Professional Documents
Culture Documents
Bond Duration Basics 1
Bond Duration Basics 1
When an investor considers investment in Bonds the relationship between the time to maturity,
yield and price is very clear in case of a zero coupon bond. A zero coupon bond has no coupons and
thus a zero coupon bond that has a face value of Rs. 100, has a maturity period of 5 years and a yield
of 5% (could also be called a required rate of return) would be priced as follows:
Price = Face Value/ (1+ y%)t = 100/(1+5%)5 = 78.15
If an investor invests in a bond that a face value of Rs. 100, has a maturity of 10 years and an
identical yield of 5%, the bond would be priced at:
100/(1+5%)10= 61.39
Similarly if the bond was 15 years the price would be 48.10
A sensitivity table of these bonds looks as follows:
1%
2%
3%
4%
5%
6%
7%
8%
5 Yr Zero
95.15
90.57
86.26
82.19
78.35
74.73
71.30
68.06
10 Yr Zero
90.53
82.03
74.41
67.56
61.39
55.84
50.83
46.32
15 Year Zero
86.13
74.30
64.19
55.53
48.10
41.73
36.24
31.52
2%
4%
5 yr Bond
6%
10 Yr Bond
8%
10%
15 Yr Bond
12%
14%
When one deals with a zero coupon bond the relationship between the price and the maturity is
very clear. However when the bonds have a coupon two bonds cannot be compared as easily as the
zero coupon bond. In a zero coupon bond the effective maturity of the a zero coupon bond is the
same as its years to maturity. By effective maturity what I mean is the period in which the original
investment of the bond is recovered
Understanding the concept of weights:
Let us assume that an investor has two Zero coupon Bonds as follows:
Face Value
Years to maturity
Yield
Bond 1
100
5
5%
Bond 2
100
10
5%
Now it is obvious that the effective period for which he is invested is 7.5 ( (5+10)/2= 7.5) ) so if that
same investor purchased a zero coupon bond of face value 200 and invested it for 7.5 years at 5%
yield the price should be the price of the above put together ????
Let us do the math:
Face Value
Years to maturity
Yield
Price
Price
Bond 1
100
5
5%
100/(1+5%)^5
78.35
Bond 2
100
10
5%
100/(1+5%)^10
61.39
Bond 3
200
7.5
5%
200/(1+5%)^7.5
138.71
You can see that the first two bonds add up to 139.74 which is very close to the third bond !!!!
You can see from the above it is the TIME element that enables the investor to replicate the
investment of two bonds into a single bond.
If in the above example I extend the period of the first bond to 7.5 years and I reduce the second
bond to 7.5 years the math would be as follows:
Face Value
Years to maturity
Yield
Price
Price
Bond 1
100
7.5
5%
100/(1+5%)^7.5
69.36
Bond 2
100
7.5
5%
100/(1+5%)^7.5
69.36
Bond 3
200
7.5
5%
200/(1+5%)^7.5
138.71
Thus we find that the time element unifies the investments !!!!
Thus when we want to find in WHAT TIME was an investment in Bond that gives coupons is
recovered the TIME element would be the best weight.
Macaulay did exactly the same thing, he took every discounted coupon amount and multiplied it
with the weight of TIME to find the recovery period of the Bond.
Let us take an actual example !!!!
Let us take a sample bond:
Face Value
Coupon
Years to Maturity
Frequency of the coupon
Yield of comparable bond in the
market
Time
100
5%
10
2
5%
Cash flows
Discounting Factor:
Cash flow X
1/(1+yield/f)^t
Cash Flow X
Discount Factor
D
Amount recovered of
investment in
%=Amount/total of
column C
Column D X T
2.5
0.9756
2.44
0.0244
0.02439
2.5
0.9518
2.38
0.0238
0.04759
2.5
0.9286
2.32
0.0232
0.06964
2.5
0.9060
2.26
0.0226
0.09060
2.5
0.8839
2.21
0.0221
0.11048
2.5
0.8623
2.16
0.0216
0.12934
2.5
0.8413
2.10
0.0210
0.14722
2.5
0.8207
2.05
0.0205
0.16415
2.5
0.8007
2.00
0.0200
0.18016
10
2.5
0.7812
1.95
0.0195
0.19530
11
2.5
0.7621
1.91
0.0191
0.20959
12
2.5
0.7436
1.86
0.0186
0.22307
13
2.5
0.7254
1.81
0.0181
0.23576
14
2.5
0.7077
1.77
0.0177
0.24770
15
2.5
0.6905
1.73
0.0173
0.25892
16
2.5
0.6736
1.68
0.0168
0.26945
17
2.5
0.6572
1.64
0.0164
0.27931
18
2.5
0.6412
1.60
0.0160
0.28852
19
2.5
0.6255
1.56
0.0156
0.29713
20
102.5
0.6103
62.55
0.6255
total of column
divided by 2 is the
Duration
12.51055
100.00
7.99
The duration is calculated in the last column as the total of all weighted cash flow (after discounting)
where TIME is the weight !!!!