This is a quick tour of the mechanics and calculations involved in calculating the risk of a fixed income portfolio. It starts from the observation that a a newly minted bond doesn’t have a price history; consequently, you can’t calculate historical volatility. So you can infer the history by pricing the bond using historical interest rates. But then how do you get historical interest rates at the exact times your bond cash flows occur? You’ll need to spline the interest rates.
We’ll cover his to manually spline the yield curve to infer historical price volatility. We’ll demonstrate cash flow mapping combined with duration calculations as an alternative to splining. Lastly, we’ll demonstrate the classic PCA approach.
An Excel workbook will demonstrate the calculations and display required R code.
