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You are on page 1of 9

UVA-F-1238

University of Virginia

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

$1,000

PA = = $376.89

(1 + .10 / 2 )20

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

1

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.

This note was written by Robert M. Conroy, Professor of Business Administration, Darden Graduate School of

Business Administration, University of Virginia. Copyright 1998 by the University of Virginia Darden School

Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to

dardencases@virginia.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a

spreadsheet or transmitted in any form or by any means-electronic, mechanical, photocopying, recording or

otherwise without the permission of the Darden School Foundation. Rev. 7/02.

-2- UVA-F-1238

If the required rate of return for each bond was to increase by 100 basis points to 11%, the prices

would then be $342.73 for Bond A and $585.43 for Bond B. This translates into a -9.1% change

in price for Bond A and -4.6% for Bond B.

Just from the pricing formulation, it is clear that any change in interest rates will have a much

Figure 1.

Comparison of 5-year and 10-year Bonds

1200

1000

800

5-year

600

10-year

400

200

greater impact on Bond A than Bond B. This is reinforced in Figure 1, where the price curve for

the 10-year bond (Bond A) is much steaper than that for the 5-year bond (Bond B). Thus, for

zero coupon bonds simple maturity can be used to compare price sensitivity.

The relationship between price and maturity is not as clear when yo u consider non-zero

coupon bonds. For a coupon-paying bond, 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. In order to deal with this, Frederick Macaulay2 in 1938 suggested that investors use the

effective maturity of a bond as a measure of interest rate sensitivity. He called this duration and

defined it as a value-weighted average of the timing of the cash flows. The easiest way to see

this is to use an example. Consider a six- year bond with face value of $1,000, and a 6.1%

coupon rate (semi-annual payments). If the current yield to maturity is 10%, the value of the

bond is found by discounting each of the semi-annual payments. This is shown in Exhibit 1.

2

Fredick Macaulay, Some Theoretical Problems Suggested by the Movement of Interest Rates, Bond Yields,

and Stock Prices in the United States since 1856 (New York: National Bureau of Economic Research, 1938).

-3- UVA-F-1238

Exhibit 1

t Cash Flow Factor Cash Flow

1 $ 30.50 0.9524 $ 29.05

2 30.50 0.9070 27.66

3 30.50 0.8638 26.35

4 30.50 0.8227 25.09

5 30.50 0.7835 23.90

6 30.50 0.7462 22.76

7 30.50 0.7107 21.68

8 30.50 0.6768 20.64

9 30.50 0.6446 19.66

10 30.50 0.6139 18.72

11 30.50 0.5847 17.83

12 1,030.50 0.5568 573.82

Macaulay Duration takes the present value of each payment and divides it by the total

bond price, P. By doing this, one has a percentage, wt , of the total bond value that is received in

each period, t.

Ct

(1 + y ) t

wt =

P

The duration or effective maturity for the bond could then be estimated by multiplying the

weight, wt , times the time, t and then summing all of the weighted values, or

Ct

Duration = ∑

T

(1 + y )t T

⋅ t = ∑ wt ⋅ t .

t =1 P t =1

This measure takes into account the relative timing of the cash flows. Calculation of the

Macaulay Duration measure is fairly straightforward but can be somewhat tedious 3 . Exhibit 2

shows how a semi-annual duration for the example shown above would be calculated.

3

Excel offers a worksheet function DURATION(.), which calculates the Macaulay Duration.

-4- UVA-F-1238

Exhibit 2

t Cash Flow Factor Cash Flow Weight t x weight

1 $ 30.50 0.9524 $ 29.05 3.51% 0.0351

2 30.50 0.9070 27.66 3.34% 0.0669

3 30.50 0.8638 26.35 3.19% 0.0956

4 30.50 0.8227 25.09 3.03% 0.1213

5 30.50 0.7835 23.90 2.89% 0.1445

6 30.50 0.7462 22.76 2.75% 0.1651

7 30.50 0.7107 21.68 2.62% 0.1834

8 30.50 0.6768 20.64 2.50% 0.1997

9 30.50 0.6446 19.66 2.38% 0.2139

10 30.50 0.6139 18.72 2.26% 0.2264

11 30.50 0.5847 17.83 2.16% 0.2371

12 1,030.50 0.5568 573.82 69.37% 8.3246

Semi-Annual

Bond Value $ 827.17 Duration 10.014

The semi- annual duration for this bond is 10.014 six- month periods. 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). In this case, the annualized duration would be 5.007 years. Note that

the Macaulay Duration for a 5- year zero coupon bond is the same as the simple maturity, 5.0

years. Hence, we can expect that the original 6-year, 6.1% coupon bond when interest rates

change to behave in a manner similar to a 5-year zero coupon bond, since their effective maturity

(Macaulay Duration) is essentially the same.

Modified Duration

If we want a more direct measure of the relationship between changes in interest rates

and changes in bond prices, we can use Modified Duration. Modified Duration, D, is defined as

the following

1 ∆P

D=− ⋅

P ∆y

where P is the bond price, ∆P is the change in bond price and ∆y is the change in the required

rate of return (yield to maturity). For those with a math background, ∆P ∆y is the first derivative

of the bond price with respect to yield to maturity. The basic pricing formulation for bonds is

-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,

∆P = − 1 ⋅ T t ⋅ C t .

∑

∆y (1 + y ) t = 1 (1 + y )t

1 1 T

Ct

D=− ⋅ − ⋅∑t ⋅

P (1 + y ) t =1 (1 + y )t

Ct

1 T

(1 + y )t

(1 + y ) ∑

D= ⋅ t⋅ .

t =1 P

Comparing this to the definition of Macaulay Duration and using that definition we can write

Modified Duration as

1

Modified Duration = D = Macaulay Duration

(1 + y )

While it is easy calculate Modified Duration once you have Macaulay Duration the

interpretations of the two are quite different. Macaulay Duration is an average or effective

maturity. Modified Duration really measures how small changes in the yield to maturity affect

the price of the bond. In fact, from the definition of Modified Duration we can write the

following relationship:

∆P

= − D ⋅ ∆y

P

or % change in bond price = - Modified Duration times the change in yield to maturity.

For example, the six- year 6.1% coupon bond above had a yield to maturity of 10% and a

semi-annual Macaulay Duration of 10.014 (5.007 annual Macaulay Duration). The Modified

Duration of this bond is 10.014 or 9.537 on a semi-annual basis or 9.537 = 4.77 years on an

(1 + .05 ) 2

-6- UVA-F-1238

annual basis 4 . Assuming that the yield to maturity of 10% increases by 25 basis points to

10.25%, based on the Modified Duration of 4.77 years the price of the bond should change by

∆P

= − D ⋅ ∆y = − 4.77 ⋅ (.25 %) = − 1.19% . The bond price should drop by 1.19% from $827.17 to $817.31

P

($827.17*(1-.0119) = $817.31). The actual calculated price at a yield to maturity of 10.25% is

$817.38.

Exhibit 3 shows the Modified Duration price change and the actual calculated price

change for different changes in yield to maturity.

Exhibit 3

Bond Data

Coupon = 6.1%

Maturity= 6 years

Face Value = $1,000

Yield to Maturity= 10%

Price = $827.17

Modifed Duration= 4.770

Maturity Yield Yield Price change* Price**

12.00% 2.00% -9.54% 748.26 -9.01% 752.68 4.42

11.75% 1.75% -8.35% 758.12 -7.94% 761.52 3.40

11.50% 1.50% -7.16% 767.99 -6.85% 770.50 2.52

11.25% 1.25% -5.96% 777.85 -5.75% 779.61 1.76

11.00% 1.00% -4.77% 787.71 -4.63% 788.85 1.13

10.75% 0.75% -3.58% 797.58 -3.50% 798.22 0.64

10.50% 0.50% -2.39% 807.44 -2.35% 807.73 0.29

10.25% 0.25% -1.19% 817.31 -1.18% 817.38 0.07

10.00% 0.00% 0.00% 827.17 -0.00% 827.17 -

9.75% -0.25% 1.19% 837.03 1.20% 837.10 0.07

9.50% -0.50% 2.39% 846.90 2.42% 847.18 0.28

9.25% -0.75% 3.58% 856.76 3.66% 857.40 0.64

9.00% -1.00% 4.77% 866.63 4.91% 867.78 1.15

8.75% -1.25% 5.96% 876.49 6.18% 878.31 1.82

8.50% -1.50% 7.16% 886.35 7.47% 889.00 2.64

8.25% -1.75% 8.35% 896.22 8.79% 899.84 3.62

8.00% -2.00% 9.54% 906.08 10.12% 910.84 4.76

* Actual % change is based on the calculated price relative to the price of $827.17.

** Actual price is the calculated price based on the yield to maturity.

*** Difference is Actual Price - Predicted Price.

Modified Duration assumes that the price changes are linear with respect to changes in

the yield to maturity. From Exhibit 3, the true relationship between the bond's price and the

yield to maturity is not linear. The Column with the differences is always positive and increases

4

If the original compounding basis on the bond was semi -annual, the Modified Duration must first be

calculated on a semi-annual basis and then annualized. You can not use the annual Macaulay Duration to calculate

the Modified Duration.

-7- UVA-F-1238

as we move away from a yield to maturity of 10%. The actual relationship between the bond

price and the yield to maturity is shown in Figure 2.

Figure 2.

Bond Prices

6-year, 6.1% Coupon (paid semi-annually) Rate, Face value = $1,000

1,600.00

1,400.00

1,200.00

1,000.00

800.00

600.00

400.00

200.00

Yield to Maturity

The curved line is the actual price curve. The straight line is the price relationship using

Modified Duration. Everywhere the actual price curve is above the Modified Duration

relationship. This is exactly what we saw in Exhibit 3. The difference was always positive, i.e.,

actual calculated price was greater than the new price using the Modified Duration relationship.

In addition, the percentage changes in price are not symmetric. 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 property is refered to as convexity. 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.

Convexity.

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. In order to more fully capture

this, practitioners use Convexity. The definition of Convexity is

1 ∆2 P

Convexity = CV = ⋅

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. The actual definition of Convexity that we

can use is

-8- UVA-F-1238

Ct

1 ∆P 2

1 T

(1 + y )t

Convexity = CV = ⋅ = ⋅ ∑ t ⋅ (t + 1) ⋅

P (∆y ) 2

(1 + y )2 t=1 P

Exhibit 4 shows the calculation of the semi- annual convexity for the six-year 6.1% coupon bond.

Exhibit 4

Convexity

Pres.

1

t Cash Value Pres. Value of Weight t x(t + 1) × weight ×

Flow Factor Cash Flow (1 + y) 2

2 30.50 0.9070 27.66 3.34% 0.1820

3 30.50 0.8638 26.35 3.19% 0.3467

4 30.50 0.8227 25.09 3.03% 0.5503

5 30.50 0.7835 23.90 2.89% 0.7861

6 30.50 0.7462 22.76 2.75% 1.0482

7 30.50 0.7107 21.68 2.62% 1.3310

8 30.50 0.6768 20.64 2.50% 1.6298

9 30.50 0.6446 19.66 2.38% 1.9403

10 30.50 0.6139 18.72 2.26% 2.2585

11 30.50 0.5847 17.83 2.16% 2.5812

12 1,030.50 0.5568 573.82 69.37% 98.1588

Value Convexity

would be 27.72. Convexity is useful to practitioners in a number of ways. 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. The formula 6 is

1

% ∆ Price = - Modified Duration × ∆y + × Convexity × (∆y)2

2

5

Convexity is annualized by dividing the calculated Convexity by the number of payments per year

squared.

6

For those with a math bent, this formula is based on using a Taylor series expansion to approximate the

value of the percentage change in price.

-9- UVA-F-1238

Adding the convexity adjustment corrects for the fact that Modified Duration understates the true

bond price. For example, in Exhibit 3, at a yield of 12% the percentage price change using only

Modified Duration was -9.54%, while the actual was -9.01%. If we use the Convexity value we

just calculated, the predicted percentage price change would be

1

% ∆ Price = - 4.77 × (.02) + × 27.72 × (.02)2 = -.0954 + .00554 = -.0899.

2

This is -8.99%, which is much closer to the actual percentage price change of -9.01%.

The pricing aspect of Convexity is much less important now since most people have access to

calculators and computers that can do the pricing. The more important use of convexity is that it

provides insight into how a bond will react to yield changes. Again from Exhibit 3 and Figure 2

we see that the price reaction to changes in yield is not symmetric. For a given change in yield,

bond prices drop less for a given increase in yield and increase more for the same decreases in

yield. The downside is less and the upside is more. This is clearly a desirable property. The

higher the Convexity of a bond the more this is true. Thus, bonds with high convexity are more

desirable.

Summary

Each of the price sensitivity measures discussed in this note is part of the everyday

language and thinking of fixed income investors. They are relative risk measures that help

investment professionals think about the risks they face.

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