Interest Rate Sensitivity of Callable Bonds and Higher-Order Approximations

Scott S. Dow and Stefanos C. Orfanos ()
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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

Risks, 2025, vol. 13, issue 4, 1-24

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.

Keywords: bond agility; bond tilt; higher-order approximations; negative convexity bonds (search for similar items in EconPapers)
JEL-codes: C G0 G1 G2 G3 K2 M2 M4 (search for similar items in EconPapers)
Date: 2025
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