Exploring risk dynamics in corporate bonds

: a study of effective and Macaulay durations

Abstract

This dissertation examines the effect of firms’ credit risk on interest rate risk using two real-world corporate bond portfolios in December 2022, one with low credit risk and the other with high credit risk. This is done by comparing the Macaulay duration with the effective duration resulting from the application of Leland and Toft (1996) structural credit risk model. It was found on average a Macaulay duration of 4.24 years versus an effective duration of 2.92years for the high-risk portfolio, while the low-risk portfolio displayed a Macaulay duration of 9.04 years in contrast to an effective duration of 7.47 years. The difference between the Macaulay and effective durations highlights the limitations of traditional risk management techniques, such as immunization, which often do not take into account the relation between interest rates and credit risk.

Date of Award	28 Jun 2023
Original language	English
Awarding Institution	Universidade Católica Portuguesa
Supervisor	Nuno Silva (Supervisor)