Interest Rate Theory and Stochastic Duration

Abstract

With the new regulations of Basel III and Solvency II there is a necessity to have tools that can measure different types of financial and insurance risk in a portfolio. Stochastic Duration is such a measure. This new type of measure, which is for the first time implemented in this thesis, can be used to analyze the sensitivity of complex portfolios of interest rate derivatives with respect to the stochastic fluctuation of the entire term structure of interest rates or the yield surface without assuming as in the classical case (Macaulay duration) flat or piecewise flat interest rates. It is conceivable that this concept will serve as an important tool within risk management and replace the classical Macaulay duration. Moreover, using the concept of immunization strategies based on stochastic duration we will be able to hedge the expected uncertainty due to the changes in the forward rate in complex bond portfolios.