# ALFO Glossary

Explore our glossary of key financial terms to support you and your organisation with financial risk management.

• Annual Percentage Yield (APY)

The real rate of return earned on a savings deposit or investment taking into account the effect of compounding interest.

• Compound Interest

Compound interest is calculated periodically and the amount is immediately added to the balance. With each period going forward, the account balance gets a little bigger, so the interest paid on the balance gets bigger as well.

• Convexity

The relationship between the price of a bond and its yield, is not linear. It means that 2 different bonds, Bond-A and Bond-B, may have the same Duration for a given price and a given yield.

Yet these 2 bonds can have completely different risk profiles, as shown by their price-yield curve. The Convexity measures the curvature in the relationship between bond prices and bond yields.

If a bond’s duration increases as yields increase, the bond has a negative convexity. Positive convexity is when the bond’s duration increases as the yields fall. The convexity is the second derivative of the price function with respect to yields.

• Current Yield

Current yield is an investment's annual income divided by the current price of the security. This measure examines the current price of a bond, rather than looking at its face value.

Also referred to as interest yield, income yield, flat yield, market yield, mark to market yield or running yield.

• DV01

A.k.a. “dollar value per 01”, “dollar value for 1 basis point”
It is a linear approximation of how a bond's value will change in response to a 1 basis point change in interest rates.

The actual relationship between a bond's value and interest rates is not linear. Therefore, dollar duration is an imperfect measure of interest rate sensitivity, and it will only provide an accurate calculation for small changes in interest rates.

• Dollar Duration

Mathematically, the dollar duration measures the change in the value of a bond portfolio for every 100 basis point change in interest rates. Sometimes “dollar duration” is referred to as ‘DV01’, but remember: 1 basis point is 0.01 of 1 percent.

• Effective Duration

It is used for bonds which have an embedded option – puttable and callable bonds. Option pricing is used to determine the value of such a bond.

The delta of such a bond is its duration. The Effective Duration is the discrete approximation of the bond’s delta.

• EURIBOR

Euro Interbank Offered Rate. A daily reference rate, published by the European Money Markets Institute, based on the averaged interest rates at which Eurozone banks offer to lend unsecured funds to other banks in the interbank market.

• Immunisation Strategy

A risk-mitigation strategy that seeks to minimise the impact of interest rates on the net value of a portfolio of assets, by matching the duration of assets and liabilities.
It can be accomplished by matching cash flows/durations/convexities, and by trading forwards, futures, and options on bonds.

Immunisation strategies need to be managed for the situations when assets increase in value, while liabilities rise at a slower rate.

• LIBOR

London Inter-Bank Offered Rate. An interest-rate average calculated from estimates submitted by the leading banks in London.

• Macaulay Duration

The weighted average maturity of cash flows, in which the time of receipt of each payment is weighted by the present value of that payment.

It is named for the economist Frederick Macaulay who introduced the concept. The Macaulay Duration is measured in years, and is used in portfolio immunisation strategies.

• Modified Duration

Modified Duration is a price sensitivity measure. It is applied when a bond (or another asset) is considered as a function of yield. Mathematically, it is defined as the logarithmic derivative of bond price with respect to yield.

It is measured as the percent change in price per one percentage point change in yield per year (for example annual yield going from 5% to 6%). This will give Modified Duration a numerical value close to the Macaulay Duration. The two are equal when rates are continuously compounded.

• SOFR

Secured Overnight Financing Rate. Measures the cost of borrowing cash overnight, collateralized by Treasury securities.
It includes all trades in the Broad General Collateral Rate plus bilateral Treasury repurchase agreement transactions (cleared through the DVP by FICC. It is calculated as a volume-weighted median.

• SONIA

Sterling OverNight Index Average. The risk-free rate published by the Bank of England. Unlike LIBOR, it does not include counter-party or liquidity risk.

SONIA is calculated taking a volume-weighted mean rate (based on the central 50% of the volume-weighted distribution of rates) of the interest rates paid on eligible transactions. It is rounded to four decimal places.

• Yield

The return to an investor from the bond's coupon payments.

• Yield to Maturity (YTM)

The total return anticipated on a bond if the bond is held until it matures. It is considered a long-term bond yield but is expressed as an annual rate.

YTM is usually quoted as a bond equivalent yield (BEY), which makes bonds with coupon payment periods less than a year easy to compare.

• Yield to Call

The total return that will be received if the bond purchased is held only until its call date instead of full maturity.