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Interest Rate Sensitivity of Callable Bonds and Higher-Order Approximations

Author

Listed:
  • Scott S. Dow

    (M. R. Greenberg School of Risk Science, J. Mack Robinson College of Business, Georgia State University, Atlanta, GA 30302, USA)

  • Stefanos C. Orfanos

    (M. R. Greenberg School of Risk Science, J. Mack Robinson College of Business, Georgia State University, Atlanta, GA 30302, USA)

Abstract

Certain fixed-income securities, such as callable bonds and mortgage-backed securities subject to prepayment, typically exhibit negative convexity at low yields and cannot be adequately immunized through duration and convexity-matching alone. To address this residual risk, we examine the concepts of bond tilt and bond agility. We provide explicit calculations and derive several approximation formulas that incorporate higher-order terms. With the help of these methods, we are able to track the price-yield dynamics of callable bonds remarkably well, achieving mean absolute errors below 2.5% across a wide variety of callable bonds for parallel yield shifts of up to ±200 basis points.

Suggested Citation

  • Scott S. Dow & Stefanos C. Orfanos, 2025. "Interest Rate Sensitivity of Callable Bonds and Higher-Order Approximations," Risks, MDPI, vol. 13(4), pages 1-24, April.
    • Handle: RePEc:gam:jrisks:v:13:y:2025:i:4:p:69-:d:1625778
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    References listed on IDEAS

    as
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