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Applying PV01 Limit for Bond Portfolio

John267

New Member
If PV01 for a bond portfolio is 2 million that means 0.01% interest rate movement either way will change portfolio price approximately by 2 million. If we set PV01 limit for the portfolio as 2 million that means we are willing to accept 2 million loss for 0.01% rate hike. Suppose the PV01 exposure for the portfolio is almost close to 2 million and on the next day rates move up further, PV01 exposure for the portfolio will come down. PV01 exposure for the portfolio does not indicate whether the next rate hike will make losses. Please explain me how this PV01 limit can be applied to a bond portfolio. Its said that if there is no PV01 limit for a portfolio then the portfolio is not maintained properly.
 

Matthew Graves

Active Member
Subscriber
PV01 is just a measure of interest rate exposure and with bond portfolios it's prudent to manage the overall rates exposure to a desirable level. Some bond portfolios want to concentrate purely on credit risk, keeping the rates exposure to a minimum, other may take a view on rates. Either way, you're managing the exposure.

With regard to your point about the direction, if rates go up bonds lose value. The PV01 is an estimate of how much you will gain/lose if rates decrease/increase. Unless your portfolio contains derivatives and/or is net-short duration, a rate increase will bring about a negative return.

I should also add that in my experience using PV01 to manage bond portfolios is unusual. Normally duration is used as it is a relative (percentage) measure rather than the absolute value provided by PV01.
 

John267

New Member
Thanks Matthew for explanation. Some points are missing in my original query.The portfolio I am referring is a Government issued Bond portfolio without any corporate bonds. All bonds are option free and short selling is not allowed in the market. There are no futures to hedge.Whats the best method that we can manage such a portfolio? How bond traders manage this type of portfolios or other bond portfolios against interest rate risk? What type of forward looking limits they usually set for bond portfolios?
 
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Matthew Graves

Active Member
Subscriber
At the most basic level, bond portfolio managers usually have a target portfolio duration to manage their overall rates exposure. This can be a target duration value just for the portfolio but is also commonly measured as "active" duration. i.e. Portfolio Duration - Benchmark Duration.

So, there will likely be a max duration limit that they do not want to exceed or may be mandated by the client but within that the manager will set his exposure based on his rates views. For example, if the portfolio manager thinks rates will increase then they will likely have a negative overall active duration (i.e. less rates exposure than the benchmark they're measured against) and vice versa.

Within the portfolio, the manager is also making decisions about where to allocate his duration in order to take advantage of relative curve moves e.g. flattening/steepening. They may therefore have a view on their Key Rate Duration exposure on a per country basis.

That's the absolute basics but of course there are a million different strategies that managers can employ. There's plenty of literature available on managing bond portfolios if you want to get into it in more detail.
 

tosuhn

Active Member
Hi Matthew, since we are on the topic here on PV01, if we r just looking an IRS trade - assuming the trade is pay fixed, receive float and rates continue to increase. Why would the pay fixed side has a positive PV01?

By the way what are the literature you would recommend for managing bond portfolio focusing in particular on the market risk side.
 

QuantMan2318

Active Member
Subscriber
@tosuhn

With regard to your point about the direction, if rates go up bonds lose value. The PV01 is an estimate of how much you will gain/lose if rates decrease/increase. Unless your portfolio contains derivatives and/or is net-short duration, a rate increase will bring about a negative return.

I think the above quote is a good starting point for your question. When you are on the payment side of fixed interest rates in a Fixed-Floating IRS, I would suppose that it is akin to being on the short side of a Fixed Coupon Bond, hence, the PV01 would be positive (being the negative change for a negative position) for such a position. I am basing my answer on the logic that any IRS can be construed as a portfolio of Bonds with a Fixed Coupon Bond on the Short Side and a Floater on the Long Side

We know that the V(Swap) = V(Floating) - V(Fixed) where it is pay Fixed and receive Floating
The revised value after a 1bps increase in Interest Rates = V(Floating) - V(Fixed 1)

Since we are on the negative side as we are short the Fixed Coupon Bond -V(Fixed 1) - (-V(Fixed)) would be positive as V(Fixed 1) would be lower than V(Fixed) and hence as we are taking the PV01 of the Fixed payout as the above formula, we can construe the same as positive for a pay fixed portion of an IRS

The above was based on intuitive reasoning and so I may be wrong as well.

Thanks
 
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