact erist ics so t hat t he Jacobian will be well-behaved
2. Calculat e t he risk of t hese inst rument s w.r.t . curve variables ( v
1
v
k
) , giving t he price Jacobian (10)
3. Using t he uni-variat e yield funct ions (13) calculat e t he inverse Jacobian (14)
4. Transform t he risk of an arbit rary set of inst rument s or port folios using t he inverse Jacobian according t o
(15)
The calculat ion in st ep (2) requires evaluat ing t he risk of a small set of t raded inst rument s, and t his (and t he
addit ional calculat ions) will usually be quick and cheap relat ive t o evaluat ing t he risk of t he whole port folio.
The t ransformat ion mat rix (15) (or 12) can t hen be applied t o t he original port folio risk, t ransforming t he
part ial DV01s from curve variables ( v
1
v
k
) t o alt ernat e yields ( y
1
y
k
) . Nat urally, t he same pro-
cess applies if t he original risk is report ed using curve input rat es ( r
1
r
k
) .
Example of Transformation to Input Variables
As an example let us t ake t he variables ( x
1
x
k
) in equat ion (9) t o be t he par rat es on t he curve input
inst rument s. In ot her words t he alt ernat e variables ( x
1
x
k
) will be t he vect or of rat es on t he swaps
shown in t able 5, reproduced here:
Instrument Forward Start Underlier yrs Coupon Rate
1yr Swap 0 1 2.
1y2y Fwd 1 1 3.014
5yr Swap 0 5 3.
10yr Swap 0 10 3.5
Furt her, let us say t hat our risk syst em can easily calculat e t he derivat ives of t hese rat es using t he curve
variables. In t his case we can apply equat ion (12) direct ly. This is an exercise only, since we should end up
wit h t he same risk as bumping t he curve input s, shown in t able 11. In t his case t he Jacobian for t he alt ernat e
variables ( x
1
x
k
) is
Table 12 - Jacobian for Curve Input Rat es (Equat ion 10)
temp.nb 17
1.01 0. 0. 0.
0. 1.015 0. 0.
0.214 0.208 0.587 0.
0.117 0.113 0.315 0.456
Applying t he t ransformat ion shown in equat ion (12) t o t he derivat ives (DV01s) w.r.t . curve variables shown in
t able 7 gives t he risk shown in t able 13, which is t he same answer as we obt ain by bumping t he curve it self,
shown in t able 11.
Table 13 - DV01 w.r.t . Curve Input Rat es for Select ed Inst rument s, Transformed via Equat ion 12
1yr Swap 1y2y Fwd 5yr Swap 10yr Swap Total
1yr Swap 0.98 0. 0. 0. 0.98
1y2y Fwd 0. 0.96 0. 0. 0.96
5yr Swap 0. 0. 4.64 0. 4.64
10yr Swap 0. 0. 0. 8.49 8.49
2yr Swap 0.98 0.95 0. 0. 1.94
3yr Swap 0.64 0.62 1.6 0. 2.87
2yr Ann 0.04 0.02 0. 0. 0.06
10yr Ann 0.08 0.05 0.54 0.79 1.46
2yr Zero 0.94 0.94 0. 0. 1.88
10yr Zero 0.08 0.05 0.54 7.7 7.03
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Inst rument s usedin fit t ing t he
curveare highlight ed.Transformedvia equat ion(12)
Example of Transformation to Par Rate Partial DV01
Now let us t urn t o a more subst ant ive example, where we wish t o measure DV01s using par swap rat es inst ead
of t he mix of spot and forward swaps used so far. In ot her words we t ake t he variables ( x
1
x
k
) in equa-
t ion (9) t o be t he par swap rat es on 1, 2, 5, and 10 year swaps:
Maturity yrs Fixed Rate
1 2
2 2.5
5 3
10 3.5
Again, let use assume t hat our risk syst em can easily calculat e t he derivat ives of t he rat es t hemselves using
t he curve variables so t hat we can apply equat ion (12) direct ly. The Jacobian for t hese rat es is:
Table 14 - Jacobian for Par Swap Rat es (Equat ion 10)
1.01 0. 0. 0.
0.511 0.499 0. 0.
0.214 0.208 0.587 0.
0.117 0.113 0.315 0.456
Applying t he t ransformat ion shown in equat ion (12) t o t he curve variable derivat ives (DV01s) shown in t able
7 gives t he risk shown in t able 15. Risk expressed in t his form may be more int uit ive t han t hat shown in t ables
7 or 11. Here a 2 year swap is sensit ive t o only t he 2 year swap, while a 3 year swap is sensit ive t o bot h t he 2
year swap rat e and t he 5 year swap rat e.
Table 15 - DV01 w.r.t . Par Swap Rat es for Select ed Inst rument s, Transformed via Equat ion 12
18 temp.nb
1yr Swap 2yr Swap 5yr Swap 10yr Swap Total
1yr Swap 0.98 0. 0. 0. 0.98
1y2y Fwd 0.99 1.95 0. 0. 0.96
5yr Swap 0. 0. 4.64 0. 4.64
10yr Swap 0. 0. 0. 8.49 8.49
2yr Swap 0. 1.94 0. 0. 1.94
3yr Swap 0. 1.27 1.6 0. 2.87
2yr Ann 0.02 0.04 0. 0. 0.06
10yr Ann 0.03 0.11 0.54 0.79 1.46
2yr Zero 0.02 1.91 0. 0. 1.88
10yr Zero 0.03 0.11 0.54 7.7 7.03
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Inst rument s usedin fit t ing t he
curveare highlight ed.Transformedvia equat ion(12)
Transformation w.r.t. Yields vs. Par Rates
There is a subt le issue concerning yield DV01 versus t he par rat e DV01 as shown in t ables 13 and 15. For a
bond t he price is
Price = coupon - PV( $1 annuit y ) + 100 - PV( $1 at mat urit y )
wit h t he PVs calculat ed from t he forward curve. The par coupon or par rat e is t he coupon t hat makes t he
price equal t o par (100):
(16)
par coupon = r =
100 PV( $100 at mat urit y )
PV( $1 annuit y )
The yield-t o-mat urit y is t he solut ion t o:
Price = `
i =1
n
coupon
( 1 + y )
i
+
100
( 1 + y )
n
(ignoring for now complicat ions relat ed t o part ial periods, compounding frequency, et c.). The yield on a par
bond (Price=100) will equal t he par coupon.
In building a swap curve we will use par swaps and we will oft en measure risk using par swap rat es. That is
what we did in t ables 13 and 15 above. But we can also t hink of t he yield of a swap - more precisely t he yield
of a bond wit h t he same fixed coupons and a final repayment of principal. The par yield will be t he same as
t he par coupon (by definit ion) but t he DV01 using t he par yield will not be quit e t he same as t he DV01 using
calculat ed bumping t he par coupon. The reason is t hat t he derivat ive of t he yield and t he coupon w.r.t . curve
variables are different :
o par coupon
o v
i
=
o par yield
o v
i
except for a flat yield curve. The difference arises because t he yield calculat ion assumes a flat yield curve,
while t he par coupon calculat ion in equat ion (16) uses t he forward curve.
We can see t he differences for our sample curve by comparing t he Jacobians (10) for t he par rat es and par
yields. Table 14, repeat ed here, shows t he derivat ives of par swap rat es w.r.t . curve paramet ers. Table 11
shows t he derivat ives of yields. For t he 1 year swap t he derivat ive of t he par rat e and t he par yield are t he
same since t he curve is flat bet ween 0 and 1 years. The derivat ives differ for t he longer mat urit y swaps.
temp.nb 19
Table 14 (repeat ed) - Jacobian for Par Swap Rat es (Equat ion 10)
f0y1y f1y2y f2y5y f5y10y
1yr Swap 1.01 0. 0. 0.
2yr Swap 0.511 0.499 0. 0.
5yr Swap 0.214 0.208 0.587 0.
10yr Swap 0.117 0.113 0.315 0.456
Table 16 - Jacobian for Par Swap Yields
f0y1y f1y2y f2y5y f5y10y
1yr Swap 1.01 0. 0. 0.
2yr Swap 0.513 0.5 0. 0.
5yr Swap 0.215 0.209 0.591 0.
10yr Swap 0.118 0.114 0.32 0.462
This difference in derivat ives gives a slight difference in t ransformed risk. The following t able shows t he
original risk t ransformed t o par bond yield part ial DV01s, and we can see t hat t here are slight differences from
t he risk report ed in t able 15.
Table 17 - DV01 w.r.t . Par Swap Yields for Select ed Inst rument s, Transformed via Equat ion 15
1yr Swap 2yr Swap 5yr Swap 10yr Swap Total
1yr Swap 0.98 0. 0. 0. 0.98
1y2y Fwd 0.99 1.95 0. 0. 0.96
5yr Swap 0. 0. 4.61 0. 4.61
10yr Swap 0. 0. 0. 8.38 8.38
2yr Swap 0. 1.94 0. 0. 1.94
3yr Swap 0. 1.27 1.59 0. 2.86
2yr Ann 0.02 0.04 0. 0. 0.06
10yr Ann 0.03 0.11 0.54 0.78 1.45
2yr Zero 0.02 1.9 0. 0. 1.88
10yr Zero 0.03 0.11 0.54 7.6 6.93
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Inst rument s usedin fit t ing t he
curveare highlight ed.The risk hereis w.r.t .yieldson par bondsinst ead ofpar coupons.Transformedvia equat ion(15)
If we wish t o calculat e t he DV01 using par rat es rat her t han yields we can employ equat ion (16) t o get t he
derivat ive of t he par coupon from price derivat ives of inst rument s:
o par coupon
o v
i
= |
o PV( $100 at mat urit y )
o v
i
+ r
o PV( $1 annuit y )
o v
i
| ! PV( $1 annuit y )
Example of Partial DV01 Using Zero Yields
Now consider an example where our risk syst em cannot direct ly calculat e t he derivat ive of t he rat e or yield.
Say t hat we want t o calculat e t he part ials using t he yields for t he following zero-coupon bonds:
Maturity yrs PV Yield Yld DV01
1 98.03 2. 0.97
2 95.14 2.51 1.88
5 86.09 3.02 4.24
10 70.28 3.56 6.9
Our risk syst em, however, can only calculat e t he derivat ives of bond prices wit h respect t o curve variables.
The following t able shows t he curve variable derivat ive of prices (t he curve variables being cont inuously-
compounded forward rat es):
20 temp.nb
Our risk syst em, however, can only calculat e t he derivat ives of bond prices wit h respect t o curve variables.
The following t able shows t he curve variable derivat ive of prices (t he curve variables being cont inuously-
compounded forward rat es):
Table 18 - Derivat ive of price w.r.t . Curve Variables (Forward Rat es)
0.98 0. 0. 0.
0.951 0.951 0. 0.
0.86 0.86 2.583 0.
0.702 0.702 2.109 3.513
We can use t he yield DV01 |
d P
d y
| shown above t o get t he inverse Jacobian of t he zero yield, equat ion (14),
shown in t he following t able:
Table 19 - Jacobian for Zero Coupon Yields
1.01 0. 0. 0.
0.506 0.506 0. 0.
0.203 0.203 0.609 0.
0.102 0.102 0.305 0.509
We can t hen use t his t o t ransform t he original part ial DV01s w.r.t . forward rat es shown in t able 4 t o DV01s
w.r.t . zero-coupon yields according t o equat ion (15):
Table 20 - DV01 w.r.t . Zero-Coupon Yields for Select ed Inst rument s, Transformed via Equat ion 15
1yr Zero 2yr Zero 5yr Zero 10yr Zero Total
1yr Swap 0.98 0. 0. 0. 0.98
1y2y Fwd 0.96 1.92 0. 0. 0.96
5yr Swap 0.03 0.11 4.47 0. 4.61
10yr Swap 0.03 0.13 0.58 7.61 8.35
2yr Swap 0.02 1.91 0. 0. 1.94
3yr Swap 0.03 1.29 1.54 0. 2.86
2yr Ann 0.02 0.04 0. 0. 0.06
10yr Ann 0.03 0.13 0.58 0.71 1.45
2yr Zero 0. 1.88 0. 0. 1.88
10yr Zero 0. 0. 0. 6.9 6.9
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Inst rument s usedin fit t ing t he
curveare highlight ed.Transformedvia equat ion(15).
Total DV01 using Different Rates - Parallel Shift
The part ial DV01s can be summed t o give a t ot al DV01, and t his is displayed in t he t ables above. This t ot al
DV01 is t he sensit ivit y t o a parallel shift in all t he underlying rat es. Examinat ion of t he t ables, however,
shows t hat t he t ot al DV01 differs for different set s of rat es. For example, t he t ot al DV01 for t he 10 year par
swap in t able 7 (shift in cc forwards) is 8.5 while in t able 17 (shift in all par yields) it is 8.38.
The fact is t hat a parallel shift in one set of rat es is not always parallel in anot her set of rat es. It will be t he
same when t he yield curve is flat and all rat es use t he same compounding, or if we work wit h zero and forward
rat es in t he same compounding basis. When we work wit h a sloped curve and par rat es or yields (i.e. inst ru-
ment s wit h int ermediat e coupons) a parallel shift in one set of rat es will not be parallel in anot her. This is
easiest t o see using a simple example wit h forward rat es and yields on par bonds. Say t he 0-5 year forward
rat e is flat at 10.00%sab or 9.7580%cc. If rat es are not in t he same basis t hen a 1bp change in t he cont inu-
ously-compounded forward t ranslat es int o a 1.05bp change in t he sab par rat e (since
d y
s
d y
c
=e
y
c
l 2
), not a 1bp
change in t he par rat e. When t he forward rat e is quot ed semi-annual bond (rat e of 10%) t hen a 1bp sab
change in t he forward does t ranslat e int o a 1bp sab change in t he par. But t his will not carry out t o longer
mat urit ies unless t he curve is flat . If t he 5-10 year forward is 20% sab (t he 10 year par 13.2819%sab) t hen a 1bp
sab change in t he forwards (10% and 20% t o 10.01% and 20.01%) t ranslat e int o a 0.95bp change in t he 10 year
par yield (from 13.2819% t o 13.2914%). In ot her words, a 1bp parallel shift in sab forwards t ranslat es int o a
non-parallel shift in sab pars:
temp.nb 21
The fact is t hat a parallel shift in one set of rat es is not always parallel in anot her set of rat es. It will be t he
same when t he yield curve is flat and all rat es use t he same compounding, or if we work wit h zero and forward
rat es in t he same compounding basis. When we work wit h a sloped curve and par rat es or yields (i.e. inst ru-
ment s wit h int ermediat e coupons) a parallel shift in one set of rat es will not be parallel in anot her. This is
easiest t o see using a simple example wit h forward rat es and yields on par bonds. Say t he 0-5 year forward
rat e is flat at 10.00%sab or 9.7580%cc. If rat es are not in t he same basis t hen a 1bp change in t he cont inu-
ously-compounded forward t ranslat es int o a 1.05bp change in t he sab par rat e (since
d y
s
d y
c
=e
y
c
l 2
), not a 1bp
change in t he par rat e. When t he forward rat e is quot ed semi-annual bond (rat e of 10%) t hen a 1bp sab
change in t he forward does t ranslat e int o a 1bp sab change in t he par. But t his will not carry out t o longer
mat urit ies unless t he curve is flat . If t he 5-10 year forward is 20% sab (t he 10 year par 13.2819%sab) t hen a 1bp
sab change in t he forwards (10% and 20% t o 10.01% and 20.01%) t ranslat e int o a 0.95bp change in t he 10 year
par yield (from 13.2819% t o 13.2914%). In ot her words, a 1bp parallel shift in sab forwards t ranslat es int o a
non-parallel shift in sab pars:
A
0 5 yr fwd
5 10 yr fwd
=
1 bp
1 bp
A
5 yr par
10 yr par
=
1 bp
0.95 bp
Fort unat ely t he Jacobian and inverse Jacobian cont ain t he informat ion on how yields shift and t he t ransla-
t ion from one parallel shift t o anot her. Say we are t ransforming from t he original cc forward rat es,
( v
1
v
k
) , t o par yields, ( y
1
y
k
) . Taking t he Jacobian and post -mult iplying by a column vect or of
ones gives t he change in {y
i
} corresponding t o a parallel shift (one unit ) in all t he {v
i
}:
Change in y
i
due t o parallel shift in v
i
=
o y
1
ov
1

o y
1
ov
k

o y
k
ov
1

o y
k
ov
k

1
while st art ing wit h t he inverse Jacobian and post -mult iplying gives t he change in {v
i
} corresponding t o a
parallel shift (one unit ) in all t he {y
i
}:
Change in v
i
due t o parallel shift in y
i
=
ov
1
o y
1

ov
1
o y
k

ov
k
o y
1

ov
k
o y
k

1
Consider again t able 17. The original variables ( v
1
v
k
) are forward rat es cont inuously-compounded
while t he alt ernat e yields ( y
1
y
k
) are par yields semi-annually compounded. The change in t he par
yields due t o a parallel shift in forwards and vice-versa are:
1yr Par 2yr Par 5y Par 10yr Par
Change in sab par
yields from parallel
shift in cc fwds
1.01 1.0124 1.0145 1.0145
0y1y fwd 1y2y fwd 2y5y fwd 5y10y fwd
Change in fwds from
parallel shift in pars
0.9901 0.9853 0.9843 0.9857
The t op panel shows t hat a parallel shift of 1bp in all forwards (cont inuously-compounded) implies a
great er-t han-1bp shift in sab par yields, wit h larger shift s at t he longer end. These dat a also show t hat ,
because a parallel shift in one set of rat es is not parallel in anot her, unless we rest rict ourselves t o zeros and
forwards in t he same compounding basis, t here is no simple way t o t ransform t he t ot al DV01 from one set
of rat es t o anot her - we must use t he t ransformat ion of equat ion (12) or (15).
Choice of Appropriate Alternate Variables
The t ransformat ion t echnique is quit e powerful, but we have t o careful in choosing t he alt ernat e inst rument s
and rat es used in t he t ransformat ion. There are some obvious rest rict ions on choosing alt ernat ive inst ru-
ment s, rest rict ions required t o ensure t he t ransformat ion works mat hemat ically. Even when t hese condit ions
are sat isfied, however, choosing rat es t hat do not mat ch t he original curve can give odd result s. We have t o
remember t hat t he t ransformat ion approach t ells us what t he risk would be if we re-built and bumped our
original curve wit h our alt ernat e inst rument s. If we choose inst rument s t hat are not appropriat e t o our
original curve we will get what appear t o be odd result s for t he risk. The t ransformat ion approach does not
involve building a new curve - it is only a t ransformat ion of t he original part ial derivat ives using t he original
variables.
22 temp.nb
The t ransformat ion t echnique is quit e powerful, but we have t o careful in choosing t he alt ernat e inst rument s
and rat es used in t he t ransformat ion. There are some obvious rest rict ions on choosing alt ernat ive inst ru-
ment s, rest rict ions required t o ensure t he t ransformat ion works mat hemat ically. Even when t hese condit ions
are sat isfied, however, choosing rat es t hat do not mat ch t he original curve can give odd result s. We have t o
remember t hat t he t ransformat ion approach t ells us what t he risk would be if we re-built and bumped our
original curve wit h our alt ernat e inst rument s. If we choose inst rument s t hat are not appropriat e t o our
original curve we will get what appear t o be odd result s for t he risk. The t ransformat ion approach does not
involve building a new curve - it is only a t ransformat ion of t he original part ial derivat ives using t he original
variables.
First t he obvious condit ions. The t ransformat ion is effect ively a coordinat e t ransformat ion. The relat ion (14)
or (13) must be invert ible. There must be t he same number of original variables ( v
1
v
k
) and new yields
( y
1
y
k
) . In addit ion t he Jacobian must be invert ible, in ot her words t he mat rix in equat ion (10) must
have non-zero det erminant . These condit ions ensure t hat t he t ransformat ion works mat hemat ically.
Even when t he t ransformat ion works mat hemat ically, however, it may not be well-behaved or make int uit ive
sense. The new variables should mat ch t he original forward curve in t he sense t hat t hey would be appropriat e
for building t he original curve. For t he examples discussed so far t he set of alt ernat e inst rument s have had
t he same mat urit ies as t he original input inst rument s (1, 2, 5, and 10 years) ensuring t hat t hey mat ch t he
original curve. In t hese cases t he t ransformat ion has worked well and t he old and new part ial DV01s measure
t he same risk from a different perspect ive. We will next t urn t o an example where t he new variables do not
mat ch t he original curve, and t he t ransformed risk looks peculiar.
Example of Transformation using Unsuitable Alternate Variables
The forward curve used in t he examples is shown in figure 2 above and is built wit h breaks at 1, 2, 5, and 10
years and forward rat es from 0-1, 1-2, 2-5, and 5-10 years. This curve is consist ent wit h inst rument mat urit ies
at 1, 2, 5, and 10 years. Let us consider what would happen if, inst ead of using a 2 year swap we subst it ut ed a
3 year swap. We could build our original curve using t he 3 year swap, but it is not really appropriat e for a
curve wit h a break at 2 and 5 years (and not at 3 years).
The original curve produces risk t hat is reasonable, reasonable in t he sense t hat inst rument s are not sensit ive
t o long-mat urit y rat es when short -mat urit y rat es are unchanged. Let us focus for now on 2 and 5 years. It is
obvious t hat none of t he 1 year swap, 1-2 year forward swap, 2 year swap, 2 year annuit y, or 2 year zero should
have sensit ivit y t o t he 2-5 year forward rat e, and looking back at t able 7 verifies t his. More import ant ly,
t ransformat ions using inst rument s wit h mat urit y at 2 and 5 years have t he same propert y. Looking at t ables
13, 14, and 19 we see t hat t hese short -dat ed inst rument s have no sensit ivit y t o 5 year rat es, as long as t he 1
and 2 year rat es are held const ant . The 3 year swap, of course, does have sensit ivit y t o 5 year rat es, holding
t he 2 year rat e fixed.
Consider now what would happen if we built our original curve (or t ransformed) using 3 and 5 year rat es
inst ead of 2 and 5 year rat es. The curve is st ill built wit h 1-2 and 2-5 year forwards - our t ransformat ion
approach does not involve building a new curve. Shift ing t he 5 year rat e shift s t he 2-5 year forward. When we
t ransformed using a 2 year inst rument t he 1-2 year forward did not change since t he 2 year inst rument did not
change. Using a 3 year inst ead of a 2 year rat e, however, requires shift ing t he 1-2 year forward t o keep t he 3
year rat e unchanged. As a result a 2 year inst rument will now have exposure t o 5 year rat es even when t he 3
year rat e is kept fixed.
Table 21 shows t he result of t ransforming a 1, 2, 5, 10 year curve using 1, 3, 5, and 10 year rat es. Inst rument s
wit h 2 year mat urit y now have exposure t o 5 year rat es, even when t he 3 year rat e is fixed. This is peculiar but
it is correct - it is t he result of t rying t o t ransform 2 year risk int o 3 year risk rat her t han building a new curve
wit h a 3 year inst rument .
Table 21 - DV01 w.r.t . 1, 3, 5, 10 year Swap Rat es for Select ed Inst rument s, Transformed via Equat ion 12
temp.nb 23
1yr Swap 3yr Swap 5yr Swap 10yr Swap Total
1yr Swap 0.98 0. 0. 0. 0.98
1y2y Fwd 0.99 4.41 2.45 0. 0.96
5yr Swap 0. 0. 4.64 0. 4.64
10yr Swap 0. 0. 0. 8.49 8.49
2yr Swap 0. 4.39 2.45 0. 1.94
3yr Swap 0. 2.87 0. 0. 2.87
2yr Ann 0.02 0.08 0.05 0. 0.06
10yr Ann 0.03 0.24 0.41 0.79 1.46
2yr Zero 0.03 4.31 2.4 0. 1.88
10yr Zero 0.03 0.24 0.41 7.7 7.03
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Inst rument s usedin fit t ing t he
curveare highlight ed.Transformedvia equat ion(11) t o representrisk w.r.t .1, 3, 5, and 10 yearswaps, but basedon a piece-wiseconst ant
curvebuiltwit h 1, 2, 5, and 10 yearswaps.
The t ransformat ion t ells us what t he risk of t he original curve would be if we built t he original curve wit h a 3
year swap, but it cannot t ell us what t he risk would be for a different curve - t o do t hat we need t o build a new
curve. Our original curve was built using market inst rument s wit h mat urit ies of 1, 2, 5, and 10 years. As a
result , t ransforming using combinat ions of forwards, pars, zeros will work fine as long as t hey have mat urit ies
of 1, 2, 5, and 10 years. But t rying t o t ransform wit h a 3 year rat e causes problems because t he original curve
is not set up for a 3 year inst rument .
Table 22 shows t he risk we would get building a curve wit h 1, 3, 5, and 10 year inst rument s. Here t he part ial
DV01 for t he 2 year is reasonable. Two year inst rument s have no sensit ivit y t o t he 5 year.
Table 22 - DV01 w.r.t . 1, 3, 5, 10 year Swap Rat es for Select ed Inst rument s, Calculat ed from Alt ernat e Curve
1yr Swap 3yr Swap 5yr Swap 10yr Swap
1yr Swap 0.98 0. 0. 0.
1y2y Fwd 0.5 1.46 0. 0.
5yr Swap 0. 0. 4.63 0.
10yr Swap 0. 0. 0. 8.49
2yr Swap 0.48 1.46 0. 0.
3yr Swap 0. 2.87 0. 0.
2yr Ann 0.03 0.03 0. 0.
10yr Ann 0.04 0.16 0.48 0.79
2yr Zero 0.45 1.43 0. 0.
10yr Zero 0.04 0.16 0.48 7.7
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Inst rument s usedin fit t ing t he
curveare highlight ed.Calculat edbydirectbumpingoft he curveinput s for a piece-wiseconst ant curvebuiltwit h 1, 3, 5, and 10 yearswaps.
DV01s w.r.t. Reduced Set of Variables - Compressing Partial DV01s
So far we have been discussing t ransforming DV01s using t he original curve variables ( v
1
v
k
) t o DV01s
using t he same number of alt ernat e variables ( x
1
x
k
) . Anot her issue t hat oft en arises is t he need t o
reduce t he dimensionalit y or compress t he DV01s: t ransform t o risk using curve variables |
v
1
-
v
j
-
] or
alt ernat e variables |
x
1
-
x
j
-
] , where j<k. In our example we might want t o express DV01s using a reduced
set of {1 year, 5 year, 10 year} swaps inst ead of t he original {1 year, 2 year, 5 year, 10 year} swaps.
Details
Rat her t han re-build a new curve and revalue t he complet e port folio using t his new curve, t here are some
simplifying t ransformat ions we can apply. The t ransformat ions (12) or (15) will not work because t he Jaco-
bian (10) will not be full rank - it will not be square since j<k.
24 temp.nb
Rat her t han re-build a new curve and revalue t he complet e port folio using t his new curve, t here are some
simplifying t ransformat ions we can apply. The t ransformat ions (12) or (15) will not work because t he Jaco-
bian (10) will not be full rank - it will not be square since j<k.
What we need is a mat rix t o t ransform from old variables t o new variables:
(17) DvDv
-
= Mat rix for Reduced Curve Variables =
ov
1
ov
1
-

ov
1
ov
j
-

ov
k
ov
1
-

ov
k
ov
j
-
If we had t his mat rix, we could simply writ e
DpDv
-
= Part ial DV01 w .r .t . Reduced Variables =
o P
1
ov
1
-

o P
1
ov
j
-

o P
n
ov
1
-

o P
n
ov
j
-
= DpDv . DvDv
-
= Derivat ive w .r .t . Curve
Variables - Reduced Mat rix =
o P
1
ov
1

o P
1
ov
k

o P
n
ov
1

o P
n
ov
k

ov
1
ov
1
-

ov
1
ov
j
-

ov
k
ov
1
-

ov
k
ov
j
-
The t ransformat ion mat rix (17) cannot be obt ained from t he original curve. Inst ead we need t o build a new
curve, using a reduced set of curve variables. We do not , however, need t o revalue t he whole port folio using
t his new curve. All we need is t he mat rix of derivat ives in equat ion (17), relat ing t he old and new curve vari-
ables. Generally, however, we cannot convenient ly calculat e (17) direct ly so we will use a set of
int ermediat e inst rument s t hat we can value using bot h t he old and new curve.
We st art wit h t he set of int ermediat e inst rument s ( x
1
x
k
) for t he original curve. First we get t he inverse
Jacobian (equat ion 11) by calculat ing t he derivat ive w.r.t . t he original curve variables:
DvDx =
ov
1
o x
1

ov
1
o x
k

ov
k
o x
1

ov
k
o x
k
=
o x
1
ov
1

o x
1
ov
k

o x
k
ov
1

o x
k
ov
k
1
Next we use t he new curve and calculat e t he derivat ive of t hese int ermediat e inst rument s w.r.t . t he new
curve variables:
DxDv
-
=
o x
1
ov
1
-

o x
1
ov
j
-

o x
k
ov
1
-

o x
k
ov
j
-
Finally, for t he new curve variables |
v
1
-
v
j
-
] and t he new alt ernat e inst rument s |
x
1
-
x
j
-
] or t heir
yields |
y
1
-
y
j
-
] we calculat e t he inverse Jacobian as in equat ion (11) or (14):
temp.nb 25
Dv
-
Dx
-
=
ov
1
-
o x
1
-

ov
1
-
o x
j
-

ov
j
-
o x
1
-

ov
j
-
o x
j
-
=
o x
1
-
ov
1
-

o x
1
-
ov
j
-

o x
j
-
ov
1
-

o x
j
-
ov
j
-
1
(18) Dv
-
Dy
-
=
|
d x
1
-
d y
1
-
|
1
o x
1
-
ov
1
-
|
d x
1
-
d y
1
-
|
1
o x
1
-
ov
j
-

|
d x
j
-
d y
j
-
|
1
o x
j
-
ov
1
-
|
d x
j
-
d y
j
-
|
1
o x
j
-
ov
j
-
1
We can now combine t hese all t o t ransform t he part ial DV01s w.r.t . t he original curve variables ( v
1
v
k
)
int o DV01s w.r.t . yields of t he new inst rument s and t he new curve |
y
1
-
y
j
-
] :
(19)
Part ial DV01s w .r .t . Reduced Variables | via yield funct ion ] =
DpDy
-
=
o P
1
o y
1
-

o P
1
o y
j
-

o P
n
o y
1
-

o P
n
o y
j
-
= DpDv . DvDx . DxDv
-
. Dv
-
Dy
-
=
o P
1
ov
1

o P
1
ov
k

o P
n
ov
1

o P
n
ov
k

o x
1
ov
1

o x
1
ov
k

o x
k
ov
1

o x
k
ov
k
1

o x
1
ov
1
-

o x
1
ov
j
-

o x
k
ov
1
-

o x
k
ov
j
-

|
d x
1
-
d y
1
-
|
1
o x
1
-
ov
1
-
|
d x
1
-
d y
1
-
|
1
x
1
-
ov
j
-

|
d x
j
-
d y
j
-
|
1
o x
j
-
ov
1
-
|
d x
j
-
d y
j
-
|
1
o x
j
-
ov
j
-
1
This looks very complicat ed, but in fact it is not . Each of t he int ermediat e st eps is a relat ively st raight forward
risk calculat ion for a small number of inst rument s:

The mat rix DpDv is t he original risk w.r.t . t he original curve variables. This is what we are t rying t o
t ransform and is given a priori.

The mat rix DvDx is (t he inverse of) t he price Jacobian (equat ion 14) for t he int ermediat e inst rument s
from t he original curve and will be t he risk of a small port folio of t raded inst rument s.

The mat rix DxDv

-
is t he derivat ive of t he int ermediat e inst rument s using t he new curve

The mat rix Dv

-
Dy
-
is t he inverse Jacobian in yield t erms, (equat ion 14), for t he new yields using t he new
curve
Example using 1, 5, 10 Year Swaps
Our original curve is based on swaps or forwards wit h breaks at 1, 2, 5, and 10 years. Our original part ial
DV01s are shown in t able 7, and in t able 14 we t ransformed it t o par swap DV01s. Say t hat we want t o express
t he risk using fewer swaps, effect ively t o compress t he risk. Say we want t o dispense wit h t he 2 year swap and
express t he risk using 1, 5, and 10 year swaps. We cannot simply combine t he risk of adjacent cat egories, we
need t o have a t ransformat ion rule such as in equat ion (18).
Our original curve has breaks at 1, 2, 5, and 10 years and is built wit h inst rument s t hat have mat urit ies at
t hese dat es. Let us build a reduced curve wit h fewer paramet ers, in t his case piece-wise const ant wit h breaks
at 1, 5, and 10 years. Let us build t he curve so t hat it re-prices t he 1, 5, and 10 year swaps:
26 temp.nb
Maturity yrs Fixed Rate Fitted Fwd
1 2 0.0199
5 3 0.0324
10 3.5 0.0406
Figure 3 shows t he original curve and t he reduced or compressed curve.
Figure 3 - Piece-Wise Constant Forward Curve, Original and Reduced
2 4 6 8 10
Mat urit y ( yrs)
0.01
0.02
0.03
0.04
Inst ant aneousForward Rat e
Solid is Origina l Curve . Da s he d is Without 2 yr Swa p
For our int ermediat e inst rument s we will use t he set of 1, 2, 5, and 10 year swaps. Using t he original curve
we can calculat e t he inverse Jacobian DvDx for t hese int ermediat e inst rument s:
1yr Swap 2yr Swap 5yr Swap 10yr Swap
f0y1y 1.006 0. 0. 0.
f1y2y 1.031 1.032 0. 0.
f2y5y 0.002 0.365 0.367 0.
f5y10y 0.001 0.003 0.254 0.258
Using t he new curve we can calculat e derivat ive of t hese int ermediat e inst rument s using t he new curve,
DxDv
-
:
f0y1y f1y5y f5y10y
1yr Swap 0.994 0. 0.
2yr Swap 0.991 0.966 0.
5yr Swap 0.992 3.686 0.
10yr Swap 0.991 3.633 3.874
We t hen calculat e t he derivat ive of our new set of swaps (1, 5, 10 years) from t he new curve, t he mat rix
Dx
-
Dv
-
, and t he vect or of yield DV01s:
f0y1y f1y5y f5y10y
1yr Swap 0.994 0. 0.
5yr Swap 0.992 3.686 0.
10yr Swap 0.991 3.633 3.874
1yr Swap 5yr Swap 10yr Swap
0.984527 4.6105 8.3755
and from t hese we can calculat e t he inverse yield Jacobian for t he new yields and new curve Dv
-
Dy
-
(equat ion 17):
temp.nb 27
and from t hese we can calculat e t he inverse yield Jacobian for t he new yields and new curve Dv
-
Dy
-
(equat ion 17):
1yr Swap 5yr Swap 10yr Swap
f0y1y 0.99 0. 0.
f1y5y 0.266 1.251 0.
f5y10y 0.003 1.173 2.162
Combining t hese gives t he t ransformat ion mat rix DvDx . DxDv
-
. Dv
-
Dy
-
:
1yr Swap 5yr Swap 10yr Swap
f0y1y 0.99 0. 0.
f1y2y 0.268 1.248 0.
f2y5y 0.266 1.252 0.
f5y10y 0.003 1.173 2.162
The following t able shows t he result of applying t his t ransformat ion (per equat ion 19) t o t he original risk
from t able 7:
Table 23 - Compressed DV01 w.r.t . Par Swap Yields for Select ed Inst rument s
1yr Swap 5yr Swap 10yr Swap
1yr Swap 0.98 0. 0.
1y2y Fwd 0.26 1.21 0.
5yr Swap 0. 4.61 0.
10yr Swap 0. 0. 8.38
2yr Swap 0.72 1.21 0.
3yr Swap 0.47 2.38 0.
2yr Ann 0.04 0.02 0.
10yr Ann 0.07 0.61 0.78
2yr Zero 0.69 1.19 0.
10yr Zero 0.07 0.61 7.6
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. The risk is compressedfrom t hat
shown in t able4 using equat ion(18)
Comparing t his wit h t able 17 we see t hat t he risk for t he 5 year and 10 year swaps is unchanged - as we should
expect . The risk of t he 2 year swap, however, is now dist ribut ed bet ween t he 1 year and 5 year swaps. The
dist ribut ion depends on t he part icular funct ional form chosen for t he forward curve. The mat rices DxDv
-
and DvDx t oget her t ell us how t he original curve variables ( v
1
v
k
) change when t he compressed curve
variables |
v
1
-
v
j
-
] change. This depends on t he funct ional form of bot h curves, and requires t he informa-
t ion embedded in t hese t wo mat rices. Choosing a different funct ional form for t he curve will lead t o a differ-
ent dist ribut ion of risk bet ween t he 1 year and 5 year swaps.
28 temp.nb
Alternate Forward Curves
All examples so far have used a piece-wise const ant forward curve but t he t ransformat ion approach has
not hing t o do wit h t he part icular curve funct ional form. Alt hough a piece-wise const ant forward curve is a
robust , simple, useful funct ional form t o use in market applicat ions it is by no means t he only possible curve.
One popular alt ernat ive is piece-wise linear zero, where cont inuously-compounded zero rat es are linearly-
int erpolat ed bet ween break point s. For t he curve t he curve variables ( v
1
v
k
) are zero rat es at t he break
point s: in t his case (zero 1yr, zero 2yr, zero 5yr, zero 10yr). Figure 4 shows t he fit t ed zero rat es and forward
rat es.
Figure 4 - Piece-Wise Linear Zero Curve
2 4 6 8 10
Mat urit y ( yrs)
0.01
0.02
0.03
0.04
Inst ant aneousRat es
Solid a re Ze ro Ra te s , Da s he d a re Forwa rd Ra te s
We can calculat e t he derivat ives of inst rument s using t he curve paramet ers, just as we did in t able 7 above.
In t his case t he sensit ivit y is wit h respect t o cont inuously-compounded zero rat es. The following t able shows
t he curve variable DV01s, in ot her words using zero rat es.
Table 24 - DV01 w.r.t . Zero Yields (cc) for Select ed Inst rument s
z1y z2y z5y z10y Total
1yr Swap 0.99 0. 0. 0. 0.99
1y2y Fwd 0.97 1.94 0. 0. 0.97
5yr Swap 0.03 0.15 4.5 0. 4.68
10yr Swap 0.04 0.17 0.65 7.63 8.49
2yr Swap 0.03 1.93 0. 0. 1.96
3yr Swap 0.03 1.94 0.94 0. 2.91
2yr Ann 0.03 0.03 0. 0. 0.06
10yr Ann 0.04 0.17 0.65 0.61 1.47
2yr Zero 0. 1.9 0. 0. 1.9
10yr Zero 0. 0. 0. 7.02 7.02
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Risk is w.r.t .cont inuously-
compoundedzero rat es. Inst rument s usedin fit t ing t he curveare highlight ed.
Next , we can t ransform t o par swap yield DV01s by calculat ing t he Jacobian and inverse Jacobians (equat ion
14). The following t able shows t he Jacobian, t he derivat ives of par swap yieldswit h respect t o zero curve
variables. This should be compared wit h t able 16 which shows t he Jacobian for t he same par swap yields but
using forward curve variables. Applying t he t ransformat ion gives t he dat a in t he t able below.
temp.nb 29
Table 25 - Jacobian for Par Swap Yields (Equat ion 10) for Transformat ion from Zero Curve Risk
z1y z2y z5y z10y
1yr Swap 1.01 0. 0. 0.
2yr Swap 0.014 0.998 0. 0.
5yr Swap 0.007 0.032 0.975 0.
10yr Swap 0.005 0.021 0.078 0.911
Table 26 - DV01 w.r.t . Par Swap Yields for Select ed Inst rument s
1yr Swap 2yr Swap 5yr Swap 10yr Swap Total
1yr Swap 0.98 0. 0. 0. 0.98
1y2y Fwd 0.99 1.94 0. 0. 0.96
5yr Swap 0. 0. 4.61 0. 4.61
10yr Swap 0. 0. 0. 8.38 8.38
2yr Swap 0. 1.94 0. 0. 1.94
3yr Swap 0. 1.91 0.96 0. 2.87
2yr Ann 0.03 0.03 0. 0. 0.06
10yr Ann 0.03 0.14 0.62 0.67 1.45
2yr Zero 0.03 1.9 0. 0. 1.88
10yr Zero 0.03 0.14 0.62 7.71 6.92
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Risk is w.r.t .par bond / swap
yields,t ransformedfrom zero curverisk. Inst rument s usedin fit t ing t he curveare highlight ed.
We can also compare t he zero and par risk calculat ed here wit h t he zero and par risk shown in t ables 20 and
17 above. Close examinat ion shows t hat t here are some differences. These differences arise from t wo sources:

First , for t he zero risk (t ables 24 versus 20) t he rat es are compounded on a different basis. The curve
variables in t able 24 are cont inuously-compounded while t he yields for t he inst rument s used in t able 20
are semi-annually compounded. The conversion bet ween risk expressed in different compounding bases
depends on (1+rat e):
1 + y
sab
l 2 = exp ( y
cc
l 2) =
d y
sab
d y
cc
= exp ( y
cc
l 2) = 1 + y
sab
l 2
The 10 year zero rat e y
sab
is 3.56% so t he conversion fact or for 10 year rat es is 1.0178. If we t ake t he risk
for t he 10 year zero bond from t able 26 and divide by 1.0178 we get t he value shown in t able 20 - in ot her
words t he difference for t he 10 year zero bond is t ot ally due t o differences in compounding bet ween
t ables 20 and 24.

The par risk in t ables 26 and 17 are quot ed on t he same basis (bot h semi-bond) so t here are no
compounding differences. Comparing t he t ables shows t hat t he DV01s for swaps used in building t he
curve (1, 2, 5, 10 year) are t he same. But part ial DV01s for inst rument s not used in building t he curve are
different . For example t he t ot al risk for t he 3 year swap is roughly t he same, but t he dist ribut ion, across
t he 2 year versus 5 year, is different . The reason is t hat t he underlying curves are fundament ally different
and t hey imply different movement s in forward rat es bet ween knot point s. The 5 year swap, for example,
has most of it s cash flows and sensit ivit y concent rat ed at t he 5 year point , and bot h curves, having t he 5
year swap as an input , are const rained t o have roughly t he same 5 year zero and par rat es. The risk for t he
5 year swap will be virt ually t he same. The curves are not const rained t o be t he same at 3 years however,
and changes in t he 2 year or 5 year input swaps will change t he 3 year zero and 3 year par rat es quit e
different ly bet ween t he curves. How t he 3 year swap responds t o changes in t he 2 year and 5 year rat es
will be different bet ween t he curves.
Conclusion
This paper has laid out a simple met hod t o t ransform curve risk or sensit ivit y from one set of rat es or yields t o
anot her. The met hod is quit e general and allows t ransformat ions bet ween arbit rary inst rument s, subject t o
cert ain const raint s. The met hod can also be used t o compress risk from a larger t o a smaller number of
variables.
30 temp.nb
This paper has laid out a simple met hod t o t ransform curve risk or sensit ivit y from one set of rat es or yields t o
anot her. The met hod is quit e general and allows t ransformat ions bet ween arbit rary inst rument s, subject t o
cert ain const raint s. The met hod can also be used t o compress risk from a larger t o a smaller number of
variables.
APPENDIX - Dynamic Interactivity
Introduction
This paper was writ t en in Wolframs Mat hemat ica and all t he t ables generat ed dynamically. This appendix
provides int eract ive explorat ion of t he t ransformat ion met hodology by making some of t he t ables dynami-
cally int eract ive.
If you are reading t he .pdf version of t his paper t he t ables are clearly not int eract ive - t hey are simply st at ic
graphics. For int eract ivit y you must use t he .cdf/ .nbp version, which is available at www.closemountain.-
com/ publications.html#RiskManagement
Wolfram has developed a plat form for enhanced digit al publicat ion - document s saved in Comput able
Document Format (.cdf) or player format (.nbp) can t hen be "read" using t he Wolfram Player (free download
available at
ht t p:/ / www.wolfram.com/ product s/ player/ ). This is analogous t o Adobe' s .pdf format wit h t he Acrobat
Reader but ext ends t he idea t o dynamic int eract ivit y. A .cdf document can be comput able and can produce
dynamic cont ent , responding t o readers' input .
In t he .cdf/ .nbp version t he reader can choose t he inst rument s for report ing t he part ial DV01s in t he t able
below and t hen t he t ransformed risk (t oget her wit h t he Jacobian and inverse Jacobian) will be re-calculat ed
and displayed. There is a port folio of t went y securit ies, including swaps, annuit ies, zeros bonds, and
forwards:
Table A1 - Securit ies Available for Int eract ive Examinat ion
temp.nb 31
Instrument Forward Start Underlier yrs Coupon Rate PV
1yr Swap 0 1 2. 0.
2yr Swap 0 2 2.5 0.
3yr Swap 0 3 2.8 0.063
5yr Swap 0 5 3. 0.
10yr Swap 0 10 3.5 0.
1yr Ann 0 1 2. 1.969
2yr Ann 0 2 2.5 4.856
3yr Ann 0 3 3. 8.61
5yr Ann 0 5 3. 13.91
10yr Ann 0 10 3.5 29.724
1yr Zero 0 1 0. 98.031
2yr Zero 0 2 0. 95.144
3yr Zero 0 3 0. 92.027
5yr Zero 0 5 0. 86.09
10yr Zero 0 10 0. 70.276
1y2y Fwd 1 1 3.014 0.
2y5y Fwd 2 3 3.36 0.
3y5y Fwd 3 2 3. 0.637
5y10y Fwd 5 5 4.101 0.
3y7y Fwd 3 4 3.5 0.737
Inst rument s usedin fit t ing t he curveare highlight ed.
A piece-wise const ant forward curve is used for valuat ion, fit t ed using t he following four inst rument s:
Table A2 - Market Inst rument Used for Building Sample Curve
Instrument Maturity yrs Coupon Rate Fwd Rate cc
1yr Swap 1 2. 0.0199
1y2y Fwd 1 3.014 0.0299
5yr Swap 5 3. 0.0333
10yr Swap 10 3.5 0.0406
Figure A1 - Piece-Wise Constant Forward Curve
32 temp.nb
2 4 6 8 10
Mat urit y ( yrs)
0.01
0.02
0.03
0.04
Inst ant aneousRat es
Solid a re Ze ro Ra te s , Da s he d a re Forwa rd Ra te s
The part ial DV01s for all t he inst rument s, calculat ed from t he piece-wise const ant forward curve, is shown in
t he following t able. The DV01s are derivat ives w.r.t . cont inuously-compounded forward rat es (t he parame-
t ers of t he curve above).
Table A3 - DV01 w.r.t . Curve Variables (Forward Rat es) for Select ed Inst rument s
f0y1y f1y2y f2y5y f5y10y Total
1yr Swap 0.99 0. 0. 0. 0.99
2yr Swap 0.99 0.97 0. 0. 1.96
3yr Swap 0.99 0.97 0.94 0. 2.9
5yr Swap 0.99 0.96 2.72 0. 4.68
10yr Swap 0.99 0.96 2.68 3.87 8.5
1yr Ann 0.01 0. 0. 0. 0.01
2yr Ann 0.04 0.02 0. 0. 0.06
3yr Ann 0.08 0.05 0.02 0. 0.15
5yr Ann 0.13 0.1 0.14 0. 0.37
10yr Ann 0.29 0.25 0.57 0.36 1.47
1yr Zero 0.98 0. 0. 0. 0.98
2yr Zero 0.95 0.95 0. 0. 1.9
3yr Zero 0.92 0.92 0.92 0. 2.76
5yr Zero 0.86 0.86 2.58 0. 4.3
10yr Zero 0.7 0.7 2.11 3.51 7.03
1y2y Fwd 0. 0.97 0. 0. 0.97
2y5y Fwd 0. 0. 2.74 0. 2.74
3y5y Fwd 0.01 0.01 1.78 0. 1.77
5y10y Fwd 0. 0. 0. 3.93 3.93
3y7y Fwd 0.01 0.01 1.77 1.66 3.42
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Curvevariablesare cont inuously-
compoundedforwardrat es. Inst rument s usedin fit t ing t he curveare highlight ed.
Dynamic Interactivity
If you are reading t he .pdf version of t his paper t he t ables are clearly not int eract ive - t hey are simply st at ic
graphics. For int eract ivit y you must use t he .cdf/ .nbp version, which is available at www.closemountain.-
com/ publications.html#RiskManagement
temp.nb 33
TransformedPartial DV01s
The t able below is init ialized t o report risk w.r.t . 1, 2, 5, and 10 year par swap yields. If you are reading t he .cdf
version you may choose alt ernat e inst rument s from t he four drop-down list s and t he risk will re-calculat e.
You can choose set s of inst rument s t hat are not appropriat e (for example using t he 3 year swap inst ead of t he
2 year swap) but t he t ransformat ion will st ill be calculat ed. If you choose a set of inst rument s for which t he
Jacobian is singular, t he risk will not display.
Table A5 - Transformed DV01 w.r.t . Alt ernat e Variables
1 yr Swa p 2 yr Swa p
5 yr Swa p 10 yr Swa p
Inverse Jacobian
Jacobian
Partial DV01s
34 temp.nb
DV01s are report edas dollarchange for a $100 not ionalinst rument per100bp change in yieldsor rat es. Inst rument s usedin fit t ing t he
curveare highlight ed.Transformedvia met hodologydiscussedin t he t ext .
References
Coleman, Thomas S. (1998), Fit t ing Forward Rat es t o Market Dat a, available from Social Science Research
Net work, ht t p:/ / ssrn.com/ abst ract =994870
Coleman, Thomas S. (2011), A Guide t o Durat ion, DV01, and Yield Curve Risk Transformat ions, available
from Social Science Research Net work, ht t p:/ / papers.ssrn.com/ abst ract =1733227
Ho, Thomas S.Y. (1992), Key Rat e Durat ions: Measures of Int erest Rat e Risks, The Journal of Fixed Income,
Sept ember 1992 Vol. 2, No. 2, pp. 29-44
Macaulay, Frederick (1938), Some Theoret ical Problems Suggest ed by t he Movement s of Int erest Rat es, Bond
Yields, and St ock Prices in t he Unit ed St at es since 1856. New York: Columbia Universit y Press.
Reit ano, Robert R., (2008), Yield Curve Risk Management , in Handbook of Finance, Frank J. Fabozzi, ed.,
vol. 3, p. 215. Hoboken, NJ: John Wiley and Sons.
Reit ano, Robert R., (1991), Mult ivariat e Durat ion Analysis, Transact ions of t he Societ y of Act uaries XLIII:
335-391, available on-line at ht t p:/ / www.soa.org/ library/ research/ t ransact ions-of-societ y-of-
act uaries/ 1990-95/ 1991/ january/ t sa91v4311.pdf
This paper, (Coleman 2011, A Guide t o Durat ion, DV01, and Yield Curve Risk Transformat ions) is also
available in .cdf/ .nbp format (Wolfram comput able document format or not ebook player) wit h dynamic
int eract ivit y enabled - see www.closemount ain.com/ publicat ions.ht ml
Endnotes
1. A 5 year par swap and 5 year par bond will have t he same risk. In t able 1 t he DV01 for t he "5 year bond"
differs slight ly from t he t able 6 t ot al DV01 for t he "5 year swap" because t he DV01 in t able 1 is wit h respect
t o yield-t o-mat urit y, while t he DV01s in t able 6 are wit h respect t o par swap rat es. The difference is
discussed more fully in a lat er sect ion. The 10 year annuit y differs in t he t hird decimal (not displayed).
temp.nb 35