Professional Documents
Culture Documents
457 CH 005
457 CH 005
Chapter 5
Chapter Outline
Chapter Outline
5.9 Quotations
5.10 Treasury Bond Futures
5.11 Eurodollar futures
5.12 The LIBOR zero curve
5.13 Duration
5.14 Duration-based hedging strategies
Maturity
(years)
0.5
Zero Rate
(% cont comp)
5.0
1.0
5.8
1.5
6.4
2.0
6.8
0.068 2 .0
98.39
Bond Yield
The bond yield is the discount rate that makes the
present value of the cash flows on the bond equal
to the market price of the bond. aka YTM
Suppose that the market price of the bond in our
example equals its theoretical price of 98.39
The bond yield is given by solving
Par Yield
The par yield for a certain maturity is the coupon
rate that causes the bond price to equal its face
value.
In our example we solve
c 0.050.5 c 0.0581.0 c 0.0641.5
e
e
e
2
2
2
c 0.0682.0
100 e
100
2
(100 100d )m
c
A
Time to
Annual
Bond
Principal
Maturity
Coupon
Price
(dollars)
(years)
(dollars)
(dollars)
100
0.25
97.5
100
0.50
94.9
100
1.00
90.0
100
1.50
96.0
100
2.00
12
101.6
Time to
Annual
Bond
Principal
Maturity
Coupon
Price
(dollars)
(years)
(dollars)
(dollars)
100
0.25
97.5
100
0.50
94.9
100
1.00
90.0
100
1.50
96.0
100
2.00
12
101.6
4e
0.104690.5
4e
0.105361.0
104e
Time to
Annual
Bond
Principal
Maturity
Coupon
Price
(dollars)
(years)
(dollars)
(dollars)
100
1.50
96.0
100
2.00
12
101.6
R1.5
96
12
Zero
Rate (%)
11
10.469
10
10.127
10.53
6
10.68
1
10.808
Maturity (yrs)
9
0
0.5
1.5
2.5
Forward Rate
(% per annum)
(% per annum)
.1 .11
100e e
100e
10.0
10.5
11.0
10.8
11.4
11.0
11.6
11.1
11.5
.21
100e
.1052
R2 T2 R1 T1
T2 T1
R
RT
T
where R is the T-year rate
Expectations
Yield
Upward
S5
S10
S10
S5D5
Market Segmentation
Preferred
S15
Habitat
both
downward and upward
sloping yield curves
S15
DD
1010
D5
Explains
10
15
D15
D15
Maturity
360
(100 Y )
n
This is referred to as the discount rate
Conversion Factor
The conversion factor for a bond is approximately
equal to the value of the bond on the assumption
that the yield curve is flat at 6% with semiannual
compounding
CBOT
T-Bonds & T-Notes
Duration
Duration of a bond that provides cash flow c i at time t i
n
is
c e yti
ti
i 1
B
Dy
B
Duration Continued
When the yield y is expressed with compounding
m times per year
BDy
B
1 y m
The expression
D
1 y m
is referred to as the modified duration
Convexity
The convexity of a bond is defined as
n
1 B
C
2
B y
so that
2
c t
i 1
2
i i
yti
B
1
2
Dy C (y )
B
2
Duration Matching
Duration Hedging
As an alternative to hedging with futures or
forwards, one can hedge by matching the
interest rate risk of assets with the interest
rate risk of liabilities.
Duration is the key to measuring interest rate
risk.
Duration Hedging
Duration measures the combined effect of
maturity, coupon rate, and YTM on bonds
price sensitivity
Measure of the bonds effective maturity
Measure of the average life of the security
Weighted average maturity of the bonds cash
flows
Duration Formula
PV (C1 ) 1 PV (C2 ) 2 PV (CT ) T
D
PV
N
Ct t
t
(
1
r
)
D tN1
Ct
t
t 1 (1 r )
Calculating Duration
Calculate the duration of a three-year bond that
pays a semi-annual coupon of $40, has a $1,000
par value when the YTM is 8% semiannually.
Calculating Duration
Years
Discount
Cash flow factor
0.5
$40.00
1
$40.00
1.5
$40.00
2
$40.00
2.5
$40.00
3 $1,040.00
0.96154
0.92456
0.88900
0.85480
0.82193
0.79031
Present Years x PV
value / Bond price
$38.46
0.0192
$36.98
0.0370
$35.56
0.0533
$34.19
0.0684
$32.88
0.0822
$821.93
2.4658
$1,000.00
2.7259 years
Bond price Bond duration
Duration
The key to bond portfolio management
Properties:
5.25
On August 1 a portfolio manager has a bond
portfolio worth $14 million. The duration of the
portfolio in October will be 7.1 years.
The December Treasury bond futures price is
currently 91-12 and the cheapest-to-deliver bond
will have a duration 0f 8.8 years at maturity
How should the manager immunize the portfolio
against changes in interest rates over the next two
months?
5.25
The treasurer should short Treasury bond futures
contract.
If bond prices go down, this futures position will
provide offsetting gains.
The number of contracts that should be shorted is
10,000 7.1
88.3
91,375 8.8