Practical yield, price, duration and convexity

approximations
D. L. Chertok

November 7, 2012
Abstract
Practical techniques for approximating yield given the price and price
given the yield are described. Duration and convexity estimations given
prices and yields at three observation points are presented. Such approxi-
mations are useful when computing prices and yields from their values at
nearby points and generating additional data for scenario analysis.
1 Price approximation given the yield and yield
approximation given the price.
The duration-convexity (second order) approximation of price given the yield of
a security is well-known[2]. The inverse relationship, i.e., the approximation or
yield given the price, is found in text books less often, however, it can be just
as useful for practical purposes.
Suppose that we know the yield of a security or portfolio of securities y
0
corresponding to the price p
0
. By Taylor expansion [1], (approximated) price p
corresponding to (known) yield y can be computed as
p(y) ≈ p
0
+
dp(y)
dy
¸
¸
¸
¸
y=y0
(y −y
0
) +
1
2
d
2
p(y)
dy
2
¸
¸
¸
¸
y=y0
(y −y
0
)
2
, (1)
or, in terms of duration and convexity,
p(y) ≈ p
0
_
1 −D(y
0
)(y −y
0
) +
1
2
C(y
0
)(y −y
0
)
2
_
, (2)
D(y
0
) = −
1
p
0
dp(y)
dy
¸
¸
¸
¸
y=y0
, (3)
C(y
0
) =
1
p
0
d
2
p(y)
dy
2
¸
¸
¸
¸
y=y0
, (4)
where:

D. L. Chertok, Ph. D., CFA, (daniel chertok@hotmail.com) is a quantitative investment
professional in Chicago, IL.
1
D(y
0
) - duration at y
0
, provided it is not undefined,
C(y
0
) - convexity at y
0
, provided it is not undefined.
Conversely, (approximated) yield y corresponding to (known) price p can be
computed as
y(p) ≈ y
0
+
dy(p)
dp
¸
¸
¸
¸
p=p0
(p −p
0
) +
1
2
d
2
y(p)
dp
2
¸
¸
¸
¸
p=p0
(p −p
0
)
2
. (5)
or, in terms of duration and convexity,
y(p) ≈ y
0

p −p
0
p
0
D(y
0
)
+
1
2
(p −p
0
)
2
C(y
0
)
p
2
0
D
3
(y
0
)
. (6)
See Appendix A for the derivation of (6).
2 Estimating approximation parameters from
observed data points
It is sometimes convenient to approximate the effective duration and convexity
of a bond (or a more complex security) rather than calculate those quantities
directly. The formulas below provide a means to perform such an approximation
using prices and yields known at three data points.
Suppose that two data points (y
1
, p
1
) and (y
2
, p
2
) are known in the neigh-
borhood of (y
0
, p
0
). To the second degree of accuracy, from (2) we get
p

(y
0
) +
1
2
∆y
1
p

(y
0
) =
∆p
1
∆y
1
, (7)
p

(y
0
) +
1
2
∆y
2
p

(y
0
) =
∆p
2
∆y
2
, (8)
where:
p

(y
0
) =
dp
dy
¸
¸
¸
¸
y=y0
, provided it is defined,
p

(y
0
) =
d
2
p
dy
2
¸
¸
¸
¸
y=y0
, provided it is defined,
∆p
i
= p
i
−p
0
, i = 1, 2 ,
∆y
i
= y
i
−y
0
, i = 1, 2 .
This is a linear system of two equations in two unknowns, p

(y
0
) and p

(y
0
).
2
The solution is given by
p

(y
0
) =
∆p
1
(∆y
2
)
2
−∆p
2
(∆y
1
)
2
∆y
1
∆y
2
(y
2
−y
1
)
, (9)
p

(y
0
) =
2(∆y
1
∆p
2
−∆y
2
∆p
1
)
∆y
1
∆y
2
(y
2
−y
1
)
. (10)
Accordingly, for duration D and convexity C:
D(y
0
) = −
p

(y
0
)
p
0
= −
∆p
1
(∆y
2
)
2
−∆p
2
(∆y
1
)
2
∆y
1
∆y
2
(y
2
−y
1
)p
0
, (11)
C(y
0
) =
p

(y
0
)
p
0
=
2(∆y
1
∆p
2
−∆y
2
∆p
1
)
∆y
1
∆y
2
(y
2
−y
1
)p
0
. (12)
See Appendix B for the derivation of (9) - (12).
3 Example
This example illustrates the approximation described above for a 1.5% 10-year
US Treasury bond
1
with a price of 99.5 (per $100 notional) currently yielding
1.5542%.
Table 1: Worked example of price, duration and convexity approximations.
Scenario Price Yield,
%
Effective
Dura-
tion,
Excel
Effective
Con-
vexity,
Excel
Effective
Dura-
tion,
approx.
Effective
Con-
vexity,
approx.
Base 99.5000 1.5542 -9.2494 94.0938 9.2494 94.0938
- 100 bp 99.5921 1.5442
+ 100 bp 99.4080 1.5642
1
Idealized, i.e., without accounting for holidays or weekends.
3
Appendix A Derivation of the yield approxi-
mation in terms of duration and
convexity
Applying the usual reasoning for inverse functions
2
to (3), we get
dy
dp
=
1
dp
dy
= −
1
pD
, (A.1)
d
2
y
dp
2
= −
d
dp
_
1
pD
_
=
D −p
dD
dp
p
2
. (A.2)
By the chain rule,
dD
dp
=
dD
dy
dy
dp
=
dD
dy
_

1
pD
_
, (A.3)
dD
dy
= −
dp
dy
p
= −
d
2
p
dy
2
p
+
_
dp
dy
_
2
p
2
= −C(y) + D
2
(y) , (A.4)
hence
dD
dp
=
D
2
−C
pD
, (A.5)
and
d
2
y
dp
2
=
D −
p
pD
_
D
2
−C
_
p
2
D
2
=
C
p
2
D
3
, (A.6)
yielding, in terms of duration and convexity,
y(p) ≈ y(p
0
) −
p −p
0
p
0
D(y
0
)
+
1
2
(p −p
0
)
2
C(y
0
)
p
2
0
D
3
(y
0
)
. (A.7)
Appendix B Derivation of duration and con-
vexity approximations
Recall that (9) - (10) is a 2x2 system of linear equations in p

(y
0
) and p

(y
0
):
p

(y
0
) =
∆p
1
(∆y
2
)
2
−∆p
2
(∆y
1
)
2
∆y
1
∆y
2
(y
2
−y
1
)
, (B.1)
p

(y
0
) =
2(∆y
1
∆p
2
−∆y
2
∆p
1
)
∆y
1
∆y
2
(y
2
−y
1
)
. (B.2)
2
Yield as a function of price for a ”reasonable” fixed income security is (at least) contin-
uously differentiable. The derivative of yield with respect to price can only be zero in trivial
cases, so we can differentiate the inverse function.
4
Computing the determinants, we obtain:
∆ =
¸
¸
¸
¸
1 0.5∆y
1
1 0.5∆y
2
¸
¸
¸
¸
= 0.5(∆y
2
−∆y
1
)
= 0.5(y
2
−y
0
−y
1
+ y
0
) = 0.5(y
2
−y
1
) = 0 , (B.3)

p
=
¸
¸
¸
¸
¸
∆p1
∆y1
0.5∆y
1
∆p2
∆y2
0.5∆y
2
¸
¸
¸
¸
¸
= 0.5
∆p
1
(∆y
2
)
2
−∆p
2
(∆y
1
)
2
∆y
1
∆y
2
, (B.4)

p
=
¸
¸
¸
¸
¸
1
∆p1
∆y1
1
∆p2
∆y2
¸
¸
¸
¸
¸
=
∆p
2
∆y
1
−∆p
1
∆y
2
∆y
1
∆y
2
. (B.5)
Hence [3],
p

(y
0
) =

p


=
∆p
1
(∆y
2
)
2
−∆p
2
(∆y
1
)
2
∆y
1
∆y
2
(y
2
−y
1
)
, (B.6)
p

(y
0
) =

p


=
2(∆p
2
∆y
1
−∆p
1
∆y
2
)
∆y
1
∆y
2
(y
2
−y
1
)
, (B.7)
Dy
0
= −
p

(y
0
)
p
0
= −
∆p
1
(∆y
2
)
2
−∆p
2
(∆y
1
)
2
∆y
1
∆y
2
(y
2
−y
1
)p
0
, (B.8)
Cy
0
=
p

(y
0
)
p
0
=
2(∆p
2
∆y
1
−∆p
1
∆y
2
)
∆y
1
∆y
2
(y
2
−y
1
)p
0
. (B.9)
References
[1] Abramowitz, M. and Stegun, I. Handbook of Mathematical Functions with
Formulas, Graphs, and Mathematical Tables. Dover Publications, 1965.
[2] F. Fabozzi. The Handbook of Fixed Income Securities. McGraw-Hill, 7th
edition, 2005.
[3] Strang, G. Linear Algebra and Its Applications. Brooks Cole, 4th edition,
2005.
5

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