UVA-F-1238

Duration and Convexity

The price of a bond is a function of the promised payments and the market required rate of return. Since the promised payments are fixed, bond prices change in response to changes in the market determined required rate of return. For investor's who hold bonds, the issue of how sensitive a bond's price is to changes in the required rate of return is important. There are four measures of bond price sensitivity that are commonly used. They are Simple Maturity, Macaulay Duration (effective maturity), Modified Duration, and Convexity. Each of these provides a more exact description of how a bond price changes relative to changes in the required rate of return. Maturity Simple maturity is just the time left to maturity on a bond. We generally think of 5-year bonds or 10-year bonds. It is straightforward and requires no calculation. The longer the time to maturity the more sensitive a particular bond is to changes in the required rate of return. Consider two zero coupon bonds, each with a face value of \$1,000. Bond A matures in 10 years and has a required rate of return of 10%. The price 1 of Bond A is \$376.89, where
PA =

(1 + .10 / 2 )20

\$1,000

= \$376.89

Bond B has a maturity of 5 years and also has a required rate of return of 10%. Its price is \$613.91 or \$1,000 PB = = \$613.91 (1 + .10 / 2 )10

By convention, zero coupon bonds are compounded on a semi -annual basis. Since almost all US bonds have semi-annual coupon payments, this note will always assume semi-annual compounding unless otherwise noted.

1

43 for Bond B. many of the cash flows occur before the actual maturity of the bond and the relative timing of these cash flows will affect the pricing of the bond. 1938). For a coupon-paying bond. the prices would then be \$342. Macaulay Duration (Effective Maturity) The relationship between price and maturity is not as clear when yo u consider non-zero coupon bonds.1% change in price for Bond A and -4. Bond Yields. In order to deal with this. This is reinforced in Figure 1.000. and Stock Prices in the United States since 1856 (New York: National Bureau of Economic Research. Just from the pricing formulation. for zero coupon bonds simple maturity can be used to compare price sensitivity. This translates into a -9. Fredick Macaulay. Some Theoretical Problems Suggested by the Movement of Interest Rates. He called this duration and defined it as a value-weighted average of the timing of the cash flows.-2- UVA-F-1238 If the required rate of return for each bond was to increase by 100 basis points to 11%. it is clear that any change in interest rates will have a much Figure 1. Thus. where the price curve for the 10-year bond (Bond A) is much steaper than that for the 5-year bond (Bond B). This is shown in Exhibit 1. The easiest way to see this is to use an example. Consider a six. If the current yield to maturity is 10%.year bond with face value of \$1. Comparison of 5-year and 10-year Bonds 1200 1000 800 600 5-year 10-year 400 200 0 Required Rate of Return greater impact on Bond A than Bond B. 2 . and a 6.1% coupon rate (semi-annual payments).73 for Bond A and \$585. the value of the bond is found by discounting each of the semi-annual payments.6% for Bond B. Frederick Macaulay2 in 1938 suggested that investors use the effective maturity of a bond as a measure of interest rate sensitivity.

t and then summing all of the weighted values. P.50 30.76 21. times the time. one has a percentage.66 26.50 30.5568 29. or Ct Duration = ∑ t =1 T (1 + y )t P ⋅ t = ∑ wt ⋅ t .9524 \$ 0. .50 30. of the total bond value that is received in each period.09 23. Calculation of the Macaulay Duration measure is fairly straightforward but can be somewhat tedious 3 .64 19.35 25.). t.8227 0. wt . Ct wt = (1 + y ) t P The duration or effective maturity for the bond could then be estimated by multiplying the weight. Value Factor Pres.90 22.9070 0. By doing this.7462 0.50 30.68 20.50 30.50 0.8638 0.030.6139 0.05 27.50 30.6768 0.7107 0.50 30.72 17. 3 Excel offers a worksheet function DURATION(.6446 0.82 Macaulay Duration takes the present value of each payment and divides it by the total bond price.7835 0.5847 0.66 18. Value of Cash Flow \$ 30. t =1 T This measure takes into account the relative timing of the cash flows. Exhibit 2 shows how a semi-annual duration for the example shown above would be calculated.50 1.50 30.50 30.-3- UVA-F-1238 Exhibit 1 t 1 2 3 4 5 6 7 8 9 10 11 12 Cash Flow Pres. which calculates the Macaulay Duration. wt .50 30.83 573.

1997 0.1651 0.51% 3.5847 0.50 30.2371 8.50 30.6139 0.2264 0.50 0.1% coupon bond when interest rates change to behave in a manner similar to a 5-year zero coupon bond.7107 0.7835 0.5568 29.50 30.50 30.030.9070 0.38% 2. Note that the Macaulay Duration for a 5. 6.8227 0. The basic pricing formulation for bonds is .6768 0.50 30.50% 2.76 21.50 30. Value Factor Pres.0351 0.64 19.05 27. the annualized duration would be 5.014 The semi.66 26. since their effective maturity (Macaulay Duration) is essentially the same. In this case.007 years.8638 0.75% 2.0669 0.year zero coupon bond is the same as the simple maturity.0 years.68 20.83 573.0956 0.82 3.50 1. D. For those with a math background. ∆P ∆y is the first derivative of the bond price with respect to yield to maturity.month periods.1834 0.50 30.50 30. Value of Cash Flow Weight \$ 30.16% 69.90 22. Modified Duration If we want a more direct measure of the relationship between changes in interest rates and changes in bond prices.19% 3.62% 2. We usually use annual duration and we annualize the semi-annual duration simply by dividing by 2 (the number of six month periods in a year).3246 Bond Value \$ 827.37% Semi-Annual Duration t x weight 0.03% 2.6446 0.2139 0.17 10.89% 2. we can expect that the original 6-year. Hence.66 18.014 six.9524 \$ 0.7462 0.1213 0. 5.35 25. ∆P is the change in bond price and ∆y is the change in the required rate of return (yield to maturity). is defined as the following D=− 1 ∆P ⋅ P ∆y where P is the bond price.50 30.26% 2.annual duration for this bond is 10.34% 3.1445 0.-4- UVA-F-1238 Exhibit 2 t 1 2 3 4 5 6 7 8 9 10 11 12 Cash Flow Pres.50 30. we can use Modified Duration. Modified Duration.09 23.72 17.

Comparing this to the definition of Macaulay Duration and using that definition we can write Modified Duration as Modified Duration = D = 1 Macaulay Duration (1 + y ) While it is easy calculate Modified Duration once you have Macaulay Duration the interpretations of the two are quite different.537 on a semi-annual basis or 9. Ct 1 D= ⋅ t⋅ (1 + y ) ∑ t =1 T (1 + y )t P . D=− T 1  1 Ct  ⋅ − ⋅∑t ⋅  P  (1 + y ) t =1 (1 + y )t  Rearranging the above slightly. ∑ ∆y (1 + y ) t = 1 (1 + y )t Inserting this into the formula for Modified Duration yields. For example.014 or 9. The Modified Duration of this bond is 10.year 6.537 = 4.014 (5. the six. Macaulay Duration is an average or effective maturity.-5- UVA-F-1238 T Ct P= ∑ t =1 (1 + y) t where Ct is the cash payment received in time period t and y is the semi-annual yield to maturity. Taking the derivative of P with respect toy.007 annual Macaulay Duration). In fact.05 ) 2 .1% coupon bond above had a yield to maturity of 10% and a semi-annual Macaulay Duration of 10.Modified Duration times the change in yield to maturity. Modified Duration really measures how small changes in the yield to maturity affect the price of the bond.77 years on an (1 + . from the definition of Modified Duration we can write the following relationship: ∆P = − D ⋅ ∆y P or % change in bond price = . ∆P = − 1 ⋅ T t ⋅ C t .

90 2.63 4.62 4.00% 827.39% 807.38.28 0.85 -5.75% 0.25% 5.17 4.25%. Exhibit 3 Bond Data Coupon = Maturity= Face Value = Yield to Maturity= Price = Modifed Duration= 6.000 10% \$827.00% 4.99 -6.75% 3.50% -2.25% 0.94% 761.54% 748.75% -3.75% 8.50% 1.19% .20% 837.49 6. You can not use the annual Macaulay Duration to calculate the Modified Duration.13 0.18% 817.00% 827.19% from \$827.75% -1.19% 817.00% 9.73 10.58 -3. *** Difference is Actual Price .64 0.00% 2.77 years the price of the bond should change by ∆P = − D ⋅ ∆y = − 4.07 0.96% 876.Predicted Price.84 8.79% 899.08 10.25% -5.15 1.17.38 10.76 1.54% 906.66% 857.50% -1.40 2.31 8. the Modified Duration must first be calculated on a semi-annual basis and then annualized.44 -2. ** Actual price is the calculated price based on the yield to maturity.35% 807.77% 866.71 -4.1% 6 years \$1.12% 910.58% 856.47% 889.-6- UVA-F-1238 annual basis 4 .58% 797.52 1.64 1. the true relationship between the bond's price and the yield to maturity is not linear.31).84 * Actual % change is based on the calculated price relative to the price of \$827.22 8.35% 758.25% -1.76 3.17*(1-.61 11.50% 2.12 -7.75% 1.50% 0.35% 896.31 P (\$827.10 9.25% -0.00% -1.18 9.75% -0.17 -0.77% 787.00% 1. The bond price should drop by 1.00% -2.75% -8.00% -4.63% 788.50% -0.17 9.18% 878.35 7.00% -9.00% 0.03 1. The actual calculated price at a yield to maturity of 10.01% 752.25% -1. Assuming that the yield to maturity of 10% increases by 25 basis points to 10.07 0.68 11. From Exhibit 3.25% is \$817.16% 767.00% 0. based on the Modified Duration of 4.16% 886.42% 847.26 -9.85 10.42 3.0119) = \$817.22 10. 4.25 %) = − 1.82 2.96% 777.31 -1.91% 867.00 8.25% 1.17 to \$817.25% 1.770 Change in Yield -D*Change in Yield Predicted Price Actual % change* Actual Price** Difference*** New Yield to Maturity 12. Exhibit 3 shows the Modified Duration price change and the actual calculated price change for different changes in yield to maturity.39% 846.50% 7. 4 .52 11.50% -7.76 Modified Duration assumes that the price changes are linear with respect to changes in the yield to maturity.19% 837.50 11.64 3.40 9.85% 770.50% 798.29 0. The Column with the differences is always positive and increases If the original compounding basis on the bond was semi -annual.75% 779.77 ⋅ (.78 8.

200. This property is refered to as convexity. Figure 2. practitioners use Convexity.e.00 200. Everywhere the actual price curve is above the Modified Duration relationship. the percentage changes in price are not symmetric.00 800. The definition of Convexity is Convexity = CV = 1 ∆2 P ⋅ P (∆y )2 Once again those with a math background will recognize the last term on the right as the second derivative of price with respect to yield to maturity. actual calculated price was greater than the new price using the Modified Duration relationship.600. i.000.00 1. The percentage decrease in price for a given increase in yield is always less than the percent increase for the same decrease in yield. This is exactly what we saw in Exhibit 3.00 1. 6. The actual relationship between the bond price and the yield to maturity is shown in Figure 2. The actual definition of Convexity that we can use is .1% Coupon (paid semi-annually) Rate.00 - Yield to Maturity The curved line is the actual price curve.-7- UVA-F-1238 as we move away from a yield to maturity of 10%. Note that the two prices are quite close for small changes in the yield to maturity but the difference grows as the change in yield to maturity becomes bigger.. From Figure 2 it is clear that the Modified Duration relationship does not fully capture the true relationship between bond prices and yield to maturity.00 400.000 1. Convexity.00 600. Bond Prices 6-year. Face value = \$1. In addition.00 1. The straight line is the price relationship using Modified Duration. In order to more fully capture this. The difference was always positive.400.

75% 2.030.76 21.88 We can annualize the semi-annual convexity of 110.50 30.8638 0.-8- UVA-F-1238 1 ∆P 1 Convexity = CV = ⋅ = ⋅ ∑ t ⋅ (t + 1) ⋅ 2 P (∆y ) (1 + y )2 t=1 2 T Ct (1 + y )t P Exhibit 4 shows the calculation of the semi.17 Weight t x(t + 1) × weight × 1 (1 + y) 2 1 2 3 4 5 6 7 8 9 10 11 12 3.50 30. Exhibit 4 Convexity t Cash Flow \$30.50 30.9403 2. The formula 6 is % ∆ Price = .90 22.50 Bond Value Pres.50 30.50 30. this formula is based on using a Taylor series expansion to approximate the value of the percentage change in price.16% 69.37% Semi-annual Convexity 0.Modified Duration × ∆y + 1 × Convexity × (∆y)2 2 5 Convexity is annualized by dividing the calculated Convexity by the number of payments per year squared.72 17.62% 2.5847 0.66 18. For those with a math bent.1588 110.annual convexity for the six-year 6.82 \$827.5812 98.50 30.7861 1. First it can be used in conjunction with duration to get a more accurate estimate of the percentage price change resulting from a change in the yield.50 30.5568 Pres.03% 2.26% 2.68 20.6768 0.1% coupon bond.50% 2.1820 0.6298 1.8227 0.64 19.72.19% 3.3467 0. Here it would be 27.3310 1.9524 0.50 30.7462 0. Value Factor 0.83 573.9070 0.6446 0.50 30.50 1.2585 2.51% 3.0482 1.7107 0.38% 2.50 30.09 23.89% 2.88 by dividing5 it by 22 or 4.05 27. Convexity is useful to practitioners in a number of ways.7835 0.34% 3. 6 .0637 0.5503 0. Value of Cash Flow \$29.35 25.6139 0.66 26.

0899. . bonds with high convexity are more desirable. the predicted percentage price change would be % ∆ Price = .72 × (. The downside is less and the upside is more.01%. while the actual was -9.00554 = -.02) + 1 × 27.77 × (.99%. Summary Each of the price sensitivity measures discussed in this note is part of the everyday language and thinking of fixed income investors.0954 + .54%. They are relative risk measures that help investment professionals think about the risks they face. at a yield of 12% the percentage price change using only Modified Duration was -9.02)2 = -. bond prices drop less for a given increase in yield and increase more for the same decreases in yield. The more important use of convexity is that it provides insight into how a bond will react to yield changes. For a given change in yield.-9- UVA-F-1238 Adding the convexity adjustment corrects for the fact that Modified Duration understates the true bond price. The higher the Convexity of a bond the more this is true.01%. in Exhibit 3.4. Thus. Again from Exhibit 3 and Figure 2 we see that the price reaction to changes in yield is not symmetric. The pricing aspect of Convexity is much less important now since most people have access to calculators and computers that can do the pricing. which is much closer to the actual percentage price change of -9. For example. 2 This is -8. This is clearly a desirable property. If we use the Convexity value we just calculated.