Welcome to Scribd, the world's digital library. Read, publish, and share books and documents. See more
Download
Standard view
Full view
of .
Look up keyword
Like this
0Activity
0 of .
Results for:
No results containing your search query
P. 1
icrddc

icrddc

Ratings: (0)|Views: 9|Likes:
Published by Jay Kab
fdgdf
fdgdf

More info:

Published by: Jay Kab on Jun 03, 2013
Copyright:Attribution Non-commercial

Availability:

Read on Scribd mobile: iPhone, iPad and Android.
download as PDF, TXT or read online from Scribd
See more
See less

06/03/2013

pdf

text

original

 
Vanguard research May 2010
Distinguishing durationfrom convexity
Authors
Donald G. Bennyhoff, CFAYan Zilbering
Executive summary.
For equity investors, the perception of risk isgenerally straightforward: Market risk—the possibility that prices maymove in an unprofitable manner—tends to be paramount. However,for bond investors, defining risk is more complicated. Many importantrisks that are specific to an individual bond—such as default risk andprepayment risk—require consideration, but only interest rate risk issystematic. Like market risk for stocks, interest rate risk is a universalrisk for bond investors, and the principal measure of interest rate risk ismodified duration (hereafter referred to simply as duration).Because the topic of duration and a related concept—convexity—canbe very complex, we offer this brief paper as a fundamental, rather thana comprehensive, overview of the topic. Our goal is to help investorsunderstand why it’s important to consider both duration and convexitywhen evaluating the interest rate risk of bonds.
Connect with Vanguard
>www.vanguard.com >global.vanguard.com (non-U.S. investors)
 
Understanding duration
Duration is a measure of the approximate sensitivityof a non-callable bond’s price to changes in interestrates. For bonds with embedded options—such ascallable bonds, mortgage-backed securities (MBS),and collateralized mortgage obligations (CMOs)—effective duration is generally the preferred measure.Effective duration incorporates the terms for earlyretirement for a bond. In other cases, such aswith Treasury Inflation-Protected Securities (TIPS),duration reflects the sensitivity to a change in
real 
 interest rates rather than nominal interest rates, aswith other bonds.
1
Specifically, duration is a way to estimate theapproximate percentage change in the price of abond for a 100-basis-point (1 percentage point)change in interest rates. A bond with a durationvalue of 4 would be expected to lose 4% of itsmarket value if interest rates rose by 100 basispoints. So why is duration measured in years? Theanswer: Because duration is technically a weightedaverage of the time to maturity of a bond’s cashflows. As such, it can help an investor assess howsoon an initial investment will be repaid—taking intoconsideration not only when the principal should bereturned but also any interest payments that are duealong the way.A bond is a loan from the bond holder or investor tothe bond issuer (for example, a corporation), so it isonly natural for investors’ concern to center on thetimely payment of interest and principal. The bond’sindenture, which is an agreement between the issuerand investors, sets forth the specific terms of thebond, including:
s7HENWILLTHEBONDMATUREANDPRINCIPAL
 be repaid?
s#ANTHEPRINCIPALBEREPAIDPRIORTOTHEMATURITY
date and, if so, at what price?
s7HATINTERESTRATECOUPONWILLBEPAIDTOTHE
bond owners?
s(OWOFTENWILLCOUPONSBEPAIDANDISTHISRATE
fixed or variable?Two bonds with the same coupon rate and the samestated maturity date can have different cash flowpatterns and hence different durations. For example,one bond may pay interest more frequently than theother. Duration can help an investor quantify howthese cash-flow differences may affect the value ofboth bonds. For any given maturity date, higher cashflows from a higher coupon rate result in a fasterpayback period for the investor, hence a shorterduration. A zero-coupon bond has a duration equalto its remaining time to maturity. The duration ofa coupon bond, on the other hand, is
shorter 
thanits time to maturity—because the investor receivesperiodic interest payments.In addition to the timing of cash flows, inflationmatters because changes in interest rates arefrequently associated with changing trends foreconomic growth and inflation. Higher-than-expectedinflation during the loan repayment period reducesthe purchasing power of both the principal at maturity
1 For more information on TIPS, see “Investing in Treasury Inflation Protected Securities.
2
 
Duration: An example
A bond is trading at $10,000, the price atwhich it was sold. If this bond has a durationof 5 years, and if interest rates rise one fullpercentage point, then the price of the bondwould be expected to fall by about 5% to$9,500—if everything else remains the same.
 
and the periodic interest payments, reducing the realreturn. As a result, investors with longer-durationloans—that is, holding longer-duration bonds—aremore exposed to changes in interest rates than thosewith shorter-duration loans.
Understanding convexity
Duration, however, captures only one aspect ofthe relationship between bond prices and interestrate changes. For larger interest rate moves, therelationship between the change in rates and thechange in bond prices is asymmetric. The bondprice
decrease 
resulting from a large interest rateincrease will generally be smaller than the price
increase 
resulting from an interest rate decline ofthe same magnitude. This asymmetry arises fromthe convex payoff pattern shown by the solid curvedline in
Figure 1
. This convex shape also means that aportion of the interest rate move remains uncapturedby duration.Figure 1 plots the relationship between the price ofa bond and its yield. The dashed line approximatesthe effect of a change in yield on the price of thebond. Duration, a measure of interest rate risk, ismathematically derived from the slope of this dashedline. The curved line represents convexity.Many bonds illustrate positive convexity and behavein the manner illustrated in Figure 1. Convexitycaptures the degree to which the actual bond price,the solid curved line, deviates from the estimatedbond price, the dashed line, when the interest ratechanges. However, as shown by the dotted line in
Figure 2
, on page 4, some bonds, such as callablebonds and mortgage-backed securities, have
negative 
 convexity at lower interest rate levels. This negativeconvexity arises from the embedded optionsdiscussed earlier: As interest rates fall, the investoris more likely to receive his principal back early, i.e.before maturity, shortening the life of the securityand making it less valuable from the standpointof total cash flow received. Thus, for a bond withnegative convexity, falling interest rates do notsignificantly drive up the bond’s price.
3
Duration versus convexity:An illustration of the differenceFigure 1.
   B  o  n   d  p  r   i  c  e
Notes: Th
i
s f
i
gure
i
s an
i
llustrat
i
on only and
i
s not
i
ntended to representa spec
i
f
i
c mathemat
i
cal relat
i
onsh
i
p
.
Y
0
 
i
s the
i
n
i
t
i
al y
i
eld; Y
1
and Y
2
aresubsequent y
i
elds
.
P
0
 
i
s the
i
n
i
t
i
al pr
i
ce; P
1
 
i
s the pr
i
ce after the f
i
rsty
i
eld change and P
2
 
i
s the pr
i
ce after the second y
i
eld change
.
Source: Vanguard
.
p
2
y
2
y
1
y
0
p
1
p
0
Slope =
p/ 
y = Duration
y
p
Bond yieldShaded area: Error in estimatingprice changes using durationincreases with larger yieldchanges because of convexity

You're Reading a Free Preview

Download
scribd
/*********** DO NOT ALTER ANYTHING BELOW THIS LINE ! ************/ var s_code=s.t();if(s_code)document.write(s_code)//-->