Bond pricing theorems

Bond convexity

The mathematical relationship between bond yields and prices

Duration
A measure of the average maturity of the stream of payments generated
by a financial asset

D = [ (1)CF1/(1+ ytm) + (2)CF2/(1+ ytm)2 + ....... + (t)CFt/(1+ ytm)t ] /(Price)

Very often used:

Modified duration: D* = D/(1+ytm)

Exemplification: A 6% coupon bond

ytm

t=-4

t=-3

t=-2

t = -1

t=0

7%

$ 966.13

$ 973.76

$ 981.92

$ 990.65

$ 1,000

6%

$ 1,000

$ 1,000

$ 1,000

$1,000

$ 1,000

5%

$ 1,032.54

$ 1,025.24

$ 1,017.57

$ 1,009.52

$ 1,000

Duration
( at 6%)

3.67

2.83

1.94

Modified
Duration

3.46

2.67

1.83

0.94

Exemplification: A 6% coupon bond

ytm

t=-4

t=-3

t=-2

t = -1

t=0

7%

$ 966.13

$ 973.76

$ 981.92

$ 990.65

$ 1,000

6%

$ 1,000

$ 1,000

$ 1,000

$1,000

$ 1,000

5%

$ 1,032.54

$ 1,025.24

$ 1,017.57

$ 1,009.52

$ 1,000

Duration
( at 6%)

3.67

2.83

1.94

Modified
Duration

3.46

2.67

1.83

0.94

Observation:
Bond prices and yields move inversely.

Exemplification: A 6% coupon bond

ytm

t=-4

t=-3

t=-2

t = -1

t=0

7%

$ 966.13

$ 973.76

$ 981.92

$ 990.65

$ 1,000

6%

$ 1,000

$ 1,000

$ 1,000

$1,000

$ 1,000

5%

$ 1,032.54

$ 1,025.24

Duration
( at 6%)

3.67

2.83

1.94

Modified
Duration

3.46

2.67

1.83

0.94

2.6% decrease in price

2.5%
increase in price
$ 1,017.57
$ 1,009.52

$ 1,000

Observation:
Dollar changes in bond prices are not symmetrical for a given basis point
increase/decrease in YTM, other things constant

Exemplification: A 6% coupon bond

ytm

t=-4

t=-3

t=-2

t = -1

t=0

7%

$ 966.13

$ 973.76

$ 981.92

$ 990.65

$ 1,000

6%

$ 1,000

$ 1,000

$ 1,000

$1,000

$ 1,000

5%

$ 1,032.54

$ 1,025.24

$ 1,017.57

$ 1,009.52

$ 1,000

Duration
( at 6%)

3.67

2.83

1.94

Modified
Duration

3.46

2.67

1.83

0.94

Observation
The longer the maturity, the longer the duration, other things held constant.

Exemplification: A 6% coupon bond

ytm

t=-4

t=-3

t=-2

t = -1

t=0

7%

$ 966.13

$ 973.76

$ 981.92

$ 990.65

$ 1,000

6%

$ 1,000

$ 1,000

$ 1,000

$1,000

$ 1,000

5%

$ 1,032.54

$ 1,025.24

$ 1,017.57

$ 1,009.52

$ 1,000

Duration
( at 6%)

3.67

2.83

1.94

Modified
Duration

3.46

2.67

1.83

0.94

Exemplification: A 6% coupon bond

ytm

t=-4

t=-3

t=-2

t = -1

7%

$ 966.13

$ 973.76

$ 981.92

$ 990.65

6%

$ 1,000

$ 1,000

$ 1,000

$1,000

5%

$ 1,032.54

Duration
( at 6%)

3.67

2.83

1.94

Modified
Duration

3.46

2.67

1.83

0.94

3.4% decrease in price

increase in $
price
$ 3.2%
1,025.24
1,017.57

$ 1,009.52

t=0
$ 1,000

0.94% decrease
in price

$ 1,000

0.95%increase
$ 1,000
in price

Observation
Longer maturity bonds are more sensitive to yield changes than shorter
maturity bonds, other things held constant

Exemplification: A 6% coupon bond

ytm

t=-4

t=-3

t=-2

t = -1

t=0

7%

$ 966.13

$ 973.76

$ 981.92

$ 990.65

$ 1,000

6%

$ 1,000

$ 1,000

$ 1,000

$1,000

$ 1,000

5%

$ 1,032.54

$ 1,025.24

$ 1,017.57

$ 1,009.52

$ 1,000

Duration
( at 6%)

3.67

2.83

1.94

Modified
Duration

3.46

2.67

1.83

0.94

Exemplification: A 6% coupon bond

ytm

t=-4

t=-3

t=-2

t = -1

t=0

7%

$ 966.13

$ 973.76

$ 981.92

$ 990.65

$ 1,000

6%

$ 1,000

$ 1,000

$ 1,000

$1,000

$ 1,000

5%

$ 1,032.54

$ 1,025.24

$ 1,017.57

$ 1,009.52

$ 1,000

Duration
( at 6%)

3.67 0.7%

2.83

Modified
Duration

3.46

2.67

decrease
in price

0.77%
decrease
in price

1.94 0.79%

decrease
in price

1.83

0.94

0.94%
decrease
in price

Observation
As maturity approaches, bond prices converge towards their face value at an
increasing rate, other things held constant.

A 6% coupon bond

ytm

t=-4

t=-3

t=-2

t = -1

t=0

7%

$ 966.13

$ 973.76

$ 981.92

$ 990.65

$ 1,000

6%

$ 1,000

$ 1,000

$ 1,000

$1,000

$ 1,000

5%

$ 1,032.54

$ 1,025.24

$ 1,017.57

$ 1,009.52

$ 1,000

Duration
( at 6%)

3.67

2.83

1.94

Modified
Duration

3.46

2.67

1.83

0.94

A 5% coupon bond
ytm

t=-4

t=-3

t=-2

t=-1

t=0

7%

$ 932.25

$ 947.51

$ 963.84

$ 981.31

$ 1,000

6%

$ 965.34

$ 973.27

$ 981.67

$ 990.57

$ 1,000

5%

$1,000

$1,000

$1,000

$1,000

$ 1,000

Duration
( at 6%)

3.71

2.85

1.952

Modified
Duration

3.5

2.69

1.84

0.94

A 6% coupon bond

ytm

t=-4

t=-3

t=-2

t = -1

t=0

7%

$ 966.13

$ 973.76

$ 981.92

$ 990.65

$ 1,000

6%

$ 1,000

$ 1,000

$ 1,000

$1,000

$ 1,000

5%

$ 1,032.54

$ 1,025.24

$ 1,017.57

$ 1,009.52

$ 1,000

Duration
( at 6%)

3.67

2.83

1.94

Modified
Duration

3.46

2.67

1.83

0.94

A 5% coupon bond
ytm

t=-4

t=-3

t=-2

t=-1

t=0

7%

$ 932.25

$ 947.51

$ 963.84

$ 981.31

$ 1,000

6%

$ 965.34

$ 973.27

$ 981.67

$ 990.57

$ 1,000

5%

$1,000

$1,000

$1,000

$1,000

$ 1,000

Duration
( at 6%)

3.71

2.85

1.952

Modified
Duration

3.5

2.69

1.84

0.94

Observation
The lower the coupon rate the longer the duration

A 6% coupon bond

ytm

t=-4

t=-3

t=-2

t = -1

t=0

7%

$ 966.13

$ 973.76

$ 981.92

$ 990.65

$ 1,000

6%

$ 1,000

$ 1,000

$ 1,000

$1,000

$ 1,000

5%

$ 1,032.54

$ 1,009.52

$ 1,000

Duration
( at 6%)

3.67

2.83

1.94

Modified
Duration

3.46

2.67

1.83

0.94

3.4% decrease in price

$3.2%
1,025.24
$ 1,017.57
increase in price
3.2% increase in price

A 5% coupon bond
ytm

t=-4

t=-3

7%

$ 932.25

6%

$ 965.34

5%

$1,000

Duration
( at 6%)

3.71

2.85

Modified
Duration

3.5

2.69

t=-2

t=-1

t=0

947.51
3.43%$decrease
in price$ 963.84
$ 973.27
$ 981.67

$ 981.31

$ 1,000

$ 990.57

$ 1,000

$1,000
$1,000
3.6% increase in price

$1,000

$ 1,000

1.952

1.84

0.94

Observation
Lower coupon bonds are more sensitive to yield changes than higher coupon bonds

Bond Pricing Theorems: A Summary

I. Bond prices and yields move inversely.
II. As maturity approaches, bond prices converge towards their face
value at an increasing rate, other things held constant.
III. Dollar changes in bond prices are not symmetrical for a given basis
point increase/decrease in YTM, other things constant.
IV. Lower coupon bonds are more sensitive to yield changes than
higher coupon bonds, other things held constant.
V. Longer maturity bonds are more sensitive to yield changes than
shorter maturity bonds, other things held constant.

Duration Theorems: A Summary

I. The duration of a zero coupon bond always equals its time to
maturity.
II. The lower the coupon rate the longer the duration, other things
held constant.
III. The longer the maturity, the longer the duration, other things held
constant.
IV. The lower the yield to maturity, the longer the duration, other
things held constant

Using duration to approximate bond price changes

The following formula approximates the change in bond prices for
small changes in yields:
(P1 - P0)/P0 = - D* (ytm1- ytm0)
A better approximation is given by the following formula:
(P1 - P0)/P0 = - D*(ytm1- ytm0) + (0.5)(Convexity)(ytm1- ytm0)2
Convexity
The rate of change of the rate of change of the bond price (the curvature of the
relationship between yields and prices).